Too Big to Fail: Not Just Bad Policy, It's Also a Total Scam

Includes: IYF, KBE, KME, KRE
by: Dave Lewis
The streams here in the Northeast US yesterday, following a solid 2 day rain, are akin to those of income enjoyed by US Banks - spilling over at record-setting levels.
As promised, today's musings will focus in more detail on US Banking sector incomes, expenses and the future of Too Big To Fail.

Banks always and everywhere make the bulk of their income from lending and the US sub-species is no exception to this rule. Bankus Americanus is, however, unique in a few regards. It is the only animal on the Endangered Species list whose dwindling numbers are a result of cannibalism. To wit, in just the past 15 years, numbers have dropped from 12,604 to 8,012 but those that remain are fatter than ever. Additionally, (and somewhat more seriously) unlike most banks in history, in recent times non-interest income has risen to more than 50% of interest income, helped in part, by the termination of Glass-Steagall restrictions. Data: FDIC- all covered institutions, aggregated

Given the substantial compensation American Bankers receive, one might expect the increased non-interest income to come via trading, investment banking or the recently allowed insurance and brokerage activities, but this is not the case. Service charges on deposit accounts earn US Banks more than trading, investment banking, insurance, or brokerage in every year for which I have data. The lowly paid back office workers, in other words, generate much more income than the highly paid traders.

Admittedly, as I learned at Chase, there are indirect benefits to having a trading desk (and other financial services). Trading, for example, requires a cash deposit which will not only generate its own set of fees but also increase lending by whatever multiple the bank deems prudent.

Regardless, in the aggregate, US bank trading profits (exclusive of employee expense) have never exceeded 10% of net interest income. And the banks haven't even begun to unwind their derivatives portfolios, an event which may well push the absolute value of trading income above that of interest income for a year or two. I suspect in the not too distant future the wisdom of bank trading will be seen as pure folly. The NIMBY (Not In My Back Yard) movement which drove, e.g. chemical processing, off to foreign lands will soon, I believe, drive trading from Banks.

Moving on to larger streams, the biggest line item in the FDIC's breakdown of non-interest income is obscurely titled "additional non-interest income." The FDIC defines this as:
All non interest income of the bank not required to be reported elsewhere, including (but exclusive to):
  1. Income and fees from the rental of safe deposit boxes;
  2. Income and fees from the sale of checks, money orders, cashiers' checks, and travelers' checks;
  3. Income and fees from the use of the bank's ATMs;
  4. Income from performing data processing services for others;
  5. Earnings on or other increases in the value of the cash surrender value of bank-owned life insurance policies;
  6. Rent and other income from Real Estate Owned.
Chalk up another win for the back office, and, better still, the electronic office. An inquiry with the FDIC informed me that ATMs (and related services) were some of the biggest earners at US Banks. How clever of Bankus Americanus. The advent of the computer and internet age led to price reductions in most industries, inspiring the then Banker in Chief Greenspan to proclaim a productivity miracle. Bankers, by contrast, increased their income.

Pause for a moment. Can you imagine the outrage if ATMs were outlawed and tipping a teller a few dollars each time one made a withdrawal became mandatory? Can you imagine how many people would suddenly get the urge to be a bank teller? Banks would then have no problem staying open 24 hours a day, just like the ATMs- and we might all enjoy a human voice saying, "Thank you for banking with us."

There's a lesson to be learned here. The aggregate data strongly suggests that bankers aren't smarter than they were 30 years ago, they are just more protected. Protection of the sector allowed a relatively small group of people to pay themselves huge salaries (and huger bonuses) while the bulk of bank income was derived not from their efforts but from normal bank services spared the ravages of tech sector cost cutting. The high priced guys are the ones who have generated the problems.

Returning to cash flows, income isn't generated for free. The network of ATMs required development (but shouldn't the patent protection for this have expired like those for pharmaceuticals?), installation, and continued service. Profits accrue only when incomes exceed expenses. Banks must borrow funds more cheaply then they lend them.

As interest income is the bulk of bank income, you would expect that interest expense (i.e. cost of funds) is the bulk of bank expense. Up until the past few years, this was true. In 1994, interest expense was $145B (interest income was $321B) while employee compensation was $70B. In 2009, interest expense was $145B (interest income was $541B) while employee compensation was $163B. Amazingly, less than 2 million bankers (actually the problem is caused by the top 10%) paid themselves more than they paid the 100s of millions of depositors for the use of their funds. They even paid themselves more than they paid the bank owners.

If this (taking new equity capital to pay off previous investors and line their pockets) sounds like a Ponzi scheme that dwarfs that of Mr. Madoff, then I've made my point.

This brings us to the bottom line. If the Banks are truly TBTF and Bank employees truly indispensible, Capitalism is well and truly dead and Banking no longer a job, but a religion. In Capitalism, shareholders, not employees, are the ultimate arbiters of business. Once net income goes to zero or below, the business, in its current form, is on borrowed time.

Free money from the Fed, and bail-outs from various governments, allowed US Bank employees to pull off a marvelous trick, thereby freeing them the normal constraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

On Tuesday, Paul Volcker said TBTF was "moral hazard writ large". He was wrong. It's a hazard before it happens. This has been going on for 3 years.

As with the Tech Boom, something has to give. The real sector in the US isn't recovering, in part because credit is just circling round in the financial markets, as was the case in the early '90s, but on a much larger scale today. Real sector borrowing rates (adjusted for tighter credit conditions) are still too high. Thus the residential mortgage problem is not going away, and likely to worsen now that the Fed is out of the game (for the moment at least) and a commercial mortgage problem is looming. Unlike the 'early 90s, there is no RTC set up to recover money for the banks, and there's that problem of who really owns the mortgages to be solved.

At current price levels it will be years before the banks are back to whatever constitutes normal these days, and I don't think we'll have that much time. Unlike the '90s, we have a government debt roll-over problem. If Banking sector NOI is roughly zero again this year, will shareholders be willing to accept zero dividends? I doubt it. Absent a sudden recovery in the real sector, US Banks, like the Irish Banks, will soon find they need more money.

Barring an unlikely substantial reduction in employee compensation (a solution I highly recommend, rolling salaries back to 1999 levels would free up roughly $70B A YEAR for loan loss provisions), the banks could dilute their own shares (but only for so long) or try to raise more overseas equity, but the amounts would be limited, in the case of foreign investment, to less than a controlling stake. I can't imagine the US population or government allowing China to hold a controlling interest in Citibank (NYSE:C) or any other big BHC.

A $ devaluation policy would alleviate the mortgage problem but the subsequent rise in interest rates would likely ignite another, much larger problem in the 200+ Trillion dollar derivatives portfolios, and our foreign creditors would be none too pleased. Sadly for them, the German option of forced liquidation is least desired by the powers that be. Devaluation, I suspect, is the only option - it just has to appear to be an accident.

Regardless, we'll likely soon discover that TBTF isn't just bad policy, it's a scam - the Tech Boom on steroids.

A note on aggregation: Sometimes this process makes it easy to miss the trees for the forest - some banks might have profitable trading desks but they get lost. Goldman Sachs comes to mind. Yet, during the crisis of 2008, GS would have gone the way of LTCM (for the same reason) but for their transformation into a BHC and the bailout of other institutions (notably AIG) which kept payments flowing. GS isn't much of a bank in the usual sense, but an investment house. They should not, in my view, have gotten the protection of commercial banks.

A note on trading: This essay might leave readers with the notion that I'm against trading. I'm not. I trade. I simply believe that for trading to provide the promised price discovery benefits, they must stand on their own as private sector businesses.