Sunday, September 13, 2009

Bank Risk-taking Returns

I have been following the spate of articles, stories and blogs related to the one-year anniversary of Lehman Brothers' bankruptcy. Uniformly, the writers are telling the same story -- that having dodged a bullet last year, the survivors have emerged stronger than ever and are back in the risk-taking business.

Banks have a relatively simple business model. They acquire deposit assets for which they pay very little interest. They leverage those holdings to lend in a fractional banking environment for which they charge a much larger spread to earn their income. Because their deposits represent a small "fraction" of what they lend, their profits are incredible.

Those profits are becoming, once again, reliable and substantial. Why? Because banks are slowly getting back into the deep end of the investment risk pool.

It was reported recently that former Treasury Secretary under George Bush, Hank Paulson, admitted to letting Lehman Brothers fail last year for one simple reason -- he had to get everyone's attention on Wall Street, Main Street and Congress that the crisis was real. Lehman Brothers was the handy scapegoat and Paulson hated Lehman's chairman Richard Fuld, "the Gorilla of Wall Street," who promoted sub-prime paper more than anyone else.

Fear was sufficient to get Congress to go along with the TARP legislation, and Utah Senate Republican, Bob Bennett, was somehow designated (more accurately "duped") as the spokesman for the effort. Bennett, respected ranking member of the Senate Banking Committee, was Hank Paulson's persona before the media outlets, and urged swift passage after the House voted it down initially.

Now, one year later, we learn Goldman Sachs, JPMorgan Chase and others that received tens of billions of dollars in federal aid are once more taking bets on big bonds, commodities and exotic financial products. For one year, however, such actions were completely suspended.

Those of us with substantial investments in time and energy supplying the raw material for securitization have waited patiently on the sidelines, but there is finally evidence of a thaw. It is our belief that uncorrelated assets -- those like life insurance products (SPIAs in particular), and not dependent on business factors per se -- represent a more stable, predictable and therefore more desirable asset pool than mortgages, credit cards and auto loans. Even consumer contracts like home security system agreements have been securitized with similarly disastrous results.

The only third-party risk associated with SPIAs is the issuer insurance companies that have weathered and prospered during this meltdown of the banks and hedge their bets on lives every day. In the front door they take life insurance premiums and the bet is people will live long and pay premiums. Out the back door they dispense SPIAs and the bet is people will live less than anticipated and their guaranteed payments to annuitants will terminate ahead of schedule.

Those who cry "foul" against such bets on people's lives are really crying foul against American enterprise, since the bets are already on the table when the products are issued. Insurable interest laws only apply in cases where there is an undisclosed purchaser who is a stranger to the insured and might benefit in the untimely death of an insured in whom the stranger has no real investment of lingering love or longevity.

I had a banker tell me this past year that he hated life insurance products and the people who sell them. He hated securitization and the people who perpetrated securitizations. The one asset he hated most on his balance sheet was the key man insurance his bank was required to keep in force. He viewed insurance as a terrible investment. I asked him if he would unload those assets if given a chance and a decent discount into a securitization pool. The thought had never crossed his mind because he was blinded by his prejudices. I'll bet you one thing -- he'll be the first at the head of the line to unload those assets when securitization in that market returns. Why? Because his employees are living longer and paying out the premiums in perpetuity in his pension plans was a sickening thought to him. That's how banks view their most trusted and valued employees? Sad but true. Imagine where that banker would be today if a securitization market had not developed in the early 80s to take those under-performing mortgages off his hands and he were still holding those assets!

Part of the suspension of risk-taking has been the uncertainty posited by President Obama's new administration. What form would threatened regulation take? When? By whom? All these questions and uncertainties now seem moot -- while there has been some reformation around the edges, no systematic changes have emerged yet because of fierce lobbying efforts to prevent it. Bankers and hedge fund managers are are finally starting to breathe more easily again. Even the insurance company lobbyists have succeeded (at least at this writing) in blunting the unwelcomed intrusions into their businesses. Reform there will come, no doubt, but it's very unlikely that it will become a single-payer system they fear so much.

The one lesson that has been learned, however, is to manage risk better. One certain improvement would be better capital levels required of banks to make certain their investment risk is adequately covered going forward. No one has said yet what that requirement might look like, but prudent bank boards will be one step ahead of regulators, one would hope.

Ironically, the government hasn't just watched the banks -- in many ways they have been the enablers to a return to normalcy. Both the Bush and the Obama administrations have ramped up trillions of dollars that went into the recovery effort. The biggest banks through the bailouts, low-cost loans and loss guarantees were designated by government through the intercession of the Federal Reserve, the FDIC and the Treasury Department to survive and prosper. Bank failures happened mostly with smaller players, but the big banks are booming again.

Goldman Sachs, JPMorgan, Wells Fargo, Citigroup and Bank of America collectively posted 2Q 2009 profits totaling $13 billion. That's more than double what they made in 2Q 2008, and nearly two-thirds as much as the $20.7 billion they earned in 2Q 2007! That's when we knew the economy was strong!

Mortgage origination totals are just as impressive. BofA and Wells Fargo now originate 41% of all home loans backed by Fannie Mae and Freddie Mac (source: Inside Mortgage Finance). The banks made $284 billion in such loans in the first half of this year, up from $124 billion during the same period last year.

And who do you think directly benefited the most by contributions to politicians from these organizations? Look no further than the members of the Senate Banking Committee, including Utah's Bob Bennett. Chairman Chris Dodd (D-Connecticut), of course, was the big winner.

Utah voters approaching Bennett's 2010 bid for re-election would do well to examine the source of his campaign contributions at

But I digress. After a dismal 2008, the 1,000 largest hedge funds in Morningstar's database posted average returns of 11.9 percent through July. In 2008, those same funds lost 22 percent on the average.

CONCLUSION: I get weary with bad economic news, naysayers and doomsdayers. Life always finds a way. Amidst all the bad news that continues to circulate, there are some signs of life emerging. Money is flowing back into the risk markets again, and it now appears the next business cycle has been reborn. The smart money says that creating an agency to oversee the prevention of ginning up attractive and safer investment instruments for banks will be difficult. Industry lobbying resisting such efforts will continue, and politicians like Dodd and Bennett will continue to be bought and paid for. As much as I hate it, it's the world of political and financial reality in which we live -- and sadly, I love normalcy as much as the next guy.

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