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.