Just 10 months ago, many banks were on the verge of collapse. In the second quarter of this year, banks have managed to produce healthy profits, as The Associated Press reports:
The big banks are making big money again, but they won't be back to health as long as they have to deal with a recession and customers defaulting on mortgages and credit cards.
The impressive numbers included a $3 billion second-quarter profit announced Friday by Citigroup and $2.4 billion for Bank of America. They followed similarly robust earnings for Goldman Sachs (GS) and JPMorgan Chase (JPM).
7 Drivers Behind Healthy Bank Profits:
- TARP, TALF – Healthy capital injections by the Federal Government have backstopped banking finances. Bad assets have been removed from the bank’s books and placed onto the Federal Government’s balance sheet. Who cares if they make risky bets, as their losses are backstopped by the Federal Reserve.
- Steep Yield Curve - The Fed has been exceptionally accommodating during this recession, far more than during past recessions. With a steep yield curve, banks can borrow at ultra-low interest rates and lend out at high interest rates.
- FDIC Guarantee – Nearly all bank deposits are guaranteed by a Federal Agency, the FDIC. The limits have been raised and the scope of coverage expanded to deal with the banking crisis.
- Mortgage Lending - Bank's second-quarter revenues are being bolstered by a spike in mortgage refinancings as interest rates have tumbled. Much of this paper is then resold to government sponsored enterprises.
- Less Competition – The shakeout has removed Lehman Brothers, Bear Stearns and smaller regional banks. The remaining banks benefit from decreased competition.
- Investment Banking – The rebound in the stock market and renewed investment banking activity have helped Goldman Sachs earn $2.7 billion in the second quarter. Despite the recent credit crisis caused by “too much leverage” and “too much derivative exposure” the banking sector is still taking on high amounts of derivative risk. Net leverage has decreased, with less competition and higher spreads, banks can make the same profits as before with less leverage. The derivatives party may be coming to an end, if Barney Frank gets his way (July 30th article on derivatives regulation).
- High Frequency Trading – A recent article in the NY Times writes that the large banks are using high frequency trading to clip a penny off of stock transactions. Full article is here.
Why All The Largesse For The Banks?
According to July 30th NY Times article, bankers paid themselves healthy bonuses during the depths of last year's financial crisis. The abuses of high frequnecy trading have recently become well-publicized. The reckless risk-taking among some of the industry's largest players that has imperiled the nation's financial system is well-known, even among high-schoolers.
Why are banks being subsidized?
The reason is that banks are efficient distributors of the Fed’s easy money. Because the government's social agenda relies on cheap and easy credit, a healthy banking system is key. Over the past half-century, the social agenda of the Federal government have been:
- High rates of home ownership.
- High levels of employment.
The banking system is the handmaiden of social policy. As such, a healthy banking system is crucial. Allowing the financial system to collapse or degrade would be akin to letting the military or the IRS collapse.
Gerrymandering The Financial System
As Niall Ferguson explained in his landmark series The Ascent of Money, The US and UK governments encouraged home ownership for political reasons. The US government gerrymandered the financial system by backstopping the GSEs, guaranteeing deposits with the FDIC and allowing tax deductions for mortgage interest.
This worked for decades, until the Federal Government decided to “kick things up a notch” by encouraging lending to less-than-credit-worthy and non-credit-worthy home buyers. A loosening of banking regulations here; a tinkering with the mortgage regulations there; and you wind up with overbuilding and speculation in residential housing. The result is subprime mortgage defaults and Alt-A mortgage loan defaults, and ARM resets. Each tinkering in the markets causes a boom and bust crisis. Each crisis causes the Government to step in and backstop the losses of the banking sector.
Banks are motivated by profits. The financial sector maximizes profits according to rules handed to them by the political sector.
The Bright Side
Easy money has a way of getting out of hand. Instead of investing in productive assets such as businesses, factories or capital equipment; inflation-spooked investors may divert significant capital into precious metals such as Silver and Gold. The rush into precious metals has already already begun as this article shows.
The good news is: with their easy money policy, the Fed is guaranteeing that we will not relive the horrors of mass unemployment witnessed during the Great Depression. The economy will recover. Meanwhile, our nation can still borrow (God willing) from China and Japan who continue to support us by buying more bonds. Business as usual… until the next crisis.
The other good news is that some of the banker's abusive practices are coming under fire. Perhaps the bankers will get less gravy.
- Legislators are championing for limits to excessive bonuses and compensation in the financial industry.
- Recently Barney Frank is pushing for regulatory reform in derivatives.
- High Frequency Trading has come under attack.
Perhaps this is just political grandstanding, and nothing will come of it. The gravy train that has been ridden these many long centuries by the finance industry is not about to be derailed. Even if some of the gravy is taken away, banking will still be a lucrative industry. That's why I say:
If you want to make money by the truckload, start a bank.
Full Disclosure: Author is long financial stocks (at least the ones that still pay dividends) The financial sector is currently one of the riskiest sectors. This article is for informational purposes only and is not meant to be construed as an invitation to invest with any specific strategy or to buy or sell any securities. You should perform your own due diligence and consult with a professional before investing.