Big Money Printing Press

I consider myself knowledgeable about many things financial: ETFs, stocks, bonds, options, the stock market, for example.  I know the difference between an income statement and a balance sheet, and can read financial statements and prospectuses as a matter of course.

I’ve had little luck deciphering bank balance sheets. Income statements yes, balance sheets no.  They tend to be very opaque, which is one obstacle.  Loans are assets while deposits (other than Federal Reserve deposits) are liabilities.  Accurately determining the quantity, quality, type, and duration of loans can be difficult if not impossible… at least to me.  Perhaps some of this info can be found in the bank’s 10K statements.  Also opaque are details of the bank’s interest rate swaps and other OTC financial contracts.

Historically, the old-style (commercial) bank followed the 3-6-3 rule:   Borrow at 3%, lend at 6%, be on the golf course at 3:00.   Such a bank would take in deposits and lend out with loans (mortgages, car loans, commercial loans).  However, banks could not lend out all the deposits; banks had to keep a fraction of the cash in reserve.  This reserve helps to avoid the “run on the bank” problem, where too many depositors ask for their money — all at the same time.

Keeping all of this spare cash at the bank (about 3-10% of assets) is cumbersome, and also encourages bank robberies.  Banks can transfer much of this physical cash to the Federal Reserve and sometimes even earn a tiny bit of interest (0% to 0.25%, “the Fed Funds Rate”) on it.  Thus the Federal Reserve serves as the bank’s bank.  The Federal Reserve System (or “The Fed”) also helps clear checks (remember those?) and move money between banks simply by moving reserve deposit balances between banks.  No need to shuttle hard currency to and fro.  Deposits are moved with a pencil, or computer transaction in the Fed’s books.

The Fed also lends out money to banks.  Banks can borrow from the Fed at 0.75% (the so-called discount rate).  This system leaves a 0.5% profit for the Fed on the difference between the Fed Funds rate and the discount rate.

Classically the Fed would try to guide the economy by moving the Fed Funds rate and discount rate.  If the Fed thought the economy was overheating (generating excessive inflation) the Fed would raise rates to “cool off the economy”.  The Fed tried to adjust the rates so as to give the economy a “soft landing”.    If the US economy got too sluggish, with high unemployment, the Fed lowered rates.  The interesting thing (no pun intended) about these rates is that they are all short-term rates.  So short-term that the Fed funds rate is sometimes called the overnight rate.

I keep saying “classically” and “historically”, is this is how things used to be done by the Fed.  What’s new, since Fed Chairman Bernanke, has been the manipulation of long-term rates with “quantitative easing” QE, and QE2.  Also new (with the cooperation of US Treasury Sec. Timothy Geithner, Congress, and President Obama) are measures such as the AIG bailout and TARP.

The Fed has shifted into uncharted territory, and in the process neglected one of its two prime mandates: price stability and low inflation.  It also seems to have overlooked the concept of real economic growth (GDP growth adjusted for inflation).  Instead the Fed seems to be fluttering in a course of wide-ranging, unprecedented, knee-jerk reactions.

Today’s Fed is not my father’s Fed, nor are today’s banks.  Today they are increasingly known unknowns.  This path is new and the ticket stub is unclear.  I don’t see a destination nor ETA, but when I look close, very close, I see a dim watermark.  Subtle, like grey on grey, I believe I see in faint yet bold letters INFLATION.

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Common Sense Money Management

On November 15, 2009, in money, by Dave

It is amazing how much simple mistakes can cost a person over the years.  A common example is banking fees.  A single overdraft fee can cost $39!  And bank like to play tricks like computing the withdrawals first in day THEN tabulating the deposits.  This banking trick can cost you.

