Tag Archives: banking

Make Banks Safe Again

Are the big banks finally safe?

Picture: New York Fed

The Financial Crisis put bank safety and soundness fully in view. The serial bailouts or failures of Bear Stearns, AIG, Fannie and Freddie, Lehman, Merrill, and Washington Mutual put the global economy at risk. The problem was systemic: all the big banks were affected, because investors weren’t certain where their money would be safe. Bank stocks fell about 70%, and yields on their bonds rose about 4%.

When this happens, banks cut back on their lending, which slows the economy because businesses can’t borrow the money they need to grow. What the banking system should do at this point is raise more capital so they can keep lending. But there’s little incentive for any company to do this: the economy is weak, levered institutions are more risky, and stock prices are low. Why sell more stock when the price is low? That’s a good way to get your owners angry.

According to Fed data, the banking system is better capitalized than it has been in years. Of course, the data showed that just prior to the financial crisis as well.

Source: St. Louis Fed

If individual banks chose to keep their equity levels high all the time, that would prevent us from having a banking crisis, but there is little incentive to do this. A higher equity level means a lower return on equity, and lower returns for shareholders.

Because of this, Fed officials have considered whether subsidizing equity issuance could help. That is, for every dollar in capital the banks raise, the government would kick in 50 cents of its own money – into bank capital. Such an approach would reduce the chances of another financial crisis and improve future economic growth by as much as 1% per year. That’s a lot of growth: imagine how much better the world would be if we never went through the Great Recession.

But subsidizing bank capital is a non-starter, politically. Bankers aren’t very sympathetic characters. If you cruise the comments section of any prominent newspaper, people still wonder why the executives in charge of the big banks during the Financial Crisis were never put behind bars. The last time a banker was portrayed positively in the movies was George Bailey in “It’s a Wonderful Life” (1946), and he was considering suicide when his capital fell short.

Banks are essential – they provide the capital that the modern world needs to grow. But they are subject to booms, busts, and periodic panics. The only way to have a risk-free banking system would be to regulate their returns. And then you wouldn’t have enough banks – or enough capital to grow.

Douglas R. Tengdin, CFA

A Brief History of Bubbles

What’s wrong with bubbles?

Photo: Michelle DiNocola. Source: Morguefile

Sir John Templeton once famously noted that the four most expensive words in the English language are, “This time it’s different.” It’s easy to get caught up in the excitement of the moment, to believe that the latest innovation will lead to a new era. But human nature doesn’t change. That’s why it’s so fascinating.

Before the first documented financial bubble—the tulip crisis in 17th century Holland—there were other markets that were manipulated and distorted. In ancient Rome, currencies, bonds, and investments changed hands in the Forum, with little regulation or security. When the emperor ran short of cash—often due to war—he would debase the currency, adding base metal to the coinage. This led to inflation, currency speculation, and economic chaos.

Speculation in Rome was followed by speculation in Holland (tulips), speculation in France (The Mississippi Company), speculation in London (The South Sea bubble, which captured Sir Isaac Newton), speculation in Brazil (Encilhamento), and speculation in New York. They all follow the same pattern: a genuinely new development takes place; prices begin to adjust, investors notice the price movement and jump on board, eventually using leverage to increase their holdings; prices become increasingly divorced from reality; finally, the bubble bursts and prices revert—suddenly—towards a more economically rational level, given current financial conditions.

Photo: Koan. Source: Morguefile

Bubbles cause economic harm in two ways: during the boom they waste resources on over-building that could have been employed productively; and the bust can cause financial retrenchment when borrowers default on underwater asset-based loans. This can lead to a systemic loss of capital in the banking sector causing banks to pull back on lending. When loans contract across an economy, a burst bubble can lead to a recession—or even a depression.

Do we have any sectors of the economy that look like bubbles now? I haven’t noticed any. But one feature of bubbles is that they’re hard to see. We fool ourselves into thinking that a new era has arrived, or is about to: a “new normal.” Hmm, maybe we’re in danger bubble-thinking after all.

Douglas R. Tengdin, CFA

Chief Investment Officer

Uber-banking?

Is there a company aiming to upend banking, the way Uber has displaced taxis?

Taxis in Budapest. Photo: Elkes Andor. Source: Wikipedia

Fifteen years ago online retail seemed pretty risky. Who would give their credit card to a web merchant? Now Amazon sells more than Macy’s, Sear’s, and Kohl’s combined. Their revenues have grown more than 20% per year for the past several years. And while many retailers have had their customers’ credit cards hacked, Amazon has been more secure even as it has disrupted the retail industry. Could something similar happen to banking? That’s the question asked by recent Wall Street Journal article.

