Big Banks Shift to Lower Gear by John Mauldin, Mauldin Economics

For today’s Outside the Box, good friend Gary Shilling has sent along a very interesting analysis of the big banks. Gary knows a lot about what went down with the big banks during and after the Great Recession, and he tells the story well.

After the bailout of banks during the financial crisis, many wanted too-big-to-fail institutions to be broken up. Big banks resisted and pointed to their rebuilt capital, but regulators are responding with restraints that strip them of proprietary trading and other lucrative activities and push them towards spread lending and other traditional commercial banking businesses. The fiasco at Citigroup Inc (NYSE:C), JPMorgan Chase & Co. (NYSE:JPM)’s London Whale, and BNP Paribas SA (EPA:BNP) (OTCMKTS:BNPQY)’s sanctions violations have spurred regulators as well.

Regulators are pressured to impose big fines and get guilty pleas for infractions. Meanwhile, big bank deleveraging proceeds. In this new climate, big banks are still profitable but at reduced levels and are moving toward utility and away from growth-stock status. The end of mortgage refinancing and weak security trading are also drags.

Banks are reacting by taking more risks, but regulators are concerned as long as depositors’ money is at risk. Still, regulators want to keep big banks financially sound and profitable enough to serve financial needs.

Gary’s analysis is extensive and thorough, but it’s only one part of his monthly Insight report. If you subscribe to Insight for $335 via email, you’ll receive a free copy of Gary Shilling’s full report on large banks, excerpted here, plus 13 monthly issues of Insight (for the price of 12), starting with their August 2014 report.

To subscribe, call them at 1-888-346-7444 or 973-467-0070 between 10 AM and 4 PM Eastern time or email [email protected]. Be sure to mention Outside the Box to get your free report on the big banks. (This offer is for new subscribers only.)

I am back from Whistler, British Columbia, where I spent the weekend at Louis Gave’s 40th birthday party. I went to Louis’s new home on the mountain, where you can ski down and take the gondola back up when you want to go home. Sunday afternoon Louis and I sat and talked for a few hours about the state of the world, interrupted now and again by the excitement of the children when a mother bear and cub walked through the yard. Later we saw another mother with two cubs.

The conversation drifted to the state of the investment industry in which we both work. It echoed similar conversations I have had over the world with other market participants. There is a growing feeling (admit it, you probably feel it too) that significant changes in the investment business are coming at us rather swiftly. Everywhere I go people are trying to figure out what those changes will entail. I’m not talking about just another bear market. In the same way, much of the music industry was sitting fat and happy in 2000 – they had little idea that Napster was just around the corner. And while Napster came and went, the way that people consume music today is significantly different than it was 10 or 15 years ago.

I have the feeling that the investment industry is getting ready to be hit by its equivalent of Napster. I’m not quite sure what that ultimately means, other than in 10 years (or maybe less) clients will be consuming their investment research and advice in a different manner. Old dogs are going to have to learn new tricks or be retired to the porch. And I am not ready to retire, so I will need to master a few new tricks, I guess. Of course, I would like to avoid Napster and go straight to Spotify. Then again, wouldn’t we all?

As Louis drove us back to the hotel – past more bears – he remarked that one does have to be careful around them. “Not really,” I said. “I have run with more than a few bears in my life and been OK.” He looked at me rather strangely, and I added. “Yeah, like Marc Faber, Gary Shilling, Rosie in his former life. Those were REAL bears. These are just cute animals.” He smiled and kept driving.

I will write my next note from Maine, where my son Trey and I will be going to fish for the 8th year in a row at what has become known as Camp Kotok. And though they tell me they are all around us there, the only bears I have seen are some of my fellow campers.

Your ready to lose the fishing contest again,
John Mauldin, Editor
Outside the Box
[email protected]

Big Banks Shift to Lower Gear

(Excerpted from the July 2014 edition of A. Gary Shilling’s INSIGHT)

In February 2007, the subprime mortgage bubble broke (Chart 1). Big British bank HSBC Holdings plc (ADR) (NYSE:HSBC) (LON:HSBA) was forced to take a $1.8 billion writedown on its U.S. Household subprime lending unit’s bad loans, at the time an unprecedented amount, and subprime mortgage lender New Century reported disappointing fourth quarter results.

Big Banks

Quick Spreading

At the time, many housing bulls tried to convince us that the problem was limited to subprime loans that were made to people they, luckily, would never have to meet. But it spread to Wall Street. Bear Stearns was laden with subprime-related securities and when market lenders refused to finance the firm, the New York Fed provided $30 billion in short-term financing. On March 16, 2008, the firm merged with JP Morgan Chase bank in a stock swap worth $2 per share, only 7% of its value two days earlier and 1% of the $172 a share price for Bear Stearns in January 2007. Morgan bank paid $1 billion and the New York Fed was stuck with $29 billion.

Lehman Brothers was next. But this time, the Fed and the Bush Administration refused to bail out that firm and it filed for bankruptcy on September 15, 2008 when outside financing of its hugely leveraged portfolio disappeared and its net worth was a negative $129 billion.

With a meltdown of major Wall Street firms in prospect that probably would have spread worldwide, the Fed and the Administration twisted Congress’ arms into passing the Troubled Asset Relief Program. TARP originally authorized $700 billion to finance troubled assets but it soon morphed into a bailout fund for banks and other troubled financial institutions and took equity positions in 707 banks. The objective was to stabilize their balance sheets and encourage them to lend.

Some $475 billion of TARP money was disbursed and all but $40 billion has been repaid. That $40 billion went to automakers GM and Chrysler as well as insurer AIG – two of them non-banks. But that didn’t stop Washington from placing most of the blame for the financial crisis on the big banks and their CEOs. After all, when a lot of people lose a lot of money, there is a cosmic need for scapegoats, and the big banks have served themselves up for this role.

