Shadow (Bank) Dancing

Following the release of third-quarter earnings by JP Morgan and Wells Fargo, concerns that compressing net interest margins could be a problem for banks. We discussed this topic briefly in Friday’s “Making Sense” report. We explained that narrower net interest margins do not hurt banks as much as they did in the days when banks held most of the mortgages they wrote on their books. Securitization, where banks pool mortgages and sell to investors, either via the GSEs or directly via the so-called “private label” market, result in mortgages not being held on banks’ balance sheets. Instead, banks keep 25 or 50 basis points of the securitized mortgages for servicing the loans. They earn this whether net interest margins are 50 or 250 basis points. Smaller net interest margins hurt consumers because it discourages banks from writing loans which cannot be securitized. Narrow net interest margins do hurt bank profitability in the sense that they discourage banks from holding loans on their books because there is not enough reward to take on the risk. However, banks which are not lending, to not have to keep larger amounts of reserves on hand and they do not have to hire more employees (another down side of tight NIMs). Still its consumers which are hurt the most as banks will not commit much of their own capital for lending purposes. If they are securitizing loans, they are committing investors’ capital. Once the bank securitizes the mortgages, it gets its capital back. The lack of lending capital is slowing the U.S. recovery. However, it is not the lack of bank lending that is the biggest difference between 2012 and 2006 or even, 2003. It is the lack of the shadow banking system. The so-called shadow banking system was comprised of non-bank lenders, such as investment banks and SIVs which would provide mortgage capital. They often used mortgage brokers to facilitate these loans. The shadow banking system collapsed after investors realized (too late) that a vehicle securitized by subprime mortgages should not be rated AAA, no matter how senior one’s tranche and that, in many cases, the institutions which issued these mortgage vehicles has no obligation to pay investors a dime, if the mortgages contained within became delinquent of defaulted. This is how we arrived at today’s predicament in which most mortgages written today are GSE-qualifying and/or are for refinancing purposes or for the purposed of purchasing high-end properties. Those who could really make use of today’s low rates often cannot obtain financing. Of course, many consumers who could make use of today’s low rates probably should not be granted credit (or low-rate credit) and probably should not have received loans five years ago. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.