What A September 2018 Fed Rate Rise Means For The Big US Banks

Includes: BAC, C, GS, JPM, WFC
by: Alan Longbon


Fed rate rises mean more income for banks from increased variable loan rates and also interest on reserves.

Credit creation is still growing the loan book at 0.52% of GDP.

Ongoing central bank rate rises will cause the interest income from the accumulated loan book to cause automatic income increases to banks on outstanding loans.

The purpose of this report is to assess if the big U.S. banks are worth investing in from a capital growth and dividend income growth perspective.

To answer this question, an assessment of the success to which the banks have enclosed the economy with debt will be used together with an assessment of how this enclosure of the economy can be made into higher profits.

The Enclosure Of The Private Sector

The chart below shows the level of private credit creation entering the private sector through commercial banks.

The above chart shows that credit creation from private banks has grown in 2017 and added $US23.3B to the economy or 0.1% of GDP. In 2018, the result so far has been much stronger with over $99B added from loan growth which is 0.52% of GDP.

The flow of credit adds to the stock of private debt in the economy, and this debt is shown in the chart below.

(Source: Professor Steve Keen)

The chart above shows that the U.S. has a high private debt level of 150% of GDP. Private debt levels reached 170% of GDP at the peak set during the GFC marked on the chart.

From the GFC 170% of GDP credit peak in 2006 to the trough in 2012, the Fed lowered rates to near zero using the logic that if we take rates to lower more credit will be demanded, and the market will be reinvigorated. The chart shows that the demand for credit fell in this period, more loans were repaid or written off than new ones generated. There was no demand response.

There is now a demand response in the face of higher rates than prevailed in 2006-2012. However, this is most likely due to less stringent lending regulations, and more borrowers are classed as a creditworthy and want a loan. These people were locked out of the market until now.

Professor Steve Keen's studies show that economies with private debt levels of 150% and over tend not to become more indebted. They hit a natural barrier where no more debt is demanded.

The reason is that such a large percentage of aggregate demand goes to debt servicing that there is a noticeable drop in the demand for real goods and services. Production goes unsold and is cut back. This leads to job losses, income losses and a further cessation of aggregate demand until the debt is repaid or written off and more income can be spent on buying production rather than debt service.

This phenomenon where debt service absorbs so much aggregate demand has been coined "debt deflation" by economist Professor Michael Hudson. This is in the sense that the real economy is deflated by the weight of the debt service. Professor Hudson likens the finance sector to a parasite riding on the back of the real economy, adding nothing while drawing out as much as possible. For example, the government could provide credit at the interbank rate and completely cut out the middlemen and their markup and false credit allocation strategies.

Lending could again go to 170% of GDP or more. 170% of GDP is the proven benchmark so far for private debt in the US, at lower rates more would be possible.

As well as growing the loan book, banks also seek to increase the return on the loan book by seeking rate rises from the Fed. The rate rises the bank industry has successfully obtained are shown in the chart below.

The next rate rise in September 2018 is said to have a 90% certainty by the bookkeepers of Wall Street.

Bank Strategy

It is the role of the banking industry to create credit and lend it out at interest and make a profit. In a bank utopia, every creditworthy citizen would be "loaned up" and paying interest.

In the U.S., this has been taken to extremes where basic things such as healthcare and college education are left almost entirely to market forces, and the result is very expensive healthcare or none, and in the latter case, a generation of students with large student loans to pay back.

The loan book is the bank's asset and provides the bank income from which to pay shareholder dividends. The aim is to make this loan book as large as possible with as little risk as possible. One could simplify the model as follows:

  1. Loan as much money out to creditworthy borrowers as possible.
  2. Seek to create a rising rate environment to maximize profit on the established loan book for as long as possible.
  3. Protect the loan book.

A three-stage process where the economy is first enclosed with loans and then squeezed to extract as much income as possible.

One can assess how successful a bank is by looking at how large its loan book is and how much of the economy's income it has secured as an income stream on that loan book.

Stage 1: Grow The Loan Book

This stage has not only been accomplished but is also being enhanced with an additional $99B of new loans in 2018.

Stage 2: Maximize Returns On The Loan Book

For the U.S., one can model the impact of this private debt on the economy over a range of interest rate levels, and this is shown in the table below. The standard home loan in the U.S. is a fixed rate over 30 years. Auto loans are normally variable and over a shorter time frame and student loans are between the two. These types of loans make up the bulk of the loan book.

