Banks Figure The Feds Are A Safer Investment Than You

If banks are doing so great, then why are they lending money to Uncle Sam instead of to you?

U.S. banks bought more Treasury debt and bonds issued by government wards Fannie Mae and Freddie Mac in the first two months of this year than they did in all of 2011, Bloomberg reported Monday.

This behavior doesn't exactly say much for the health of the economy. And it raises questions about the true health of the banks, just ahead of the results of a new round of bank stress tests, due later this week.

Interest rates on Treasury bonds are near their lowest in decades, meaning banks aren't getting a ton of return on their investment in government-related debt -- the benchmark 10-year Treasury note yielded 2.03 percent Monday afternoon. But banks are also getting essentially zero-percent overnight loans from the Federal Reserve, so any interest above that is mostly profit.

In other words, they're borrowing from one federal institution to turn a profit from lending to another federal institution. Nice work, if you can get it.

And government debt is more or less risk-free right now, as the Fed is out buying Treasury bonds and Fannie and Freddie debt in its effort to turn the economy from a lumbering caterpillar into a beautiful butterfly.

In contrast, it's riskier to lend money to a home buyer or a small business -- some poor slob, in other words, who is not lucky enough to have the backing of the federal government and the Federal Reserve. Banks can charge more interest, but only so much, and people sometimes don't pay loans back.

Warren Buffett and other investors have argued repeatedly that buying Treasury bonds is absolutely bonkers. These bonds pay very little interest and their prices are near record highs. Buy oh-so-cheap stocks, they argue! And if the economy starts to boom, which will totally happen any second now, then stock prices will soar, and interest rates could jump, which tends to crush investments in bonds.

The banks aren't hearing it. (Neither are investors, for that matter, but that's another story.)

The banks are relying on the Fed to keep interest rates at rock bottom for at least a couple of years, which it is doing because it sees the economy as dead in the water.

And the banks are sitting on that cash hoard because they, too, see the economy as dead in the water, which is the sort of thing that makes them anxious about their own financial health.

They're all expected to pass the stress tests with flying color this week, which will give them leeway to raise their dividends and other payments to shareholders, which will make them look even healthier. That will maybe encourage more investors to give banks still more money, in a virtuous cycle of mutual love and trust. Kumbaya, my Lord, kumbaya.

But the last set of stress tests led to more shareholder payouts, too, even though FDIC chief Sheila Bair argued the banks weren't ready to part with that cash. The banks won that argument, as ProPublica reported recently.

Banks are arguably in better shape than they were a year ago, but they still rely on government assistance, including the free money from the Fed that they take and buy guaranteed bonds from the government.

If they were feeling hale and hearty, maybe they'd use more of that easy Fed cash to make riskier loans rather than park so much of it in risk-free (for now) government debt.