Revenge of the Debt Zombies — or — “What are Banks for Anyway?”
What are banks for?Â Typically, banks are described as intermediaries that take deposits and lend them out, earning what is called net interest margin on the gap between what is paid on the savings and what is earned on loans.Â From where I stand, this description is wrong on three counts.
First, it suggests that banks need deposits to make loans.Â In truth, banks create deposits in the process of granting a loan. Rather, the quest for deposits is motivated by two overriding profitability concerns, namely securing customers that can generate fee and loan revenue — bank customers are notoriously “sticky” so once you have them, you have them — and second, minimizing the outflow of net payments from customers to other institutions. These net outflows create liabilities in the overnight markets through clearing and settlement systems such as the ACSS and LVTS.Â Â Net outflows entail borrowing costs. The name of the game is to minimize these costs by increasing the flow of deposits into your institution.Â Large banks like RBC benefit from their extensive network of branches and large customer base — chances are, their customers write cheques to other RBC customers leading to no net outflow and no overnight borrowing requirement.
Second, the traditional story implies that lending volume has something to do with the cost of funds.Â There is some truth in this proposition but I would argue that the greater truth is that lending is a demand-driven process shaped by expectations and changing asset valuations (or at least perceived valuations), which is why borrowing in the US is currently in the toilet.Â Demand just isn’t there. Â The real constraint on lending then is not deposits but credit-worthy customers and capital requirement / leverage rules imposed by regulators. More on this in a moment.
Third and finally, the traditional story misses the real function of private banks, which is to solve an information problem in the purest Hayekian senses.Â That is, banks are or should be specialists in risk assessment and risk taking.Â They should know their client, understand the local market and have their pulse on the broad economy.Â Arguably, if properly structured, they can and should do this better than other entities such as governments.Â In other words, the proper role of banks should be underwriting — lend money, hold the debt, and bear the risk.Â Which is a long-winded way of getting to the main point of this post.
In the 1990s and 2000s, banks here and abroad tried to increase their lending capacity by offloading mortgage and other loan assets (lowering leverage ratios) through securitization.Â Securitized assets were believed to be “off the books” — no longer the bank’s liability.Â This freed up capital for new lending in two ways.Â First, and it bears repeating, it removed the loans off the books.Â Second, it allowed the bank to realize a profit on the loans immediately (albeit discounted relative to the hypothetical value of a buy-and-hold scenario), presumably juicing retained earnings and capital overall.Â Â Of course, we now know that the banks generally did a lousy job of underwriting these loans — of doing their due diligence — because they believed they could offload them almost immediately.Â They would not be the ones who were caught without a chair when the music stopped.Â Or so it seemed.Â The Barron’s piece cited below suggests otherwise.
The upshot of all this is that IF investors successfully put back these investments onto the banks, then this undermines the case for securitization — accountants will be hard-pressed to justify putting securitized assets “off balance sheet.”Â Â This can only be a good thing as it will force the banks to get back to doing what they should do best — understanding and underwriting risk.Â We should wish these investors well.
(Barronâ€™s â€“ Jonathan R. Laing) â€“ Credit Risk/Losses
A new threat has emerged for U.S. banks that could seriously affect their earnings power over the next few years: the potential liability facing bankers from the (US)$2 trillion in subprime, alt-A and option-adjustable rate mortgages that they underwrote and sold to investors. The losses on the mortgages will be horrendous before the dust settles – over (US)$700 billion according to some experts.
And now investors – from the federal housing giants Fannie Mae and Freddie Mac to major bond managers like PIMCO and BlackRock – are fighting back. They are seeking to put back the mortgages to the banks from whence they came and force the banks to eat much of the mortgage losses. Their argument hinges on the arcane contract principle of representations and warranties. Namely, did the mortgages go bad because of the unanticipated nationwide collapse in home prices (a so-called exogenous factor) or are the banks responsible for the mess because they “misrepresented” to the mortgage purchasers the shoddy quality of the mortgages they put in securities and pools?
Already some buyers, such as Fannie, Freddie and the monolines have enjoyed a modicum of success in their putback efforts because they have stronger contractual language in their mortgage deals and thereby superior leverage in demanding documentation of all the mortgage loans underlying the securities.
But the biggest putback battles figure to come from the investors themselves in the subprime, alt-A and option ARM nonagency or “private label” securitizations who have suffered grievous losses. How much of a loss the big banks will suffer as a result of investors’ putbacks is anyone’s guess. The law in this area is largely untested. The banks figure to put up an epic battle because the stakes are so large and no federal bailout of big banks seems likely in this political climate. They are on their own. The guesses on the bank private-label securities losses range from as low as (US)$23 billion to worst-case scenario estimates of (US)$180 billion.