It is pretty easy to avoid this these pricey fees.   First find a bank/credit union that offers overdraft protection.  One kind will automatically transfer from savings to checking if there is is a potential overdraft.    A second, more powerful kind features an unsecured line of credit that will cover overdrafts but charge and interest rate.   I have had both for years .   If there is not enough money in checking, money is automatically pulled from savings.  If there is not enough money there, it comes out of the line of credit.  I have not paid an overdraft fee since I set this up years ago.

Bottom line: don’t settle for crappy banking.  Read the fine print and shop around.   Personally I’ve tended to have better luck with credit unions than with banks… but everything varies.  There are some good banks out there and some good credit unions.  Just avoid the bad ones.  And if your good one turns bad have the cojones to switch to a better institution.

Another area to avoid pesky expenses is with credit cards.   An important step to avoiding late fees is to set up an automatic monthly payment of your credit card(s).    Doing so can help avoid any late fees.  For example I have my two credit cards set up to be paid $100 every month a day  before the due date.   This does not pay off the full balance, but will pay the minimum balance and avoid a late fee.   Typically I will pay the full balance on line as well.

This advice will help you avoid fees.  Next I will give a few tips about how to make a little profit.

The first tip is to check out “dividend rewards” checking.  This is offered by a lot of banks/credit unions.  Typically an above market interest rate is paid on checking accounts, say 3.51%, if certain actions are followed on a monthly basis.  Usually these actions include one direct deposit into the account each month, one monthly withdrawal (say a credit card payment), and 12 debit card transactions.

This does take some discipline.  Banks make money because people fail to jump through the debit card hoop each month.  But if you are disciplined it is pretty easy.  Use your debit card early in the month for small purchases at say, your favorite latte store.   Use it to buy lunch.  Make your you make the minimum amount of debit purchases each month by tracking you account online.  Then laugh all the way to the bank as you see a nice interest rate.

Finally, find a credit card that pays cash back.  (Do this only if you have the self discipline to pay off the monthly balance in full every month.)  There are cards that pay 1% cash back on every purchase with no limit.  Pay your monthly expenses such as utilities, internet, cell phone, etc. on this card.  Bingo, instant 1% discount.   When you buy a car put the max on this card [often $3000 or $5000] and get some bucks back.  This is small but it will add up.   Just remember, this only works in you favor if you pay off your balance in full every month.

These “tricks” are really pretty simple, but effective.  They require investigation, discipline, and tenacity.  But if you use them correctly they can help keep a few extra twenties in you proverbial wallet every month.  And that will add up over the years.  Be bold, be persistent, and yes a little paranoid and you can profit.

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The next step in dissecting bank involves something called securitization.  Securitization is a method of turning an asset (e.g. a bunch of loans) into securities.  Let’s say ACME Bank has 5 home loans with a balance of $200K each — or $1M in mortgage assets.  It can divvy this $1M bundle of loans into 100 pieces each with a nominal value of $10K each.   Companies or people can buy these mortgage backed securities (MBS).   This is the basic idea, anyhow.

Basically banks can make loans and repackage them into various MBSs.    The simplest kind is a pass-through MBS.   In the example for ACME each “share” of the MBS would get 1 percent of the mortgage pool payment stream (less fees).

There are other methods of slicing and dicing MBSs such as collateralized mortgage obligations or CMOs.  CMOs repartion the mortgage pool into different flavors or tranches.  For example there may be a principal-only tranche that pays only the principal stream and an interest-only tranche that pays out from the interest portion of mortgage payments.

One thing MBSs allow banks to do is to take assets off their balance sheet.  They can turn a pile of loans into a bunch of securities they can sell at the market for cash.  The other thing banks and investment companies can do is buy MBOs.

Now the basic idea is a pretty good one.  The securitization process worked pretty well for many years.  And it still does work even today (check out Bill Gross’s excellent PIMCO Total return fund for example).  But things can and did go wrong when companies quit buying certain MBOs due to legitimate concerns.  No buyer equals no market.  And no market spells trouble for companies with too many unpopular MBOs on their books.

