An Ode to George Bailey, Credit in a Banking-less World and How Much QE Is Enough

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There was a time not so long ago when many high-traffic count intersections in America were home to a Savings and Loan Association. To many of us, an S&Ls is still visualized in the image of the Bailey Building and Loan Association as captured in the cinema version of “It’s a Wonderful Life.” If you missed it, it will no doubt re-run this Christmas. It always does.

Considering how many Americans resent banker bailouts, it’s difficult to imagine that a sentimental movie capturing hard times at a building and loan association could garner six Academy Award nominations. But it did. More astonishingly by today’s perspective, the movie is ranked number one on the list of America’s most inspiring movies. Those were the days when a lending officer such as George Bailey who cared about his clients was pure American apple pie.

It turns out Bailey’s Building and Loan was not the only S&L to bite the dust, as the industry has imploded from 12,804 institutions in 1927 to barely 500 today. Since financial institutions are “institutions,” something rather dramatic must have happened for them to become an endangered species.

Well, a glance at today’s high-traffic count intersections reveals that commercial banks have expanded into many of the same physical locations vacated by the S&Ls, but they too will eventually find themselves an endangered species for the same reasons the hometown S&Ls bit the dust.

The reason is really quite simple: The government doesn’t want to cover their losses anymore.

What both species of institutions have in common is, decades apart and for different reasons, they both took large hits to their asset values, and the government’s financial safety net required bailouts. These bailouts came in the form of either deposit insurance payouts or subsidies to the banks to prevent large-scale deposit insurance losses. This is what TARP and the Fed’s QE were all about.

What happened to the Bailey Building and Loan Associations, and what’s happening to commercial banks today, is that regulation has erected significant barriers and costs to both borrowers and lenders for the purpose of reducing the government’s exposure to future bank bailouts. Fewer loans and smaller guaranteed banks are preferred by a financially strapped government.

But when credit is deflected from regulated and insured institutions, entrepreneurs find new ways to fill the void in the financial marketplace. So long as borrowers wish to borrow and savers seek investment income, finance will take place. The question then is in what form this finance will take and how much will it cost. Also evolving is what we will call the “banks” or “building and loans” that take their place. Furthermore what will be the stylization of the financing documents or financial packages and whose newly created or expanded balance sheet will host these financial obligations?

It turns out that the demise of the S&L held mortgage loan was engineered around by entrepreneurs (mostly investment banks) who purchased residential mortgage loans and securitized them into financial packages that were dubbed some form of “mortgage-backed bonds.” The securitization part is important because many financial entities can only hold SEC-registered securities. Furthermore, to provide the newly created mortgage bonds with pedigree, rating agencies rated the mortgage bonds so that some third party could claim they were high quality.

This opened up the way for the erstwhile S&L mortgages to be packaged and held by a great variety of entities such as insurance companies, pension funds, endowments, and even commercial banks here and especially abroad.

Hence the end-run around the George Baileys of the world was complete.

Much the same is happening today to engineer credit around the commercial banks, whose hands are tied by post-financial crisis regulators to whom no loan is good enough. But in many cases, there are those with a less-jaundiced eye who tend to look more approvingly at the same loans or securities that banks must turn away from. This is the world of non-bank banks, which are sometimes characterized as shadow banks when less is known about them.

A good  example these days is United Development Funding, which itself is an SEC-registered non-traded REIT that is securitizing erstwhile bank loans to homebuilders at interest rates that range between 11% and 15%. The information on its latest offering and the details on the underlying loans can be found on pages 37-40 of its 3rd Quarter 2013 filing with the SEC.

What is most revealing is that homebuilders traditional were commercial bank clients, and the audacious rates paid for credit in these days of “zero interest rate” policy are an indication of how much borrowers will pay for funding, so long as it does not involve the regulatory costs, delays and burdens of the due diligence process imposed by post-financial crisis regulation. This barrier is better known as qualifying for a loan and is what bank credit restrictions do.

Investor access to be a funder in this market place is subject to broker dealer compliance review of the offering and investor suitability requirements so that the SEC gets into the business of regulating the non-bank bank financial offering primarily for disclosure and investor suitability rather than making a judgment on the credit quality of the underlying loans in the package.

The common shares of the non-traded REIT are distributed via participating registered RIAs, for example, from Beck Capital Management in Austin, TX where I learned of them. As a result, though with the usual caveat that this is a fact and not a recommendation, I find myself in the position of being a shareholder of the non-bank REIT in which the dividend rate has been upwards of 8% plus additional quarterly distributions.

