A Yield-Curve Rally on Wall Street

The upward-sloped yield curve has come to Wall Street for a real bailout of the big banks.

Today, Citigroup CEO Vikram Pandit told Bloomberg that the bank has turned profitable with its best numbers since 2007. This echoes what BofA CEO Ken Lewis told CNBC about two weeks ago. At the heart of this newfound profitability is a very simple but powerful idea: When short-term Treasury rates are well under long-term rates, banks profit. This is principally because banks borrow short to lend longer.

Back in 2006 and 2007 the yield curve was inverted, and it took its toll on the banking system — playing a major role in the credit crunch. Now, however, Citi, BofA, and probably many others are experiencing good trading profits and good money on their various servicing functions for consumers, corporations, and governments.

Net interest margins are rising. Short-term money is almost free these days, with the fed funds rate near zero and T-bills around 25 basis points. But the rest of the curve is 2 to 3 percent. Additionally, FDIC-guaranteed deposits are surging at all the major banks, providing a strong lending base.

All of this has created a huge 300-point rally in Wall Street trading — led by the financials, but extending across-the-board to all sectors on strong volume.

The banks do have plenty of underwater toxic assets. But there is too much obsessing about these assets, which are held for long-run investment and should not be marked to market as there is no distressed market. Instead, investors should look at positive cash flows — and the strong profitability from these cash flows — in the new interest-rate environment of the upward-sloping Treasury curve.

What’s more, the banks are funding their daily positions with no trouble. When Bear and Lehman failed it was because they couldn’t finance their daily positions. Obviously the banks are in better shape.

Helping today’s trading, Rep. Barney Frank announced that the SEC would be restoring the uptick rule for short sellers, which has been in place for a long time over the past couple of years. This means bear raids on banks will be tougher since traders will have to wait for a stock to go up in price before they short it. But selling shares on a downtick in price greases the skids towards ridiculously low share prices for banks and others (think GE).

There also is a lot of rumbling about a liberalization of the mark-to-market rule, which has wreaked so much havoc on bank profits and capital. One way out is to ask the banks for a market mark, but to amortize the implied losses over a period of five-to-seven years for regulatory capital purposes. This also would buy plenty of time for better bank earnings to bolster bank capital positions.

Whether today’s big rally marks a turnaround or just a dead-cat bounce from an oversold market remains to be seen. But surely the return to profitability of America’s biggest banks is a good sign for economic recovery.