The Banks are Back, But Be Very Careful!
Joe El Rady
The banks are back and attracting investors; but, employ extreme caution in your banking sector investments. For your own portfolio, shy away from banks that borrow more short-term money than long-term money! If you don’t feel like reading why, you don’t have to… this is actually enough to steer you in the proper direction when buying commercial bank stocks. If you want to know why… read on for the details…
Let’s Play Yield Curve Arbitrage. This is a great game; you are going to love it! Put up none of your own money and make a bundle. Sound too good to be true… well, this is one of the rare cases in which something that sounds too good, actually is true. In fact, banks have been doing this for years. In fact, this is what banks do; it’s their meat and potatoes. Banks borrow short-term and lend long-term… it’s one of the greatest money making games ever invented! Borrow at 5%, lend the money at 7%, and pocket the 2%. Awesome, I love it… it’s why I’ve always wanted to own a bank—but wait.
Okay, why can we lend for higher rates long-term than we borrow short-term? Remember, investments returns compensate four items: inflation, loss of liquidity, opportunity cost, and risk. Money held for longer periods must compensate for more liquidity loss and more opportunity cost. This causes the arbitrage.
Okay, so what’s the problem? The problem lies in the mismatch of the assets and the liabilities: we need to pay back the borrowed money before we get paid back the lent money. Thus, the short term maturity of the borrowed money hinders the game. Generally, this isn’t a problem; we just borrow more short-term money to pay back the maturing short-term borrowed money. In banking, we call this “rolling over the debt.” This works like a charm, until short-term rates jump higher and we need to refinance at a rate higher than the one we charged our borrowers. Again, generally this has not hindered the game much because we can lend at floating interest rates; thus, if the credit market tightens, causing us to pay more to borrow, the parties to whom we lent would concurrently owe us more due to the same conditions increasing the spread over the reference rate we imposed on their floating rate loans. Even when we cannot lend at floating rates (say we wanted to lend or buy a bunch of 30 year mortgages at fixed rates) we could enter into a series of swaps to hedge that risk and generally, through sophisticated financial engineering, we would still be okay.
So what’s the problem? The real disaster occurs (and this just happened last year) when we have lent a bunch of money long term but nobody wants to keep lending to us in the short-term. Suddenly, we need to repay all of the money that we borrowed short-term, but we don’t have it, because we lent it long-term. This is what famously happened to Bear Stearns: they borrowed short-term and used the money to buy mortgage backed securities (MBSs), using the MBSs as collateral for the short-term borrowing. But one day, their creditors woke up and said, “hey, we don’t think the collateral is worth what you guys say it’s worth, so we don’t want to lend you any more money and want to collect the money we did you loan you.” This situation, along with the Financial Instability Hypothesis I noted in a previous post, causes liquidity crises.
So what should banks do? Well, the smartest way to operate is to mix the aggressive and money-making borrow short / lend long strategy with a more conservative borrow long / lend long strategy. Basically, allocate some of your business operations to each strategy instead of just doing one or the other. But wait, how can a bank charge more for money it lends long than it pays for money it borrows long? Remember, investment returns compensate not just for liquidity loss and opportunity cost, but also for risk. Notwithstanding recent credit turmoil, banks are pretty creditworthy and their customers are less creditworthy, so the rate arbitrage still exists even when borrowing and lending long, albeit at a smaller spread. This is why banks lock us into CDs. They want us to lend to them long so they can turn around and lend it themselves long. Sure, it’s not the fast and easy money of the borrow short / lend long strategy, but it is safer.
So, for your own portfolio, shy away from investing in financial institutions that borrow more short-term money than long-term money. Wells Fargo, for example, borrows about half as much short-term money as long-term money. More aggressive banks, such as Bank of America, borrow twice as much short-term money as they do long-term money. Check out Bank of America’s losses this past year and compare them to Wells Fargo’s performance.
Short-term aggressiveness can mint money in the short-term but it places a bank’s balance sheet at the mercy of sudden shifts in the credit market that have historically led to financial disasters such as the one faced by Bear Stearns last year. Remember, keep a long-term horizon. You may feel like you are missing out on big returns during go-go times, but when financial trouble starts, stable conservative financial institutions such as Wells Fargo maintain a competitive advantage over more aggressive banks that will find themselves in trouble. The more conservative financial institutions will have money when the others do not and that is a recipe for long-term success and shareholder value creation.
