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Interest Rates Start to Matter Again
November 7, 2005

You would expect that a man of the stature and reputation of Federal Reserve Board Chairman Alan Greenspan would have no trouble finding employment after his years of government service. Thus our surprise when we saw a report in the American Banker noting that the venerable central banker had started writing research reports again, his first in over a decade.

In cooperation with senior economist James Kennedy, Chairman Greenspan authored a study entitled �Estimates of Home Mortgage Originations, Repayments, and Debt
On One-to-Four-Family Residences,� which among other things looked at the size of mortgage finance vs. overall consumer spending. He discovered that some $600 billion or roughly 7% of all disposable income was financed in cash terms through home equity loans.

Far from a conundrum, the role of mortgage finance in keeping Americans consuming at the levels we all expect is apparent and has created a number of anomalies in the
US economy, particularly within the portfolios of banks and investors who facilitate the housing mania. This fact is apparently what troubles Chairman Greenspan and has fueled some of his criticism of the role of the GSEs in encouraging �home ownership.�

Suffice it to say that the latest Fed rate hike and the promise that US interest rates � and also the dollar -- will continue rising has caused us to assume an even more bearish stance than is usually our custom. Fact is, the only way that the Fed can squeeze the inflationary tendencies out of the
US economy is to take the cost of money and the�international�value of that paper dollar to levels where employment and domestic business activity will slump, to put it mildly. If incoming Fed chief Ben Bernanke follows a true inflation rule, a US recession is a given.

Subscribers to the IRA Bank Monitor, who for the past several years have been puzzling over historic low bank loan default rates and business model skews in favor of mortgage and consumer finance, will not find Greenspan�s concerns surprising. Nor will they be taken unawares by our decision today to downgrade the last three positively rated banks in our model portfolio � US Bancorp (NYSE:USB), Wachovia (NYSE:WB) and Comerica (NYSE:CMA) � to �3-Neutral� and to put a negative bias on the entire group.

The surge in US home prices has not only imbedded a huge proportion of the mortgage market�s aggregate risk on the balance sheets of US banks and broker dealers, but has done so at a time when tangible levels of bank capital are at all time lows, a shown in the chart below.

Lead Bank Equity Capital vs. Total Assets

June 30, 2005




Bank of America



JP Morgan Chase









Wells Fargo



Washington Mutual



US Bancorp









World Savings




Notice that measured based on tangible capital, the bank subsidiary of Golden West Financial (NYSE:GDW), one of the most conservative mortgage lenders in the US, and the $141 billion unit of HSCB, are the best capitalized lead bank units among the ten largest US banks.

Question for the
US bank regulators appearing Thursday before the Senate Banking Committee in Washington regarding Basel II : If tangible levels of capital at the largest US banks are already so low, especially at this stage in the economic cycle, why should the US seek to further reduce bank capital levels by embracing Basel II?

As rising interest rates slowly wean Americans off of their addiction to mortgage refinance as a surrogate for creating real wealth, the revenue and earnings of banks will also come under pressure � and this at precisely the time when banks need to be building capital levels to offset rising default rates.

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