Below is a link to a video from today’s talk about earnings at Goldman and Bank of America. Before you watch the video, let me say a few words about Fed policy and net interest margins plus a bit on Goldman and BofA.
Last November, in anticipation of QE2, I wrote a post called “How Quantitative Easing and Permanent Zero are Toxic To Bank Net Interest Margins”. The gist of the post was that if the ‘extended period’ for low rates was too long, net interest margins would suffer, especially during a recession. I was looking at Japan and their economic policies and seeing low yields and super-low net interest margins killing bank earnings.
I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).
My thinking last November was that since long-term yields represent an aggregation of future short-term yields, low Japanese long-term yields were a reflection of anticipated future Bank of Japan policy rates of near zero percent.
As I wrote in April:
If long rates are largely determined by expected future short rates, the longer short rates are at zero percent, the lower long rates will go. That’s toxic for bank interest margins. Look at 77 bank as an example.
Now that we are seeing more movement down on net interest margins (BofA and Wells Fargo both showed margin compression for example), the mainstream media is finally catching on to the connection between Fed policy and net interest margins. You heard it here first though.
Here’s the thing:
Operation Twist can only move rates a few basis points. And since the Fed is targeting quantity not price AGAIN, it’s not even clear that rates will decline. Rates are already so low that these basis points won’t make ANY difference. I see this as a non-event, a big fat yawn. It’s not treason at all. It won’t even be effective.
Long-term yields have been moving higher, not lower. So far at least, Operation Twist is a bust. I am less concerned about net interest margins now and more concerned about them during and after the next recession.
Banks are still getting a huge boost from reducing loan loss provisions. At Wells Fargo for example, FT Alphaville notes that loan loss reserves went down to $20.0 billion from $23.9 billion in Q3 last year from a loan book of $760bn. Wells Chief Risk Officer said “Absent significant deterioration in the economy, we continue to expect future reserve releases.”That has a huge impact on their income statement.
Just a reminder of what is happening here on the accounting of releasing reserves and writing up assets. Here’s John Hussman last October:
In early 2009, many major U.S. banks were faced with clear capital shortfalls that effectively rendered them insolvent – their liabilities exceeded their assets. Instead of restructuring this debt, or dealing with the problem in a sustainable way, the Financial Accounting Standards Board, responding to Congressional pressure, suspended "mark to market rules" and allowed major U.S. financials to use "substantial discretion" in valuing their assets. Since it was neither possible nor credible for banks to immediately write up those assets overnight, loans from the Troubled Asset Relief Program (TARP) were critical in bridging the immediate shortfall. Over the following quarters, banks substantially wrote up their assets, and they issued a large volume of additional stock. The new issuance created a moderate but legitimate improvement in the financial position of these banks, but the asset writeups appear to be inconsistent with the growing volume of delinquent and unforeclosed homes, and the deteriorating debt-service performance of commercial mortgage-backed securities. Presently, the U.S. financial sector is essentially opacity masquerading as solvency.
As Meredith Whitney has observed, the "recovery" of the U.S. financial sector has been a two stage process – massive writeups of troubled assets on balance sheets, followed by large reductions in loan loss reserves on income statements. This activity has not only driven the improvement in operating earnings reported by banks, but has been one of the primary contributors to the recovery in the aggregate earnings of the S&P 500 Index. It is not a process that should be extrapolated.
I said at the time:
“Notice the part about asset writeups instead writedowns in an environment of record foreclosures. Why are loan loss reserves falling instead of rising?”
I ask that question here again.
Last November my thinking was as follows:
PZ [Permanent Zero] will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.
This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.
If solvency is the banks’ problem, QE and PZ will be toxic.
The banks have reduced loan loss provisions and this is buoying earnings. In a recession, these provisions will skyrocket. Write-ups will become writedowns. And as my friend Gaius Marius wrote me on twitter: “while this happens, big servicers (eg BAC) also face rocketing non-int expense as they take on housing collateral”
At the same time, interest rates will decline, killing net interest markets. That’s why a double dip will be bad for banks. The problem for banks is that their funding cost cannot decline because of the zero lower bound. So if their lending rate does decline, their margin automatically shrinks. If we have a severe recession anytime before 2013, BAC would be in trouble. In the meantime, they must sell assets and shrink risk.
At Goldman, the story is different. Their franchise value remains largely unchanged despite the recent loss. Remember, last quarter was devastating for hedge funds, the worst since the panic of 2008 – this after a bad Q2 as well. I make that comparison because Goldman is unique amongst the large US banks. Pre-crisis there were 4 big banks: JPMorgan Chase, Wells Fargo, Bank of America and Citigroup. There were also 5 big investment banks, Goldman, Morgan Stanley, Merrill, Bear and Lehman. Lehman went bust, bear and Merrill were absorbed by banks and Goldman and Morgan Stanley converted to banks.
That leaves four large banks and two investment banks. Goldman is the most pure play investment bank of the lot. Wells doesn’t have a large sales & trading and advisory function, JPMorgan, Citi and BofA do but they are attached to their commercial banking enterprise. And Morgan Stanley has retail. Goldman is really a pure play sales & trading shop. In today’s world, that’s a play with a lot less leverage, no legal proprietary income outside of private equity and lower volume. Goldman, while the best of breed in this business, will necessarily have lower return on capital.
That’s my piece. Here’s the video (click on the picture for link)