Too Big To Fail

Much of Wall Street is financed by very short-term loans, often only overnight. So if one firm gets in trouble, funding woes can spread quickly to other firms in the same business, regardless of their individual size, as lending dries up. This is the systemic risk problem. Nevertheless, Congress addressed the situation with such measures as “living wills,” plans prepared by banks to liquidate themselves quickly in the event of future troubles. But if a specific bank were in deep difficulty, would others remain untouched? Can you “keep your head when all about are losing theirs and blaming it on you?”

Then there is the Volcker Rule, proposed by former Fed Chairman Paul Volcker and part of the 2010 Dodd-Frank financial reform law. It strips banks of proprietary trading for their own accounts even though proprietary trading was not a problem for any troubled firms during the financial crisis.

Most significant is the Too-Big-To-Fail concept, the belief that big banks need to be broken up so they can fail individually without endangering the entire financial system. Proponents apparently dismiss the systemic risk reality and forget that bank runs took down many small banks in the early 1930s as well as large ones. We recall a story of people queued up to withdraw their money from a bank in a line that stretched past another bank. So they made a run on that second bank while waiting!

The too-big-to-fail concept originated
in the 1980s when Continental Illinois
had to be rescued. That bank wasn’t
involved in exotic financial activities but rather straightforward commercial banking, taking deposits and making loans. Unfortunately, it made too many bad loans, as have failed predecessors over the centuries.

Bank Concentration

The too-big-to-fail concept is also fueled by the increasing concentration of bank assets. Sure, the number of banks continues to fall (Chart 2), largely due to mergers. The FDIC now insures 6,730 institutions, down from an earlier peak of 18,000 in 1985. But most of the decline of 10,000 banks in the 1984-2011 years was among small banks with less than $100 million in assets due to mergers, consolidations and failures, with 17% of banks collapsing. Increasing costs of regulations since 2008 has also speeded the demise of small banks. At the same time, the number of banks with $100 million to $1 billion in assets has risen since 1985. More regulation in response to earlier collapse in the residential mortgage market, and economies of scale, are encouraging mergers of medium-sized banks into larger units.

Big Banks

Many observers believe banks with less than $1 billion in assets are too small to cope with increased regulation. Last year, in 204 bank mergers, the target bank had assets under that level, about the same as the 206 in 2012 but up hugely from 102 in 2009 before the pressure to merge was fully felt. Not only Dodd-Frank regulations, but also the new “qualified mortgage” rules by the Consumer Finance Protection Bureau that insures borrowers can afford mortgages, are very costly for small banks.

Also, the number of bank branches continues to drop, in part due to mobile and electronic banking. Last year, 2,563 branches disappeared and reduced the total to 96,339 in mid-2013 (Chart 3). This is a far cry from the situation in the early 1960s when I was working on my Ph.D at Stanford and a girlfriend from the Chicago area was visiting me in the summer. She had a letter of introduction from Continental Illinois so she could cash checks at Bank of America Corp (NYSE:BAC), then entirely located in California. While filling out the Bank of America forms in San Francisco, she was stymied by the blank that called for the branch of her bank. Illinois at the time had only unit banking, one location per bank. The Bank of America officer in turn couldn’t understand her problem because of that bank’s statewide branch network.

Big Banks

Big Banks Balloon

Nevertheless, the largest banks’ share of assets continues to leap. It was propelled in the 1990s by the progressive relaxation and final elimination in 1999 of the Depression- era Glass-Steagall law that kept commercial banks out of investment banking. Then with the 2008 financial crisis, stronger big banks bought weaker competitors – with government encouragement, we might add. JP Morgan Chase took over failed Washington Mutual as well as Bear Stearns, Bank of America acquired mortgage lender Countrywide and Merrill Lynch, and Wells Fargo purchased Wachovia. At the end of 2013, the five largest institutions controlled 44.2% of total bank assets, up from 38.4% in 2007. As of March 31, 2014, those 107 institutions with over $10 billion in assets were only 1.7% of the total number but held 80.8% of all bank assets (Chart 4).

Big Banks

In addition, critics of big banks note that buyers of bank debt are more lax in their due diligence of a bank that’s too big to fail because they anticipate a government bailout if needed. This allows the leaders of these banks to borrow cheaply and take bigger risks in a self-feeding cycle of more leverage and more risks.

A recent New York Fed study found that big banks pay 0.31 percentage points less than smaller banks when issuing high-quality bonds, and an even bigger advantage in comparison with nonfinancial corporations where the spread is 0.5 percentage points. Similarly, the IMF reports a borrowing advantage of 0.6 percentage points for too-big-to-fail banks in Japan and the U.K. and 0.9 in the eurozone.

Furthermore, bank CEO pay is much more linked to size than performance. A recent study revealed that the eight U.S. “Systemically Important Banks” – Wells Fargo & Co (NYSE:WFC), JPMorgan Chase & Co. (NYSE:JPM), Goldman Sachs Group Inc (NYSE:GS), State Street Corporation (NYSE:STT), The Bank of New York Mellon Corporation (NYSE:BK), Morgan Stanley (NYSE:MS), Citigroup Inc (NYSE:C) and Bank of America Corp (NYSE:BAC) – had a median stockholder total return (stock appreciation plus dividends) of 38% since 2009 while the return for smaller banks like US Bancorp, PNC and Sun Trust exceeded 100%. But the median total pay, including cash and stock awards of the large banks between 2010 and 2013, was $57 million compared with $35 million for the second tier. Sure, larger firms are more complex and harder to manage but they can make bigger mistakes, as shown by JP Morgan’s $6.2 billion loss with the London Whale, as we’ll discuss later. No wonder big bank CEOs resist dismemberment and

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