Thursday, January 21, 2010

How are banks making record profits?

I need help with this one. I have a serious question, and I think I know the answer, but I need confirmation that I am correct (or correction, if I am not.)

Commercial and investment banks are all of a sudden making huge profits, even though from what I have read, the typical lending and underwriting activities of these institutions hasn't recovered much at all from the economic crisis.

So where is the profit coming from?

Here is what I suspect: The Federal Reserve's balance sheet has ballooned, much of it due to providing massive amounts of liquidity to the banking system in order to forestall collapse. The discount rate (the interest rate the Fed charges member banks when they borrow money from the Fed) is at 0.0%.

Which means the Fed has basically said:

"The government will not let you fail. No matter how bad your own balance sheet, no matter how much your own assets have fallen in value, even if you are completely insolvent from a asset/liability standpoint, we will lend you money so your depositors know they can get their money back if they want it."

Normally, insolvent banks just fail. But in the collapse of 2008 and 2009, both Bush and Obama bought the "too big to fail" line, and the government stepped in to provide banks with the liquidity that the markets would certainly have not.

Which gets me back to my original question: So how and why are these banks making so much money now? Are their balance sheets now healthy? Are their banking activities now generating record revenue? If so, how could this possibly be the case if the economy is still so putrid?

Here is what I am pretty sure is the answer, and I would very much appreciate someone with more recent industry knowledge than myself to confirm this:

Banks are borrowing massive amounts from the Federal Reserve at zero percent, and lending that money to the ..... FEDERAL GOVERNMENT by buying treasury bonds to finance the deficit.

So if you can borrow basically unlimited amounts at 0% and then "invest" it in Treasury Notes at 2-3%, what a great business model! I wish I owned a bank. I'd think I could manage to turn a profit doing that.

So if I am right, this is just the federal government monetizing its debt, with a 2-3% leakage to commercial banks. From the taxpayer standpoint, we get doubly screwed. Monetizing the debt is hugely inflationary, but normally the government can do it without simultaneously enriching the managers of insolvent financial institutions!

So this brings me to the Obama "tough on banks" rhetoric and his bank tax idea. It is so disingenuous. Should these bank managers be earning huge bonuses? ABSOLUTELY NOT! If I am right about the above, their profits are basically just 100% taxpayer subsidy. Why should they make millions by running a government sanctioned scam in which they borrow money from the taxpayers and then lend it back to us for a 3% spread?

The structural damage this causes is almost incomprehensible. First, when does it end? If the Fed stops lending money to the banks at zero percent, or starts charging what the market would charge for banks with insolvent balance sheets, the banks would fail. So is the Fed going to continue to lend at zero until these bank assets somehow recover in value? That is just not going to happen. These sub-prime loans were NEVER worth what they were valued at, so they will certainly never "recover" to that level.

The only way the bank balance sheets can "recover" to a point where the capital markets will once again lend to them and get them off of the Fed's dole, is by either getting new capital from investors (some of which has happened, but I am pretty sure not anywhere near enough to make the banking sector's balance sheets healthy) or by the US Government taking the toxic assets off their hands at above market values.

In the case of the latter - which is what the TARP program was supposed to do - this is just another form of subsidy.

So the upshot is: Why SHOULDN'T we object when banks are now paying huge bonuses, if their profits are basically from public subsidy?

But I resent we are in this situation in the first place. It was absolutely predictable as soon as we bought the notion of "too big to fail." If we bail out the banks, they will be dependent on taxpayer largesse to survive. And that puts us in the position of either accepting whatever the bank managers want to pay themselves for the "profit" they squeeze out of us taxpayers, or start regulating the salaries of the "private" sector.

Thanks a lot, Bush and Obama!


Anonymous said...

I have no personal expertise in banking. Your analysis agrees with the opinions of many guests and commentators on business TV and Radio.

I hope the IRS is collecting all taxes due on those bonuses.

The consumption capacity of holders of treasury securities (paying paltry interest) as well as bank stockholders getting minimal dividends has got to be a continuing drag on GDP.

Anonymous said...

Rob I am pretty sure you are 100% correct here. The banks are not making money being banks, they are just siphoning money from the Fed, channeling it back to the federal government, and taking a fee.

Why should we allow them to be paid huge bonuses for leeching out tax dollars?

Anonymous said...

The other side of "too big to fail" is "being crushed under a weight we can't support."

My inclination to let them continue paying bonuses is simply that it puts an excellent spotlight on what happens when the government reaches for the private sector pie.

Anonymous said...

I think your analysis is correct, but there's something you left out.

