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Why aren't big banks issuing more long-term debt?
During the financial crisis, several large financial institutions heavily relied on short-term borrowings to support their operations. This became a major problem. As credit markets froze, the banks were unable to renew their expiring short-term loans and thus were in danger of failing because they couldn't borrow enough to operate. This was one of the reasons why the government had to step in with temporary debt guarantees and lending programs.

Recently, the Wall Street Journal ran an interesting piece by writer David Wessel about the "hidden benefits" of the Fed's quantitative easing. Wessel rightly points out that a benefit of quantitative easing is the ability of corporations to fund themselves cheaply with stable long-term debt.

Regrettably, while non-financial institutions seem to understand the wisdom of funding "long" in the current interest rate environment, financial institutions apparently do not. Instead, they are reducing reliance on long-term debt in favor of deposits, most of which are backed by the FDIC, and short-term loans known as "repos." Indeed, the percentage of banks' liabilities funded with long-term debt has declined from a peak of 21.3% in 2009 to 15.7% at the end of the third quarter of 2012. Deposits, meanwhile, have increased from 40.6% to 44.5% during the same time period. Repos have increased as well from 13.6% to 14.1%. As the WSJ's David Reilly has pointed out, among the biggest U.S. banks, repo financing is now almost as large as long-term debt outstanding.

Replacing long-term debt with deposits, of course, enables the banks to improve their net interest margins as the cost of government-backed deposits is next to nothing, while the interest that must be paid on, say, a 10-year bond issue is over 3%. But it also increases the government's exposure if the banks get into trouble again, shifting risk from private bondholders to the government. And while insured deposits are "sticky" -- that is, they are not prone to sudden destabilizing "runs" as are repos, commercial paper, and other short-term borrowings -- their cost can go up. When interest rates riseand at some point, they will have to go upbanks will need to pay higher interest rates to keep those deposits, while low rates on long-term debt are locked in for several years.

Acknowledging the risks of quantitative easing, Wessel also shows potential bubbles building in the prices of high-yield debt and agriculture land. Of course, many feel that the biggest bubble of all is the one that has been building for many years on Treasury bonds. The yield on 10-year US Treasury debt is 1.6%, down from about 6.5% in 2000, when our economy and our fiscal situation were considerably stronger. These low yields simply cannot be justified by the credit fundamentals of our government, given the inability of our elected leaders to effectively grapple with our burgeoning national debt.

Wessel is right to point out QE's hidden benefit to corporations in their ability to access cheap long-term funding. Unfortunately, it appears that many financial institutions are thinking more about maximizing short-term profits than about building a stable base of funding that will protect them when interest rates inevitably rise again.



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