To The Moon

I want to short banks for two main reasons:

• The flat yield curve cuts their current income
• They are actually boosting earnings now by bringing back previous loan loss reserves but they will soon have to start adding to reserves.

These are two huge factors for the banking sector and will increasingly weigh on the banking sector. They basically sum up the two major income streams for banks.

The shape of the yield curve is a proxy for bank profitability. Most of banking profits come from, as they say, borrowing short and lending long.

Translated into English that means that they get most of the money they lend from the short end of the yield curve but most of their lending goes to longer maturities.

I worked as the treasurer of a Swiss Bank in one of my past lives. My job was to make sure that there was money for the corporate lending officers. A lot of that money comes from demand deposits which is a fancy name for checking accounts. They are a great source of money for our bank because we didn’t have to pay them any interest but the bad news was that they could withdraw it at a moment’s notice. That is the ultimate of borrowing short.

The next biggest source of funds were short term loans in the Eurodollar market. Our credit rating was good so we could issue Eurodollars (borrowing in dollars but not in the US) for, say, 90 days very cheaply. And we could roll over those 90 day Eurodollars constantly. We had to pay a little interest but not much.

On the other side, we would lend money to corporations for months out to years. We would lend long term for mortgages.

So you can see that our borrowing costs were based on short term interest rates which are controlled by the Fed but lent long term at rates mainly set by the free market.

The shape of the yield curve determined much of our profit margin.

The other thing was loan losses. Fortunately, our loan losses were small because the bank was very conservative in their lending. Increasing loan loss reserves occur when it looks like some loans will be defaulted on and defaults obviously cause the bank to lose money.

I believe that shorting the banking sector will be one of my big winners in the coming year.

Here’s why:

I believe we are going into a recession by the first quarter of next year. That will mean that banks will have to start adding to their loan loss reserves likely starting in the 2Q2023 as the recession starts to hit corporate balance sheets. The chart above shows additions and deletions from bank loan loss reserves. You can see that they had to add to their loan loss reserves over the past year due to the Covid mess. That shows as a negative number on the chart above.

But the booming economy has enabled them to take money out of reserves and add it back into their profits. That shows on the chart above as a positive number.

You may expect banks to increase their profits until the end of the year as they take money out of reserves and into profits.

So this means that I may not be shorting banks for several months!

Another reason I won’t be shorting right away is that the shape of the yield curve still means banks can make money. They can borrow any money from under 2 years maturity and lend it longer than that and make money.

At the same time, the Fed has basically mapped out a path to 3% interest rates by the end of the year and that would push short term interest rates to about the level of long term rates. At that point, the banks will not longer be making money from their normal banking businesses.

The increase in loan loss reserves will kick in 1Q2023 or 2Q2023 and banks will start losing money.

But we can short before that and make money in 2022.

How?

Remember that stocks are a leading indicator. So the market has yet to figure out that banks will lose money next year but, when it does, the stocks will start to tumble and that will be sometime this year.

So that means we need to start watching the bank stocks now looking for a sign of technical weakness.

I think the best way to play it is to short ETFs like KBE. I think the money center banks will be hit the hardest so prefer to short them. We can also buy the 3X Inverse ETF BNKD.

And, of course, we can short the individual stocks. Here, I would favor shorting C and WF. I am already short the German bank, DB.