Small Bank Business Loans And The Jobless Recovery

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Includes: APO, BKCC, BX, IYF, KKR, OCSL
by: John Rutledge

Summary

Jobs are growing but employment/population is still 6 million jobs below pre-crisis levels.

Dodd-Frank has killed small bank loans to small businesses and caused non-price rationing and 15-25% borrowing costs for small businesses.

Own stocks of non-bank lenders to profit from non-price rationing.

Today's +278K increase in non-farm payroll jobs is glass-half-full story. Employment (139.4M) has increased by almost 10M jobs from its February 2010 low at the bottom of the financial crisis but is barely above its December 2007 pre-crisis peak in spite of increases in population. Many workers have become discouraged and left the workforce; the employment-population ratio is more than 4% (6M jobs) below pre-crisis levels. And real incomes have barely budged. What's going on?

One important factor in this story is the demise of small business loans. Total business loans actually look OK. They fell by $400B from their pre-crisis peak of $1600B in October 2008 to $1200B in July 2010 but are now climbed back to $1759B. But a careful look reveals the problem. As you can see in the chart, above, almost all of the increase in business loans came from big banks. Small bank business loans have barely increased from their lows and are still some 20% below pre-crisis levels.

The reason is simple. Dodd-Frank--so-called financial reform--has buried small banks under a mountain of new regulations. Compliance costs are enormous. Big banks can afford the compliance costs; small banks can't. That's why there are half as many banks today as there were in 2007.

I'm sure you catch the irony. Financial reform was supposed to end the risk-taking behavior of big banks. It ended up increasing big bank market share dramatically.

This is important because big and small banks serve different customers. Big banks loan to private equity sponsors, hedge funds, and big companies doing M&A. Small banks lend to local small businesses and local home owners. Small businesses are where all new jobs come from. Mystery solved.

The resulting non-price credit rationing for small firms has created a second irony. The Federal Reserve tells us that short-term interest rates are nearly zero. But that is the interest rate on the loans that small businesses can't get. In reality, they are starved for working capital. This is a great opportunity for private equity investors, who are providing that capital at 15-25% rates of return. But it is not good for jobs, for growth, or for family incomes.

This is not all bad news for investors, of course. Slow job growth has encouraged the Fed to keep interest rates--the ones you read in the Wall Street Journal--near zero. Hedge funds, private equity firms, and public companies that are customers of big banks are drinking from a fire-hose of cheap credit.

How to position a portfolio for this bizarre situation? If you are a hedge fund, you can buy big banks and short small ones. If you are a private equity investor you can buy orphaned small companies and breather life back into them by giving them growth capital. If you are a stock market investor, you can benefit simply by owning the financial sector ETF (NYSEARCA:IYF), which is largely made up of large bank stocks. You can invest directly in private equity sponsors like Blackstone (NYSE:BX), KKR (NYSE:KKR), or Apollo (NYSE:APO). Or you can buy shares of the Business Development Companies like Blackrock Kelso Capital (NASDAQ:BKCC) and Fifth Street Finance (FSC) that provide capital to orphaned small business borrowers and pass along credit-shortage returns to investors in the form of double-digit dividend yields. I have positions in all of them in my portfolio today.

Disclosure: The author is long BX, APO, BKCC, FSC, IYF.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.