CHRIS WHALEN: Hi, I'm Chris Whalen, Chairman
of Whalen Global Advisors. I'm an investment banker and author. I work with banks, non-bank, financial institutions,
mortgage banks, helping them raise money to finance operations. I also do some M&A and work on really strange
mortgage assets with my friends at Ginnie Mae. So, that's how I spend my time when I'm not
blogging or on Twitter. Banks fund themselves in a variety of different
ways. It really depends how big they are. If you're talking about a little bank below
billion dollars in total assets, and that's most of the industry by the way, most of the
deposits through checking account, small business deposits, things like that. The other big source for small banks is the
Federal Home Loan Banks, because they can take a mortgage, let's say they give you a
mortgage to buy a house. And they can finance that asset with the Home
Loan Bank. So, it's a repurchase agreement. So, they sell it and they get funding, they
go out and make another mortgage. They can also sell those mortgages to Fannie
Mae or Freddie Mac, or whoever and they get their money back plus a little gain. And they go out and do it again. So, it's all about production, if you will,
so like manufacturing assets. The bigger banks have a lot more diversity
in terms of funding. If you look at JP Morgan, or Goldman Sachs,
most of their funding actually comes from Wall Street. It doesn't come from deposits. JP is about 50% deposits, Goldman Sachs around
15. Why? Well, Goldman's a broker dealer, they're an
investment bank, that's what they do. And they're trying to build that bank. But compared to say, Key or US Bank, who are
still 70%, 80% deposits, they have a big advantage over the "universal banks", who have to fund
themselves on the street every day. Well, if you think about the outlook for different
financial institutions, you can separate them in a couple of groups. Smaller banks, and by that small, I mean anything
below about 100 billion total assets. They're funded with deposits primarily. They really don't have Wall Street operations. They don't trade. They lend. They take deposits. They may have an off-balance sheet trust department,
that kind of thing. So, their rates are determined by Main Street,
and they tend to move pretty slow. The funding costs for smaller banks rises
less quickly than the big banks. You look at someone like Capital One, for
example. It's a credit card business. There is a retail bank in there somewhere,
but the credit card business is the biggest part of it. And they actually fund most of their broker
deposits, which are expensive, but they can manage it every day. They can change that number every day. And it's a money market operation. JPMorgan Chase, same thing, half the bank
is deposits. The other half is from the bond market. So, each one of these banks has a different
funding profile, the Wall Street banks tend to feel changes in Fed policy and market direction
much more quickly, simply because they are very sensitive to those short term liabilities. And they have to go out and reprice like every
30 days. Your typical community bank is in a very different
position. They know where their funding is, it's in
their customers, and it recurs every 30 days. The mortgage payments, the payroll, everything
else, that's your strength. So, that's really the biggest difference in
any of the non-banks who have to borrow their money from big banks. That's where they get the money. They have very limited sources other than
that. So it's a chain, if you will. And the smaller community banks, will they
lend to a non-bank? Not so much they'll lend to their customers. They'll lend to people that they actually
know and have a certain size, but it's really the big banks that play the money market side
of this of this game. If you look at what the trends have been in
funding costs for banks and interest rates, generally, you go back to the Financial Crisis. After the Financial Crisis, the Fed pushed
the cost of funds for the banking industry down about 90%. And why did they do this? They did this to protect the banks, the banks
are in the middle of writing off about $100 billion in bad loans. And they had to finance this. So, the Fed deliberately reduced funding costs,
at one point, they got down to about $11 billion per quarter for the whole industry. The industry is $15 trillion in assets. And normally on a quarterly basis, it would
cost about $100 billion or so to finance everything. Goes down to $11 billion. So, what was happening there was savers were
being taxed, essentially. And that money was being transferred to the
equity holders of banks. So, whereas in the '80s, and the '70s, probably
50%, 60% 70% of the money a bank made went to depositors and bondholders. Today, it's the other way around, at one point
90% of the cash flow earned by banks on interest was going to equity holders. So, we're rebalancing that now. But it's a structural thing. It has nothing to do with what the Fed does
with interest rates or other policy measures. It's really a function of what they did to
interest rates in 2009, 2010 and how that slowly now reversing. Well, interestingly, the trend in interest
income during this extraordinary period that the Fed engineered was pretty good. They maintain their spread because their cost
of funds were so low. They were still making money on loans. And the break that they made on loans fell
more slowly than the cost of funds. So, they got a big gift from the Fed. The Fed also started paying interest on what
we call excess reserves, deposits at the Fed. That gave them another $10 billion a quarter
of income. But now, we've been seeing the cost of funds
really for the past two and a half years galloping long 50%, 60%, 70% annual rates have increased. And it's starting to slow now. But that's coming right out of bank income. So, last quarter, as we have predicted about
a year ago, income for banks, net interest income actually fell. And it's now we're going to flatten out and
probably go down a little bit simply because some markets are not repricing loans. In other words, banks can't make more money
on their loans as their cost of funds is going up. Well, why is that? Because banks are competing with everybody. The competition for both funding on the deposit
