Steve Blitz Morning Notes

As the FOMC meets and decides that things are better but not good there will also be, I imagine, some chatter regarding getting the banks to lend. Fair enough considering the bailout money. Banks, however, come out of recessions building up relative holdings in Treasurys before lending grows apace. Treasury holdings generally peak as a percent total bank assets a year or two after the recession is officially over (see chart).

Banks to are not going to let credit flow except to the Treasury because their liquidity hasn't materially improved -- certainly not with over 30% of bank assets tied up in real estate. The Fed can repo as much of these securities and loans as it wants, but the underlying collateral is still sitting on bank balance sheets. Banks have spent the past 25 years increasing their real estate assets to the point where the asset distribution looks like a mutual savings bank's.

Banks got that way, in part, because nonfinancial corporations don't need them like they used to. Firms borrow directly from the capital markets and use all sorts of financial engineering to get the average maturity and cost of funds that they want. The bump in C&I lending early in this recession occurred because credit markets were frozen and firms wanted to husband cash before their banks closed the credit line.

Looking at current ratios banks haven't even begun to reliquefy and there is every reason to believe the normal cyclical pattern will be followed -- banks will spend the next several years building up holdings of Treasurys relative to other assets. And making a good profit along the way given that their cost-of-funds is close to zero. The whole reliquefication process is going to take time and a lot of Treasurys. If you assume a repeat of the post 1990-91 recession experience with bank behavior and asset growth of 8% (average since 1973) then the weekly reporting banks will increase their Treasury holdings $1.7 trillion -- a 128% increase over 3 years. My view is that it is going to take a lot longer and banks will end up with a higher percentage of their assets in Treasurys. So if you were wondering who is going to bidding for all those Treasurys, the banks are.