After TARP: Hidden bank subsidies-12/30/2009 (BAC; C; FNM; FRE)

From NASDAQ:

Citigroup and Wells Fargo repaid $45 billion of government funds under the Troubled Asset Relief program last week, freeing their management teams to increase executive compensation without government interference. As a result, the general perception has been that these banks and others that received TARP money at the height of the financial crisis are now free of taxpayer support.

But these institutions are still enjoying extensive benefits at the public''s expense--albeit with much less publicity. In this first installment of a two-part special report, we will explore three unspoken subsidies the banks still receive, and will probably continue to enjoy, long into the future.

Subsidy No. 1: Cheap Money

Banks can now repay government funds because they''re getting virtually free money from the Federal Reserve''s low-interest rate policies. Case in point: Bank of America, the country''s biggest lender.

Between Dec. 31, 2008, and Sept. 30, 2009, BAC''s deposit base grew 10 percent to $975 billion, but its interest expenses on those deposits plunged by 56 percent to $1.7 billion. The cost of its short-term borrowings, which consist of commercial paper and notes tied to the Libor index, fell 62 percent to $1.2 billion over the same period.

However, despite higher long-term borrowing costs, BAC''s overall interest expense fell 33 percent between the fourth quarter of 2008 and the third quarter.

Of course, the company earned less money as many of its loans adjusted lower because they''re tied to short-term interest rates. But its overall interest income fell barely half as much--by 17 percent--during the same period.

BAC also bulked up on "cash and cash equivalents," quadrupling them to $152 billion, and shrank its loan portfolio by about 1.8 percent.

In other words, the company took much less risk yet still earned almost the same amount of money from its core banking business because of cheap money afforded by the Fed''s lending policies. The low rates also helped revive the broader capital markets, which allowed BAC to add $5.9 billion of income from investment-banking and trading activities over the same period.

Instead of receiving the public''s money in the form of government support, banks now simply pay much less interest on the public''s deposits. This will reduce Americans'' taxable incomes on savings and make them more likely to put capital into investments like gold or foreign equities, which reduces investment at home. The Fed''s plan to keep rates low for an "extended period" suggests that we may face an extended period of capital flight similar to Japan in the wake of its financial crisis.

Subsidy No. 2: Agency Bonds

Banks traditionally held Treasuries as their "cash and cash equivalent" assets. But over the last 20 years, the financial sector has come to rely almost entirely upon Fannie Mae and Freddie Mac securities as their "cash."

The nice thing for the banks is that these "agency" bonds yield more than ordinary Treasury securities. For instance, on Dec. 16, Fannie Mae sold $1 billion of five-year notes at a yield of 2.526 percent. That same day, the five-year Treasuries yielded 2.35 percent. While 18 basis points might not sound like much, it''s massive in fixed income--especially for "risk free" assets and when you''re paying almost nothing on deposits.

FNM and FRE are now largely insolvent wards of the state. Their balance sheets are so choked with bad mortgages that the Treasury Department quietly issued a decision on Christmas Eve giving them unlimited access to public funds. (This also came just days after the White House allowed their chief executives to collect $6 million of annual pay in cash--unlike widely criticized Goldman Sachs, where top executives will receive their bonuses in company stock.)

So the banks increasingly rely on the yield-rich government-sponsored enterprises, and those same GSEs are wholly dependent on the Treasury. Letting banks invest so heavily in taxpayer-supported bonds that pay higher yields amounts to another hidden subsidy....MORE