Monday, January 18, 2010

Yield Curve & Bank Profits

Rolfe Winkler published a post in which he showed the banks are not profiting from the steep yield curve.  One reason is the banks are not lending; they are plowing their cash into more liquid securities.  He argues banks need to lend at higher rates, because the curve is steep at low rates and they cannot capture the whole spread based on what they actually have to pay for more deposits.  The banks also carry floating assets in the form of credit card and corporate loans and ARMs that key off indices.  Higher rates would would in turn mean lower real estate prices and higher default rates.

Tyler Durden had a post in which he demonstrated that foreign investors (indirect bidders) were fleeing the short bond.  Contrary to conventional wisdom, foreign investors are buying the longer bonds with steeper yields.  Yet, each auction is seeing high Primary Dealer (US banks and bond broker-dealers) purchases.  With the expectation of inflation around the corner, how are investors going to be persuaded to leave the short-term bills and buy the "riskier" long-term bills?

Karl Denninger observed that the Primary Dealers (banks) are heavy buyers (crowding out?) of the 13 week and 26 week bills with near zero yield.  This means they are not only not lending, but, in my opinion, they are hoarding cash.  The question becomes what do they know?  What makes them afraid to lend and make money?  Who does the steep yield curve benefit?

Econbrowser has published a post breaking down the Fed's recent profit of $46.1 billion given to the Treasury,  Besides finding the number is coincidentally the same as the revenue from US Treasuries and MBS, James Hamilton found the profits were from a strategy of borrowing short and lending long.  The Fed may be funding the purchase of MBS with near zero interest Treasuries.  This means the Fed must be able to continue to rollover the short term debt (continue to convince banks to keep holding excess reserves) or liquidate the long position (sell the MBS) without a loss or uncontrolled impact on interest rates.

We have been commenting for many months that the Fed appears to be encouraging banks to deposit excess reserves rather than lend.  Meanwhile, unemployment will stay high for years, consumer credit and spending will remain low, and small business credit availability will remain unusually low.  For whose benefit is this "recovery"?

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