End of Easy Bank Profits? Not a Chance!

The NYT reports that Fed Move May Signal End to Easy Bank Profits:

Federal reserve to Wall Street: The days of easy money — and, just maybe, easy profits — are numbered, Graham Bowley and Eric Dash report in The New York Times.

News on Thursday that the Fed would raise the interest rate that it charges banks for temporary loans was seen by lenders as a sign that their long, profitable period of ultralow rates was coming to an end.

The move suggested that policy makers believed the nation’s banks had healed enough to withdraw some of the extraordinary support that Washington put in place during the financial crisis. And, while all those bailouts stabilized the banking industry, it was low rates from the Fed that helped propel banks’ rapid recovery.

Even though the Fed had telegraphed its intention to raise the largely symbolic discount rate, the timing of the move, coming between scheduled policy meetings, caught some economists by surprise. Stocks and bonds sank in after-hours trading, suggesting Friday could be an anxious day for the markets.

“This is a victory lap by the Fed,” Zach Pandl, economist at Nomura Securities, said. “It is a signal that the Fed is very confident in the health of the banking system. Fundamentally, these actions are a sign of policy success.”

Since the crisis, the Fed has nursed banks back to health with extraordinarily low rates. Banks have been able to borrow money cheaply and put it to work in lucrative ways, whether using the money to make loans at higher rates or to trade in the markets.

The difference between short- and long-term interest rates is near a record high, presenting a profitable opportunity for banks. The difference between two- and 10-year Treasury rates, for instance, is about 2.9 percentage points. Buoyed by such policies, banks’ profits — and banking stocks — have rocketed over the last year.

Many economists said banks were no longer borrowing in large amounts from the Fed using the discount rate, and so the move on Thursday was, in a sense, purely technical.

But it was a sign that the threat of a collapse in financial markets — so real just a year and a half ago — had dissipated. Some economists said that, with unemployment high and the economy growing slowly, the Fed would not be raising the more important benchmark interest rates for some time.

“This does not say anything about interest rates, but it does say something about what has happened on the ground, that the financial industry is not under same stress as it was previously,” Frederic S. Mishkin, a professor at Columbia and a former member of the Fed’s board of governors, said.

Others countered that the move at least brought forward the moment when interest rates would begin to rise again — and put an end to the banks’ period of easy money.

Louis V. Crandall, chief economist at Wrightson ICAP, said it demonstrated “a willingness to entertain an early start to the real business of retreating from the Fed’s very accommodating stance.”

Unnerved by this prospect, at least in the short term, the bond market fell after the Fed’s announcement, driving up the yield on 10-year Treasury notes about seven basis points, or seven-hundredths of a percentage point, to 3.8 percent.

Stock futures also fell in after-hours trading. Financial shares were particularly hard hit, with shares of big banks like JPMorgan Chase and Bank of America each falling about 1 percent.

The uncertainty over what the Fed will do next, and when, is a big worry for bankers.

“It creates real havoc in managing a bank when you have to ride through these cycles when interest rates change rapidly,” said Douglas J. Leech, the chairman and chief executive of Centra Bank, in Morgantown, W.Va.

Many banks are still coping with bad mortgages and other loans. “This poses a new threat,” Mr. Leech said.

Rising interest rates will invariably squeeze banks’ profit margins and reduce the value of some lenders’ own investments. Taken together, those developments will hurt banks’ bottom lines, a particular worry for the many small and midsize banks that are struggling to cope with the weak economy.

Many banks have tried to prepare for an inevitable rise in rates by locking up customers’ deposits, which provide a stable source of funding for loans. Centra, for instance, began extending the term of its certificates of deposits to 16 months, from 12 months, last year. The bank also began offering low-rate loans that it can reset at higher rates in 18 months, in case, as Mr. Leech expects, interest rates rise.

The stock market dipped Friday morning and then climbed back up to close marginally in the green. It was another option expiration blowout.

Does the Fed's move signal hard times ahead for banks? Absolutely not. As I mentioned yesterday, the U.S. recovery is not just fluff and policy remains highly accommodating. Jon Najarian was on Tech Ticker on Friday saying that the money machine is still hot:

Given the rate hike came on the eve of options expiration and after a 3% rally in the S&P 500, Najarian says the upside bias Friday is notably bullish. That's even more so given the bears have been saying the market would tumble at the first signs of the Fed starting to slow the easy money gravy train.

