Monday, August 29, 2016

Four Reasons for the 2007-08 Financial Crisis

A recent Bank Think post by ConnectOne Bank CEO Frank Sorrentino regarding restoring Glass-Steagall got me thinking about how far the debate has drifted from the root causes of the 2007-08 financial crisis.

There have been quite a number of research pieces offered as to the root causes (read a good one here by University of North Carolina). In researching this post, I sifted through some interesting, and some not so interesting opinions. Which reminds me that the old axiom "figures don't lie, but liars figure" may be closer to accurate than we would like.

Here is what I think caused the financial crisis based on what I read, what I experienced, common sense, and my interpretation of the facts.

1.  People borrowed more than they could repay if they experienced a modest financial setback.

If you know me personally, I will always put more weight on personal responsibility than the boogeyman. Yes there was some degree of fraud perpetuated on the borrowing public. But, by and large, people knew how much they were borrowing, what their payments were, and that some of their mortgage payments would rise if rates rose. 

In 1974, household debt stood at approximately 60% of annual disposable personal income. In 2007, that number climbed to 127%. It should be noted that in 2006, 40% of purchase mortgages were for investment or vacation property. But you won't see the real estate investor losing his/her shirt on 20/20.

Absolving people of personal responsibility is a problem in our society. As one of my Navy lieutenants once told me: "Be careful pointing the finger, because the other fingers are pointing back at you". Words to live by.

So, in my opinion, number one exceeds all others. It will not get me personal kudos in the news media.

2.  Credit risk was too far removed from the loan closing table.

This is the moral hazard argument, where the people that have the relationship with the customer, that stare the customer in the face and say "yes" or "no" to the loan, were not the same people assuming the risk should the customer default, in most cases. The shoulders where credit risk ultimately came to rest, investors, were placated by insurance and bond ratings. 

Community financial institutions make their debut here, as they purchased bonds, typically highly rated, backed by mortgages that also had insurance applied to them.

3.  There was a lot of money looking for investments, and Wall Street met the demand. Mortgage-Backed Securities (MBS) almost tripled between 1996 and 2007, to $7.3 trillion, as investors lined up to participate in the US housing market. This led to creative means to take a risky mortgage at the closing table, to a perceived "safe" investment in the bond market after it was combined with hundreds of other mortgages, parsed into traunches, insured by a bond insurer, and rated by a ratings agency. What could go wrong?

See the list of top 10 sub prime mortgage lenders from 2007. Note the absence of anything resembling a community bank. BNC was owned by Lehman Bros. EMC-Bear Stearns. First Franklin, a JV between National City Bank (emergency sale to PNC) and Merrill Lynch (emergency sale to BofA). Option One was sold to shark investor Wilbur Ross for its servicing rights. Ameriquest was purchased by Citi, and its origination arm shut down. The table indicates that loans were closed in these banks'/entities' names. A community financial institution that sells its loans in the secondary market would typically close the loan in its own name, and then sell it. So the absence of community financial institutions implies that these loans were originated by mortgage brokers or the listed banks themselves, and not a community FI. This is consistent with my experience. 

The MBS bond-creation engine was a well oiled, end-to-end machine designed to satisfy the appetite of investors.

4.  Government's participation in the mortgage market. Way back to the Great Depression, when mortgages were typically five-year balloons, the Federal Government has intervened in mortgage lending. When the five years were up, the government didn't want people tossed from their homes because they couldn't refinance due to economic hardships. A respectable goal. But this intervention played a role in what we have today, a separation between the borrower and the ultimate lender. 

Note that Presidents Reagan, Bush, Clinton, Bush, and even Obama openly encourage home ownership because it has a causal relationship with household wealth creation.

But the reason why community financial institutions shy from putting 30-year, fixed rate mortgages on their books is because there is no 30-year, fixed rate funding instrument. It creates unpalatable interest rate risk. 

If interest rate risk drives the wedge between borrower (i.e. homeowner), and the desired lender (i.e. local bank that retains the credit on their books), then perhaps a 5/1 mortgage should be the norm. This answers the interest rate risk problem, while allowing borrowers to keep their mortgage and therefore their home if they befall some economic setback after five years.

And note, a local financial institution has more flexibility to alter the terms of the loan if it is on their books, rather than owned by an investor.

Back to my original point regarding re-instating Glass-Steagall. What does this have to do with the four points above? We should ask the same question about every article within Dodd-Frank.

~ Jeff 

Friday, August 12, 2016

Bankers: Give Your Employees a Bucket of Balls

Very few financial institutions commit to the level of employee development found in some of our largest corporations. The fear, aside from the cost of a homegrown development program, is that employees will leave. I have news for you, you should be afraid the untrained will stay.

What banks do you know that have a formal employee development program?

~ Jeff

Saturday, August 06, 2016

Fact or Fiction: Bank Service Is Getting Worse

In my firm's most recent podcast, I editorialized near the end of the episode about declining service levels in banks, particularly the largest banks. I compared service levels to airlines, citing my recent spate of bad luck with air travel.

I should note that I type these words while waiting at the Minneapolis airport for my Southwest Airlines flight, which is delayed for an unknown reason for at least an hour. It's sunny at MSP and I squint as I write so I can see the screen. Perhaps it's delayed due to windshield glare.

