The Fed's War on Inflation Expectations

When the Fed more than doubled its balance sheet during the financial crisis, many believed inflation was unavoidable. Since then, the dollar has fallen 15% and gold, other commodities, and commodity-linked currencies have soared. But the inflation expectations that moved markets throughout 2009 were never justified by data, with economic data indicating deflation was the real concern.

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Chinese Banking Strength

Chinese banks' non-performing loan ratio dropped from 2.42% in January 2009 to 1.66% at the end of Q3 2009. In contrast, Western banks have steadily increased loan-loss reserves. Some (such as Tony Wang and Grace Tian of ChinaKnowledge) have pointed to this change as proof that the Chinese banking sector has grown stronger during the financial crisis and is well situated to expand abroad.

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Structural Reform Is More Effective Than Regulation

The discussion on banking reform usually focuses on higher capital requirements, less leverage, and more oversight. In my opinion, this focus is misguided. Repealing the de-regulatory acts of the late 90s might be more effective because structural limitations are generally harder to bypass than something judgement-based, such as risk-weighted capital. I think history is on my side.

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Commercial Real Estate and Bank Capital

Lesley Deutch, VP at John Burns Real Estate Consulting, gives a very negative outlook for commercial real estate in this week's Advisor Perspectives newsletter. She argues the fallout in commercial real estate will hit commercial banks harder than residential mortgages. One of the reasons for this is that banks hold a much greater percentage of commercial mortgages than residential mortgages.

Commercial banks hold about 45% of all commercial real estate mortgages, compared to 21.3% of residential mortgages (though residential mortgages are a bigger market). Deutch expects banks to recover less than 20% of their CRE loans and predicts government involvement to exceed what we've seen so far. I doubt much of these losses will come from further declines in prices, which seem to have bottomed:

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The Importance of Regulation for Bank Earnings

A recent study by a JPMorgan research team predicted profits at large investment banks such as Goldman Sachs, Morgan Stanley, and Citigroup could fall by a third. While I haven't seen the report, I can't envision any way financial regulation wouldn't have a drastic effect on bank earnings. Three forces will be especially powerful:

1. Higher capital requirements: Over the last decade, the balance sheets of the five biggest investment banks have surged 16.3% annually, rising from $1.27T to $4.27T. This rise in total assets was aided by innovative forms of regulatory arbitrage that will no longer be viable. Higher capital requirements as well as crackdowns on loopholes will shrink banks' total assets. As assets generated income of some sort, earnings will decline.

2. Changes to Off-Balance Sheet accounting: the FASB's crackdown on SPEs will limit banks' ability to bypass capital requirements. It will also force banks to bring derecognized assets back on their books at the end of the year, using up more capital and decreasing leverage.

3. Regulation of OTC derivatives: OTC derivatives are blockbusters on Wall Street. The fees are high but corporations still like OTC derivatives because collateral requirements are low, depending on credit rating. But if interest rate swaps, credit default swaps, and other standardized derivatives are moved to exchanges, banks stand to lose a lucrative cash cow. Fees are lower on standardized deals, plus exchanges have higher margin requirements, making derivatives less attractive to corporations. The notional value of these deals are huge. Interest rate swaps alone have grown from $29T to $328T in the last decade and account for 55% of total contracts outstanding, according to the BIS.

Armageddon In Retrospect, Part 1

With the anniversary of the Lehman collapse a few days away, I thought it would be interesting to look at what has changed for consumers, the banking industry, and finance as a whole over the last year. Today I will focus on how banking has changed for the consumer, using Washington Mutual as a case study.

In 2003, CEO and Chairman of WaMu, Kerry Killinger, boldly claimed, "We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs, and Lowe's-Home Depot did to their industry. And I think if we've done our job, five years from now you're not going to call us a bank." Killinger was right for the wrong reasons. A little over five years later, I doubt anyone would call WaMu a bank anymore.

WaMu's business model focused on building a consumer friendly way of banking, without ATM fees, monthly checking charges, and so on. Its ubiquitous commercials featured young people in casual clothes rallying against the old-fashioned commercial banks, represented by old men in fancy suits often depicted counting money (see here and here). Another line of commercials used the slogan "The Power of Yes" to emphasize WaMu's "flexible lending rules", underscoring the tremendous amount of loans originated by WaMu (for a particularly funny commercial, see here). These commercials underscore WaMu's success in issuing loans and gathering deposits. But WaMu's democratization of commercial banking ended up being its downfall. Its large amount of home loans left it very vulnerable during the subprime crisis. Its "flexible lending rules" meant that half of its $119bn mortgages were option ARMs (aka POAs, see here). When depositors pulled out $16.7bn in 10 days, WaMu was left with almost no capital. Ironically, JPMorgan Chase, the archetype of an old-fashioned commercial bank, ended up acquiring WaMu at a fire sale price.

From a business perspective, Washington Mutual deserved to fail. Its lending was irresponsible and myopic. But from a consumer's perspective, the failure of WaMu represents a bank that was friendly to the little guy being taken over by a bank that was too big to fail (and a $25bn TARP recipient). A friend of mine who banked at WaMu was dismayed to hear the new owners had instated the very fees WaMu had promised to avoid.

JPMorgan deservedly came out stronger from this crisis than it went in. But from a consumer's perspective, the consolidation that has occurred in the banking industry over the last year is not a good thing. A recent WashPost article describes how the crisis has created an oligopoly of four large banks--JPM, Citi, Wells Fargo, and BoA. These banks now issue one of every two mortgages and two of every three credit cards. Remember that before the financial crisis, regulations prevented any bank from having more than 10% of the nation's deposits. Now the top 3 commercial banks all violate this benchmark.

The most striking effect of this consolidation has been the increase in fees. In the last quarter, the top four banks have raised fees related to deposits by 8%, while smaller firms have lowered fees by 12%. Data shows that large banks have the ability to borrow more cheaply because they are assumed to have negligible counterparty risk. Large banks with more than $100bn in assets are borrowing at .34% less than the industry. In 2007, this number was only .08%. For a commercial bank, this lower cost of funding is a huge competitive advantage. One consequence is that large banks are able to easily outprice smaller ones.

The consolidation in the banking industry, caused by the financial crisis, can't be undone. In economics, one characteristic of an oligopoly is that fragmented buyers will have less bargaining power, resulting in prices higher than equilibrium. This strongly supports the need for the Consumer Financial Protection Agency. But something further needs to be done to promote competition among banks of all sizes. So far, there have been no proposals addressing the massive challenges facing small and mid-size banks in the future.