The following is a guest contribution from the analysts at Annaly Capital Management:
The problem with Fannie Mae and Freddie Mac was always that they served two masters, their public shareholders and their government charter. Satisfying the requirements of these two masters was sometimes in conflict and we now know the results were disastrous. Banks today face a similar conflict. They are trying to heal themselves after excessive risk-taking over the past few years and are likely preparing for even more problems down the road in their legacy portfolios, and at the same time their government regulators are urging them to lend more. FDIC Chairman Sheila Bair summed up the tension in an interview yesterday for Bloomberg TV: “There was too much credit out there…and some of that needed to be reined in, but we don’t want to recoil in the opposite direction. I am concerned now that only the safest loans are being made. And there needs to be on the margin some prudent, well-managed risk-taking to get the economy again going, especially with small business and commercial lending which are key drivers of employment.” (Emphasis ours.)
It is true that lending is down and that big banks are disproportionately responsible for the downturn. In the last six months through November, Commercial and Industrial loans (C&I) at large commercial banks fell 10.6%, twice the speed of small commercial banks, and in the last three months large banks’ C&I loan balances have fallen at triple the rate of small banks. In the last 12 months and six months, C&I loans at all commercial banks have fallen $274 billion and $162 billion, respectively, to $1.36 trillion. At the same time, banks are flush with more cash than ever thanks to the Federal Reserve’s liquidity push, creating a unique situation where banks have almost as much cash on their books as C&I loans.
While banks are ostensibly making only the safest loans, the public debt markets are picking up the slack. Investment grade bond issuance is $655 billion year-to-date, up 28% over last year. High yield debt issuance is $129 billion year to date, up 153% over last year. Last week was perhaps the busiest of the year for corporate bond and syndicated loan issuance. And pricing is attractive for the borrowers, particularly investment grade borrowers who can lock in 30-year money at attractive fixed rates. Consolidated Edison, rated A3/A-, issued $600 million of 5.5% bonds due 12/1/39, and Boston Scientific, rated Ba1/BBB-, issued $300 million of 7.375% bonds due 1/15/40. Below-investment-grade borrowers are selling new issues with yields ranging from 8% to 12%, mostly to refinance existing debt. So who is supplying all this credit? The three main lending sources are insurance companies, pensions and mutual funds, all seeking higher risk-adjusted returns, and they are getting it. Year-to-date returns through November for the Merrill Lynch High Yield and investment grade Corporate Indexes are 53% and 21%, respectively.
Banks have cash and are sitting on it because they are defensive and cautious (and perhaps they believe the Fed will drain it away at a moment’s notice). Companies needing to refinance and restructure their debt are finding capital, and at a fair price (indirectly benefitting from Fed liquidity programs). Investors are willing to lend because they are receiving attractive risk-adjusted returns. Eventually, banks will heal themselves and start lending again, and outsized returns in bond markets will get bid away.
Policymakers please note: There is nothing at all wrong with this picture.
Source: Annaly Capital
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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