Some Banks Are Stretching For Risk

According to Matt Wirz in his article “Banks Apply Lever to Cash Positions” in the Wall Street Journal, this morning (http://professional.wsj.com/article/SB10001424053111904103404576559100934308730.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj) some commercial banks, generally the larger ones, are stretching for higher yields by taking on more risk.

I have recently discussed this problem in several posts (http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will, and http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation) and how it is related to the current policy of the Federal Reserve to keep interest rates at such low levels for the next two years.  Basically, commercial banks cannot earn the interest spreads they need with the term structure of interest rates being so flat.  And, any effort to achieve an even flatter yield curve through an “interest rate twist” policy will just exacerbate the situation.

With the term structure so flat, what is a bank to do? 

Rely on fees?

For an answer to this question see my recent post (http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future). Given the recent volatility in financial markets, larger banks are experiencing substantial shortfalls in trading and investment banking activity which is resulting in much lower fee income than in the past year or two.   New regulations are also resulting in lower fee income.

So with other sources of income shrinking, some banks are turning to higher risk loans in order to gain higher returns to “goose up” earnings.

According to Wirz, “Much of the lending is taking the form of so-called leveraged loans.  They are floating-rate loans made to companies with ‘junk’ or non-investment grade credit ratings, and typically used to finance buyout deals or refinance existing debt.”

In August, for example, leveraged loans totaled $36 billion, a small monthly amount for this year, yet the junk bond market and the IPO market only produced $2 billion combined. 

Wirz states, “there are signs that the risk in this line of lending is rising.  The large leveraged buyouts that banks arranged in the first seven months of the year carried 14 percent more leverage than those underwritten in the same period of 2010…That puts leverage on current deals on par with those financed in 2006, but below 2007 levels.”

Another type of risky loan, called pro-rata loans, is made to “stronger companies with junk ratings—typically rated BB—to boost interest earned…” This type of loan, through July of this year, is already up 16 percent from all of 2010.

Do we have here a case of the “law of unintended consequences”?  The Federal Reserve, in its fear that it will not do enough to prevent a double-dip recession, may be creating an environment that will result in outcomes that, over the longer-haul, may not be what it would like.

It is a good thing to get banks lending again and to get the economy expanding.  However, the loans that are being discussed in the above-mentioned article are not going to economy expanding business investment.  There are plenty of articles elsewhere that indicate there is not a robust amount of demand for loans on the part of businesses, especially those that deal with small- and medium-sized banks.  And, many small- and medium-sized banks are not that anxious to make more “new” loans, given the state of their balance sheets. 

Do we want banks to be making risk-stretching loans for the purpose of financing buy-out deals or refinancing existing debt?  

Historically, we see that this is not the way that the economy usually achieves more rapid economic growth.  Historically, additional risk taking is connected with periods of credit inflation.  Much of what the Federal Reserve has done in recent years, especially the execution of QE2, can be classified under the title of credit inflation. 

And, credit inflation is what we have experienced for the past fifty years!

The consequences of this credit inflation?

Higher rates of under-employment, unused manufacturing capacity, greater income inequality, a busted housing system, and sagging morale. 

Credit inflation does not result in improving productivity but instead results in speculation and bubbles.  As we have gone through the past fifty years, this is exactly what we have gotten…slower economic growth…and more financial innovation and risk exposure. 

Seeing commercial banks beginning to stretch for risk at this stage of the economic recovery is, to say the least, a little disconcerting.