Saturday, March 21, 2009

The Fed Is Sowing The Seeds For Our Next Banking Disaster

Banking should be conservative and rather boring. It shouldn't be a place for extraordinary returns and aggressive risk taking. There should be more thinking and less algorithms in bank credit decisions. If our current credit meltdown doesn't teach us a long term lesson our future will evolve into a very unstable, rough ride.

The old banking saw was the 3-6-3 rule: pay depositors 3%, lend the money out at 6%, and be at the golf club by 3 o'clock. That 3% net interest margin, more like 4% in recent decades, didn't allow for many lending mistakes. Significant losses were hard to make up when you only earned 3-4% NIM. Bankers knew this and behaved. Earnings came slowly and incrementally. Mistakes caused an increase in loan loss provisions, greatly reduced net profits, and several years of pain and stagnation. Bankers said NO to questionable deals.

After a decade of behavior modification and an abandonment of the above mindset, banks should be embracing their former practices. They may see the wisdom of returning to their roots and be scared to death by the ramifications of their past actions, but the Federal Reserve is pushing them toward a encore performance.
Instead of a normalized interest rate structure, the Fed has pushed funding costs to a very low level with resulting net interest margin growth. Restraint in lending will be short lived. Net interest margins of 5-6% will induce another round of credit card, mortgage, and business lending. Exactly what the politicians and news media want to see happen. Getting the banks to lend again. But they shouldn't. However, large margins get the braintrust salivating and reinforces the belief that you can underwrite loans with an acceptable level of losses since the interest spreads are so favorable. Unfortunately, bad credit is bad credit and while a lender may be able to absorb stupid decisions for awhile, the environment can change and here we go again.

Not only is the Fed destroying the fruits of years of thrift by savers, through miniscule interest rates on deposits and money funds, they are encouraging bankers to repeat their mistakes in the name of restarting lending to energize the economy. Banks will lend if the pressure becomes intense enough and if the margins grow large enough. We shouldn't want them to.

At present there isn't huge loan demand from credit worthy individuals and businesses. However, there is considerable demand from the uncreditworthy and companies that would facilitate that lending. But, that group is at the heart of our current problems. Selling homes, cars, tvs, and vacations to those that can't afford those items is not a worthy endeavor. Especially since amazing numbers of borrowers are walking away from homes, credit cards, and home equity lines of credit. Not paying has become easy and will not be forgotten by borrowers. Lenders, and the Fed, appear willing to forget.

We may avoid the nationalization of American banks this time around, but if margins become large and banks, once again, under the influence of politicians and the Fed, rationalize the extension of credit to those that do not deserve it then we will all get our loans from the government after the next meltdown.

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