Blame Ben, Not Jamie

I could write a whole post on whether this whole JP Morgan trading loss is being under or overstated but I won’t.  For the record, I think given that the $2bil loss, which is ~0.5% of JPM’s total capital, shows that the magnitude is being a bit overstated. Nevertheless, the concerns of the critics are reasonable.  Does Dimon even know what risks JPM is taking? How can the banking industry keep any semblance of credibility when the most conservative of the TBTF’s had a massive risk failure? I digress to my main point.

Wealth effect & impact of QE

It is well established that Ben Bernanke is a big proponent of the “wealth effect”.  That is, if the stock market is higher people “feel wealthier” and thus react accordingly.  The mechanism of this is also clear and straight-forward.  The Fed has purchased trillions of dollars worth of US Treasuries, Agency Debt, and Agency MBS.  How does it work mechanically? The Fed sends newly created reserves to banks and in return receives the securities.  So while no new “net financial assets” are created, fewer securities are in the financial system and a whole lot more reserves.  This is what many refer to as “printing money”.

As I’ve talked about here and here QE has undeniably pushed up asset prices.  We have 30yr current coupon Agency MBS with a yield under 3%, IG spreads at ~200bps, and higher grade non-agency MBS yields pushed down to 4-5% in some cases.  Let’s not forget covenant lite deals returning in the levered loan space.  Mortgage REITs have quintupled in asset size as investors salivate over 15% yields. (Hint: levering up 8x on a 2.75% asset which is hedged using swaptions is no slam dunk. These will blow up at some point).  No need to go on any further.  As my friend likes to say, this is the “great incredible paper chase”.

Amount of excess reserves is NOT caused by lack of lending

As we have gone over so many times, the quantity of bank reserves are determined entirely by the size of the Federal Reserve’s policy initiatives and in NO way reflects bank lending. The moral of the story is these reserves will be at SOME bank, only selling securities would “drain” these reserves.

Banks are in a pickle

Are there any negative implications of the QE policies?  The quantity of risk free securities is down (Fed owns ~15% of Agency MBS as well as USTs etc).  Banks and other institutions can continue to bid up the prices of these “risk free” assets but eventually they can also opt instead to earn IOER of 25bps at the Fed.

Why do banks need to follow suit with this yield chase?  The are attempting to save any sort of profitability as measured by ROA and/or NIM.  One major reason that NIM (net interest margin) is under pressure is that banks have already lowered the cost of their liabilities as much as possible. You probably realise your bank pays you little/nothing on your deposits.  Now that they already pay little on deposits, lowering their cost of funds/liabilities any further is no longer material.

The obvious next step to saving NIM is making it up on the asset side.  Assuming growing loans/increasing pricing isn’t feasible today, banks are attempting to save margin in their investment portfolio.  With the Fed pricing many banks out of the Agency MBS & Treasury market, they are forced to either take on greater duration (interest rate risk) or go down in the credit spectrum (credit risk).

Ben, you had to know this was coming

Some institutions are buying longer bonds, and others are returning to structured products such as non-agency MBS and CMBS.  Other banks afraid of taking on credit risk are buying long duration bonds which exposes them to great amounts of interest rate risk in a rising rate environment.

Banks are starving for interest income due to the ZIRP environment.  The Fed has fundamentally propped up these markets and  forced banks among others to either invest at inflated prices or go chase credit.  Guess what Bernanke wanted and guess what is happening?

Bernanke is not responsible for risk failures at JP Morgan or any other TBTF bank.  BUT, he certainly has fostered an environment that has encouraged investors (which includes banks) to take on risk due to their meager alternatives.  Risk has crept into an area that is typically conservative on many levels.

It is said that the job of a central bank is to pull away the punch bowl before it gets out of hand.  While the Fed pays close attention to inflation, it has left the punch bowl out in the chase for risk assets and is contemplating spiking it even further (QE3).

How will this end?  Should we expect that revelations such as the JP Morgan trading losses will not occur given such policies?  A chase for risk is what the Fed wanted, only the intention was not for it to occur at banks.

This one’s on you Ben.

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