Friday, May 11, 2012

Banking 101, Demand Deposits, Loans, Government and Taxpayer Losses

Banking losses are in the news again today.

Late yesterday JP Morgan reported potential mark-to-market losses of up to $2 billion (mark-to-market means the losses may or may not actually occur when the assets are sold down the road, but they're underwater now).

The blue chip bank's shares are being hammered today and are down ~8%. See J.P. Morgan's $2 billion Blunder.

For the sake of clarity and full disclosure, I own JP Morgan shares and have for several years now.  I expect to continue to own them for several more years. I also consider Wells Fargo and US Bank as key holdings.

In fact, I believe that JP Morgan shares are a better buy today than they were yesterday. That's because they're cheaper today. They're on sale.

And I'll also suggest that ten years from today they'll likely be from 50% to 100% or greater than today's share price (~$37 per share), while paying cash dividends all along the way. The stock currently yields over 3% and will likely double its dividend over the next ten years, thus resulting in a 6% return on money invested today.

But so much for that.  Let's discuss banking in general today and how it works. Accordingly, we'll use the KISS approach in an effort to explain the mysterious world and role of banking.

Here goes.

Assume persons A, B and C are all honest and in different economic circumstances.

Able A has $100,000 to invest, having worked hard all his life, saved and avoided debt. Banker B owns a bank whose business it is to bring together those with money and those in need of money. B acts as an intermediary, as all bankers do.  Customer C wants to borrow money from B to buy a house.

So A deposits $100,000 with B and B loans the $100,000 to C.  So far, so good.

The deal B makes with A is that A can withdraw his $100,000 at any time and in the interim will collect 1% interest on the money deposited. That's called a demand deposit.

B earns a profit in his banking business by loaning deposits to customers at rates of interest greater than B pays in interest to depositors like A.

We call this deposit to loan rate differential B's "spread." That is, if A receives 1% from B and C pays 4% to B, B's spread or profit is 3% on the amount involved.

Here's B's VAR (value-at-risk) problem. He loaned A's demand deposit to C for 30 long years at a fixed rate of 4%.  Meanwhile, A can withdraw his deposit at any time. In other words, B borrowed from A for the short term and loaned to C for the long term. That's a very risky proposition for several reasons, but that's banking.

If A wants to take his money out of the bank for whatever reason, he simply withdraws it from B's bank, even though B doesn't have the money A deposited.

That's because B loaned A's money to C and the $100,000 won't be repaid for another 30 years. 

Or even if A keeps it on deposit, if interest rates rise, A will demand from B a higher than 1% interest rate on his deposit. As that happens, the spread or profit will be lower for B, since he has loaned the money to C for a fixed rate of interest at 4%.

Or C can stop paying his interest and may well elect to do so if the value of the home decreases.  He borrowed and owes $100,000, but the house may now be worth only $65,000 if the previous real estate bubble has burst. 

If C walks away from the loan, B has a house worth $65,000 but he still owes A $100,000. And B hasn't yet sold the house.

What's B to do? Well, government regulations come to the rescue. 

B has to have some skin in the game, so to speak, so he has money invested in the banking business. Maybe 10% to 15% or so of total loans outstanding, at least in our example. Hence, $10,000 or $15,000 are invested by B.

Thus, B's reserves, capital or owner's equity now comes into play.  Banks are required to hold some percentage of loans in reserve over and above the amount of the banks' loans outstanding.

So we'll assume that B has contributed $15,000 in equity.  But the home is only worth $35,000 less than the debt owed, so B is not only broke but owes $20,000 more than he's owed. He's wiped out, as is C.

Banking is risky.  That's why spreads need to be high enough to generate an acceptable profit for the Bs of the world. And bank capital would be quite expensive if B assumed all the risk of loss himself, assuming no government "help." 

In other words, if B tried to charge C an interest rate of 20% for the loan instead of 4% (which 20% would more likely properly reward B for the total actual risk taken on the 30 year fixed rate loan at ~100% of the purchase price, and which C may not be able to service properly, let alone repay on time), C probably couldn't afford to borrow from B at the "market rate."

But as a society we decided a long time ago as a matter of policy to foster home ownership and make home loans affordable or inexpensive (now it's student loans), so we subsidize them and thereby encourage excessive borrowing by individuals. That's the wrong thing to do, but that's a fact.

Government to the Rescue

So enter the all knowing, providing and protecting government policy makers.

And it's not only interest deductibility on mortgage loans and property taxes that are involved. They're not much of a factor at all, when the various other government inducements are fully considered.

To wit, A's deposits are FDIC, aka government, guaranteed in case B goes broke.

But if C walks, loses his job or,otherwise can't or won't pay, B still gets paid by Fannie Mae or Freddie Mac, government agencies.

So here's why it's a good deal for A.  A will put his money on deposit with a a risky bank, because his fellow taxpayers are guaranteeing he can withdraw his money, even if it isn't there and has been loaned to uncreditworthy borrower C.

And here's why it's a good deal for B. B will loan the money to A for 30 years at 4%, even though a limited amount of B's capital investment is at risk.

That's because B doesn't have $100,000 at risk or even $50,000.  It's more like $10,000 or $15,000.  And if C comes through and pays on time, B receives $4,000 in interest each year, realizing an annual profit of 30%  or perhaps 40% on his investment. Of course, that return on investment is due in no small part to the government's role, aka the taxpayer.

Thus, it is really the government, aka taxpayer, who is making these loans available at lower than market interest rates to uncreditworthy borrowers for fixed rates over many years.

What Should Happen

Bank investors should be required to have more capital at risk. That, however, would make loans more expensive for borrowers, since bank investors will insist on an acceptable return on their money invested. 

That in turn would mean higher interest rates on loans and less affordability for home purchasers, thereby leading to fewer home purchases.

But that won't happen anytime soon. You see, government leaders always want to encourage people to take out risky loans and buy homes that they wouldn't buy if the market were allowed to work.

The government incentives for people to do the wrong thing is called public policy.

Summing Up

That's a very brief KISS overview of banking, debt, risk, public policy and who ultimately bears the risks and losses.

The ultimate losers---all too often, are the taxpayers, that's who.

If banks were required to hold more capital, as they should be, they wouldn't have to try as hard as they do to hedge their bets, as JP Morgan did here. They'd have more of a cushion against bad loans.

And they'd make fewer bad loans, since it would be the banks' investors that would bear the losses and not the taxpayers.

Yes, banking is a risky game, but the banks' shareholders aren't nearly as at risk as are We the People-- aka the taxpayers.

But I'm still a shareholder of JP Morgan and other banks, and plan to be for the foreseeable future as well.

It's all about risk and reward.

Thanks. Bob.