It should come as no surprise that banking is a cyclical business. After the bubble bursts, there is always lots of hand wringing and vows to be more rigorous in underwriting. Then the bubble refills and people start to worry more about losing market share to companies with less disciplined underwriting approaches. This leads to a free-for-all as everybody scrambles for market share by lowering their credit standards. The bad loans don't get paid back and the cycle starts anew.
In the past, the Fed has been able to recapitalize banks during the down times by cutting interest rates. Since banks were tightening their credit terms, the interest rates on loans remained high or got even higher. But with the lower interest rates, the amount that banks paid depositors immediately dropped. As a result, the spread between loan and deposit rates widened and the resulting net interest revenue helped to replenish banks' capital.
That is sort of happening now. Since the Fed cut rates from 5.25% to 2%, banks' net interest margins have widened. A look at Citigroup Inc.'s (NYSE: C) most recent quarterly statement reveals that between Q2 2007 and Q2 2008 its net interest margin climbed from 2.41% to 3.18%. During that same time, the average amount Citi charged for loans declined slightly from 6.41% to 6.21% but the rates it paid depositors fell much more -- from 4.42% to 3.30%. Unfortunately, I said it's sort of happening now because the wider spread is not generating enough additional capital to offset Citi's writedowns.
The good news is that Citi's net interest revenue -- the difference between what it earns on loans and what it pays for its funding -- climbed 26% for a total of $2.9 billion additional net interest revenue. The bad news is that the amount Citi set aside for bad loans grew much more and overwhelmed the gain from the wider net margins. Specifically, Citi's provision for credit losses spiked 167% -- by $4.5 billion -- which is almost one-and-a-half times greater than the increase in net interest revenue.
Unfortunately, this example grossly oversimplifies the problems facing many big banks. They have hundreds of billions of Level 3 assets, which lack discernible market value and overwhelm their thin capital bases. There are trillions of derivatives that have uncertain values and risks. And there are enormous off-balance-sheet entities that are complex and potentially costly.
But if this pattern at banks like Citi continues across the banking industry, it's easy to see that credit losses will win the race against wider net interest margins resulting from the low Fed interest rates. And this will make it harder for banks to keep their capital where it needs to be for them to make new loans.
How can we break this cycle of booms and busts for good? I don't know, but here's an idea.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
8-20-2008 @ 12:46PM
william lindblad said...
It is not a perfect world. If it were, the prospect of loan/interest difference would have an impact. Rate cuts and what is paid for deposit vs loss works, as long as the entire system in in alignment. As you say, it's competitive and when the others loosen standards the result is the present mess.
Even the interest on deposit accounts is highly competitive and people do move to greener pasture.
As to you previous "bubble" - all that is required to keep the system in good health is oversight and honest regulation.
Since this is lacking due to lobbyists, PAC's and the rest of the capitol hill buzzards the only thing sure is that they will pick our bones. The purpose behind government regulation goes way back to laissez faire, Tammany Hall & the Customs House. Adam Smith thought that monopoly and price fixing were prudent, but like many other theorists he forgot the human element and the corruption that accompanies it.
You speak of the "repeat cycle" and I agree wholeheartedly as 100% financing and the rest of the so called "liar loan" tactics are still being advertised en masse.
Barney Franks - where are you at???
(I know -in someone's pocket)