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Bernanke's New Dance Is Called 'The Tighten Up'


In actuality, the only thing that matters is whether or not the bond market is tightening.

The Fed releases information about the commercial banking system balance sheet composition in their weekly H.8 report. Studying this report provides some very interesting trends that would suggest QE has not had the desired effect in stimulating credit creation.

The asset side of a bank's balance sheet is primarily made up of credit assets which are the sum of loans and securities. As of the week ended 5/29/13 total banking system credit was $10.022 trillion consisting of $7.282 trillion in loans and $2.739 trillion in securities. The result is a record low loan-to-deposit ratio with banks holding a historical high percentage of assets in securities. These two metrics are not indicative of a robust lending environment to say the least.

Bank Loan to Deposit Ratio Vs. Securities

In the 30 years between May 1973 and May 2003, total credit assets grew by $5.262 trillion, consisting of $$3.845 trillion in loans representing 73% of the credit growth and $1.416 trillion in securities representing 27%. Between May 2003 and May 2008, during the five-year credit bubble, total banking system credit grew by $3.128 trillion, consisting of $2.638 trillion in loan growth, representing 84.5% of total credit growth with only $489 billion in securities representing 15.5%.

In the five years since May 2008, total credit has grown by $1.014 trillion with loan growth consisting of only $357 billion or 35% of total credit growth, while securities have grown by $657 billion, representing a whopping 65% of the total credit growth. Breaking down this same period since August 2010 when QE II was announced shows how MBSs have grown to take a larger share of bank credit assets. Of the $818 billion in credit growth since QE II was announced, MBSs have accounted for $318 billion of the $361 billion in securities growth with loans representing a mere $457 billion. That is remarkable.

Since the initial QE III targeted MBSs, banks backed off a bit, and with total credit growing by $235 billion, MBSs have only accounted for $23 billion of the $96 billion in securities. However it is notable that most of this MBS purchasing has occurred in 2013, and when you break down the YTD allocation of securities, the results show that MBS purchases remain a major allocation for bank credit.

Total bank credit has only grown by $17 billion YTD broken down into loan growth of $14.8 billion and securities of only $2.3 billion. The securities portfolio can be easily broken down into US Government securities including MBSs and Non-MBS agencies and Other securities. Of the $2.3 billion, the Treasury breakdown reflects a $26 billion increase in MBSs and a $43 billion decrease in Non-MBS agencies for a net negative $17 billion. The Other securities classification grew by $19 billion, which gets you to the $2.3 billion net number.

This breakdown highlights the aforementioned reinvestment risk banks have been facing during QE. The decline in Non-MBS agencies was likely not sales but rather redemptions in the form of maturities and calls. Ideally, in a robust lending environment the $43 billion in proceeds would have been rotated into loan demand, but banks have instead opted to buy bonds. In fact, the YTD $26 billion increase in MBS holdings exceeds the $14.8 billion in total loan growth. Again this is remarkable.

Despite an exhausting and unprecedented attempt by monetary policy, the data does not show that QE has had any positive impact on stimulating bank lending. Arguably, the bigger impact of QE has been increased balance sheet risk in the banking system. This dynamic has no doubt been at play with recent pressure in the MBS market, which has borne the brunt of the rise in real yields.

When the Fed opted to forgo an extension of QE II in June of 2011, the risk markets responded with a vicious unwinding of the reflation correlation trade, producing a massive flight to quality that pushed bond yields to record lows. This rally provided a nice windfall for banks as their unrealized gain on portfolios nearly doubled in two months from $17 billion at the end of July to $32 billion in September.

Throughout 2012 this gain continued to rise, and when QE III was announced, MBS yields and spreads collapsed the unrealized gain peaked at $43.5 billion in October. During the 2009 financial crisis reversal this line item showed an unrealized loss of over $50 billion, so this was a big swing for the banking system's capital position. However, what the bond market giveth, the bond market taketh away. Friday's H.8 release showed the unrealized gain had declined by 32% to $29.4 billion representing only a 1.07% profit cushion on the $2.7 trillion securities portfolio.

What gets lost in the cost benefit analysis of QE is that the benefit to the borrower in lower interest rates is a cost to the lender in lower coupons. The negative real rate regime has not induced lending and banks have continued to increase their allocation to securities. To complicate matters, the length of the program has, in effect, loaded the banking system full of their largest allocation to securities at the highest price with the most market risk. As much of a benefit QE was on liquefying capital in the banking system, as yields fell, there is potentially a greater cost in how the resulting low coupons will make this capital exponentially more illiquid as yields rise. This is Bernanke's Pyrrhic victory.

Between now and the June FOMC meeting, you are going to hear a lot about whether the Fed is going to taper QE, by how much, and when. You are going to be told that tapering isn't an exit from QE nor is it a tightening of monetary policy. Well none of that matters. The only thing that matters is whether the bond market is tightening. In a relatively short period of time, and with no change in monetary policy, the bond market has raised real interest rates by nearly 100bps. This has been a rapid tightening of credit conditions, and if I am correct, then it won't take long for this tightening to filter through the banking system and in into the real economy.

Twitter: @exantefactor
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