Banking is about getting money from people who have it to people who need it. Deposits are insured—that’s why people don’t worry about them; it’s also why banking needs to be regulated, and why it’s so expensive. Compliance with the Fair Lending Act, Community Reinvestment Act, CFPB, OCC, FDIC, and Federal Reserve is costly. There are a lot of regulations to follow and reports to run.

So app-based peer-to-peer lenders have started to pop up, like Prosper or Lending Tree or Social Finance. This is no great surprise. The economy has been growing for seven years now—it’s one of the longest economic expansions since World War II. While the Federal Reserve has lowered rates, banks still need to cover a lot of their fixed costs, so loans are still expensive. By cutting out the banks, peer-to-peer lenders can loan more cheaply and offer investors higher interest.

Lending Tree Stock Price. Source: Bloomberg

But many of these app banks make money by securitizing their loans and selling them, just like an investment bank. When the economy turns south, many those loans will go bad. People can’t pay their debts when they don’t have jobs. And securities backed by these loans will go south, too.

App-based lending will expand, for now, because your smartphone is their branch. All they need to grow is to add more servers. But there’s no free lunch. What low costs can give, low costs can take away. If banking gets uber-ized, there’s no need to pay a lender—or an app developer—much of anything at all.

Douglas R. Tengdin, CFA

Chief Investment Officer

Bootleggers and Bankers

Are banks out of control?

Photo: Nightscream. Source: Wikimedia

Many people are still hurting as a result the Financial Crisis. And there’s a lot to be upset about. By some measures upwards of $5 trillion in wealth was destroyed. The crisis triggered the Great Recession of 2008-9, and led to government bailouts and fiscal stimulus packages around the world.

At the heart of the crisis was our overly complex banking system. Fundamentally, banking is pretty simple: move money from people who have it to people who need it. People need money for lots of reasons: buying a home or car, starting and running a business, financing large projects like roads, bridges, or fiber optic cables. People have money from their long-term savings, their transaction accounts, and from the “rainy day funds” they need to set aside

This is pretty basic, but it gets lost in the arcane world of mortgage-backed securities, venture capital funding, and collateralized debt obligations. Banks have always been regulated – after all, establishing sound money is an essential government function – but in our global financial system regulatory difference between countries encourage large financial institutions to game the system. And the more rules there are, the more gaming that takes place.

This is why smaller banks are almost always a lot simpler than big banks. The big banks have Caiman Island subsidiaries, Eurodollar deposits, and foreign exchange desks that small banks don’t. These are necessary to serve the needs of their clients, but they also become profit-centers in their own right. It’s easy to look at these operations and say that they’re too risky, full of moral hazard. And wasn’t it trading in sub-prime mortgages that led to the failures of AIG and Washington Mutual and Lehman?

Not really. The institutions that traded these toxic financial instruments only lost a few hundred million dollars. That’s a lot, but it’s not enough to take down the system. It was the banks that bought and held the products—you know, long-term investing, the kind that politicians and pundits are always praising but never seem to support with their policies—that collapsed.

Source: Wikipedia

In the aftermath, Congress passed the Dodd-Frank bill, many of the details of which are still being hashed out more than five years after its passage. The devil is in the details, though, and the lack of clear direction by Congress gives regulators some pretty wide-ranging authority. Currently, the regulators are floating a rule to control the compensation of senior bank managers as well as the bank’s traders—the ones who make markets in government bonds and foreign exchange.

There’s a “Bootleggers and Baptists” problem here, where it’s in the big banks’ interests to have the regulations as complex as possible. In the short-run, these rules cost them money. But they cost everyone money—and the largest institutions can afford the systems and risk-management staff and legal counsel to make sure they comply, while smaller firms struggle. So the system devolves into an oligopoly, and too-big-to-fail banks become bigger and bigger.

Source: St. Louis Fed

The answer isn’t having even more complex rules. It’s having clear, unambiguous legislation with more specific direction by Congress – leaving less to regulatory discretion – which often appears capricious and contradictory. You can’t regulate your way to simplicity. But you can make simplicity more profitable. And let the market make it less risky.

Douglas R. Tengdin, CFA

Chief Investment Officer

Banking on Trouble?

What’s wrong with the banks?

Photo: IvoShandor. Source: Wikipedia

So far this year, equities are down about 10%. Shares of financial firms have led the way, down about 15%. And longer term, bank stocks still haven’t recovered from their losses during the financial crisis. What’s wrong with them?

You could throw up your hands and attribute it to random price action, but that doesn’t make sense. Even though they’re hard to predict, there’s still some semblance of rationality to stock prices. When oil prices plunged, the energy sector fell at the same time. When that same drop in oil prices put more money into consumers’ pockets, consumer stocks rallied. So what’s the market telling us about the financial sector?

