A significant recession could develop, if banks decide to sell the loans they own rather than make new ones. At present, the pressure to take this path is rising.
Pension funds and insurance companies are in a panic to obtain instruments with higher yields. Banks are fighting to obtain good loans but the pricing environment is not facilitating this.
The easy solution for everyone is for the banks to sell relatively high yielding loans to buyers who want that yield. In so doing, the banks would book significant profits and build funds for reinvesting when yields rise again.
The smartest bank on the block
I would argue that JP Morgan Chase is probably the best run bank in the U.S. because it has superior intellectual capital. This bank is a leader in the industry because it understands markets and it has demonstrated the knowhow to make money from them.
JP Morgan clearly comprehends the current banking dilemma and it is acting to benefit from the situation.
In the 12 months ending in June 2019, bank loans, overall, have risen by just under 5%. JPMorgan's loan portfolio is up by 0.9%. Year-to-date, in 2019, the bank has reduced the size of its loan portfolio by $27.7 billion. It has reduced loans to the home loan sector by $20.3 billion.
Auto loans are down by $1.3 billion; other consumer lending is off by $0.6 billion. Corporate and investment loans are down by $6.3 billion. These declines are partially offset by small gains in other lending sectors, the most important of which appears to be margin loans on securities.
Credit card lending is up by $0.9 billion so far in 2019, but the bank is supposedly trying to sell $1 billion of these loans. The bank is putting the new money coming in, and using the proceeds from loan sales, to grow its trading and derivatives portfolios, and its securities portfolios. The former are up by $104 billion and the latter by $74 billion in 2019.
These moves are brilliant. They reduce the bank's exposure to losses. They increase its profits from trading, and they obtain securities gains as longer duration securities continue to rise in price.
One assumes that the bank will post good profits in the third and fourth quarters this year.
Adam Smith was wrong
One of Adam Smith's key tenets was that by helping oneself, individuals and businesses help the overall economy — the invisible hand.
If JPMorgan continues its policy of selling rather than originating loans, it will help itself. It will fail the economy, however.
Banks are expected to provide money to facilitate growth not shift money away from the private sector by buying government bonds. One has to consider how long the banks that are not following JPMorgan's strategy will continue to struggle to make loans at what could be declining margins, rather than booking the easy money to be made by selling whole loans.
When third quarter banking industry earnings are produced in October, it is highly likely that banks that have been originating loans will be explaining why their margins fell, their loan losses went up, and the earnings growth was muted. Banks who were selling loans and managing their securities portfolios will be discussing why their profits were so high.
If the banking industry then decides to shift its strategy and stop placing as much money into the private sector and place the funds, instead, into government bonds, it will be facilitating a shift in funding away from growing the economy to buying the government debt – i.e., shifting funds out of the real economy into the financial sector.
An industrial recession
Banks will have more incentive to follow JPMorgan's lead for other reasons.
Latest figures argue that the industrial sector in the U.S. is already in recession. Apparently, manufacturers did not make the decision to start building products that are now being made in China. They decided to wait and hold back capital spending until there is some certainty as to where the economy is growing.
In the residential mortgage sector, anecdotal data indicates that banks lose money on every home loan that they originate. The product is a loss leader as opposed to a solid profit contributor. Thus, the incentive to sell loans and book high profits is also being driven by the inability to garner the returns desired by making loans.
If banks take the easy road outlined by JPMorgan it will stress the economy.
The Fed will have no power to stimulate growth in this instance. It can cut rates all it chooses but if the banks simply refuse to lend, the rate cuts will only further stimulate the banks' unwillingness to lend and the desire to sell loans.
—Dick Bove is the chief strategist at Odeon Capital Group.