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New York | First a travel note. The Institutional Risk Analyst will be at the Structured Finance Industry Group (SFIG) conference in Los Vegas this week to participate in a discussion about permanent financing for MSRs. Please come say hello if you are attending this important event. And if you're really lucky, you'll meet former GNMA head and new SFIG CEO Michael Bright.
We’ll also be speaking at the Docutech event at the Phoenician later in the week about the outlook for interest rates, the Federal Open Market Committee and the mortgage finance sector. Gestational REPO anyone? Look forward to the discussion with Docutech CEO Amy Brandt and Americatalyst founder Toni Moss.
Last week the FDIC released the banking industry data for Q4 2018. Profits are steady, default rates are low but credit loss provisions are starting to rise. Interest expense rose 55% year-over-year to $37 billion in Q4, while income rose 14% YOY. The dollar rate of change in interest expense should catch up to income by Q2 2019. This data point regarding bank funding costs also reveals that the level of financial repression is slowly falling. The Financial Times defines the term financial repression thus:
“Financial repression is a term used to describe measures sometimes used by governments to boost their coffers and/or reduce debt. These measures include the deliberate attempt to hold down interest rates to below inflation, representing a tax on savers and a transfer of benefits from lenders to borrowers.”
We measure financial repression in the $17 trillion US banking sector, but you can impute a similar skewed distribution to other fixed income asset classes. The Financial Repression Index was first described in a 2018 paper ("The Financial Repression Index: U.S Banking System Since 1984"). In Q4 '18 it fell below 80% for first time since the 2008 financial crisis. Now "only" 79% of bank interest income is going to equity holders vs a bit over 20% for creditors such as depositors, lenders and bond holders as shown in the chart below.
Since the 1980s, bank depositors and investors have been the victims of significant financial repression as public sector debt balances have increased and interest rates have fallen to accommodate. Since the 1990s and particularly since the 2008 financial crisis, it is possible to precisely measure a dramatic shift in net interest income in favor of banks, their equity holders and all manner of debtors public and private. Prior to the 1990s, depositors, bond investors and lenders received the lion’s share of the interest income earned by banks, but today most of the flow is taken by equity.
The biggest beneficiaries of financial repression are governments. The trend toward providing explicit subsidy to debtors and particularly sovereign nations via Quantitative Easing or “QE” is a key component of financial repression. When some observers criticize the use of cheap debt to fund share buybacks, they are also reacting unknowingly to the effect of financial repression. Thanks to the Trump tax cuts, equity investors are getting an even bigger share of the interest income dollar from all enterprises.
But with the benefits of QE there are also costs beyond the permanent inflation of asset prices and lower asset returns. Though US banks and non-banks have received a significant subsidy due to financial repression, banks and other intermediaries have also suffered decreased asset returns as a result of the low interest rates policies and open market operations of the Federal Open Market Committee.
The clearly demonstrated diminution of income as interest rates fall would seem to conclusively refute the idea of negative interest rates as a valid policy tool, but instead economists persist in thinking that merely lowering the cost of debt can solve the challenge of employment much less price stability. Negative interest rates of course represent the confiscation of capital by a heavily indebted administrative state. Reducing the equity stock of a the private economy to feed the indebted public sector seems completely absurd but that is the substance of US monetary policy today.
At present, return on earning assets (ROEA) in US banks is moving sideways at about 83bp on $15.9 trillion in earning assets as shown in the chart below. This may be the peak in ROEA for this cycle. Notice that the ROEA was low during the inflationary period of the 1980s, then spiked to over 1% in the 1990s, but today is a good 20bp below the average peak earnings on the 1990s through 2008 period.
Of course, the same market dynamic that reduces income to depositors and bond holders also reduces the gross spread on loans, encouraging the use of leverage in all manner of asset classes. When you consider the clustering of investment grade rated issuers around the “BBB” cliff edge, it is pretty clear that monetary policies such as QE and negative interest rates are in direct conflict with the legal responsibility of the central bank to ensure the safety and soundness of banks and non-banks alike. Just how does one ensure financial stability while pouring gasoline on the fires of asset price inflation?
In the next issue of The Institutional Risk Analyst, Ralph Delguidice will be talking about the end of the carry trade and what it implies for the leveraged mortgage sector. Also, the next issue of The IRA Bank Book will be out in March, including the most recent IRA Top Ten list of banks, ranked by equity returns.
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