Are Fed Policies Hurting Lending to Small Businesses?

The Federal Reserve’s current policy of near-zero interest rates has given banks a golden opportunity to recapitalize while still maintaining low lending rates to the private sector. Because the federal funds rate has been held so low, banks are able to borrow funds cheaply, reinvest in Government debt, and profit off the spreads. This Fed policy has the effect of discouraging banks from making loans to the private sector where funds are desperately needed to fuel a recovery. Bloomberg’s Cordell Eddings describes the practice in detail:

Holdings of Treasuries and agency debt rose each of the past five weeks, an increase of $63.2 billion to $1.5 trillion, according to Federal Reserve data. At the same time, commercial and industrial loans climbed less than 1 percent to $1.27 trillion and are down 23 percent from the record high level in October 2008.

Banks, facing increased regulation after posting $1.78 trillion of writedowns and losses since the start of 2007, are taking advantage of the record gap between their borrowing costs and yields on U.S. debt instead of lending, according to data compiled by Bloomberg. Bank demand for Treasuries is helping cap yields as President Barack Obama sells record amounts of bonds to finance a budget deficit that exceeds $1 trillion.

“The risk of owning Treasures is lower than creating loans,” said Anthony Crescenzi, a market strategist and money manager at Newport Beach, California-based Pacific Investment Management Co., the world’s largest bond-fund manager. “There is no clarity on what the capital climates will be domestically or on a global scale with regulation coming down the pipes, which means banks will be banking their money in safer assets.”

The only winners in the Fed’s near-zero interest-rate policy are (1.) the banks making steady returns reinvesting cheap funds back into U.S. debt, and (2.) the Government which will continue to get competitive bids on further debt issuances – ultimately to be footed by the taxpayer. This has led to comparisons of the policy with that pursued by the Japanese government during their decade-and-a-half long depression in the 1990s, writes Eddings:

Buying longer-term debt is reminiscent of Japan, where banks increased their holdings of government bonds to record levels during the country’s so-called lost decade of economic stagnation that began in the 1990s, according to Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey.

Like Japan’s response to the real estate collapse in the 1990s, the U.S. flooded the economy with cash only to see financial institutions sock the money away in bonds instead of making loans. Yields on 10-year Japanese bonds ended last week at 1.27 percent.

“It’s the Japanese movie, just an American version,” said Cheah, who worked for Singapore’s central bank. “The next scene is that after banks buy more and more government bonds it will be very difficult for the Fed to raise interest rates because they will lead to massive losses in the banks and cause them trouble all over again.”

Eddings notes that while U.S. debt holdings have skyrocketed to $1.5 trillion, commercial and industrial loans are still 23 percent lower from the peak in Oct. 2008.