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Written by Boris Schlossberg, Senior Currency Strategist

The Fed Pause – Its Not Just About Economic Growth

On the surface the US banking sector appears to be in tip top shape. At a time when the rest of the stock market is mired in range bound doldrums the Philadelphia KBW Bank index has posted a gain of 7.3% since the end of 2005 compared to a paltry 2.4% return from the broader S&P 500. While some investors worry that the broad slowdown in the economy will negatively impact big money center banks such as Bank of America and Wells Fargo, the market ignores these worries, rallying the stocks of both to record highs at beginning of August. Yet beneath the veneer of success reside nagging questions regarding the true health of the banking sector remain unanswered.  The Fed’s recent decision to take a pause in its interest rate hike cycle may have more to do with monetary officials’ private worries about the state of these bank’s balance sheets than about the state of economic growth in the broader economy.

Is ARM a Ticking Bomb?

The advent of mass marketing of home mortgages over the past several years introduced a variety of “exotic” products to consumers. The most common new mortgage held by millions of households in the United States is the payment option ARM (Adjustable Rate Mortgage) that allows borrows to pick from a menu of selections. Borrowers can choose to fully amortize the loan, pay interest only or opt for the most dangerous choice of all by paying only a portion of the interest payments due each month - known as a negative amortization loan.  In plain English this means that the size of the borrower’s mortgage actually increases over time because the unpaid interest payments continue to compound and accrue as liabilities. However, faced with escalating housing prices and stagnant wages, many US consumers have opted for the negative amortization option as a means of buying a home. Until now, most neg- amortization purchasers have enjoyed the benefit of rising house prices which allowed then to extract mortgage equity from their homes and in effect “grow out of their debts”. yet, with housing market cooling rapidly as days of double digit year on year gains clearly over, this strategy is no longer a viable solution.

As John C. Dugan, Controller of the Currency, recently noted,
 “The fundamental problem with payment option ARMs, other than the growing principal balance due to negative amortization, is payment shock. A traditional 30-year fixed-rate mortgage requires the borrower to amortize the principal balance through equal payments over the 30-year life of the loan. In contrast, a typical payment-option ARM is a 30-year mortgage that permits five years of negative amortization by allowing a borrower to make very low minimum monthly payments during that period. Beginning in the sixth year, the borrower must begin paying the full amount of interest accruing each month, and must also begin amortizing the increased principal over the remaining 25-year life of the loan. The combination of these factors can produce sharply increased payments in year six. For example, a typical payment-option mortgage of $360,000 at 6 percent can produce a monthly payment increase of nearly 50 percent in that year, assuming no change in interest rates. If rates rise to just 8 percent, the payment increase when amortization begins would nearly double.”

The doubling of monthly mortgage payments would of course send many of these already stretched-to-the-limit consumers into foreclosure, rapidly increasing the number of non performing loans for the banks. This is one reason that Federal regulators recently proposed new guidance with respect to these non-traditional mortgage products, trying to curb some of the lax lending practices that that have permeated the industry.

The Unintended Consequences of Sarbanes-Oxley

Yet in what is shaping up to be one of the greatest ironies of legislation gone awry the Sarbanes-Oxley bill, originally designed to protect consumers from such financial fiascos as Enron and Worldcom may be preventing banks from setting aside sufficient loan reserves against these possible defaults. In a recent article entitled “Has Congress Sparked a Banking Crunch?” MoneyCentral columnist Jim Jubak noted that “the Sarbanes-Oxley accounting reforms have made it just about impossible for banks to prepare for the credit cycle's turn. Accountants and the Securities and Exchange Commission (SEC) are applying Sarbanes-Oxley in a way that forces banks to cut reserves for delinquent and bad loans just when they need to put money aside for the rainy days that will come.” According to the interpretation of the Sarbanes-Oxley by the SEC, banks and finance companies are only allowed to put aside reserves against specific problem loans.  The reasoning by the SEC for this policy directive is that it will force the banks to provide a truer picture of their financial performance to investors because they would not be able to tap a large loan-loss reserve anytime a loan would go bad - a practice that in the past allowed banks to blunt the impact of such losses on the their current income statements. Yet by no longer allowing banks to put money aside for unallocated reserves, Sarbanes-Oxley has made financial institutions more, rather than less vulnerable to a potential shock to the system.

Rising Rates Shrinking Profits

Banks earn profits on the spread between long-term interest rates – what they charge borrowers who take out mortgages – and short term rates – what they pay in interest to their depositors. As the Fed raised short term rates from 1% in 2004 to 5..25% currently, the yield curve – the difference between the long term and the short term rates has flattened and even at times inverted (with short term rates yielding more that long term rates). A flat or inverted yield curve makes it much more difficult for banks to make money as the spread between the rates they must pay depositors and the rates they receive from the borrowers narrows considerably. Already, some cracks in the picture are beginning to appear. Suntrust, the 7th largest US bank, reported last week that it expects lower revenue growth as the result of interest rate pressures and increased competition. Suntrust, which operates primarily in the US Southeast – a booming market for residential real estate – also disclosed the existence of a $200 million problem loan. The loan, according to Suntrust Chief Executive Phillip Humann involved a large corporate client. Mr. Humann, however, did not specify the client’s line of business. As a result Suntrust stock declined nearly 4% on the day of the announcement and has traded lower since.

Mindful of Japan’s “Lost Decade”

Whether Suntrust’s problems are an insolated incident or a start of something far more serious in the US banking sector remains to be seen. One idea appears to be fairly certain however. The Fed Chairman Ben Bernanke is keenly mindful of the bursting of the real estate bubble in 1980’s Japan and the concomitant “lost decade” that followed, as that country was plunged into decade long deflation punctuated by three recessions before its banking sector was able to purge itself of all the massive non-performing loans on its books. Dr. Bernanke is adamant about not making the same policy mistakes in the US. Therefore, while the official policy line for the Fed pause may be the slowdown of growth in the overall economy, the real reason for the halt of monetary tightening may be due to concerns over the health of the banking sector. All of which could mean that fundamental economic factors may play a smaller role in future Fed policy making than the market currently believes and that the pause is likely to remain in place at least until the end of the year.