Nov. 2 (Bloomberg) -- U.S. banks are buying Treasuries at the fastest pace since just after the last recession, helping shore up demand now that the Federal Reserve has finished purchasing $300 billion worth to hold down borrowing costs.

Even after banks including Bank of America Corp. and Capital One Financial Corp. increased such investments 26 percent to $125 billion in the 12 months through June, they have only about 1 percent of their assets in Treasuries, Fed data show. That’s down from the 8.5 percent average for the year after the past five recessions. Banks would have to buy $1 trillion more to reach past levels, so demand “could remain quite high for some time,” Barclays Plc said.

Banks including JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. are recapitalizing an industry that remains hesitant to take risks as joblessness approaches 10 percent. They’re profiting from a steepening yield curve, buying longer- term Treasuries with money acquired at short-term rates kept low by the Fed’s near-zero benchmark. That may temper yield increases amid record sums of new U.S. debt, keeping borrowing costs down even as banks lend out the smallest portion of their deposits in 15 years.

“Banks will continue to purchase Treasuries for the next several quarters, at least until the end of 2010, as they continue to be reasonably risk averse,” said Ira Jersey, an interest-rate strategist in New York at RBC Capital Markets, which trades with the Fed as a primary government-debt dealer. The demand will help keep 10-year yields, at 3.41 percent today, below 4 percent through 2010, he said.

Consistent Trend

The biggest one-year increase in Treasury holdings since the year after the 2001 recession is consistent with past downturns, even as banks reduced the proportion of government debt in their assets from 64 percent at the end of 1945 to 0.9 percent on June 30.

During or just after each recession since then, banks bulked up on U.S. bonds before scaling back, with the peak usually coming within two years of resumed growth. The year after the 1980-82 recession, 9.5 percent of bank assets were in Treasuries, up from 7.1 percent the year before the downturn. That share rose from 5.1 percent in 1989 to 8.3 percent in the second year after the 1990-91 recession ended.

The trend this time has continued since June as banks rebuild capital after $1.66 trillion in losses and write-downs since 2007 started, weekly Fed data indicate.

Behind China

Combined purchases of Treasuries and bonds from such government-chartered companies as Fannie Mae rose 18 percent to $1.4 trillion in the 52 weeks through mid-October. Prior to this year, that’s the biggest such jump since 2003. The Fed doesn’t break out Treasuries separately each week; detailed third- quarter data will be released in December.

The banks’ purchases rank far behind China’s U.S. debt investments as the country again becomes the biggest single Treasuries buyer. It held $797 billion as of Aug. 31, up $223 billion in a year, almost nine times the size of U.S. banks’ increase.

Once the recovery picks up steam, banks likely will become less enamored of Treasuries, said William Larkin, who helps oversee fixed-income investments in Salem, Massachusetts, at Cabot Money Management. Even as job losses unexpectedly accelerated in September, the world’s largest economy expanded at a more-than-forecast 3.5 percent pace in the third quarter.

“As the tide turns, a lot of participants in Treasuries, including banks, will look elsewhere,” said Larkin, whose company manages $500 million. “Treasuries will become a bit higher risk now that the Fed is out of the market. The interest- rate policy has to be adjusted higher. No one knows when the recovery will gain traction, but it is likely.”

Lots of Liquidity

The industry’s buying pace likely will slow even as it continues being “a big force in supporting government bond markets” because the “proportion of liquid assets on banks’ balance sheets already is quite high,” Barclays said in an Oct. 9 report.

About 21 percent of the combined assets of Bank of America, JPMorgan, Citigroup and Wells Fargo -- the four largest U.S. banks -- is in cash, Treasuries that qualify as overnight collateral or other cash-like securities, according to third- quarter earnings reports. That’s up from 15 percent in the quarter before Lehman Brothers Holdings Inc.’s September 2008 bankruptcy triggered the worst financial crisis since the Great Depression.

Bernanke’s Plan

The Fed stopped buying Treasuries Oct. 29. The program, announced March 18 and begun seven days later, was part of a series of emergency measures under which the U.S. spent, lent or guaranteed $11.6 trillion to snap the deepest global recession since World War II.

Fed Chairman Ben S. Bernanke was trying to hold down rates on everything from mortgages and car loans to corporate bonds, which are tied to Treasury yields.

The day the Fed unveiled the program, the 10-year rate fell 47 basis points, or 0.47 percentage point, the most since 1962, to 2.53 percent. It rose to as high as 4 percent, on June 11, amid concern supply of the securities would swamp demand as the economy rebounded. The U.S.’s marketable debt hit a record $7.01 trillion in September, and it will issue $2.4 trillion in the fiscal year that began Oct. 1, up from an unprecedented $1.8 trillion in the prior 12 months, according to Goldman Sachs Group Inc., a primary dealer.

