Ramblings of a Portfolio Manager

“Dude, you’ll need a different board to catch a phat ride without a rad curve!”


It’s been nearly two weeks since the Federal Reserve last met and made the historic pronouncement of their intent to start purchasing long-dated treasuries with the runoff from their maturing MBS portfolio. Since that decision the Dow and S&P500 have fallen roughly 5% each. Harder hit, however, have been the bank stocks, which have fallen 8% as expressed by the Keefe Bruyette Bank Index, and small cap stocks with the financial-heavy Russell 2000 Index also down 8%. Thanks guys!

We opined last week on the reasons for the market’s ill take on the Fed’s decision so we won’t repeat it. Rather, we question whether the market is “getting it” in its negative view on bank stocks in particular and by extension, equities in general. The conventional wisdom of the portfolio manager is that the flattening of the treasury yield curve from the Fed’s actions will crimp bank earnings—particularly in the current environment in which most banks have been “surfing the curve” by using their near zero cost of funding (from Fed Funds, negative real rates on time deposits after fees and pitiful CD rates) to reinvest in long-dated, risk-free treasuries. We don’t disagree--with a steep yield curve, the banks were literally printing money with little risk given the Fed’s promise to hold short-term rates low for a very, very long time. Now, however, that little game seems to be over and with the other arm of the Government rushing to “help” with the Financial Reform bill, estimates are that earnings of banks and other financial institutions will fall significantly (25% or more by some estimates). Where we disagree is with the extension of the conventional wisdom to encompass the belief that this will dampen the incentive to lend, thus weakening the economy. We lost count of how many PMs appeared on TV over the last two weeks with a statement to the effect of “the market cannot recover without the banks leading the way.”

It’s been too short a time to analyze bank balance sheets to determine whether the Fed’s decision has made any substantial change in Management behavior and it could take up to a quarter or so for the information to work its way into financial statements. In the short-term, however, we can see the immediate effect on consumer behavior and at the end of the day, that’s what we all care about anyhow. Last week, mortgage refinancings were up 16%--an immediate reaction attributable to the rapid drop in long term rates. That little blip alone should put substantially more money in the pocket of the beleaguered consumer, more than whatever new fees the banks might extract thanks to Fin Reg. That’s a net positive to the economy. But what about those banks? Will a flat curve hurt them? We believe the Fed’s actions were designed to do just the opposite. By flattening the yield curve, the Fed did two things, both of which were intentional: First, it brought down mortgage rates, a shot in the arm to the ailing housing market. Secondly, it sent a message to the banks that the risk-free surfing is over and that’s a good thing. If bank Management wants to stay employed and appease shareholders, they’re going to have to find new sources of revenue. One, as we mentioned, will be to raise fees to depositors, but we feel the lower long-rate environment will more than make up for that in consumer wallets. The other is to boost net interest margin by reaching for yield—that is, by taking some risks like making loans or even buying MBSs themselves. In the latter case, the banks would be taking over the Fed’s recent job (the market didn’t like the Fed’s decision to stop MBS purchases), driving mortgage rates even lower, and in the former they would actually be spurring on economic growth. Either action would be good for the housing market, the overall economy and, ultimately, for the equity markets. We just need the Obama Administration to get out of the way and let the banks do what they do best.