(Source: Author calculation based on Trading Economics dot com GDP data and Prof. Steve Keen private debt data)

One can see at present that about 6.27% of GDP/aggregate demand goes to private commercial banks as debt service cost and not on real goods and services in the real economy. This is based on the assumption that the loan book averages a return of 4%. Four to five percent is nearer the truth when one adds in business loans and auto loans that tend to be at a higher rate. Not to mention credit cards at over 20% or more and exploding rates when one misses a payment.

One can also conclude that this interest payment from loans underpins the dividend income one can receive from U.S. banks. The largest bank, JP Morgan (JPM), shown in the chart below, yields a dividend of 1.95% and shows steady five-year growth in the share price.

One notices how the bank share price rose strongly after the Fed rate rises started in late 2015, after late 2016, there was no looking back.

The U.S. has five of the world's largest banks by market capitalization. The other banks have similar growth and dividend patterns as the market leader.

Bank Name Code Dividend Yield Market Capitalization
Wells Fargo & Co. (WFC) 2.93% $283B
Bank of America Corporation. (BAC) 1.54% $311B
Citibank Inc. (C) 2.52% $179B
Goldman Sachs Group Inc. (GS) 1.35% $89B

Bank profits and dividends can be expected to rise with central bank rate rises, and history has shown this has happened since late 2015.

Interbank rates now are considered too low at only 1%-1.5% and should be "normalized" to at least 3% to 3.5%. Such a scenario would see variable rates increase to 5% to 6%. By this time, banks will be earning about $1676B of extra income per year. A figure about twice the loan book earnings at present. All based on the loan book remaining static with no extra effort on behalf of the banks to generate more loans. The dividend could potentially more than double given the cost base is the same, and yet the rising rates have brought in more income.

America has started the rate rise and QE unwinding process as one can see in the chart below.

From the table above, in the previous section, we can see that each one percent rate rise adds over $US291B to loan interest income when passed onto the consumer.

The unwinding of QE is the selling of Mortgage Back Securities [MBS] and long-dated bonds back to the banks in return for excess reserves they may be holding. This means the banks will be swapping their low-income excess reserve balances for higher-yielding treasuries and other long-dated bonds at a time when the return on those long-dated bonds is rising with the Fed rate increases.

An estimate of how much income can be produced from the existing stock of treasuries is shown below.

Each rate rise of 0.25% adds $53B in state money income to the economy. The Fed plans to reduce its $4T+ balance sheet of long-dated bonds, to unwind QE. Banks are one of the main recipients of such securities; it was where they came from in the first place during the GFC. If this $4T were returned to the banking sector, the income stream from the bonds would also add to banking income streams. Three percent of $4T is $120B per year of additional income as an estimate of how much this could be.

What happens when central banks across the globe start the same QT process?

This was brought to my attention by Seeking Alpha Marketplace Contributor Mr. Robert P Balan and his PAM team. Mr. Balan's latest public article on this subject is located here. And this very important chart is reproduced from it below:

The following chart is one that Mr. Balan produced for this article and provides a clear picture of the falling world GDP and Central Bank bank balances. Asset markets will follow this downward trend, and due to the lag between flow increases and asset market response, the decline is now baked in even if the flows were to reverse now.

Stage 3: Protect The Loan Book

All five banks appear in the top ten list of the largest banks in the world by market capitalization as the chart below shows.

By assets under management (size of loan book), six of the U.S. banks also feature in the top fifty banks in the world as the chart below from Wikipedia shows.

In the event of a crisis, the "too big to fail" card will be played again and will work as it did in 2006-2009 where national governments across the world guaranteed bank liquidity. What this means is that the banks are backstopped by the national government, which is sovereign in its currency and therefore has unlimited U.S. dollars.

In the event of a problem, QE will be activated. Bad loans and long-dated bonds will be bought from the private banks by the central bank, at par though nearly worthless, in exchange for excess reserves. It happened last time, all around the world, and will happen again as well. Profits are privatized, and losses are socialized.

TINA (there is no alternative) will emerge again. The actual alternative is a nationalized banking industry lending at interbank rates. Cheaper, safer and better for everybody, and backed by the currency sovereign. But, for the private banking industry that would be beyond the pale.

Summary Conclusion And Recommendation

What does this mean for investors? It means that the banks and its accumulated loan book are safe. One can invest in the U.S. big banks with some certainty that both the stock price and dividend will rise with Fed rate rises and QE unwinding. Rate rises for the banks by the banks.

The time to exit is when the yield curve inverts as this warns of a recession twelve to eighteen months later due to the banks running out of credit-worthy borrowers and falling long-term rates and because they have absorbed a critical mass of real aggregate income and deflated real aggregate demand for real goods and services.

Disclosure: I/we 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.