Do I have a point? Or is it perception? According to Federal Bureau of Transportation Statistics (yes, this agency does exist, and you are paying for it), US airline flights were on time 83.45% in May 2016, up from 80.48% in May 2015. I went back five years and the trend is similarly positive.

So I'm wrong about airlines, right?

Not so fast. How do they measure those stats? Ever wonder why airlines board planes and push off the gate only to wait on the tarmac? Hmmm. Wonder if they measure "on time" from the time you push from the gate. The devil is in the details.

If airlines were so good, why do we not feel it? Why does, pwc's consulting arm, describe air travel as remaining "for many a disappointing, grumble-worthy experience"?

My theory is that airline mergers have reduced our choices. So our overall experience is "disappointing", simply because our options to economically get from point A to point B might be with one or two airlines for that route.

On to banks. My theory is similar. But the proof, like in airlines, is elusive. According to the J.D. Power 2016 US Retail Banking Satisfaction Study, our satisfaction with big banks rose for the sixth consecutive year. Satisfaction with mid sized banks dropped for the first time since 2010.

Again, I think the devil is in the details. I always wondered when working with community banks how they achieved such high satisfaction numbers, usually high 80's to mid 90's. And it seems like every large bank has a trophy case of J.D. Power hardware. But my experience with large banks points to inflexibility, lack of front line empowerment, and basically an "I don't care about you" attitude.

Similar to airlines, I think it relates to how much of US banking assets are in the comfortable arms of so few banks. Seventy five percent of US bank assets are held by the top 50 banks. Losing individual customers is no big deal. But drop a notch in BSA or CRA, that's a big deal. In other words, they don't necessarily care as much about being flexible with you as they do about rigidly complying with bureaucrats. 

This feels like how socialism begins. Continue to consolidate power into fewer and fewer hands, be it government or large oligopolies, and pretty soon we're giving blood samples for our DNA to open a savings account.

If a bureaucrat reads this, he/she is probably thinking: "Not a bad idea. We'll say we're doing it 'for the children'!"

It could happen! 

~ Jeff

Monday, August 01, 2016

Why No De Novo Banks? Math.

There is increasing chatter about relatively small banks, under $100 million in assets, looking for an exit. Because they are so small, there may not be a line of buyers waiting for a book to come out from the investment banker. So perhaps an investor group would be interested in taking out current shareholders and recapitalizing the bank?

During previous periods of bank consolidation, the net decline in financial institutions was buffered by the number of de novo banks. For example, in 1997, the merger peak in the past 20 years, there were 725 mergers, and 199 de novo banks.

Not so today. Conventional wisdom puts the blame on regulators. They’re not approving charters, or making it extremely difficult to do so. The regulators deny this. But there is truth to it, in my opinion.

If a bank has a business model that is unique, or serves a narrow constituency, regulators push back in the name of concentration risk, or untried business models. I recall an Internet bank that was trying to get off of the ground in Michigan in the late 1990’s. The concept was new, and growth was projected to be robust, albeit not off the charts.

The FDIC required the bank to raise $20 million in capital, a tidy sum back in the 1990’s when banks got started with less than half as much. So because the business model was relatively unique, the regulators required a very high level of capital. The bankers couldn’t raise it, and the de novo never got off of the ground.

Today, regulators still favor plain old business models. Yet they are also requiring high levels of capital. Primary Bank in New Hampshire, started last year, raised around $27 million. Sure more is better from a safety and soundness perspective. But that capital comes from somewhere. And that somewhere, investors, have choices on where to invest their money.

In comes the math problem.

Let’s say an investor group, tired of big banks making decisions about their communities hundreds of miles away, decide to explore starting a bank. They put together an outline of a business plan, project out their financials several years, and go visit the FDIC.

The FDIC looks at the business plan, critiquing any part of it that is outside the norm, serving a particular industry or industries, relying on non-traditional distribution methods, and so on. They suggest that being more plain vanilla will increase their chances of approval. And by the way, it will require $25 million in startup capital.

The investor group puts together a prospectus, and begins soliciting shareholders for commitments. 

Now, Joe Investor has $10,000 to invest. Does he put it with this new bank? Or does he invest in an S&P 500 Index Fund?

The S&P 500 has a compound annual growth rate of 5.0% over the past 10 years, and 13.0% for the past five years. And The 10-year includes the Great Recession, so Joe Investor projects the S&P 500 compound annual growth rate of 9.0% for the next 10 years. For reference, the S&P 500 grew 9.2% annually during all of my adult years since 1984. 

For Startup Bank, the organizers have projected the following over the next 10 years.

A $10,000 investment in a de novo bank pales in comparison to the return Joe Investor could receive by investing in an S&P 500 mutual fund. And if Joe needs his money out of the fund, he places his trade and the money is in his bank account within three days.

Startup Bank, on the other hand, would likely trade very little. For all publicly traded banks between $400-$500 million in assets, the average trading volume is 1,432 shares per day. Joe putting in a sell order on his holdings could move the market and decrease his value. I learned this the hard way, by the way. So take it from my experience.

Lest you think that the dearth of de novo banks is a regulatory problem. I got news for you. It’s a math problem.

~ Jeff