What Exactly is a Bank?
You illustrate the common mistake by naive investors of not looking at risk.
Thank you for your article on banks, describing them as "cash machines." You have described exactly how not to look at a bank stock. You choose to look at the reward side, that they do make money (returns) over time. You illustrate the common mistake by naive investors of not looking at risk.
A bank is basically a hedge fund: as they extract spreads. The big money center banks have a parasitic relationship with the Fed: they borrow at low interest rates from them and lend at higher ones to customers. When spreads are high, like when economic activity is picking up but interest rates are still low they can de-lever and make a decent return. When spreads are narrow like when the yield curve is flat they lever up to make the same "spread." The average bank lever factor is around 30X their "stated" capital; this is much more than any hedge fund uses today.
More and more of that spread risk is now taken in mortgage loans, so they have more and more exposure to the real estate market in general.
Big banks also conduct other risky activities like brokerage and derivative trading. JP Morgan (JPM) is the largest derivative dealer in the world by far. I am going to make a statement, one not off the cuff, but from analysis as best we can do: if you net out JPM derivative exposure ($60 billion long and $60 billion short), I believe JPM has NO capital. I said this about Fannie Mae (FNM), who was just deemed by the SEC to have "fraudulent" accounting and I used essentially the same analysis on JPM.
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