High Unemployment

Last month, the 10-year yield fell to as low as 3.1 percent on speculation the recovery would falter after unemployment increased to 9.8 percent in September, the highest since 1983. The yield ended October at 37 basis points higher than its 3.01 percent close the day before the Fed announced the program.

“Holding all things constant, Fed buying has reduced rates 35 to 50 basis points over the last six-months,” said George Goncalves, chief fixed-income rates strategist at primary dealer Cantor Fitzgerald LP, in an email. “The Fed buy program has done more work at smoothing out the yield curve and providing liquidity.”

Fixed rates on 30-year home loans averaged 5 percent in the week ended Oct. 22, down from as high as 6.63 percent last year and from 5.05 percent in March, according to Freddie Mac, the McLean, Virginia, mortgage-finance company. Investment-grade corporate bond yields averaged 5.06 percent on Oct. 30, down from peaks of 7.96 percent in March and 9.54 after Lehman’s collapse, Bloomberg data show. U.S. corporations have sold $1.11 trillion of bonds in 2009, the fastest pace on record, according to the data.

‘Plain’ Gets ‘Juicier’

Mizuho Securities Co., a unit of Japan’s second biggest bank, predicted in October that Treasury yields may fall below 3 percent this year as U.S. banks shift money to “plain” government debt that suddenly has been made “juicier” by cheap funding costs.

Two-year yields now are almost 2.5 percentage points less than 10-year rates, twice late December’s gap. The spread between the federal funds rate for overnight loans between banks and the two-year averaged 80 basis points in October, up from less than 4 over the previous three years.

Citigroup’s holdings of Treasuries in trading accounts or available for sale increased $6 billion in the first half, to $17 billion, according to quarterly consolidated financial statements filed with the Fed. Wells Fargo, in San Francisco, California, almost quadrupled its holdings of U.S. debt in the 12 months to June 30 to $2.5 billion. McLean, Virginia-based Capital One’s stockpile of Treasuries more than doubled in that period to $441 million. Bank of America’s totaled $31 billion as of June 30, up $10 billion from a year earlier.

‘Prudent Step’

“We are building up cash and improving our liquidity,” said Jerry Dubrowski, a spokesman for the Charlotte, North Carolina-based bank. “That is, in our view, a prudent step to take given the current climate.”

Even as banks help Bernanke achieve a primary objective in combating the economic crisis by keeping borrowing costs in check, they are defeating that policy’s purpose by limiting loans at a time when businesses are wary of taking on new debt.

“Banks have been buying Treasuries as their loan-to- deposit ratios have been very low,” said John Spinello, a strategist at Jefferies Group Inc., a primary dealer in New York. “Credit criteria has gotten more stringent, so it’s a combination of less demand for loans and the fact that they are not very willing to lend that has pushed them to buy Treasuries.”

Deposits totaled $7.6 trillion on Oct. 21, or $959 billion more than outstanding loans. That gap, up $24 billion at the end of last year, is the widest on record, Bloomberg data show. The loan-to-deposit ratio of 0.87 is the lowest since 1994. Commercial and industrial loans have fallen 17 percent from a record high a year ago to 1.37 trillion as of Oct. 21, an unprecedented drop.

Less Lending

About 44 percent of banks questioned by the Fed said demand for business loans dropped in the second quarter as “they continued to tighten standards and terms” for both companies and households, the central bank said in its quarterly survey report.

“Demands for loans continued to weaken across all major categories except for prime residential mortgages,” it said. “Respondents nearly unanimously cited a less favorable or more uncertain economic outlook, and large majorities cited a reduced tolerance for risk.”

That’s why Cullen/Frost Bankers Inc. in San Antonio, Texas, increased Treasuries holdings to about $440 million, from $39 million on Dec. 31, according to regulatory filings for the company, which has Standard & Poor’s 400 Regional Banks Index’s biggest weighting.

New Regulations

“Loan demand has been somewhat weak,” said Phil Green, Cullen/Frost’s chief financial officer. “Treasuries represent a middle-of-the-road position for us to take as we look at the various alternatives available to us in the securities or money markets.”

The prospect of new regulations that would force banks to have more capital on hand in advance of another crisis is helping drive them toward Treasuries.

The Basel Committee on Banking Supervision, a 35-year-old panel that sets international capital guidelines, plans to propose a “new minimum global liquidity standard” by year’s end, according to a Sept. 15 statement from the Financial Stability Board, which coordinates the Group of 20 nations’ regulatory initiatives.

U.S. House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, unveiled a bill Oct. 27 that would authorize the Fed to impose capital requirements on some financial companies. Treasury Secretary Timothy Geithner praised the measure two days later.

“Regulators are re-defining the liquidity buffer that banks have to hold in light of recent market events,” Barclays strategists led by Laurent Fransolet wrote in their report on Treasury purchases. “There is no doubt that these liquidity regulations do/will favor the buying of government debt.”

To contact the reporter on this story: Susanne Walker in New York at swalker33@bloomberg.net

Last Updated: November 2, 2009 06:50 EST