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Bank Watch: The Dead Man's Yield Curve

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Beware the return of carry trades.

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"With the yield curve this steep, banks should be minting money." If one more CNBC commentator says that, I'm going to throw a brick through my TV.

Don't get me wrong; I understand the concept: Banks can, in theory, borrow from the Federal Reserve at 18 basis points (bps) (yesterday's Effective Fed Funds Rate), purchase 10-year Treasuries at 3.70%, and book the difference.

But I'd offer that the reality in our current banking system makes that concept more than ridiculous - at least for any meaningful amount.

To rewind the tape, a major contributor to our current banking crisis is exactly what TV pundits are now encouraging banks to repeat - what's known in the industry as "the carry trade." Borrow short/lend long and let the yield curve do all the work. And for those who may have already forgotten, this was done not just on bank and investment bank balance sheets, but through SIVs and structured commercial paper vehicles as well. A toxic combination of leverage and asset/liabilities mismatches, not to mention credit risk.

And what did we and the banking regulators all learn from this? Liquidity matters. And now more than ever.

So at a time when banks would really like to reload the carry trade in size, bank regulators are demanding more and more bank-investment holdings to be in cash or cash equivalents - the absolute other end of the yield curve.

Worse, the regulators are trying to wean banks like JPMorgan (JPM), Bank of America (BAC) and Bank of New York (BK) off the FDIC-insured debt-issuance program, demanding -- as a precondition to TARP repayment -- that banks demonstrate that they can issue large volumes of long-term uninsured debt. (And in this regard, I'd highlight Goldman Sachs' (GS) $1.0 billion reopening of its 10-year bond at 337.5 bps over the 10-year - or 7.50%. To these eyes, this is arguably a far worse reverse carry trade; borrow long at high spreads and do what with it profitably without taking either extreme credit or market risk?)

Finally, with bank transaction deposits yielding nothing, the average consumer is moving into CDs, trying to take advantage of that same yield curve that the pundits are suggesting banks exploit going the other direction.

The net of all of this is that there are any number of countervailing forces at work, making it all but impossible for banks to capture the opportunity at hand. And as yesterday's FDIC Quarterly Banking Profile highlights, even with all of the government's help to date driving the short end of the curve to zero, bank net-interest margins aren't expanding.

And in the case of smaller banks, they're continuing to shrink.
Position in SPY options and JPM
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