Friday, March 13, 2009

The Real Bank Bailout: Upward Sloping Yield Curve


Larry Kudlow -- Out of the blue, bank stocks mounted an impressive rally this week, jumping nearly 40% on the S&P financial list. One after another, big-bank CEOs like Vikram Pandit of Citi, Ken Lewis of BofA, and Jamie Dimon of JPMorgan are telling investors they will turn a handsome profit in the first quarter, their best money gain since 2007. This is big news. And it triggered the first weekly stock gain for the Obama administration.

But this anticipated-profits turnaround doesn’t seem to have anything to do with the TARP. It’s about something called the Treasury yield curve — a medical diagnostic chart for banks and the economy. When the Fed loosens money, and short-term rates are pulled well below long rates, banks profit enormously from the upward-sloping yield curve. This is principally because banks borrow short in order to lend long. If bankers can buy money for near zero cost, and loan it for 2, 3, or 4%, they’re in fat city. Their broker-dealer operations make money, as do all their lending divisions.
So the upward-sloped yield curve is the real bailout for the banking system.

Now, turn the clock back to 2006 and 2007. In those days the Treasury curve was upside down. Due to the Federal Reserve’s extremely tight credit policies, short-term rates moved well above long-term rates for an extended period, and that played a major role in producing the credit crunch. Since interest margins turned negative, the banks had to turn off the credit spigot, and all those exotic securities — like mortgage-backed bonds and various credit derivatives — could no longer be financed.

The Fed’s long-lived credit-tightening also wreaked havoc on home prices and was directly responsible for the recession that began in late 2007. At the time, Fed head Ben Bernanke said the inverted yield curve wouldn’t matter. Gosh was he wrong.

Today, however, after about a year of a positively sloped yield curve, bank interest margins and profits are turning up. In fact, despite the perpetual pessimism, the normalized yield curve is a leading indicator of economic recovery, according to models created by the New York Fed and others.

MP: The charts above illustrate Larry Kudlow's analysis.

The top chart shows the 30-year mortgage rate and the 1-month CD rate over the last five years, and the bottom chart shows the difference between those two rates as an estimate of a typical bank's net interest margin (a slightly different measure of interest rate spreads than the 3-month to 10-year Treasury spread). The current net interest margin for banks is close to a five-year high of almost 5%, explaining the recent bank stock rally. And the historically narrow 1% spread between 30-year and 1-month rates in 2006 and 2007 reflects the credit crunch that Larry describes.

9 Comments:

At 3/13/2009 9:14 PM, Blogger fboness said...

Every silver lining has a big, black cloud wrapped around it. In this case, people are not paid a decent return on their savings.

 
At 3/13/2009 9:32 PM, Blogger rufus said...

What Larry Kudlow doesn't mention is that he was on tv every single day haranguing the Fed to raise interest rates "higher" to strengthen the dollar.

Every. Single. Day.

 
At 3/13/2009 9:37 PM, Anonymous Anonymous said...

rufus: I dont recall this. What time period are you referring to? I clearly remember Kudlow advocating rate cuts long before the Fed cut rates.

 
At 3/13/2009 9:58 PM, Blogger BxCapricorn said...

I will guarantee you that starting 10:35 am EST on Monday, the financial sector "corrects". This was merely a short-covering by bears, who realize that everything that was "said" by banking executives this week, is a series of orchestrated lies. We will know they are lies, when they all report by mid-April. I loaded up on FAZ, BGZ, EDZ, etc. in the close today, and will buy more, if I get a beautiful gap down on Monday. Prediction: We hit a sub-peak on April 13th in the market when all the 401K transfers, from media beievers, runs dry and reality shows up. A nation of Money Managers, who are forced to adhere to Modern Portfolio Theory, will robotically lose the other half of everyone's retirement savings. Sad but true.

 
At 3/13/2009 11:20 PM, Blogger rufus said...

Anon, if you will go back to the time period when Bernanke had just taken over he had raised interest rates to 4% and was showing signs of wanting to stop. Commentors like myself were weeping, and crying and begging for cessation, and Kudlow was pounding the table every day calling for higher rates to bring back "king dollar."

Remember the "Monetary Manhood" nonsense he threw on Bernanke at this time?

Look up when Bernanke took over, and then go back through the archives of Kudlow's blog. He's wiped out all comments, but the original posts should still be there.

 
At 3/14/2009 1:05 PM, Anonymous Anonymous said...

This is the strategy that the Fed employed following the savings and loan crisis.

I wonder why this strategy wasn't employed, by the federal government, when the credit markets froze up? At the time global investors were selling corporates in a panic and excepting low, and in some cases negative, yields on treasuries. The government could have helped calm the panic and facilitated the reallocation of capital by taking the other side of that trade.

By selling treasuries at very low rates and buying corporates they would have provided liquidity to the market and taken the position of lender of last resort. Corporations would have found a market for their debt and every payment cycle would have strengthened the federal balance sheet, reducing the deficit. The fed did intervene directly in the overnight corporate paper market to support money market funds, they could have extended that intervention further down the corporate yield curve to the benefit of taxpayers.

 
At 3/14/2009 4:29 PM, Blogger Jack Miller said...

BxCapricorn: missing the boat!

In the summer of 2007, the world wide yield curve predicted the recession and now it is predicting the recovery. Sure, Monday, the market maybe down or maybe not, but the economic turn is in progress. The "big battleship" real estate is turning in most markets. Banks will enjoy the writing up of the securities they have been forced to write down.

 
At 3/14/2009 5:53 PM, Blogger marketdoc said...

Excellent and informative pieces of information MP! What we saw last week was capitalism and the free markets at work. Financials tend to lead the rest of the economy and historically they must do well for the rest of the economy to recover. Its part of an old economic term we used to call the business cycle.

 
At 3/17/2009 8:13 PM, Anonymous WildWil said...

BxCapricorn, so much for YOUR guarantee. Are you sure you are not Kudlow in disguise?

 

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