side of the balance sheet and for loans is intense, especially for larger banks. They're competing with pension funds and private
equity funds, and anybody could think of, all chasing the same assets. So, it's hard for JP Morgan or any of these
commercial lenders to get an extra quarter point on a loan when that customer can just
walk cross the street and do better. It's extremely a competitive market right
now. But unfortunately, the cost of funds is going
to still go up. It's about $55 billion per quarter now. I think it's going to go up to $70 or $80
billion easily in this cycle. The interesting thing is over the long term,
if you go back 30 years, banks were actually making less money per dollar of assets. And this is a wasting effect of interest rates
slowly in a secular sense going down. And it's troublesome because you want banks
to be profitable. The reason US banks cleaned up the mess so
easily in 2009, 2010 is because they made money. You look at Europe, the banks there don't
make money. And that's why they can't clean things up. It's a big difference. If you look at the competitive landscape for
banks, especially larger banks, they are head to head with insurance companies, pension
funds, private equity, Blackstone, BlackRock, Apollo, whoever. Commercial real estate, for example. That's an asset to the insurance company will
finance for an investor and keep, they're not even going to sell it in the securities
market, they just keep it because they like real estate, they like that kind of asset. So, a Citibank, JP Morgan, if you look at
what they actually make on real estate lending, it's pretty bad. Their best book in the entire bank is consumer. That's where they make their money. You've seen non-banks and investors get into
auto lending. Auto lending has doubled since 2008. It's the fastest growing asset class. You've also seen banks get out of residential
mortgages in a big way, the sales of residential mortgage has been cut in half in the past
five years. They just don't want the risk. So, the competitive landscape is such that
there are certain kinds of commercial lending that banks make the most money on, where if
you're Citi Bank or Capital One, you got a credit card book, deals on that are very good,
but with more risk, because you can see defaults go up. And then all the other consumer stuff, residential
mortgages, it's a loss leader. The banks don't really make money on that. So, if you think about it, they have to focus
on commercial lending, that's their most profitable category. And as they get bigger, the big banks run
into the big non-banks who want to steal that asset from them. The smaller banks have better pricing power. If you look at say, BB&T, or any of the smaller
banks below that level, they'll be a point and point and have better yield on their loan
book than a large bank. And it's simply because of competition for
big assets. Because think about it Citibank, do they care
about a half million dollar loan? No. They're looking for billions of dollars at
a time because it takes the same resources to process each one. So, you might as well go for the big ones. And the other thing to keep in mind is most
banks, a fifth of their book runs off every year. So, they have to go replace those loans. And then they have to go make new ones if
they want growth. That's the tough part. A smaller bank, or like Bank of America, who
keeps a lot of 30-year mortgages on their books, they have an average life of 10 years. So, a very different situation, less than
10% of their book is running off every year. But if you're Citibank, it's like 25% might
and they have to run fast to keep up with that. I think investors, when we talk about net
interest income, a lot of investors have this programmed response in their head. They think, well, interest rates are going
up, in other words, the 10-Year Bond, Fed Funds, all of that. That doesn't necessarily translate into the
banker being able to make more money on his loan book, or really even on agency securities. Most banks over the last two years have moved
from being liability sensitive, in other words, they were focused on their funding costs,
to being more asset sensitive. And ironically, last Thanksgiving, when the
10-Year Bond was at 3.25%, they weren't buying it. Now, they're buying it at 2%. And it just shows you that the volatility
that the Fed has put into the market with all of these extraordinary measures has made
it really hard to manage a bank. So, people see rates falling, and they're
like, oh, funding costs are going to go down. No, because the short end of the yield curve
is still propped up around 2%, 2.5%, that's not going to change. See, the thing you're going to do is understand
about banks and investors, if rates fall too much, they just won't lend money. It's not worth their time. They'd rather just keep the cash. So, there's a very fine balance that the Fed
has to strike, because if you really drove rates down to zero, I think the economy would
die. And banks too. Anybody with leverage would be advantaged
and all the savers, which includes banks, they would be losers. The industry's rate of return right now is
a little over 1% on assets, about 12%, 13% on equity. Historically, that's low. We still haven't gotten back to where we were
before 2008 in terms of equity returns for banks. And that's even after the tax bill. The tax bill effectively increased the amount
the banks payout to their shareholders. And even with that, we still haven't gotten
back to where we were in 2007, 2006. So, pricing is the biggest issue facing banks
today. Do they have to compete for funding? Yes, of course they do. But the question is, what are they going to
do with the funding? Right now, loans in the US are growing about
5% a year, which sounds like a lot. But that doesn't necessarily translate into
great profitability for the banks. And the question is, how much capital do you
have to put up against it? So, if I make a commercial loan, $8 for every
$100 worth the loan, that's what we call 100% risk weight. Mortgages, 50%, $4, and so on. So, their calculus for the bank is not just
how much do I make on the loan? But how much capital do I have to put behind
it? Because ultimately, the risk adjusted returns
are what mattered for banks. Well, credit is tomorrow's problem. Today's problem is liquidity. And that's the reason that the Fed stopped