Some worry about the strong dollar and a weakening corporate profit picture, but that affects mostly exporters, who fund themselves in the capital markets, not via the banks. Others point to the increased regulatory burden caused by Dodd Frank and other post-crisis regulations, but those have been with us for a while. My bet is that global deflationary fears are infecting the financial sector. Deflation is like kryptonite for banks. Even a whiff weakens them. And it makes sense: banks are levered institutions. When the assets that secure their loans go down in price, those assets are more risky. A higher risk-premium is going to depress the value of bank shares.

Source: Financial Times

That’s why both stock and bond prices have fallen lately for banks around the world. The global economy isn’t necessarily headed for a recession, but it’s a risky place. Bankers could do everything right—control their credit risk, make sure they’re operationally tight, know their customers—and still hear politicians and regulators calling for Congress to break them up. Too big to fail is too big, they say. And banks are bigger now than they were in 2007, before the crisis.

That’s what’s weighing on banks. Just remember: banks are leveraged. They magnify the downside of things, but when the world doesn’t end, they have a way of roaring back.

Douglas R. Tengdin, CFA

Chief Investment Officer

Show Us The Money

Why don’t people trust bankers?

Source: Gallup

In a survey of how people rate the honesty of folks in different lines of work, medical professionals came out on top; members of Congress and car dealers were on the bottom. Bankers, lawyers, and journalists were pretty much in the middle. Confidence in financial professionals took a big hit after the latest financial crisis and Madoff scandal, as it did after the S&L crisis of the early ‘90s.

Few people have experienced real losses when it comes to banking—as opposed to investing in the stock market. (Stockbrokers—as opposed to bankers—have a very low approval rating.) So their low opinion of bankers isn’t based on experience. Rather, it’s a matter of their public profile. But the professions that are rated highest—doctors, teachers, clergy—are ones where we remember a positive experience. Conversely, the lowest-rated jobs are ones where people have been personally swindled. Maybe we were laid off by an incoming business executive who then collected a fat bonus. Or that fancy car I just bought turned out to be a lemon.

Bob Hope once quipped that a bank is a place that will lend you money–if you can prove you don’t need it. Money may be a necessary evil, but we need to trust those who keep our cash. For people to trust a profession, they have to benefit personally. For bankers and finance professionals to improve their public image, it has to be more about the client, and less about the money.

Douglas R. Tengdin, CFA

Chief Investment Officer

Dark Matters

Dark Matters

Is anything holding our financial universe together?

Globular Star Cluster. Photo: Skeeze. Source: Pixabay

In 1932 a Dutch astronomer couldn’t account for the movement of the stars given the current measurement of visible mass in the universe. He posited that dark matter must be holding the galaxies together. His hypothesis was confirmed 40 years later by another astronomer making observations about galactic rotation.

In the same way, our economic galaxy appears to be spinning apart, lurching from one crisis to the next. 50 years ago currencies were backed by gold reserves, loans were secured, and central banks had a mandate to “lend freely against good collateral.” Now every major nation has a fiat currency, secured bonds are less common, and central banks are critical supports to the global financial system. There’s nothing tangible holding borrowers to their commitments. For example, it’s estimated that the European Central Bank holds over €130 billion in unsecured deposits in Greek banks—over 5% of its balance sheet.

And it’s not just Greece. Secured bonds in the US have declined from 35% of the bond market to just 25% over the past 25 years, while unsecured government debt has risen by that amount. There’s not as much security serving as financial mass. Our monetary infrastructure is now based on a set of promises and paper agreements. But if those break down, there’s nothing holding it together.

In the “Star Wars” films, Luke was taught to “use the Force”—a mysterious energy field that “binds the galaxy together,”—something a lot like dark matter. But there’s nothing mysterious about our financial system today: trust has become the dark matter of finance.

Douglas R. Tengdin, CFA

Chief Investment Officer

Long Live the Queen?

The King is dead.

That’s what I thought when I heard that Emilio Botin, Chairman of Banco Santander, had died. Botin had been running Santander—based in Madrid, Spain—since 1986. His father, grandfather, and great-grandfather had all been bankers. He took what was then a sleepy, regional bank and built it into one of the largest banks in the world. He was a canny manager, acquiring Sovereign Bank in the northeastern United States for $3 / share in late 2008, when it might have cost $40 / share in 2006. And Santander weathered the Financial Crisis well, never taking a bailout, and never cutting its hefty dividend.

Continue reading Long Live the Queen?

Banking on Change (Part 4)

The last challenge for banks is technology.

Bankers have always had to adapt to new technology—whether it was drive-through tellers or debit cards or ATM machines. But the mobile revolution creates especially significant demands. Now, almost half of all depositors prefer to manage their accounts via PC or cell phone. By contrast, five years ago only a quarter of their customers did their banking this way.

Continue reading Banking on Change (Part 4)