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Why Won’t Those Banks Lend?
OR
How Should I be Investing Now?
We believe that there are multiple issues facing investors today. While the March 2009
market lows appeared to anticipate a severe and long depression, the subsequent recovery
in stock prices appears to anticipate a rapidly expanding world and US economy in which
company profitability accelerates. Most prognosticators are calling for additional
positive stock price movement in 2010. In part, we can agree. Returns in other assets,
primarily bonds and real estate, will probably be close to zero or even negative during
2010. Reaching for better returns, investors will likely be moving additional funds into
the stock market.
Unfortunately, the road to economic recovery may be neither straight nor smooth. While
the asset allocation for each investor needs to be consistent with their specific financial
goals and risk tolerance, we believe that large capitalization companies with extensive
international exposure, proven track records and strong financials should be focus of
most portfolios with substantial equity exposure. We reach this conclusion through
multiple analyses of the current economic situation. The following commentary
examines one of these analyses.
President Obama recently exhorted fat-cat bankers, having taken government aid, to do
their job and start lending money. Many economists consider additional lending to be
essential for economic recovery in the US. We believe a consideration of this issue can
provide investors with an appreciation for the potential risks and rewards for various
investment scenarios and will help answer the question of how they should be investing
now. It is, unfortunately, not a simple matter to explain. Here goes.
Bank lending has been anemic. While many banks have been touting the amount of loans
they have been making (that being politically expedient in these times), it appears that
most of these are simply roll-overs of loans already on the books. If you are not a longstanding customer of a bank, forget about a new loan. Moreover, banks have tightened
standards for making loans, returning to their roots of lending money only to people and
companies that don’t need it.
How can this be so, when the Federal Reserve (often referred to as “the Fed”) has
pumped a trillion dollars into bank reserves? Bank reserves are supposed to be lent out,
creating more money in the financial system and in peoples’ pockets, from which it can
be spent. We think the answer is some combination of the following factors:
1. Banks have lots of bad loans and don’t want any more. If you don’t make a
loan, you can’t make a bad loan.
2. Regulators have informally tightened bank capital standards. More than 100
banks have been closed and reportedly another 500 are in serious trouble.
Without a bit of finagling (having banks prepay three years of FDIC assessments
and a special assessment), the Federal Deposit Insurance fund would be broke.
Regulators want banks to have high risk-based capital ratios, so the best
investment for a bank is not a loan, but a low risk government debt security.
3. The Federal Reserve has kept short-term interest rates low and has announced
that it will keep short-term rates around 0% for the foreseeable future. Banks can
thus borrow at extremely low rates and re-invest the funds in low-risk
intermediate term bonds and make 3-4%.
The Federal Reserves stance in this case is designed to improve bank profitability and
support improvement in bank balance sheets over the near term. In addition to bad loans,
banks have lots of other investments whose value is questionable. As the bank regulator,
the Federal Reserve likes excess reserves. Presumably, the FDIC does also.
As it turns out, the actions of US consumers as a group are consistent with this approach.
Consumers are reducing their borrowings to improve their own balance sheets.
Economists and market commentators have widely divergent opinions about how long
this trend will last, but for the moment, this increased saving is reducing demand for
goods and services. This reduced demand means the economy is either not growing or
growing more slowly, with all the consequent bad results, including high unemployment.
Unfortunately, banks are also not lending to small and medium-sized businesses. These
are the folks who create jobs. Many of these businesses previously obtained funds from
commercial finance companies like CIT Group, which recently emerged from bankruptcy
as a much smaller operation. Without funding, these businesses cannot expand and often
cannot operate at all. Just look at the empty store-fronts in many strip malls.
Now, let’s think about what could happen to all those excess reserves that banks hold.
There are two major possibilities.
1. The combination of better bank profits and loosened regulatory standards
(clearly possible as most of the tightened regulatory standards are not in the rules)
results in banks using the reserves to make loans, or
2. The Federal Reserve acts to reduce the excess reserves, limiting the ability for
banks to increase lending.
