Thursday, October 1, 2009

Banks Require Zero Cost of Funds

It's well known that commercial banks have faced strong headwinds for the past several years. While banking commentators acknowledge that all of the problem mortgage loans haven't been foreclosed yet and commercial real estate problems loom, the industry has been saved by the combined action of the Fed and the Treasury. Share prices have moved dramatically upward off the fear induced bottom. Many seem inclined to believe that there is more upside to be had as long as the Fed keeps interest rates near zero.

Even with a very accommodative Federal Reserve, bank share prices will not stabilize at higher prices. Earnings power is becoming an issue. Where investors were once willing to celebrate the lack of failure and push shares up, they will shortly start to concentrate on what can banks earn with more capital, less leverage, a changed fee and expense structure, and examiners breathing down their backs. The answer is going to be that banks will earn substantially less than at their peak earnings.

Zero interest cost for overnight funds is necessary to offset the following:
1. Continued Loan Loss Reserve funding so mortgages can be foreclosed, HELOCs and credit cards can be written off, and commercial real estate loans restructured. Cummulative LLRs are not adequate to avoid future provisons on a grand scale.
2.Reflecting the above, the FDIC must be refunded and the two year advance premium payment the banks are now required to pay, even with the funny accounting treatment, will impact the banks ability to lend.
3.Regulatory changes in credit card rate changes will start to impact P&Ls.
4.The same will be true for Overdraft Fees, a major source of income for banks.
5.With quality loan demand slack, investment alternatives are not carrying high yields.
Treasuries and Agencies barely exceed overnight funding costs which has pushed bankers into GinnieMaes to find yield.
6.Finally, Regulators are behaving excessively tough on existing portfolios and requiring more reserves for a growing number of loans that are being classified as "substandard". Pressure is not inducive to extending new credit.

Earnings are apt to be "substandard" for banks for the next several years.

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