"The bears have got the bad news that they want and they haven't been able to drive" the market down, he says.

Similarly, Najarian says the conventional wisdom that the Fed's action is negative for the banks is overstated, and misses a crucial fact: The yield curve remains very steep, meaning the difference between short- and long-term rates is very wide. As long as that's the case, banks have a "money machine" at their disposal, he says. "I don't see dramatic downside action in the financials [and] I'm not looking for that."

Najarian is long Goldman, Wells Fargo, US Bancorp and JP Morgan, albeit with hedges as he's expecting the group to remain range-bound for the time being.

The trader and CNBC contributor has the same outlook for the market as a whole, barring an upside surprise on jobs or a negative shock from Iran; Mahmoud Ahmadinejad is a bigger "wild card" for investors right now than Ben Bernanke, he says.

Earlier this week, Martin Roberge, Portfolio Strategist & Quantitative Analyst at Dundee Capital Markets wrote that the M&A revival has begun!:

Non-financial companies have built enormous cash balances over the last few years owing to global economic uncertainties freezing corporate spending activities. With the confidence of corporate CEOs now recovering, the size of recent M&A transactions suggests that this hoard of cash is ready to be redeployed, which should act as a support for broad equity markets over the balance of the year.

Yesterday in the fertilizer sector, Terra Industries agreed to a friendly takeover by competitor Yara for a $4.3B all-cash bid. Also, Simon Group Properties (a shopping-mall operator) made a $10B offer to acquire General Growth Properties, including $9B in cash. Obviously, these sizable “cash” transactions have sparked an M&A revival that is likely to continue for the balance of the year with the most recent reading in US CEOs confidence (64) returning to a 5-year high.

As we reported in our Winter 2010 Strategy Report earlier this year, global non financial companies generated a record $3.6 billion in free cash flows (FCF) in 2009 (Chart above, 1st panel). As a percentage of enterprise value (EV), the FCF yield for global non-financial companies increased from 8.2% in 2007 to 10.3% in 2009. A high FCF yield not only means excess cash on companies’ balance sheets that could be used to 1) buy back stocks or 2) increase dividends, but 3) it provides fundamental value for potential acquirers. Interestingly, Canada represents a land of opportunity as the 11.7% FCF yield of the S&P/TSX non-financial index is the highest among G7 countries.

At the sector level, the biggest FCF generators and FCF yielders are energy, industrials, consumer discretionary and telecom (Chart, 2nd and 3rd panels above). While telecoms (15.6% FCF yield) offer few M&A opportunities, it is the best positioned to increase dividends among all sectors which is why it is our favourite defensive play. As for energy and industrials, M&A transactions are likely to take centre stage as these two industries remain highly fragmented still.

Bottom line: Yesterday’s sizable cash takeover offers sparked a much awaited M&A revival. With non-financial companies sitting on enormous cash balances and CEO confidence building higher, expect more M&A transactions in 2010, likely to involve bidding wars and “white nights”. Finally, share buybacks and/or dividend increases should become more frequent. These are all supportive factors arguing against a renewed equity bear market.

The M&A revival will bring additional fees to big banks, adding to their bottom line. So don't shed a tear for banks; the money machine is still hot and banks will continue printing profits as the Fed raises the discount rate and will continue even after the Fed raises the key Fed funds rate.

Finally, banks are still making a killing on prop trading and OTC derivatives. On that subject, please take the time to watch PBS Frontline's show, The Warning. It aired Friday night (first aired back in October 2009) and is absolutely brilliant. I also embedded it below.

Very few people know that it was under the Clinton administration that deregulation of OTC derivatives really took off. Years of speculative activity led to the last financial crisis. I quote:

"We didn't truly know the dangers of the market, because it was a dark market," says Brooksley Born, the head of an obscure federal regulatory agency -- the Commodity Futures Trading Commission [CFTC] -- who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country's key economic powerbrokers to take actions that could have helped avert the crisis. "They were totally opposed to it," Born says. "That puzzled me. What was it that was in this market that had to be hidden?"

We now know what was in the market that had to be hidden. Financial garbage with AAA ratings. After watching that episode, I came away admiring Brooksley Born for her principled stance and her dire warning at the end of the episode is absolutely correct. As long as we allow banks to continue printing profits by taking stupid risks, the next financial crisis is only a matter of time.