The Fed Is No Longer Banks' Best Friend

No matter what it says, the Fed is worried about inflation.

Why doubt the central bank's repeated assertions that price pressures aren't an issue?

Well, Fed Chairman Alan Greenspan recently aired concerns about the banking sector that strongly suggested he wanted to cut the Fed's target interest rate by half a percentage point Wednesday.

Instead, the Federal Open Market Committee edged down the fed funds rate Wednesday by only a quarter of a point, to 3.75%.

Either Greenspan overstated his fears for the banking sector in his Senate testimony last week or the Fed is being disingenuous about inflation in Wednesday's rate- cut release, where it said: "The associated easing of pressures on labor and product markets are expected to keep inflation contained." It's mighty tough to reconcile both positions.

Looking at problems in the banking sector, and remembering that the Fed chairman has always moved quickly to aid the financial industry, Greenspan probably wanted to cut by half a point. Maybe other, more hawkish Fed members resisted such a big move.

Motivations

Though he can never say it explicitly, one of Greenspan's motivations for aggressively loosening monetary policy has been to create easy profits for the banks at a time when the sluggish economy has led to more bad loans and slower loan growth.

To a limited extent, he's gotten what he wanted. Banks have been quick to exploit the large difference between short-term and long-term interest rates to print profits. Their own borrowing costs have plunged sharply, and institutions with large capital markets exposure have made a killing from debt issuance and the interest-rate derivatives linked to that issuance.

However, all this could be short-lived. Such no-brainer gains will be much harder to reap in the third and fourth quarters as the Fed's medicine loses its power. In fact, with banks, as well as hedge funds, apparently all betting in the same direction, the potential for large trading and derivative losses has much increased if bond prices drop sharply. And Merrill Lynch's (MER Quote - Cramer on MER - Stock Picks) crushing earnings warning Tuesday shows that the equity markets aren't going to make up for a potentially problematic debt market anytime soon.

Just as important, credit quality isn't even close to a nadir and a good chunk of problem loans, in both the consumer and commercial sectors, are going to go bad no matter how generous the Fed has been. And most large banks are still significantly under-reserved against higher charge-offs.

The View

All this is on view at the nation's second-largest bank, Bank of America (BAC Quote - Cramer on BAC - Stock Picks), which has seen its stock soar this year as Fed largesse has shored up its profits. In the first quarter, the Charlotte, N.C.-based behemoth benefited massively from a lower interest-rate expense and buoyant trading profits.

Even though overall loans dropped from the fourth quarter and the interest it receives from loans slumped, the bank's own interest expense dropped by a cool $871 million, ensuring a hefty uptick in lending profits. And trading profits of $699 million in the first quarter were double those seen in the previous quarter.

So, how much further can banks' borrowing costs come down? At the end of the first quarter, Fed data show that banks were borrowing for three months at 4.7%, down a lot from 6.21% at the end of 2000. While that rate has continued to fall in the second quarter -- it was 3.56% on June 25 -- the magnitude of the drop is less. What happens if bank borrowing rates don't fall from here? Institutions like Bank of America will have to start growing their balance sheets -- even if reasonable quality borrowers can't be found.

As for credit quality, banks in general remain underprotected. For example, UBS Warburg analysts recently estimated that, on a risk-adjusted basis, Bank of America is a stunning $2 billion underreserved. That might just be tolerable if most of its bad credits had been worked out, charged off or sold off -- and the economy was about to take off.

However, a good number of loans arranged by Bank of America are trading at substantial discounts on the secondary market. It's no surprise that the bank staunchly opposes a Goldman Sachs (GS Quote - Cramer on GS - Stock Picks) proposal that all banks carry loans at their market values. Bank of America didn't immediately comment. It should also be pointed out that loans arranged by other large lenders are also trading at discounts.

Stress in the System

Greenspan surely knows about such issues and sees stress in the banking sector. In his Senate testimony last week, he said: "Many of the traditional quantitative and qualitative indicators suggest that bank asset quality is deteriorating and that supervisors need to be more sensitive to problems at individual banks, both currently and in the months ahead."

Yet, conversely, Greenspan warned banks against tightening their standards too much. "Such policies are demonstrably not in the best interests of banks' shareholders or the economy," he said. Such tightening will "lead to an unnecessary degree of cyclical volatility in earnings; more importantly, such policies contribute to increased economic instability."

Seeing the bind banks are in, Greenspan would normally prescribe another big dose of easy money through lower rates. The Fed agreed to inject only half the medicine Greenspan might have wanted. That means inflation is starting to bug some key members. As a result, the central bank is no longer the banks' best friend.