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Voodoo Banking Part 1


From regulation to deregulation to anything goes.


Citigroup (C) recently announced that it was seeking Board members who had "expertise in finance and investments." What was the experience and expertise of the Citi Board and senior management that has registered over $45 billion in losses? Shareholders, especially the ones that have provided over $40 billion in new capital, will be hoping that the new recruits also possess "magic" to restore Citi's fortunes. The same applies to the banking sector generally.

Banking, especially investment banking, has delivered strong returns to shareholders in recent years. The "high" returns of financial stocks and the future earning prospects need careful examination.

Until the late 1970's or early 1980's, banking was highly regulated. It was the world of George Bailey (played by Jimmy Stewart) in It's A Wonderful Life. Community banking was the rule. The banker could dip into his "honeymoon money" to stave of a potential bank run. It also fueled jokes - the "3-6-3" rule; borrow at 3%, lend at 6%, hit the golf course at 3 p.m.

Once de-regulated, banks evolved into complex organizations providing varied financial services. De-regulation brought benefits for the economy (better access to capital and more varied investment opportunities) and the banks (growth and higher profits).

Over the last 15 years, increased competition (within the industry and increasingly from non-banking institutions) and the reduction of earning from the commoditization of products forced banks to rely on "voodoo banking" - performance enhancement to boost returns. Focus on risk adjusted returns (introduced in the early 1990s by JP Morgan (JPM) and Bankers Trust) changed the "business model".

Traditionally banks made loans that tied up their capital for long periods - e.g. up to 25/30 years in a mortgage. In the new "originate to distribute" model, banks "underwrote" the loan, "warehoused" it on its balance sheet for a short time and then parceled them up with other loans and created securities that could be sold to investors ("securitization"). The bank tied up capital for a short time (until the loans were sold off) and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognized immediately. Banks increased the "velocity of capital" – effectively sweating the same capital harder to increase returns.

In the traditional model, banks earned the net interest rate margin over the life of the loan – "annuity" income. When loan assets are sold off and the earnings recognized up-front, banks need to make new loans to be sold off to maintain earnings. This created pressure on banks to find "new" borrowers. Initially, creditworthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to "innovate" to maintain lending volumes.

Banks created substantial new markets for borrowing:

  • Retail Clients: Expanding traditional lending (housing and car finance) and developing new credit facilities (credit cards and home equity loans).
  • Private Equity: Providing borrowings in leveraged buyouts and sundry other highly leveraged transactions.
  • Hedge Funds / Private Investors: Providing (often) high levels of debt against the value of assets.

Banks increasingly also out sourced the origination of the loans to brokers, incentivized by large "upfront" fees.

The expansion in debt provision relied increasingly on quantitative models for assessing risk. It also relied on collateral - the borrower put up a portion of the price of the asset and agreed to cover any fall in value with additional cash cover.

The model allowed banks to expand the quantum of loans and allowed extension of credit to lower rated borrowers. Banks did not plan to hold the loan long term and were only exposed to "underwriting" risk in the period before the loans were sold off. Where the loan was collateralized, the value of the asset and the agreement to "top up" the collateral where the asset value fell was considered to provide ample protection.

Favorable regulatory rules (the capital required was modest), optimistic views of market liquidity and faith in models underpinned this growth in lending.

Part 2 can be found here and Part 3 here.

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