The Smaller Banks and Rising Interest Rates

The “sure” bet over the past year or so has been that the Federal Reserve would keep short term interest rates as low as they could for a long time.

In fact, the Fed told us they would keep short term interest rates low for “an extended period” of time, guaranteeing speculative bets on interest rates.

Long term interest rates have also been “low” during this time as liquidity splashed over from the shorter end of the financial markets to the longer end.

However, the spread between long term interest rates and short term interest rates have been very, very nice for a lot of investors and certainly, the bank regulators have not been displeased by the interest rate spreads that have been available to investors, particularly commercial banks and other financial intermediaries who have been able to build up profits to strengthen their institutions.

This spread has been nice for profits but this was not exactly all that the Federal Reserve wanted throughout this period of quantitative easing. In fact, the Fed was very clear that one of the main reasons it was engaged in quantitative easing was that by flooding the financial markets with liquidity, longer term assets, which under other circumstances proved to be very illiquid, could be disposed of when the markets were in a much more fluid situation. The banks were supposed to sell off a lot of their long-term or less-liquid long-term securities.

Furthermore, this would ease the pressure of “mark-to-market” accounting on the banks since such sales at prices closer to purchase value would allow the banks to escape the need to write down other, similar assets even though there was no intent on the part of the banks to sell the securities in the near term.

The larger commercial banks in the system took advantage of this interest rate spread in the earlier stages of the recovery to generate healthy profits and get themselves back on the way to greater solvency, with reduced regulatory oversight.

Then, the larger banks moved on to other things, once the regulators backed off and government money was repaid. The biggest banks are not nearly as mismatched as they were two years ago.

In my opinion, the interest rate policy of the Federal Reserve did more to help the biggest banks regain their “mojo” than did any other part of the bailouts. The Fed’s policy was a grand subsidization program carried out under the cover of helping to get the economy moving again.

The smaller banks, however, have not prospered from the quantitative easing. The maturity mis-match has allowed these smaller organizations to counter some of the enormous losses in commercial and residential mortgages they had to absorb.

But, offsetting these loses did not get the smaller banks back to a robust profitability and, since it was the only game in town, did not allow these banks to deleverage their balance sheets in the way that the larger banks did.

It was the “only game in town” because this maturity arbitrage was profitable, whereas the banks had a lot of bad assets to work out, and making new bank loans, in many markets, were either difficult in terms of finding credit-worthy borrowers or were not guaranteed profit-makers.

As we have seen, the smaller commercial banks in the United States have not been lenders over the last two years or so. Since July 2008, the smaller commercial banks have grown in asset size by about 5 percent, but the increases have come in cash assets and securities holdings. Interest rate arbitrage has been more important to them than initiating new loans, especially with so many existing loans to work out.

Total loans and leases at the smaller commercial banks peaked in February 2009, commercial and industrial (business) loans peaked in November 2008. Both of these categories have been on a downward trend ever since.

The smaller banks still suffer and continue to face the close scrutiny of the examiners in terms of their viability.

Thus, we are sitting on the edge of a rise in interest rates, both long- and short-term, and many of the smaller banks have not gotten out from under the cloud of the longer term assets they hold on their balance sheets.

Of course when interest rates begin to rise, short-term interest rates will rise faster than will longer-term rates and spreads will decline. But, with the specter of interest rates rising, selling long term securities will not be as easy as it has been to sell them over the past year or so.

The smaller commercial banks have benefitted over the past two years by the Fed’s policy of quantitative easing in the sense that they have been able to arbitrage long-term and short-term interest rates. It has provided earnings through the maturity mis-match and it has allowed the banks time to work out some of their assets, charging others off in an orderly fashion. But, this has resulted in few new loans.

As a consequence, the prospect for strong earnings in this sector is slim. The question then becomes, “What are the regulators going to do as the asset portfolios of these banks lose market value as interest rates rise?”

The Federal Reserve cannot continue to keep quantitative easing going, underwriting short term interest rates that are near zero! On this see my recent posts, http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation, and http://seekingalpha.com/article/262429-trichet-delivers-ecb-hikes-its-interest-rate.

Or, can it?

This would allow the smaller banks the opportunity to carry on with their interest rate arbitrage. However, what really needs to change for many of these smaller banks to survive the times is for real estate prices to rise enough so that the banks’ portfolios of residential loans and commercial real estate loans become solvent again.

We probably will get the rise in prices. But, will the rise really help the properties behind the banks’ problem loans?