Joe El Rady
The banks are back and attracting investors; but, employ extreme caution in your banking sector investments. For your own portfolio, shy away from banks that borrow more short-term money than long-term money! If you don’t feel like reading why, you don’t have to… this is actually enough to steer you in the proper direction when buying commercial bank stocks. If you want to know why… read on for the details…
Let’s Play Yield Curve Arbitrage. This is a great game; you are going to love it! Put up none of your own money and make a bundle. Sound too good to be true… well, this is one of the rare cases in which something that sounds too good, actually is true. In fact, banks have been doing this for years. In fact, this is what banks do; it’s their meat and potatoes. Banks borrow short-term and lend long-term… it’s one of the greatest money making games ever invented! Borrow at 5%, lend the money at 7%, and pocket the 2%. Awesome, I love it… it’s why I’ve always wanted to own a bank—but wait.
Okay, why can we lend for higher rates long-term than we borrow short-term? Remember, investments returns compensate four items: inflation, loss of liquidity, opportunity cost, and risk. Money held for longer periods must compensate for more liquidity loss and more opportunity cost. This causes the arbitrage.
Okay, so what’s the problem? The problem lies in the mismatch of the assets and the liabilities: we need to pay back the borrowed money before we get paid back the lent money. Thus, the short term maturity of the borrowed money hinders the game. Generally, this isn’t a problem; we just borrow more short-term money to pay back the maturing short-term borrowed money. In banking, we call this “rolling over the debt.” This works like a charm, until short-term rates jump higher and we need to refinance at a rate higher than the one we charged our borrowers. Again, generally this has not hindered the game much because we can lend at floating interest rates; thus, if the credit market tightens, causing us to pay more to borrow, the parties to whom we lent would concurrently owe us more due to the same conditions increasing the spread over the reference rate we imposed on their floating rate loans. Even when we cannot lend at floating rates (say we wanted to lend or buy a bunch of 30 year mortgages at fixed rates) we could enter into a series of swaps to hedge that risk and generally, through sophisticated financial engineering, we would still be okay.
So what’s the problem? The real disaster occurs (and this just happened last year) when we have lent a bunch of money long term but nobody wants to keep lending to us in the short-term. Suddenly, we need to repay all of the money that we borrowed short-term, but we don’t have it, because we lent it long-term. This is what famously happened to Bear Stearns: they borrowed short-term and used the money to buy mortgage backed securities (MBSs), using the MBSs as collateral for the short-term borrowing. But one day, their creditors woke up and said, “hey, we don’t think the collateral is worth what you guys say it’s worth, so we don’t want to lend you any more money and want to collect the money we did you loan you.” This situation, along with the Financial Instability Hypothesis I noted in a previous post, causes liquidity crises.
So what should banks do? Well, the smartest way to operate is to mix the aggressive and money-making borrow short / lend long strategy with a more conservative borrow long / lend long strategy. Basically, allocate some of your business operations to each strategy instead of just doing one or the other. But wait, how can a bank charge more for money it lends long than it pays for money it borrows long? Remember, investment returns compensate not just for liquidity loss and opportunity cost, but also for risk. Notwithstanding recent credit turmoil, banks are pretty creditworthy and their customers are less creditworthy, so the rate arbitrage still exists even when borrowing and lending long, albeit at a smaller spread. This is why banks lock us into CDs. They want us to lend to them long so they can turn around and lend it themselves long. Sure, it’s not the fast and easy money of the borrow short / lend long strategy, but it is safer.
So, for your own portfolio, shy away from investing in financial institutions that borrow more short-term money than long-term money. Wells Fargo, for example, borrows about half as much short-term money as long-term money. More aggressive banks, such as Bank of America, borrow twice as much short-term money as they do long-term money. Check out Bank of America’s losses this past year and compare them to Wells Fargo’s performance.
Short-term aggressiveness can mint money in the short-term but it places a bank’s balance sheet at the mercy of sudden shifts in the credit market that have historically led to financial disasters such as the one faced by Bear Stearns last year. Remember, keep a long-term horizon. You may feel like you are missing out on big returns during go-go times, but when financial trouble starts, stable conservative financial institutions such as Wells Fargo maintain a competitive advantage over more aggressive banks that will find themselves in trouble. The more conservative financial institutions will have money when the others do not and that is a recipe for long-term success and shareholder value creation.
posted by Joe El Rady at
12:17 PM
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