At the end of last month, I spotted some positive news for the much-maligned U.S. financial sector: bad mortgages were down. As bad mortgages represent "toxic assets" (which should win an award for buzzword of the decade), it looked like the future might finally be getting brighter for financials.
While I never advocate trading on news, it's obviously important to follow developments. And today, there's a significant one. The U.S. Comptroller says banks should be pretty nervous:
'New product' risk is increasing as banks seek to enter new or less familiar markets to offset declines in revenues from core lines of business.
Interestingly enough, the report also concludes that low interest rates are actually damaging to banks' profitability. As everyone knows, the low interest rates are because of the Fed's ZIRP (zero interest rate policy), which is intended to increase liquidity and encourage borrowing. (Your daily dose of irony.)
The full report is available here. It's fairly long -- 30 pages -- but is an important need for investors with significant capital allocations in the financial sector.
A Deeper Look at ZIRP
The best analysis of ZIRP I've seen so far comes from David Einhorn in his article "The Fed's Jelly Donut Policy." This is another excellent-if-long read, but the short version is this:
My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn't giving us energy or making us feel better.
Einhorn's argument is born out by the facts, which are cited in the report. Marty Pfinsgraff (the Deputy Comptroller) put it this way:
When you've had four years of low rates, that benefit [low borrowing costs] has already worked through your portfolio. Low rates are now negatively impacting bank revenues, as yields on loans and securities plumb new lows.
ZIRP's Got Risk On Going -- In The Wrong Way
The conclusion I draw from the report (and Einhorn's analysis) is that the current zero interest rate policy is unlikely to provide the economy with any additional benefit. The policy has been in place long enough that any entity wanting to borrow on the cheap has had an opportunity to do so -- and as extensive further borrowing is not being seen, it stands to reason that a continuation of ZIRP is unlikely to stimulate additional borrowing. Even worse, because ZIRP inhibits banks' abilities to earn revenue through lending, banks are now having to take on riskier assets to compensate for lost earnings.
Investors should be cautious of such activity -- after all, the financial crash caused by excessive risk-taking is still a pretty fresh memory. While the currently depressed financial sector makes for a decent contrarian play, I would personally shy away from allocating significant amounts of capital to the sector as a whole. The problems are not yet sorted out, and Fed policies intended to help may actually be causing harm.
It's worth noting that the report concludes that small banks at just as much -- or more -- risk than the big ones like JPMorgan (JPM), Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC). So if you've been buying positions in smaller regional banks, you may want to examine their balance sheets to see just what type of risks they've been taking, and whether those are risks that you are comfortable taking.