Systematic Relative Strength

Bank stocks have recovered substantially from their lows. Yet according to a report from Moody’s, excerpted here in the Financial Times, banks could have significant funding problems going forward.

There are several problems. First, banks now have very short debt maturities. It’s not a good idea to fund a long-term asset with short-term liabilities, so their funding costs may go up just as they move out on the yield curve and issue longer-term paper to redeem short-term debt as it comes due.

A bigger issue, though, is what happens to bank funding costs if government supports are removed. The Financial Times summarizes it like this:

And just to get really wonky — here’s a demonstration of that increased funding cost:

Suppose, a Baa-rated bank had issued short-term debt under an Aaa-rated government guarantee programme and had been paying a coupon of about 1.3 per cent. It would need to pay a 7.75 per cent coupon for issuing a 10-year bond on its own today — a 645bp increase. The same move by a Ba-rated bank would result in a 929bp increase. Considering that the issuance of Aaa-rated government-backed unsecured debt for banks globally (ex-US) is up 23 per cent, while issuance without government backing is down 22 per cent — you can get a sense of just how much money banks have actually been saving due to the guarantee programmes.

Those government-guarantee programmes around the world will of course expire in coming years. At the same time you will also probably get a wind-down of central bank asset purchases and further regulatory pressure on banks’ capital — all of which means significant upward pressure on banks’ funding costs, at a time when many will still be dealing with copious amounts of bad debt, according to Moody’s.

It looks like the government supports are going to need to be around for quite some time, at least long enough for the banks to clear most of the bad assets off their balance sheets.

The world economic system is kind of like a giant beanbag chair. If you smush down the chair in one spot, another area bulges out. By distorting the banking situation-and policy makers may have no choice-it’s going to cause distortions (oh, what the heck-bubbles) in other areas. We may not know what the distortions will be yet, but there’s usually a way to identify and profit from them if you have an adaptive, systematic investment process in place.