Fiscal Cliff Threatens Bank Stocks

The impending threat to U.S. banks, domestic and global economies, and the stock market in general, is the federal “fiscal cliff”—the term coined by the media and analysts broadly covers:

These important components of the fiscal cliff weigh heavily on banks, the financial sector and the world economy.

The tax cuts enacted by President George W. Bush through the Economic Growth & Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) and extended under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 are scheduled to expire at the end of 2012. The expiration will leave nearly all U.S. taxpayers facing the prospect of an increase in income tax rates. Unless the winner of the presidential election and/or Congress act, the effective marginal income tax rates are set to revert to their higher level. In addition, a whole host of tax deductions and reduced dividend and capital gain tax rates are also set to expire. Here is just one example of the marginal tax rate change if the Bush tax cuts are actually allowed to expire:

There is some debate about what will happen to the economy and bank stocks if the cuts expire rather than be continued. The Congressional Budget Office (CBO) estimated an extension of the tax cuts from 2011 through 2020 would add $3.3 trillion to the national debt, comprising $2.65 trillion in lost tax revenue plus another $0.66 trillion for interest and debt service costs. But, on the flip side, consider the economic costs and even lost revenue if the tax cuts are not extended.

One clear economic cost will be the higher taxes Americans will have to pay and the downstream effects if they spend less as a result. Less consumer spending means businesses will shrink, lowering the demand for capital and the need to borrow money. With a decrease in lending activity, the banks’ primary source of revenue, interest income, will shrink, reducing earnings and eventually stock prices.

To a lesser degree, banks may also be negatively impacted as dividend and capital gains rates also revert to higher tax rates. To avoid paying the higher rates, investors will rush to sell higher dividend-paying stocks before 2013, including many of the bank stocks on our highest bank dividend paying stocks. Or, investors may pressure banks to raise their dividend rate as a way to offset the adverse tax impact. Either way, it will cost banks operating cash that would otherwise be invested in growing their business.

The budget sequester process will force automatic, across-the-board spending cuts if Congress has not agreed on or passed a new budget by the implied deadline of December 31. Of course, Congress can always push the deadline by creating another extension as it did in August 2011. However, this would not solve the problem but merely push it out another “six” months.

There is a strong indication that this is exactly what might happen again given that after the national elections Congress will be in a “lame-duck” session through late January 2013. Most experts do not see the lame-duck congressional session as being a productive time to pass landmark legislation nor is there any incentive since many of the members of Congress will not be in office come 2013.

Sequestration was designed as an enforcement tool in the Budget Control Act of 2011 (BCA) and under the Statutory Pay-As-You-Go Act of 2010 (Statutory PAYGO). In either case, certain programs are exempt from sequestration, and special rules govern the effects of sequestration on others.

Nonetheless, arbitrary spending cuts, if made, to all programs including entitlements would be devastating to the economy, individuals and businesses. This would reduce lending activity as the economy contracts and hurt banking profits. Even if Congress makes cuts to the budget on its own, instead of allowing the across-the-board mandated cuts in sequestration, there is no guarantee the cuts won’t be detrimental to businesses or the banking industry.

Any uncertainty in government policy or lack of fiscal action will continue to hamper the fragile economic recovery and might even throw us back into a recession. Banks profits would suffer from the inaction.

The last time Congress raised the debt ceiling was in August 2011, predicated on future reduction in government spending. Now, the new $16.4 trillion debt ceiling is expected to be reached sometime in January 2013, according to a recent Wall Street Journal article. This is a bit later than originally forecast due to a government surplus of $75 billion in September, but as of October 11, 2012, the U.S. is just $275 billion under its borrowing limit and reaching the current ceiling seems inevitable.

So what happens if we hit the debt ceiling again without reaching an agreement to raise our borrowing limit? Remember the threats of government shutdowns and stopping payments on such entitlements as Social Security or paying government workers in the summer of 2011? Well, that is exactly what is in store for us again! Even the threat of this action, would cripple the already-fragile U.S. economy. Even the U.S.’ sovereign debt rating was a casualty of the last round of cliff hanging. So you can bet on consequences to the economy, stocks and banks if there is another replay.

Whatever happens, it is clear something needs to be done. U.S. government debt, as seen in the graph below, is now 103 percent of gross domestic product (GDP). If allowed to go unabated, this will surely have a negative impact on the U.S. economy in that the government will have to contract in order to get debt and spending under control. Evidence of this can also be seen in the graph of the GDP annual growth rate below, with the growth rates trending down over several quarters including some of the lowest rates during last summer’s mini-fiscal crisis.

Operation Twist was an initiative of the U.S. Federal Reserve (“the Fed”) to stimulate the economy in late 2011 and 2012. The Fed’s strategy was to buy longer-term Treasuries while simultaneously selling shorter-dated Treasury bonds it already held in order to bring down long-term interest rates. The term Operation Twist, a takeoff from the famous Chubby Checker song, was first used in 1961 when the Fed employed a similar policy to stimulate the economy. Lower interest rates encourage increased borrowing by individuals and businesses to promote business expansion and home and auto purchases. And naturally, the increase in lending is a boon for banks.

Operation Twist was the third in a series of major policy responses by the Fed to the financial crisis of 2008. The first initiative cut short-term rates to an effective rate of zero, and that made it impossible for the central bank to rely on further rate cuts to spur growth. So, its next step was quantitative easing—an attempt to lower long-term rates by making open-market purchases of longer-dated U.S. Treasuries and mortgage-backed securities. The Fed has now conducted three rounds of quantitative easing, which market watchers dubbed “QE”, “QE2” and “QE3.” Shortly after QE2 concluded in the summer of 2011, the economy began to show signs of renewed weakness. Rather than immediately opting for a QE3, the Fed responded by announcing Operation Twist but has since implemented QE3 hoping to support the tentative recovery.

It is unclear whether additional monetary stimulus can actually improve the underlying economy without addressing the primary causes of weakness—mainly high unemployment, the uncertainty about tax liabilities for individuals and businesses and continued government spending.
It seems clear that simply throwing money at the economy and telling businesses and consumers to spend without knowing the consequences, is not going to fix the problem. Perhaps a real attempt at fixing uncertain government policies will. But, without clear leadership and coherent policy from the administration and Congress, no effective fix will be likely in the short term.

Gene Kirsch, senior banking analyst at Weiss Ratings, has more than 20 years of financial industry experience in credit-risk management, commercial lending and loan review analysis within various sized credit unions, finance companies and banks at both the retail and commercial level. He leads the firm's bank and thrift ratings division and developed the methodology for Weiss' credit union and global bank ratings.