I’ve only scratched the surface of this more complicated portion of the bank mess.   This is partially to keep the discussion interesting (or at least less boring) and partially because I don’t have more specific data at this time.

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The classic banking model is actually quite simple.   In this basic model banks collect deposits in the form of savings and checking accounts as well as CDs.  They then lend this money out to in a variety of loans, while holding a bit of money in reserve.  Banks often make money because they can generally pay a lower average rate on deposits and charge a higher average rate on loans.  We can call this difference an interest rate spread .  Looking at the whole portfolio of deposits and loans the total difference between interest paid and interest received could be called gross interest income.

This business model does has some potential vulnerabilities.  The paramount issue is that some loans will not be paid back.  This is called defaulting on a loan.   If the costs of defaults exceed the gross interest income then the bank is losing money.  Additionally, when a bank admits to a loan gone bad they do a write off or a write down on the load.  These write downs are subtracted from the bank’s reserve ratio.  If this ratio goes below the required reserve ratio the bank has to fix the problem by borrowing money from other banks, people, companies, or the Federal Reserve (“The Fed”).

Banks employ several techniques to reduce and manage the risks of default.  The biggest hammer in their bag of tricks is collateral.  Many banks issue a lot of collateralized loans such as mortgages, which stipulate that the borrower will surrender the house to the bank if they default on the mortgage.  Thus the bank loses the amount of the unpaid loan, but gains a house.  This is OK if the house is worth the same or more than when it was purchase.  But it is bad news for the bank if the house is worth less than the outstanding loan balance.  The bigger the difference, the bigger the write down.

To try to further reduce default risk, banks seek diversification.  One type of diversification is geographical.  A bank might issue mortgages on homes in California, Michigan, Washington and Texas.  The ideas is that while Michigan, say may have a bad couple of years due to auto industry problems, the other states may fair better.  There might be a lots of defaults in Michigan, but the are hopefully offset by fewer defaults in other areas.

A few more words about mortgage defaults and write downs.   Defaults happen in good times and bad.  When housing prices are stable, they are inconvenient for banks, but generally result in only modest write downs and losses.  When housing prices drop significantly, however, banks experience a double whammy.  First, each default is more costly — houses are worth much less than the loan.  Second, default rates are generally higher due economic problems that tend to go hand-in-hand with falling home prices.  Additionally some less credit-worthy individuals simply chose to walk away (default on) from their now “underwater” mortgages where the amount owed is more than the home is worth.

The 2008-2009 “banking crisis” can be explained in large part by the observation that key assumptions were made that turned out to be overly optimist or flat out wrong.

  • Assumption#1:  Geographic diversification will dramatically reduce overall default risk, especially for large, highly-diversified banks.
  • Assumption #2:  Housing prices, on average, will continue to rise or at least remain stable.
  • Assumption #3:  Clever strategies and new financial instruments will help transform, shape, reduce, and even eliminate default and other risks.

The Shiller Housing Index helps illustrate why assumptions #1 and #2 turned out wrong in 2008.   I believe that up until this point the basic problem is pretty clear:

Banks make assumptions and lend lots of money.  For a while this seems to work.   Banks grow more confident and make more optimistic assumptions and rationalize this behavior with risk manager positions, computer risk models, and fancy looking charts, presentations, and Nobelaureate-blessed  terminology.   When these lofty assumptions suddenly turn false, many banks quickly find themselves spiraling towards collapse.

In a future blog I hope to dive into the more complex problems hinted at but Assumption #3.   Understanding the impact of Assumptions #1 and #2 helps explain how fuel and spark were created to start dangerous fires in many banks’ balance sheets.   As I delve into Assumption #3 I hope to show how powerful and dangerous financial gasoline was created, stored, and shipped between the banks and other financial institutions.  I also hope to delve into how financial building codes and practices have changed– enabling banks and other companies to remove firewalls, sprinkler systems, and other “old fashioned” safety measures because of the implied security of Assumption #3.

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