Buying assets to lower risk
Let's leave the question of just how smart this decision is aside for the moment and look at its effects.
Let's say a bank wants to lower the amount of core capital it has to raise to meet Basel III rules instead of paying the price to raise more capital or taking the hit that more capital would bring to the bank's return on capital. It could, of course, shrink its balance sheet by selling off assets. There's probably not exactly a rip-roaring market for the kind of assets it would most like to sell -- those with high risk, according to regulators. Selling would trigger a write-down in many cases, because banks haven't marked down the price of many riskier assets to market values.
Or the bank can lower the risk on its balance sheet by buying and holding assets judged risk-free by Basel III regulators. There is plenty of sovereign debt to go around these days, so it's not hard to buy as much as you want. And while the less risky of this sovereign debt doesn't yield much, it's not as if these banks are turning away more lucrative commercial loans. Deposits at U.S. banks exceeded loans by a record $1.45 trillion in May, according to the Federal Reserve. (In the 10 years before the financial crisis in 2008, loans exceeded deposits by an average of $100 billion.) As long as the lending market remains in its current near-comatose state, buying sovereign debt seems like a no-brainer.
How big could the bank appetite for Treasurys be? It's already quite healthy. Banks have increased their holdings of Treasurys and other government-related debt to $1.68 trillion in May from $1.08 trillion in early 2008, according to Bloomberg. Barclays Capital estimates that Basel III calculations of risk could reduce core capital ratios for the median U.S. bank by 3 percentage points. If banks were to make up that core-capital-ratio shortfall strictly by raising capital, they'd have to raise about $250 billion in new capital, Barclays calculates. Adding Treasurys to a portfolio would reduce the need for new capital.
I'd say that the appetite for Treasurys from U.S. banks would be enough to pick up a great deal of the slack from the end of QE2.
But remember, we're not talking about a problem for just U.S. banks. Basel III is a set of global rules, and banks everywhere face the same challenge of higher core capital ratios. So you'll see banks in the eurozone, Japan and the United Kingdom buying Treasurys along with their U.S. counterparts.
And they'll be buying the sovereign debt of Japan, the United Kingdom, France, Italy and Spain, too, as long as the final Basel III rules and regulations give a thumbs-up to the concept of risk-free sovereign debt. This is a huge boon to the central banks of the United Kingdom and Japan -- which have both expanded their balance sheets in the fight to stabilize their own banking systems and economies.
At one further remove, it will be a boon to the European Central Bank, which will be able to garner more support for its own expanded balance sheet from eurozone central banks. The European Central Bank relies on contributions from eurozone member states for its funding. So far, the eurozone doesn't issue its own common debt, but I think the Greek crisis and Basel III are likely to push the monetary union toward some kind of eurobond.
Not all good news
The dangers in this "solution" should be clear to anyone who has been following the Greek debt crisis.
First, it's not really a solution. It merely kicks the problem down the road (as the proposed Greek "solution" would do), with a hope that better economic conditions in the future will provide an actual solution.
Second, it involves exactly the same kind of debt-rating deception that was at the heart of the U.S. mortgage-backed securities collapse and that contributed to the Greek debt crisis. Calling sovereign debt risk-free and incentivizing banks to buy this debt exposes them to potentially crippling losses if the debt turns out not to be risk-free. I think it's naive to assume that banks will resist these incentives. They certainly didn't resist the incentives of higher yields and AAA ratings in the run-up to the mortgage-backed securities collapse.
Third, this "solution" comes with a built-in time limit. Banks will find the minimal yields of U.S. Treasurys attractive only as long as the loan market remains in the tank. When loan demand picks up, the Treasury market is likely to see increased selling by banks eager to get back into the banking business. That could accelerate the pace at which Treasury prices fall and yields climb in any U.S. economic recovery.
Basel III, in short, may rescue the Treasury market in the short term, but it's also another reason to worry, if not about 2011, then about 2013.
At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund's portfolio here.
Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register here.
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