It’s a Wonderful Business

Bailey Bros Building and Loan

Throughout the mortgage meltdown and wider financial crisis, we all heard a hundred times that the whole problem was that lenders didn’t keep the risk of mortgage loans they made. You know, like George Bailey did when he didn’t foreclose on the good people of Bedford Falls, and kept the town’s mortgage lender alive?

Tonight I had the chance to watch the classic “It’s a Wonderful Life,” and it was much as I remembered it, with a few details that hadn’t registered before. For example, did you remember that Bailey Brothers were also builders of “spec” houses? Or that they financed those houses with no-down-payment subprime loans to borrowers who couldn’t qualify at a regular bank?

Strangely, the staffing and layout of the Hollywood “building and loan” was pretty much like a typical suburban bank branch today. There were a half dozen full-time people there, with teller windows, a loan officer or assistant manager in offices off to the side, and a corner office with a branch manager. The only difference these days is a teller manning the drive-up window.

What you don’t see today is a dozen customers patiently waiting to make deposits or withdrawals, as there were in the movie. Today’s customers use their smartphones or their online banking at home, and they pay for their groceries with debit or credit cards, so they don’t even need cash to make it through the week the way George Bailey’s customers did.

So why are all those full-time people in the branch now, and how does the bank make its money these days?

At the mega-banks, the answer is complex, but boils down to this: they pay a lower interest rate in their big-money trading business than their financial strength would support, and they control a derivative betting parlor that can make awesome amounts of money unless they get on the wrong side of a really big trade.

Part of the lower borrowing rate comes from their history of being “too big to fail,” but the big reason is the taxpayer guarantee on their deposits. So what is that worth? Let’s say the borrowing is 20 basis points lower, per year, than it would be without the guarantee. On the just over $2 trillion in assets at the four biggest banks, that’s $4 billion in additional profit at each of the big four. But that pales in comparison to the revenue and profit from trading.

In the most recent OCC report on derivatives, we see that our insured banks earned 44% of their consolidated holding company revenue through trading those “exotic” instruments. At the holding company level, that amounted to $31.471 billion from derivatives on credit, interest rates, foreign exchange, equities and commodities in the half year ending June of 2014.

bank deriv profits

For the biggest banks, the real reason to have basically empty branches scattered across suburbia may be so they keep the image of community banking while the trading room at the head office is where the serious money is being made. If you listen to the rhetoric about preventing regulation of derivative trading risk at the banks, you’ll hear about the poor community bankers struggling under an unbearable regulatory burden. That argument wouldn’t work too well if we couldn’t walk into bank branches in our neighborhoods and see those comforting signs of community banking with the tellers, loan officers, and branch managers who are part of our communities.

But what about the real community banks, the ones who don’t have the swaps, CDS and Forex trading desks?

A friend who lives in a small city with lots of struggling working poor people told me the banks there have plenty of customers waiting to see their tellers. They are cashing checks from their two or three part-time jobs or bringing in cash from tips to pay their $30 overdraft fees on their debit cards, paying check cashing fees, and even fees to use the automated teller machines or get a monthly statement in the mail. Those branches are busy.

So there you have it. Small banks with lower middle class customers are making their money on dozens of fees, fees that keep going up. Big banks are making their money trading derivatives or originating corporate loans and mortgages and selling them off to securitizers. Banks that don’t have one or the other business model are being absorbed by the big boys, or combining as the stronger small bank survivors swallow up their local competitors and then raise their “nuisance” fees.

But what about the banker that knows the borrower and takes the credit risk for the life of the loan? Wouldn’t we be better if there were thousands of George Baileys who know every borrower?

The failure of this ideal came in the Savings & Loan Crisis of the 80s. Those mortgages the S&Ls held onto were killing them because they only paid 6%, but the CDs the banks had to offer to stay competitive were paying out double-digit returns. Take in six, pay out twelve. Guaranteed failure.

As I showed in Finance Monsters, there is also a risk from that kind of community banking that can destroy their host community, taking the good credit borrowers down when the weaker ones fail:

       One very popular idea is to return to a community-based lending model, a romanticized view of banking and mortgage lending personified in Frank Capra’s holiday classic “It’s a Wonderful Life” in which George Bailey runs his Building and Loan solely for the good of the people.
      Certainly, a community-based mortgage lending system would be more trustworthy, as local lenders would know their borrowers and hold the credit risk of the loans they issue until maturity. Unfortunately, the problem faced by community-based lenders is mismatched funding. The primary reason for the development of the Freddie Mac and Fannie Mae securitization programs was to offload the long duration risk of thirty-year fixed-rate mortgages from savings banks which were unable to fund themselves with equally long duration deposits.
      There are obvious and serious risks when a bank concentrates its credit risk in a local area. An event that hurts enough local borrowers almost guarantees that the entire area will be affected. At that point, a locality or region under stress will need better access to credit, not worse, just when a bank is least able to provide it.
      These issues become even more meaningful for subprime credits. While there may be local areas with higher concentrations of subprime borrowers, prudent bank management requires that banks limit their exposure to higher risk credits. When a region has a downturn in economic activity, the last thing we want is credit providers to fail.

It’s still a great movie.

hh

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2 Responses to It’s a Wonderful Business

  1. Stacey says:

    Might not the problem lie in the fact that it takes the common layperson 30 years to payoff a mortgage loan on an over-valued piece of property/building? Perhaps the community lending model would work if the risk was not as great and property/home values (let alone values of everything else based on fiat money supply) was reduced to something that more reflected reality. It is absolutely staggering to think that my grandmother paid a pittance for the house she lived in from the 1940s and comparing to what it would sell for today. A 98% devaluation in the dollar doesn’t even do it justice.

  2. hhill51 says:

    Hi, Stacey —

    (Sorry it took until the weekend to get back and respond.)

    I think you’re talking about two different things, affordability and inflation.

    I tend to look at our basic needs (food, clothing, shelter, transportation, medical care) in terms of how much labor needs to be traded for that need. That’s the affordability problem, and strangely enough, even at the peak the US housing market was more affordable than virtually every other G10 economy, yet our market triggered the global collapse, not the others.

    If rent or housing costs eat up half the family income, then we are at the high end of the range for housing. Certainly the final blow-off top in single family housing prices in the hot areas of the country took it too high. That happened in the late 80s, too, but that time the prices of housing basically stayed flat until income could catch up.

    Regarding inflation (the dollar dilution thing), paying back debt with devalued dollars works in favor of the borrowers.

    Still, the community lending model is fundamentally flawed if interest rates vary with market conditions. If we had settled on adjustable rate mortgages as the only kind available in the US, it wouldn’t be a problem, but the maturity mismatch between fixed-rate mortgage assets and deposit liabilities that are always shorter maturity means every community bank goes out of business when interest rates go up, even if every borrower makes every payment.

    hh

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