The big U.S. banks have a loan book that is over 150% of GDP and some pay a dividend of over 2%.
Credit creation is still growing the loan book at 0.1% 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 central bank and government stand behind the too-big-to-fail banks and stand ready to assist them in a crisis should 2007-09 repeat.
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 2018 and added about $US190B to the economy or 0.98% of GDP. This is a strong result considering that in 2017 the result was only $23B and 0.2% of GDP.
This is a good result however as a comparison the Federal Government creates and puts into circulation on average $60B per month which dwarfs the impact of the commercial banks.
The flow of credit money adds to the stock of private debt in the private domestic sector, and this is shown in the chart below.
The chart below shows the same information as a percentage of GDP.
The chart above shows that the U.S. has a high private debt level of over 200% of GDP.
One sees from the chart above tracking private debt from the 1950s to the present day that there have been dramatic peaks and troughs building up to and them following each of the last three major booms and busts. The Savings and Loans crisis of the 1990s, the Dotcom of the 2000s and the more recent Global Financial Crisis [GFC] if the mid-2000s.
What happens is the real economy is deflated by a phenomenon known as debt deflation and is also known as secular stagflation and is defined by Professor Micheal Hudson very succinctly below:
Debt Deflation: The financial stage following debt-leveraged asset-price inflation, which leaves a residue of debt once new lending stops and repayment time arrives. The term was coined in 1933 by Irving Fisher to explain how bankruptcies and the difficulty of paying debts wiped out bank credit and hence the ability of economies to invest and hire new workers.1 Paying debt service diverts spending away from consumer goods and new business investment.
(Source: Hudson, Michael. J IS FOR JUNK ECONOMICS: A Guide To Reality In An Age Of Deception. ISLET/Verlag. Kindle Edition.)
The charts and information above show that the US banks have been very successful in creating credit and growing out their loan books after the GFC doldrums. Just last year saw a massive increase in new credit despite rate increases from the Federal Reserve that logically would have deterred new borrowing however the banks are more willing to lend at a higher price than a lower one.
The Trump administration has also been at work dismantling bank regulation so that once again the credit growth genie of credit creation can be let out of the bottle. In the fullness of time, we will see a repeat of the boom-bust phases of the S&L, Dotcom, and GFC.
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.
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:
- Loan as much money out to creditworthy borrowers as possible.
- Seek to create a rising rate environment to maximize profit on the established loan book for as long as possible.
- 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
In the case of the U.S., the banking sector has been very successful as the charts above show. One could reasonably expect the loan book to grow out to 213% of GDP, as proven possible in 2009. The real limit is the capacity of the economy to support further loans. The lower the rate, the higher the stock of debt that can be carried. Even a static loan book can provide a rising income for a long time without growing in size so long as rates rise. That said, it is still growing at almost 1% of GDP per year in 2018.
Mission accomplished, it is over 200% of GDP. One of the highest in the world. Not much more can be expected, though it is possible and indeed accelerating at the moment for the last year.
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 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.
The table below shows the interest rate burden over a range of interest rate levels. Marked in green in the current Federal Funds Rate [FFR]. Banks loans are more than this rate. Home loans make up the bulk of bank loans and are in now in the 4% to 5% range for a 30 year Jumbo Loan. Auto loans are more than this.
(Source: Author calculation based on Trading Economics dot com data)
One can see at present that over about 10% 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 illustrates the mechanism by which the real economy is deflated by debt service. What households and businesses have to spend on debt service cannot be spent on real production, and so real production of goods and services slows down.
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 3.17% and shows steady five-year growth in the share price. Now might be a good time to buy given the current market retrace and rising FFR. Opportunity knocks.
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 leader market leader.
|Bank Name||Code||Dividend Yield||Market Capitalization|
|Wells Fargo & Co.||(WFC)||3.55%||$227B|
|Bank of America Corporation.||(BAC)||1.54%||$259B|
|Goldman Sachs Group Inc.||(GS)||1.79%||$66B|
Bank profits and dividends can be expected to rise with central bank rate rises.
The central bank is raising rates, and this can be seen in the chart below.
Recent history shows that once the Federal Reserve starts raising rates, it does not stop until a recession comes.
Each recession in proceeded by a Fed rate rising phase. Once the raising process starts, it goes quickly upwards. It is in this phase that the banks make the most money from the increasing rates before an economic collapse comes.
From the table above, in the previous section, we can see that each one percent rate rise adds over $US393B to loan interest income when passed onto the consumer.
The unwinding of QE is the selling of Mortgage Backed 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 is received from the existing stock of treasuries is shown below.
Each rate rise of 0.25% adds $55B in sovereign money income to the economy. The Fed is now reducing it's once $4T+ balance sheet of long-dated bonds, to unwind QE. Banks are one of the primary 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 from the bonds would also add to banking income streams. Three percent of $4T is $120B per year of additional revenue as an estimate of how much this could be.
Even without the bond income, the banks have interest on reserves income from the Fed. The interest on reserves rate is shown in the chart below and is almost as much as the FFR.
This income is almost as much as if the banks were still holding the bonds that were bought off them in the GFC in exchange for the reserves.
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), four of the U.S. banks also feature in the top twenty 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 is 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.
The political issue erupts when debts cannot be paid. The debt crisis requires nations to decide whether to save the creditors’ claims for payment (by foreclosure) or save the economy. After 2008 the Obama Administration saved the banks and bondholders, leaving the economy to limp along in a state of debt deflation. Economic shrinkage must continue until the debts are written down.
(Hudson, Michael. J IS FOR JUNK ECONOMICS: A Guide To Reality In An Age Of Deception. ISLET/Verlag. Kindle Edition.)
Credit should be managed, distributed and allocated at cost like a public utility such as roads or water. When it is not treated in this way the finance capitalism genie is let out of its bottle and leads to measurable and timeable booms and busts
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 current market retrace is offering the big banks for sale and at higher dividend yield returns than are normal and is a good time to go bargain shopping.
Yes, the system is evil and wrong but learn it and profit from the knowledge.
A diversified exposure to the American banking system and its many sub-sectors can be obtained via the ETFs listed below.
Financial Select Sector SPDR Fund
Vanguard Financials ETF
SPDR S&P Regional Banking ETF
SPDR S&P Bank ETF
iShares U.S. Financials ETF
Direxion Daily Financial Bull 3X Shares
iShares U.S. Financial Services ETF
First Trust Financials AlphaDEX Fund
First Trust Nasdaq Bank ETF
Fidelity MSCI Financials Index ETF
PowerShares KBW Bank Portfolio
ProShares Ultra Financials
iShares U.S. Regional Banks ETF
PowerShares KBW High Dividend Yield Financial Portfolio
First Trust NASDAQ ABA Community Bank Index
PowerShares S&P SmallCap Financials Portfolio
PowerShares KBW Regional Banking Portfolio
SPDR S&P Capital Markets ETF
PowerShares KBW Property & Casualty Insurance Portfolio
Davis Select Financial ETF
PowerShares DWA Financial Momentum Portfolio
John Hancock Multi-Factor Financials ETF
Oppenheimer Financials Sector Revenue ETF
ProShares UltraPro Financials
Direxion Daily Regional Banks Bull 3X Shares
iShares Edge MSCI Multifactor Financials ETF
Personally, I prefer KRE as it is representative of domestic U.S. banks who enjoy the full benefit of the rate rise.
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.