the runoff on their balance sheet this week. They had to say, the squeeze on liquidity
is too great, we're starting to see problems. And you had had a couple of hiccups in the
past several months with some nonbanks and some funds that were seeing runs. Credit, we'll see in a couple of years. Because the problem with what the Fed did
was it made asset prices go up, so credit looks great. Every time there was a default in a building
or a house, they just sell the collateral, and they make money. In fact, the default rate on multifamily housing
financed by banks for the past five years has been negative, because in the rare event,
there was actually a default, they sell a building and they make money, they pay off
the full amount of the loan. So, that's not normal. And so, as we come back, and we normalize
these relationships, we're going to start to see the real cost of credit. Because right now, if you look at the numbers,
credit has no cost. When was the last time that was? 2005. So, we're replaying the tape again, it'll
be different this time, it always is, but I don't think we can escape a bit of an uptick
in credit costs say 18, two years out, especially for consumers. Because during this period, you've had junk
come the market gets finance like it's A paper, and it's just not the case. The slope of the yield curves discussed a
lot, you hear everybody going on and on about the fact that the medium and long maturities
are lower than say anything from Fed Funds out to two or three years. And that's because of the Fed. The signal that people take from that is that
a recession is coming. And in the old days, of 10, 15, 20 years ago,
when rates were higher, it certainly did function that way. Now, I'm not so sure. There's such a demand for US Treasuries all
over the world that when you see the bond rally the way it did from Thanksgiving to
now, point in the quarter in seven months. I'm just not sure what it's telling us anymore. It may not mean that we have a recession,
it may mean that people are flying from other markets and they'd rather hold our paper. People keep saying, oh, the Chinese are going
to stop buying our bonds. Well, who cares? If the Chinese stop buying our bonds tomorrow,
I got news for the Bank of Japan and Norinchukin Bank, one of the biggest banks in that country
would buy it all. They would just say ship it in right now. And so, you have to realize that the market
dynamics have changed when it comes to interest rate, both for what that means for the economy
and what it means for financial institutions. I think my biggest concern about regulation
is that we've done too much in some cases. And the different regulators don't know what
the other is doing. In other words, we don't have a holistic perspective
from the Fed and the other agencies, it says, what do we want to achieve? Because if you're trying to have growth, you
need lending. That's the only way an economy grows is if
you have leverage. So, for example, we're not building enough
homes, it's clear that we're not building enough housing to satisfy demand. But banks have been told not to do construction
lending, they've cut the leverage by a third. So, whereas in the past, you could get a construction
loan and finance three houses, now you could finance two with the same amount of capital. So, you're a builder, that slows things down. So, I think that we have to try and harmonize
and tune the regulatory. So, we're not providing blockages that are
unnecessary. In other words, we're hurting ourselves. And it's very much the case with the Fed. The Fed market out the money markets and credit
robs us of indicators that we need to think about credit risk. So, if the numbers are wrong, well, what are
they going to normalize so that they're meaningful again? And that's a big concern I have, because we
don't know. Honestly, we really don't know. There's probably embedded credit risk in all
the banks today but you can't see it. One basic view in the industry is slow growth
on the top line in terms of revenue, funding costs are going to be a concern, they're going
to keep rising slowly, but they aren't going to keep rising. And the capital markets side for the big banks
to Goldman Sachs, Morgan Stanleys is going to be choppy as it's been. There's not a lot of visibility there. The deal flow has been relatively small. So, it's been harder and harder for them to
sustain growth in those areas. And you've seen Goldman, every quarter, they're
trying to come up with a new narrative for this and they're struggling because they're
competing with JP Morgan and JP Morgan is much bigger, they have a much bigger balance
sheet and they were able to go out and win business because of that. So, the way I look at it is a consumer focused
shops that people like Citi, Capital One are actually going to do better than their peers
because they make more money on those businesses. If we see credit become a concern down the
road, then it'll hurt them. But I think right now, to me, the most interesting
story in the top four is Citi. The rest of them are- Wells is in the penalty
box, Bank of America is okay, but continues to muddle along. They're very risk-averse. Bank of America, they've pulled back in every
aspect. So, to me, there's not a lot of growth here. As Kevin O'Leary said on TV the other day,
it's dead money. And I think he's right. In a sense, if I'm an investor, is that where
I'm going to put my money on a risk adjusted basis? Not so much. In December, I could tell you what I did. I lightened up on mortgage exposures, I had
owned NRC, New Residential for a long time because it had a 12% dividend, and I bought
US Bank common and preferred, 5.5% on a preferred from US Bank is pretty cool. I bought a preferred from Citi which is almost
10%. Bank of America, same thing, they all traded
off. So, I've moved to income. I like boring. I like sleeping. And I'm an investment banker, I can't have
a margin account. It's too much of a pain in the ass. So, that's my take. I see the biggest opportunities in the smaller
banks. That's where it always is. And for investors who can tolerate the lack
of liquidity, I think it's the only place you want to be in banks right now. The rest of the sector, non-bank lenders,
I think you want to careful, I really do. I think we're headed into a choppy phase in
terms of both credit costs and funding.
