BANK OF AMERICA, CITIGROUP, JPMORGAN AND WELLS FARGO STOCKING UP ON LIQUIDITY / SEEKING ALPHA ( RECOMMENDED READING )

Bank of America, Citigroup, JP Morgan and Wells Fargo Stocking Up on Liquidity

by: Michael Steinberg

November 03, 2009

Geithner’s Treasury and Congressional politicians are telling banks publicly to expand lending and boost the economy. At the same time Bernanke’s Federal Reserve is telling banks to increase liquidity as the banks see little loan demand from qualified borrowers.

Adequate capital and adequate liquidity are two completely separate concepts as Bear Stearns and Lehman found out the hard way. Capital is purely an accounting concept, generally consisting of common and certain preferred equity. Liquidity on the other hand is the cash either available or that can be generated to meet funding obligations in the event of deposit withdrawals or a freeze in short-term credit.

Bloomberg’s “Bank of America Joins China as Buyer of Treasuries” and “Pandit ‘Near Death’ Cash Hoard Signals Lower U.S. Bank Profits” explore how bank fears and regulatory pressures are moving banks counter to the economic recovery. Liquidity is generally defined as cash, deposits at other banks and any debt securities that the Fed will accept as collateral for overnight loans. Citigroup (C) only earns 0.63% on liquid assets vs. 7.2% it could earn on loans.

Bank of America (BAC) September liquidity stood at $422.6B, 19% of assets; Citigroup $450.3B, 24% of assets; JP Morgan (JPM) $453.6B, 22% of assets and Wells Fargo (WFC) $201B, 16% of assets. In cash alone, JP Morgan is holding $80.7B and Citigroup an amazing $245B. The big four banks are claiming that they are protecting themselves from adverse conditions. None of the banks reported regulatory pressure.

Wells Fargo claims that it has less need for liquidity than its other top rivals. In the ratio of deposits, long-term debt and equity to assets; Wells Fargo stands at 92% compared to Bank of America at 75%, Citigroup at 72% and JP Morgan at 63%. From the exposure to short-term funding risks, JP Morgan is showing its investment banking characteristics far more than the others.

Whether JP Morgan is more or less risky than its big four peers might be judged on the quality of its assets. The term risk weighted assets is often thrown around when discussing adequate capitalization of the banks. Each category of asset is weighted from 0% risk for treasuries to a very high weighting for leveraged loans and risky consumer finance. Then the weighted assets are summarized and divided by the various capital definitions.

The level of haircut the Fed takes on collateral is probably similar to risk weighting for regulatory purposes. The trouble is that the risk weighting is credit based and does not take into account interest rate risk. So too liquidity has an interest rate risk in all but the shortest term assets. Therefore, a bank’s liquidity could shrink with a rise in interest rates.

With this heightened emphasis on liquidity, it is interesting that banks are holding only a composite $125B or about 1% of assets in treasuries. Barclays (BCS) says that the norm after recessions is for banks to hold an average 8.5% of assets in treasuries, giving them the capacity to hold up to $1T. Barclays believes that banks will jump in as the Fed has quit quantitative easing (monetizing the debt). This might be a stretch as the interest rate risk in treasuries is especially high and banks have used Fannie Mae (FNM) and Freddie Mac (FRE) debt as higher paying 0% risk weighted alternatives.

Treasuries still have the role as the main currency on Wall Street. So demand will always exist for the short-term near zero rate instruments. Bank of America is holding $31B in treasuries and Citigroup has $17B in treasuries “available for sale.”

Given that investment grade corporate bond yield fell from a post Lehman average 7.96% to an average 5.06%, the Fed has certainly created a bubble. Perhaps this is why our big four banks are willing to forgo earnings to keep such a large percentage of their liquid assets in cash. In essence, returning money to the Fed for nearly free to forgo interest rate risk.

I like the new emphasis on liquidity by the top commercial banks, but caution that it might not provide as much security as it appears. Former Fed Chairman Greenspan is already warning that excess bank liquidity is unsustainable with market expected bank profits, economic growth and that tainted word "innovation."

Bloomberg’s “Private Equity IPOs Slump as Goldman, Citigroup Can’t Sell AEI” is reporting additional difficulties on the investment banking side. Institutional investors are not willing to accept IPOs with less than stellar balance sheets. Goldman Sachs (GS) and Citigroup were unable to float AEI, a former Enron power plant and natural gas pipeline operator, at any price. That is not good for IB fees and a sign of continuing trouble for private equity.

The consumer business is getting tougher; credit card reforms and other consumer protections will soon start taking their toll on profits. The mortgage origination business could also begin to falter when the Fed starts easing its purchases of Fannie and Freddie securities, interest rates climb and the pool of qualified home buyers shrinks.

All told the best that I can say is banks are on the road to lower, steadier earnings. I like my banks becoming utilities; that’s why I am staying clear of the “unbanks” Goldman Sachs and Morgan Stanley (MS).