In normal times, a dollar of excess bank reserves creates about nine dollars in new loans.
The reason for this is well beyond the scope of this commentary, but think of it this way.
If I borrow $10,000 to buy a boat, the seller of the boat will probably put at least part of
the money back in a bank, from which it gets lent again.
With $1 trillion in excess reserves, banks could conceivably create $9 trillion in new
bank loans. This would make the $787 billion stimulus package look, well not like
peanuts, but relatively small. If banks lent even part of this money, it could really
stimulate the economy.
Some observers see high inflation as the result of such an increase in lending. With more
money chasing the same amount of goods and services, you have a classic demand
inflation scenario. While we see this as a real risk a couple of years out, we do not see it
as an immediate risk as: (a) factory utilization in the US is now about 71% and demand
inflation usually does not start until utilization is above 80%, (b) unemployment is
extremely high, with more than 15 million people unemployed or under-employed, which
will restrain labor cost increases, and (c) as mentioned above, consumers are reducing
debt, restraining demand for goods and services. Still, as the economy begins to grow,
we could see serious inflation in a couple of years.
Alternatively, the Federal Reserve could remove these excess reserves, restraining the
growth in bank lending. With the termination or reduction of federal stimulus spending
(we cannot run a federal deficit of $1.5 trillion a year for very long), we need real
economic growth produced by business expansion and investment. This means we need
growth (not rollovers) in bank lending.
We consider the actions of the Federal Reserve on this issue (and the related issue of
when to allow interest rates to seek a higher, less artificial, level) to be the key policy
decision in 2010.
We believe that the Federal Reserve will act to remove a good part of the excess reserves
as bank balance sheets improve. Unfortunately, Congress (which has been unable to
balance the US budget for time immemorial) has recently intruded more strongly in
monetary policy. As such, we do not think the Federal Reserve will have the ability
(politically) to remove reserves in anticipation of economic growth, with the result that
increases in inflation are, in our opinion, highly likely. Additionally, we believe the Fed
will keep short-term interest rates at 0% until there is a substantial improvement in the
unemployment situation. This means that short-term instruments such as money market
funds will continue to generate little or no return.
Moreover, many policy makers believe that inflation is a small price to pay for its
benefits. The benefits go, of course, to debtors and not to investors in debt. Inflation will
increase the nominal value of homes, making them appear more valuable relative to the
non-inflated amount of the related mortgage. All debtors will be repaying their debt in
less valuable dollars. Under the inflation scenario, bond investments will suffer.
Another consequence of domestic inflation will be the continued decline of the dollar
relative to foreign currencies. Companies with foreign operations will benefit from the
continued decline in the dollar.
We should not forget, however, that the Federal Reserve may err on the other side,
removing excess reserves too fast. Another similar scenario is that excess reserves stay
high but regulatory policies inhibit bank lending. Assuming a reduction in federal
government stimulus spending combined with the increases in taxes that is sure to come,
this could result in low or no economic growth with the real prospect of a another
recession. While we assign a lower probability to this outcome than the inflation
scenario, it is certainly possible. In such a scenario, short-term and Treasury interest
rates would remain artificially low while longer term rates on other bonds are unlikely to
compensate investors adequately for the increased risk. On the equity side, we see such a
scenario seriously impacting the businesses of smaller, more domestic oriented firms.
There is, of course, one other scenario: the Federal Reserve gets it exactly right. It
increases interest rates appropriately and drains most but not all the excess reserves as the
economy recovers, leading to real growth, improving employment and moderate
inflation. In this case, every investment asset will benefit, though some more than others
depending on the exact nature of the recovery.
We believe, however, that investors should position themselves to handle a less than
perfect policy response. Our recommendations are: (1) that debt investors stay with high
quality corporate or municipal bonds with short to intermediate (3-7 year) maturities and
(2) that equity investors remain well diversified among industries and favor larger,
financially stronger companies with well-established businesses operating throughout the
world.
Charles W. Schweizer
January 2010