By keeping interest rates artificially low, the Fed is helping the banks recover from all their loan losses. Banks are posting record profits, but it's going to take a long time for some banks to acknowledge and write off all the bad loans on their balance sheets. Meantime, when you and I and any of your readers try to invest some of our rainy day money in a safe place, such as a savings account at a bank or in a Treasury bill, we get screwed: the interest rates we get are practically zero, and what little we do make is taxed and then its value is eroded by inflation.

It's sick, and there's not a darned thing we can do about it.

Jack Roberts said...

I don't pretend to fully understand this, Rob, but I believe a lot of these bankers are paid for their performance as money managers and the stock market has made a pretty strong comeback this year. When you are managing literally billions of dollars, even a small percentage bonus can add up to big dollars.

The real issue should not be "punishing" either bankers or bankers but looking at structural changes in how banks are allowed to compensate their employees to get away from the incentive to engage in manipulative investments for short-term gains that put the eonomy at whole at risk.

Unforturnately, figuring out how to do that takes time, research, analysis and mature judgment. Somehow, I doubt that is going to comje out of either the Obama Administration or Congress.

Rob Kremer said...

Jack -
I think you are at least partly correct. The investment banks like Goldman no doubt made their money this year through management fees, with a market going up.

Commercial banks are not in that business, however. So it doesn't explain how they made huge profits.

But even for the investment banks - what a huge moral hazard. They lose huge - we bail them out. They have good year, get huge bonuses.

I am all for big salaries for people making money. I am totally against bailing out failure, and rewarding the risk taking that we might have to bail out again.

Jack Roberts said...

Rob, I absolutely agree with you on the moral hazard issue. But, of course, the answer is to keep the banks from becoming "too big to fail" without, at the same time, losing the major financial management business to Japanese or other foreign banks (which was the risk we were running at the time Glass-Steagal was repealled).

Ironically, the people in the Obama Administration best able to evaluate and help solve this problem are also the one's most compromised by it--namely, Larry Summers and Tim Geithner.

My fear is that Ă–bama is going to embrace the "anti-business populists" in the effort to counter the success of our "anti-government populists" so that the result could be to make things worse rather than better.

This, incidentally, mirrors much of what happened in the New Deal, where Roosevelt's more balanced tone in his first election gave way to a more anti-rich, anti-business tone in his second--before he overreached with the court-packing scheme and other radical measures in 1937 and he saw his governing coalition break apart (only to be salvaged by the on-coming of World War II).

Rob Kremer said...

That is the question: "Too big to fail" - is this a reality, or is it just the financial elites trying to scare the crap out of us so we save them from their recklessness?

Back in late 2008, John Fund from the WSJ was in town, speaking at the Executive Club. I asked him what would happen to the financial system if the government did not bail it out. Would there indeed be a worldwide collapse?

He couldn't answer. He kind of shrugged. Didn't know, or at least didn't try to make an intellectual case that no bailout would have been a disaster.

So I remain unconvinced. I believe in the Schumpetarian "creative destruction," view of capitalism. Would there have been short term problems if we let the banks fail? Absolutely.

But they sold it as preventing long term collapse. I have more belief in capitalism than that. And what we got (and have now) looks a lot like a long term problem.

So the bailout brought us the controversy over bank bonuses. If we had principled leadership from Bush and Obama, leaders who actually understand and believe in the American capitalism system as opposed to the cronyism we have, this would not be an isse.

Jack Roberts said...

Well, I don't necessarily regard John Fund as an expert on this, but the fact that he was unable to predict what the consequences of letting the big banks fail would be is not reassuring. I'm more comfortable with Ben Bernanke's assessment and he was very concerned about those consequences.

People are complaining now about the big bank bonuses, but if the banking industry had collapsed and taken the economy with it, most of us would be saying, "I don't care how much those bankers made if the banking industry would simply get back on its feet."

Whether or not these banks were too big to fail, I think the risk was too great to try to find out. Now the challenge is how to reform the system to keep this from happening again by focusing on economics and not political correctness, which is what I fear the Obama administration is about to do.

Anonymous said...

If the larger insurance companies and investment banks had failed in'08 the money market mutual funds most stock brokerage accounts store cash in would have failed. I and millions of others would have taken a huge hit since stocks were out of favor at the time. At that time money markets were paying 1.5% or more with no government backing. Money markets received protection in late '08. In late "09 fed backing was removed but the mms are now paying less than .05% Similar reductions apply to interest rates on bank CDs.

Those investing in "safe" treasuries and CDs as well as somewhat risky mms are paying heavily for the bailouts in the form of reduced interest income. Along with reduced or eliminated stock dividends hardly a good omen for future availability of discretionary income to boost consumption of consumer goods.

Tim Lyman said...

'"Too big to fail" - is this a reality, or is it just the financial elites trying to scare the crap out of us so we save them from their recklessness'

Unfortunately, both.

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