In order to ensure that large banks did not fail earlier this year, banks were told to repair their balance sheets. They were:

-          Force fed money from the feds to ensure their balance sheets showed a solvent bank.

-          Told to raise equity (issue more shares)

-          Told to raise money from bond issuances.

In so doing, we dodged a bullet. But the cost is yet to come, and risk has been added to our banking system as a result of actions taken earlier this year. Banks issued a lot of debt (bond offerings) this year. Normally this would be a minor drag on operating performance because the debt would be repaid many years into the future. But US bank debt average maturity has dropped from 7.8 years to 3.2 years. That means bank cash flow will come under pressure since this change in debt maturity doubles the monthly payments.

Earlier this year, no one wanted to loan to banks for a long period of time, so most of the debt raised by US banks earlier this year had a short term on it. FYI: the US gov’t is facing the same cash crunch.  US banks were able to issue short term debt earlier this year for very cheap rates because the US Federal Gov’t stood behind (guaranteed) the debt. The program ended last month and was called the Temporary Liquidity Guarantee Program.  Now banks have to issue bonds based on their own balance sheet strength. That means they’ll be paying much higher interest rates to investors as they issue new debt – as the debt (see bullets below) rolls over. This hurts their cash flow –at a time when they need massive positive cash flow to rebuild their balance sheets and repay the coming 2 years of debt.  Let’s just hope that the revenue they are counting on from people paying their mortgages manages to materialize. Given the article in Tuesday’s newsletter on US housing this is a risky bet.

Data:

-          Approx $10T in global bank debt is coming due between now & 2015

-          Approx $7T is coming due by 2012 (next 2 years)

-          Citigroup has $30B in next year, $39.5B in 2011, and $59.3B in 2012.  Ouch.

-          Bank of America has $55.4B next year, $35.3B in 2011, and $58.4B in 2012.  More ouch.

-          JP Morgan has approx $130B in 2010 – 2012.

How does this impact how we invest?  This information shows that our banking system will remain under strain for a few more years. I did not bother to mention that we’ve lost over 120 banks in the US so far this year and that we’ll lose a few hundred more in the next 2-3 years. The upshot is:

-          As long as the US banking system has significant systemic risk, we should be ready to hedge our positions in a big way if “all hell starts to break loose again”.  That, we are.

-          If we were (if I were) a gambler / sociopath, I’d invest in an ETF that held US bank stocks.  Even better, one with leverage. I’m not.  And to be 100% crystal clear: I am vehemently opposed to holding such an asset.

• I found a leveraged ETF that captures 2X the index of the US financial sector. It was priced at $73 in February 2007. It fell to $1.37 earlier this year.  It has since risen all the way back up to $5.69.  

Also of note –lest you think I’m beating up US Banks – the IMF says that Europe’s big banks are worse off than ours, and are more likely to be hiding losses. Indeed, the IMF says that up to half of European bank losses may be hidden. (How does one do that?)

If the US banking system makes it through the next 3 years unscathed, it will come out the other side strong enough to not be a concern. In the meantime, why assume the risk if you don’t have to?  Invest where banks are less likely to fail.  FYI: that is not Japan, Mexico, or anywhere in western or eastern Europe. That’s why we’re invested where we are.  That’s also why we continue to look for international short term bond ETFs with no exposure to Europe & Japan (& Russia). We have not found any yet.