Fed's Latest Move Means Low Profit, High Risk for Banks

Don’t be fooled by the Fed’s announcement of zero to 25BP Fed Funds. They just panicked and panic will surely prevail after this afternoon’s euphoria passes. The rate implies a 3.25% prime rate, unprofitable given the banks cost of funds to run a matched book. The banks will likely just increase every borrower’s margin over prime making the stated prime rate meaningless.

Pressuring banks to lower lending rates with intense competition for deposits will create a tsunami-sized squeeze on bank interest margins. The Fed implied that it will directly control mortgage rates by creating a market for agency debt and entering other end markets at will. Where does this leave banks? They will appease the Fed with any product that they can sell, removing any future credit and interest rate risk. All other loan products will be priced according to the cost of funds and risk.

The Fed is telling us that bank profits will be low for the foreseeable future and banks will be engaging in substantial interest rate risk. Banks need to be viewed as utilities, without the security of guaranteed margins. The new mantra is low profit and high risk.

We are moving beyond toxic asset risk to long term margin risk. That is why bank stocks will fall and stay flat. There will be plenty of time to re-enter when the Fed starts raising rates to fight inflation.

Comments

[JasonC:]

"a tsunami-sized squeeze on bank interest margins"

You've got to be kidding. Banks can buy corporate bonds yielding 10-20%. Spreads are at record levels. They are *not* going to get killed by absence of interest margin. Their net interest margins were running 3% before the last quarter's crash, short rate falls, and further widening of credit spreads. There isn't a single category of loans outside of the original subprime mortgage area (already written off to zero, long since) where rates on the loans don't cover the loan losses and to spare.

Banks were sells at full prices and narrow spreads a year or two ago, but they are screaming buys at low prices and wide spreads now. The forward PE of major money center banks, not on one year out earnings but likely long run averages, is about 2 right now. Yes you read that correctly.

2008 Dec 16 05:50 PM

[pepster:]

JasonC said:

"There isn't a single category of loans outside of the original subprime mortgage area (already written off to zero, long since) where rates on the loans don't cover the loan losses and to spare."

I disagree. There will be MASSIVE losses on Alt-A loans starting in 2009.

2008 Dec 16 06:49 PM

[SW Richmond:]

Or have the banks just been saved by turning them into mere agents of the Fed? The Fed can pressure banks to lend out the money it has printed and will print. But the Fed's printing press is still the ultimate backstop. The Fed is the source of the low-interest "capital". What will the banks do with their new loan portfolios, sell them to the Fed for more cash?

It seems to me that "quantitative easing" merely moves the problem one step higher up the chain where it can be printed away. Single-purpose mortgage mills just got replaced by multi-purpose money-center bank loan mills. Instead of selling the good, bad, and ugly loans to Deutsche Bank, they're gonna sell them to the Fed. How is this better?

2008 Dec 16 07:06 PM

[jepittman:]

You should go back to your IT field and stay out of money and banking. Your conclusions are IMO terribly flawed. The Fed is REDUCING the bank's cost of capital and allowing them to recapitalize by WIDENING their margins. There is no way bank stocks would be rallying hard on this news if their margins were being narrowed. I respectfully suggest you go back to your field of expertise.

2008 Dec 16 08:50 PM

[Jimmy Lathrop:]

Attention American Homeowners!

If your Alt-A adjustible rate mortgage was all set to change to a float against the T-Bill, you just got yourself a heck of a break. Get out there and spend, save us all!

Yours Very Truly

Ben and Friends.

On Dec 16 06:49 PM pepster wrote:

> JasonC said:
>
> "There isn't a single category of loans outside of the original subprime
> mortgage area (already written off to zero, long since) where rates
> on the loans don't cover the loan losses and to spare."
>
> I disagree. There will be MASSIVE losses on Alt-A loans starting
> in 2009.

2008 Dec 16 08:56 PM

[Scalpulator:]

It has been demonstrated that it doesn't matter at all what we think; we are wrong if we trade against the fed now and for the recognizeable future.

This is the start of either the new world order or massive depression or both. But not until the fed has spent all our tax money making bets for us.

2008 Dec 16 10:44 PM

[John Lounsbury:]

I agree with most of the comments and disagree with the article. Prime is the rate customarily charged by banks to their most credit-worthy customers. Given the sensitivity of reserves exposures that banks have, how many "most credit-worthy customers" are there? When there is competition to attract borrowers, the "most credit-worthy" bar gets lowered, as in the past few years. When there is competition to attract lenders, as now, the "most credit-worthy" bar gets raised very high.

I apologize for giving a quote without attribution, but during the Great Depression (I believe), some sage observer said something like: "There are plenty of loans available, but only to those that don't need them".

2008 Dec 16 10:48 PM

[Lin:]

Re

I have stated previously on this site " this was going to be a total meltdown for the US economy ". The alt A's don't reset in mass until May 09 ! . These loans are MUCH larger that the subprime 140 ,000 ! Jim Rogers has stated That The US banks are insolvent ".Unemployment #'s will be 1000000 /month by summer 09 . The jobs are long gone + aren't coming back . MBA's building bridges + digging water /sewer lines ? GET REAL ! Welcome to the USSR ! What's coming will make the Great Depression seam like a walk in the Park !

2008 Dec 16 11:14 PM