The Federal Reserve Won't Taper: Commercial Banks In Worse Shape Than Thought

Includes: SPY, UDN, UUP
by: John M. Mason

Has Sheila Bair been a "leading indicator?"

On Tuesday I wrote about the article that Ms. Bair, former chair of the Federal Deposit Insurance Corporation (FDIC), published in the Financial Times.

The article was titled "Tapering Threatens a Stormy Outlook for America."

The point Ms. Bair was making was this: "Regrettably, banks are only marginally safer than they were before the 2008 crisis."

Tapering, which could result in long-term interest rates moving higher, could be very troublesome for the banking system, especially, Ms. Bair argues, for the megabanks. Why? Because those megabanks have lots and lots of low-yielding bonds sitting on their balance sheets.

"All those low-yielding bonds sitting on their balance sheets will lose market value as rates climb, which under new capital rules will eat into their capital base. At the four biggest banks, the value of Treasury and mortgage-backed securities holdings fell by $13bn in the second quarter because of rising rates, with Bank of America taking the biggest hit."

The consequences spread throughout the system: "Millions of families that suffered in the Great Recession are only now clawing their way back. For their sake, let us hope the Fed can gradually end this era of cheap money without significant market upheaval."

Oh, the damage that tapering might do to the banking system.

In my post, mentioned above, I stated that I have argued for a long time that a lot of the rationale for quantitative easing, inside the Fed, has been that the banking system has still been carrying a lot of "underwater" assets, loans as well as securities. The Fed has been doing this, the argument continued, so that the banks would be able to remain open and the FDIC could then smoothly and efficiently escort failed banks out of existence. In the last year or so, this practice has evolved into more and more bank acquisitions to remove the weakened organizations from the banking system.

So, here is Ms. Bair arguing that tapering might result in "significant market upheaval."

And, who should know the condition of the banking system better than Ms. Bair, head of the banks' insuring agency?

The Federal Reserve has not alluded to the condition of the banking system through all three editions of quantitative easing. They have focused on economic growth and on high levels of unemployment.

The release today maintains this focus. Federal Reserve officials "decided to await more evidence that progress will be sustained before adjusting the pace of purchases." These Fed's release stated that "the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market…." Fed officials said that they wanted time to observe this situation. These quotes from the Federal Reserve's press release.

So, the Federal Reserve stays on message.

One still has to wonder.

The economy is recovering and has been doing so since July 2009, over four years ago. The unemployment rate is coming down, but not because people are getting put back to work. The unemployment rate is falling because people are leaving the work force. This is a structural problem and not a cyclical problem.

The banking system is not lending and almost all of the reserves the Fed is injecting into the banking system is going into excess reserves. This is not the sign of a healthy banking system even though loan demand is not strong. Furthermore, I have questions about the condition of commercial real estate loans on the books of the banks smaller than the largest 25 domestically chartered banks in the US. This doesn't even get into the problem with underwater bonds that Ms. Bair is concerned about, and residential real estate loans with rising interest rates.

The stock market is ecstatic about the failure to begin tapering. The S&P 500, which was down about 5 points this morning, is now up more than 20 points. The yield on the 10-year Treasury note is down about 30 basis points.

The only negative in this is the foreign exchange market where the US dollar is taking a beating.

But, this should tell you a lot. The foreign exchange market sees a perpetual push for more and more credit inflation. And, this is the bottom line.

Let the bubbles continue!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.