Hidden Profits

"It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." - Henry Ford

"I believe that banking institutions are more dangerous to our liberties than standing armies." - Thomas Jefferson

It is common knowledge that the banking institutions in America are riding a wave of profitability.  It is also interesting to note that a number of economic recoveries are due to the profits of the banking industry pointing to economic growth.  They are a major cog in the economic wheel as they grease the economic engine with financial liquidity.  So the fact that they are and have been making massive amounts of profit is very interesting in that the economy has not picked up and loan originations are not providing the necessary boost to their earnings.  So it begs the questions where are these profits coming from and is this a forebearer of good economic news?

In answer to the second question first, unfortunately these profits are definitely not pointing to a stronger economy.  All the market metrics from unemployment to GDP growth are all pointing in the wrong direction or are sluggishly creeping forward.  Nothing is pointing toward economic growth in the magnitude of the growth of banking profits over the last few years.  So with all this poor economic news it was interesting to read a number of articles this week uncovering not only where these profits are coming from but also the risks to the economy that these profits are posing. 

Profits in the banking industry are largely coming from two areas.  The first is from the Federal Reserve itself and the second is from the every burgeoning derivative market.  Looking at the Federal Reserve, back in 2008 new legislation was put in place giving the Federal Reserve the right to pay interest on banking reserves.  With this legislation the reserve ratio, the amount of reserves that a bank needed to hold at the Federal Reserve as a safety net, was removed.  In the past banks only held the Federal Reserve's mandated minimum as it was money that earned no interest but now that they receive interest banks are piling cash into reserves.  The reason for this is that the interest that they pay out on money market funds is essentially zero while the interest that they receive from the Federal Reserve, even though it is only 0.25%, is essentially risk free profits.  Now there is nothing more that a bank enjoys than risk free profits so bank reserves have morphed from next to nothing to over $1.5 trillion.  Considering that the Federal Reserves balance sheet has increased by just over $2.5 trillion and you can see why the economy continues to struggle.

But that is not risky money so why is there a danger?  Well the first thing to understand is that a spread of 0.25% even if it is risk free is not enough to generate the kinds of profits that we are witnessing at the banks.  It is a fantastic start but as always bankers are looking for more.  So in order to generate large profits with minimal loan portfolios you require leverage and this leverage is coming from the derivative markets.  The derivative market has spiraled to over $1 quadrillion that is a thousand trillion or $1,000,000,000,000,000 of nominal value!!!  To understand this better when you invest in a derivative you place a small amount of money upfront called margin and this leverages a large nominal value.  If you bet correctly you reap a massive return on your investment but if you bet incorrectly you are left to pay out on the larger amount.  Margins therefore can quickly be extinguished and large losses can explode in an instant.  So while things are going in the right direction (read the stock market and other bubbly investments) the banks are making billions of dollars.  The day that this house of cards comes toppling down the losses are going to be enormous and there is no way that the Federal Reserve can cover these debts.

For these reasons it is important that you realize and understand the risks to the current market and, when the next market upheaval arrives, that we do not once again as tax payers step in and shoulder the burden of banking excesses.