Other non-bank banks include Business Development Corporations, CLOs, Money Market Mutuals, hedge funds or even open-ended exchange-traded funds or mutual funds. Some of the loan packages are leveraged, some are not, and there are combinations of either debt or equity claims against the packages of loans that investors can access.

An even more unusual species of the non-bank today is typified by Apple, Inc. In April of this year, the iPhone maker borrowed (for the first time in almost 20 years) $17 billion despite having a cash hoard of $147 billion on hand. The market cost of funds to Apple of 0.51% for its three-year debt securities, 1.07% for five years, and 2.41% for ten years proved too tempting to not stockpile yet more “cash” — which it no doubt quickly invested into higher-yielding securities.

This turned Apple into a non-bank bank as well as a manufacturer of techware. They are living on their interest rate spreads just like a bank does. Corporations with record cash of $1.84 trillion (or 7% of their balance sheets) have, in effect, become members of the credit-creating non-bank bank world.  Apple is not alone as this year corporate bonds issuance has surpassed $1 Trillion.

Today, the non-bank banks are in an ascendance, not just as a way to work around bank regulation, but also because the  massive QEs generate cash for those who sold their assets to the Fed . This provides the funding to either purchase corporate securities or other newly created financial packages, or to fund the non-banks’ ability to purchase the thusly created conduits.

So it’s no coincidence that the Federal Reserve Bank of New York recently estimated that the annual rate of non-bank credit creation was running $1 trillion per year, which essentially matches the annual rate of the Fed’s QE. This rate of credit expansion by all sources is found in the Federal Reserve Flow of Funds reporting with The Net Acquisition of Financial Assets in Q2, 2013 running at a $940 billion annual rate, just short of the annual rate of QE additions to the monetary base.

In contrast, commercial bank loans and leases — while growing at a modest rate shown to the left— have only offset the contraction experienced during the Great Recession.

A better indicator that banks have been constrained from the credit expansion mechanism is that banks’ loans and leases as a percent of deposits have dramatically declined as shown below.

If one were to view the Fed’s role as creating credit so that borrowers have the resources to invest or spend, the QEs have been effective as of late.

While it’s true that the non-bank banks cannot multiply the increase in the monetary base by “creating” deposit money at the good old multipliers of near 10, as banks could. This implies that to obtain the same credit creation by the non-bank banks requires nearly 10 times the amount of base money to finance the same lending and spending outcome via the non-bank banks and the securities market.

The same credit expansion without commercial bank deposit expansion is a very fundamental rethinking of our understanding of the economic and financial world.

Because the restraining bank credit regulation is the result of Dodd-Frank legislation, the Fed is basically offsetting the lending repression induced in the normal expansion of commercial bank lending.

Hence, paradoxically the Fed is providing ultra-low rates but in a great Catch-22, few can borrow.

The latest reports indicate that we are possibly on the verge of yet another mutation of the monetary response to the Great Recession.

The Fed is trial-ballooning another patch on the broken system of bank credit availability —  negative interest rates on bank cash holdings — as a perverse incentive to entice banks to make loans for which few can qualify.  If so, banks will likely respond with negative deposit rates to maintain their spread between assets and liabilities. In this case, savers will really migrate away from funding the dormant banks, and finance will further migrate into the shadows. It would amount to a regulatory Dark Ages of financial repression in which bank loans rates will be even tantalizingly cheaper, but no one can have one.

In this ode to the George Baileys of yore, there are important observations to be made:

First, credit creation is occurring, but it’s neither coming from the usual lenders, nor taking its usual form. It’s also not being captured in the usual monetary statistics.

Second, a $1 trillion per year credit expansion — which amounts to 7% of GDP — is sufficient to finance a cyclical economic expansion, so we are getting a GDP lift that is now showing up in the employment numbers. Credit expansion is taking place via the securitized route rather than bank loans.

Third, taking away commercial banks’ ability to ramp up credit with the usual multiplier (taught in undergraduate economics for six decades) due to lending (and capital constraints) requires an outsized central bank expansion to generate the same credit for an economy.

So the size of the appropriate QE needs to be evaluated in these terms, so long as banks are largely taken out of the credit equation and credit is pushed into the non-bank shadows.

Offsetting financial repression with indefinite QE is a second-best solution at best, but forcing a negative deposit rate on banks is straight out of the regulatory Dark Ages as it further shrinks the banking system.

A first-best solution would be to free banks from the yoke of financial repression, require them to play the game with their own capital (as opposed to government bailouts) as a self-regulatory device, and eliminate the smothering financial regulation that pushes finance into the shadows at usurious rates.

 

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