Friday, February 27, 2009

Four times slaughtering a dead horse

Editors note

This is the fourth post on a quarterly set of numbers from Bank of America.  That post sent my in-box on fire.  The disagreement was absolutely vehement.  Even when I mention global warming I do not stir up passions like this.

If you want to follow the saga read the posts in reverse order.  Start with this post, then this and then this.  Finally get to this current post.  However if you are willing to accept my assertion that bank margins are rising regardless of subsidies then just ignore all but the first post.

I fully agree that – if at the moment – the FDIC guarantee were removed then Bank of America would fail.  That failure would happen regardless of whether Bank of America is actually capital adequate or not.

However if the guarantee were removed the few banks around that were considered solvent would be flooded with money from people who wanted to put it there.  

They would get those deposits very cheaply.  Really cheaply.  Free in fact.

The lending situation would be truly diabolical though.  The rate customers would pay would go up sharply.  

Bank margins would be truly spectacular.  The problem would be survival to take advantage of those margins.

There is only one reason at all you are paid interest on bank deposits.  It is that they are guaranteed.  

Go to  Look up the highest rate you can find.  It is usually Corus Bank – which as noted here – is truly diabolical.

If you want to attract deposits you have to compete with Corus Bank.  Corus Bank has those deposits and has the ability to attract them purely because it is guaranteed.

Note this.  The guarantee raises the number of serious competitors in the deposit market.  It raises the cost of deposits and it hence lowers bank margins.

Yes I stand by the assertion that if the guarantee were removed bank margins would rise – and deposit costs would fall.

Access to funds at all would be the issue.  Not their price.  Offering to pay for funds would not help (see the Akerlof Paper on the Market for Lemons for a good theoretical explanation).  

Now when is it that my readers - usually with good economics training - stopped believing that the main determinant of margins is competition - and that subsidies given widely do not increase the income of the receiving industry - but just get competed away?


epicaricacy said...

I've found people will simply not believe positive stories, even positive facts about bank income statements at this point in time, yet negative statements, say "the whole of the American banking system is insolvent" are deemed credulous with no evidence provided.

Maybe the feedback is a contrarian purchase signal?

Tom Lindmark said...

Keep at it. Your analysis is spot on. People are getting so hooked on bad news that they view positive outlooks as disenfranchisement.

Anonymous said...

John, if you feel that the maimed horse just has entirely too much life in it, it could be useful to break out a few bank balance sheets to show the components of recurrent income from its different operations over time.

If they saw how the losses in the dragging components of the company (trading, derivatives, etc.) would still be significantly covered by the rising revenues in regular lending if given the necessary time.

You could roughly simulate 8-12Qs of a balance sheet without too much trouble I would think. If not, I'm not a bank analyst, but I am a fiscal policy analyst ;) and would be interested to give it a whack. However, I don't think I'd have the time to do this for another week (traveling). But, you could even produce an incidence of simulations, run through them and see what the results are.

Swedish Lex said...

Sure, resurrection will come at one point. When? Not clear. Which the legal entities will be that rise after Armageddon, we do not know. At least, I do not.

We are at the junction of finance and politics. The outcome will depend on both. Get the politics wrong, and your financial assessment is meaningless.

There will be huge profits to be made over time, for sure. But to me, there are still to many unknowns.

jadioj said...

It is true that in times when lending is constricted, margins improve. I hate using this phrase but is it different this time?? Here are some of my issues which I hope you can address:

1. Everyone is becoming a bank, that can't be good for deposit pricing as it makes it more competitive. Look at what GMAC is offering.
2. Administration is trying to push mortgage rates to 4.5%. Again hurting margins. I know mortgages aren't the only category out there and banks can also chase yield by going to the secondary market at the expense of economic growth.
3. FDIC just released their 4Q banking profile and stated margins are at a 20 year low of 3.34%.

I think your increase in NII is only happening at large, perceived to be quality banks.

Isam Laroui said...

Nobody believed the negative stories before the crisis whatever the merits. Now nobody believes the positive stories. Par for the course.

anonymous said...

excellent point.

if you really want to see something interesting, go look at Fannie's 4Q report.

the media is focused on the headline loss, but the reality is that revenue exploded in 2H 08. The NIM widened substantially and g-fees went through the roof.

2yrs ago, cash revenue (nim+g fee) was running at an $11B annual rate. in 2H 08, it was running at a $20B annual rate. and rising. cash operating expenses are about $3B per year. so they have $17B of pre-tax pre provision income to deal with the problems.

and, as an added bonus much of the loss in the 2H is the negative mark on their interest rate swaption. this is the primary instrument they use to keep their duration gap within +/- 6mos. this negative mark is offset by the rising value of their on balance sheet retained portfolio that is held to maturity and thus not reflected in GAAP financials. the negative mark on the swaption will accrete back into the NIM over the next 4.5yrs (duration of retained portfolio), thereby reversing roughly $16B of negative marks taken in CY08.

and wait - it gets better. another $20B of losses this year were attributable to the write down of the deferred tax asset. the accountants wouldn't let them keep the DTA on the books when they are being run as a non-profit for the foreseeable future. again, though, this is a non-cash charge that doesn't necessarily reflect economic reality.

how big are the losses, you ask? check out fannie's 10-K supplement. they provide cumulative default curves by vintage year for their entire book. it appears the 06/07 books are tracking to 4-7% cum defaults. that's roughly $70B of defaulted balances. at an average severity of 60% that's $42B of cum losses, or 2.5 years of pre tax pre provision income.

maybe we can better understand now why paulson and bernanke were keen to nationalize. the last thing in the world they wanted was a shareholder owned duopoly exercising its pricing power in a tight credit environment.

and maybe, just maybe, that's why the financials sold off so aggressively after these guys moved on the GSE's. it was the first sign that the politicians were going to "force" financial institutions to be run in the public interest through the recession.

wouldn't it be ironic if it turns out that in their ill conceived efforts to "stabilize" the economy, bernanke, paulson, geithner and lockhart triggered the very depression they hoped to avoid.

history will not look kindly on any of these public officials

MattJ said...

Surely, a new, safe bank, unencumbered by past losses, could compete for deposits against BOA even in this environment. Right now, there is no incentive for a depositor to leave more than the minimal amount of cash needed to cover monthly costs in BOA, as they are offering basically no interest. Absent government interference, how can BOA and the other zombie banks expect to hold onto their cheap deposits long enough to cover their losses?

Anonymous said...

now I could be wrong since I have not done the requisite research and analysis on BOFA's numbers, but it was my understanding that BOFA was in the best financial shape until Ken Lewis got drunk with power and embarked on a fools errand of empire building by acquiring Countrywide and Merrill.
Therefore, although BOFA's net income is growing at a healthy rate, its liabilities-both seen and unseen, have increased by a factor many times greater than the rate of BOFA's net income growth.

Not only have the liabilities grown astronomically, the liabilities in question are of the "toxic/hard to value/level 3" brand, which the bank cannot sell to the market for liquidity without taking a huge writedown which leaves BOFA hopelessly insolvent, without a Govt bailout/backstop.

John Hempton said...

Anon's last post is wrong. BofA did not consolidate Merrill until 9 January.

Countrywide is small.

Revenue will be up very sharply again this quarter.

But that will be in part Merrill.


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