Wednesday, April 23, 2008


When the federal government cooperated in "saving the banking system" by killing Bear Sterns, it created a lot of mistrust. As David Kotok has noted, banks continue to hoard cash. Instead of lending funds to one another at the fed funds rate, many banks are quoting higher rates in order to reduce the amount of over night lending that they do.

The run on Bear Sterns occurred because the "sharks in the water" smelled blood. The remaining banks do not want to appear weak because they know that there could be the next Bear Sterns.

I am reminded of days at Merrill Lynch. My branch manager practiced the coal mine canary method of assuring a hard working sales force. Brokers are highly paid salesmen. My average earnings during the 1980's was around $280,000 per year. Still, my job was threatened a couple of times along the way. The way the canary system works is that ever so often the manager picks out one of the brokers who is near the bottom of the list of producers and fires him. He then hires a few trainees with hopes to find one good producer to replace the fired individual. In the meantime, three or four brokers who barely missed being fired work long and hard hours to get off the bottom of the list. The scramble becomes all the more intense if one of the trainees climbs above those who are near the bottom.

Now that the majority of mortgage loans have already reset, the increase in the foreclosure rate is slowing. There is already a dribble of write ups starting to occur as homes are sold or refinanced. The sales pace is slow relative to the past few years but still around 5 million units per year. As bank balance sheets are repaired, the fear of being the low bank on the list will gradually subside. In the meantime, good mortgage terms are available. Banks can and must make healthy lending deals and they are. In particular, commercial lending is still strong. The boom in US exports is causing an increase in US investment.

Politicians whine about foreign investment and, in almost the same breath, about trade deficits. Politically it may make sense for them to "have it both ways" but it is economically impossible to experience capital account surpluses and trade account surpluses. One of the questions we need to ask ourselves is would we rather have the Chinese lend us money at very low interest rates or buy more raw materials in order to produce more low priced goods? Do we want trade deficits or capital account deficits?

Equity is defined as assets minus liabilities. Working capital is the difference in current assets and current liabilities and, while it may sound good to have working capital that is equal to assets as a result of having no liabilities, this is not the formula for profit maximization. To maximize profits, a company and even a nation should take on debts that cost less than the returns available. If one can borrow at the fed funds rate of 2.5% and lend that money at a net price of 5%, then the profit of 2.5% was created out of thin air. The USA makes a lot of money by being in debt. No politician will try to explain that reality to you but it would not be wise for the US government to pay off all its debts. Our net interest cost is well below our earnings on those borrowed funds.

Today, extra large profits are available to thousands of businesses. Funds are available for the lending needed to expanded business and expanded profits. The banks are not maximizing their returns right now as they "protect" themselves from the federal sharks, but they are lending on very solid projects. The banks are taking care to spill no blood in the water but they are feeding well and building their strength. The market will not reward the gradual dribble of write ups anywhere near the way it punished the write downs but, over time, a great percentage of the losses will be recovered as an addition to normal profit margins.