Give banks unlimited access to financing at close to 0% and a steep yield curve, exempt them from marking their worst assets to market, and they will earn money, even when their combined commercial loan book is shrinking at an annual rate of 20% – (click to enlarge)
– and consumer credit is shrinking by 10% a year (click to enlarge).
The lending businesses are losing money, but fixed income trading — the use of leverage by bank treasury departments — more than compensates. The first quarter saw an extraordinary tightening in high-yield credit spreads, and an enormous opportunity to book fixed-income profits. What do you do for an encore?
A year ago I was too early in proposing to take profits in banks: when the market expected doomsday, I was sure that the banks would show positive results:
The panic over the banks that prompted Citigroup’s great tumble from $3.50 on Feb. 13 to $0.97 on March 5 erupted out of nothing. Dithering on the part of the Obama administration lent credence to fears that banks were about to be nationalized, as propounded by the irresponsible academic tinkerers and social engineers. It should have been obvious that the banks were making money during the first quarter. Now that FASB 157 with its procyclical mark to market requirement is on the shelf, we can expect modest positives for the banks.
I underestimated the extent to which the new government-bank combination would allow banks to crank out earnings. But none of this has much to do with the rest of the economy. The banking system is financing about three-quarters of the $1.6 trillion Federal deficit, lending to the government at 1% for 2-year notes, with virtually no capital coverage required. Now, that’s an efficient use of bank capital, namely zero to finance Treasury securities on the carry trade.
This is how Japan squeaked through the 1990s. In theory it can go on forever (Japan has been doing it for 20 years). In practice, any number of things can go wrong.