Question for Liz Warren: How Many Subsidies Does a Zombie Bank Need?
"All right," thought the Devil. "We will have a tussle. I'll give you land enough; and by means of that land I will get you into my power."
“How Much Land Does a Man Need?” (1886)
Last week, Senator Elizabeth Warren (D-MA) incurred the ire of the banking industry by suggesting that their cost of funds is subsidized to the tune of $80 billion annually. Bloomberg News reports:
“Warren questioned Fed Chairman Ben S. Bernanke over what she said was a taxpayer subsidy worth $83 billion, citing an International Monetary Fund working paper on the funding advantage big banks get because of the market perception that they are protected by the government against failure. In their brief, the industry groups said the paper cited by Warren used data on banks’ borrowing costs before Dodd-Frank was passed.”
Unfortunately, neither Senator Warren nor the folks at the IMF have a full appreciation for the scope of the subsidies that run through the P&Ls of the US banking industry and, in particular, the top-four zombie banks -- C, WFC, BAC and JOM -- which account for more than two-thirds of the total assets in the industry. And you don't need to count any of the emergency programs and subsidies put in place after the 2007 subprime crisis in order to understand the subsidy flows to the zombie dance queens.
By my conservative reckoning, the subsidies for the zombie banks total more than $3 annually for every dollar in income reported by the industry in profit. The industry reported $35 billion in profits in Q4 2012, so we’ll call annual income about $150 billion annually. Let’s start with the broadest subsidies that affect all banks and work our way up the food chain to those subsidies that only impact the TBTF zombie queens.
First and to Senator Warren’s point, the Fed is currently subsidizing the cost of funds for the US banking industry to the tune of about $90 billion per quarter or $360 billion annually. That is a tad higher than the $83 billion in supposed annual “spread” subsidy calculated by the IMF. While I agree that the TBTF banks certainly get an absolute advantage in the market in terms of funding, the subsidy due to Fed market manipulation such as QE is much bigger and very tangible. In Q4 2012, the interest expense for the entire US banking sector was just $15 billion vs. over $100 billion at the start of 2007, according to the FDIC’s Quarterly Banking Profile.
The second major subsidy for the US banking industry is federal deposit insurance. In Q3 2012, all US banks paid $2.937 billion in FDIC assessments to unconditionally insure $7,405 billion in insured deposits or a premium of about 0.04% or just 4 bps vs. the insured balance. Now the FDIC is a mutual insurance scheme backed by the income and capital of all insured banks, but behind the FDIC stands the US Treasury. Having that backstop is worth serious money, far more than 0.04% or 4 basis points annually. Specific assessment fees range between 2.5 and 45 bp, depending on the riskiness of the institution.
If we compare the FDIC deposit insurance premiums with, say, an FHA mortgage insurance premium, which is measured in points on the principal amount, the subsidy becomes clear. Were the FDIC insurance were closer to a “free market” price of 40bp per quarter, the quarterly cost would be close to $30 billion or just about the entire income for the industry. Since banks are really not that profitable, however, instead we have federal subsidies. The lack of basic profitability, and not the avarice of bankers, is the reason for the subsidies.
Next after federal deposit insurance on the subsidy hit parade we have government guaranteed loans. The list of government loan guarantees is long and varied, including housing, small business and various other special needs groups and constituencies that are deserving of the support of the American people. Chief among these is housing, a marvelous and very special industry. Banks write loans, collect fees, retain servicing, and then sell the some or all of the credit risk to Uncle Sam.
Uncle Sam collects a fee for taking the credit risk when loans are bundled into securities and sold to investors. In the case of the GSEs, such as Fannie Mae and Freddie Mac, the agencies share first loss risk with private mortgage insurers. In the case of Ginnie Mae, the agency stands in fourth loss position behind the home owner, FHA, and most important, the issuer of the securities. All of these subsidies are provided to stimulate home ownership, mind you, which allows Americans to think that a 3%, 30-year mortgage is a normal and natural occurrence. The real, free market cost of a 30-year prime mortgage is closer to 6%.
The guarantee fees charged by Washington for mortgages are still far below rates where private investors would take first loss risk. Revenue from loan origination, sale and servicing for FDIC insured banks selling into the agency markets total into the tens of billions of dollars annually. Let’s be conservative and call the annual subsidy to banks from the federal housing agencies a hundred billion annually, but again, that is almost the entire income of the industry! Thus we have subsidies.
So far, we have identified about half a trillion dollars in subsidies for the US banking industry as a whole, several times more that the industry reports in profits each year. Now let’s narrow the focus to the zombie dance queens and add up a few of the special subsidies that make it possible for a zombie banks to survive. Big banks are not, contrary to what you may have heard, more profitable or efficient than little banks. As I noted in the recent Zero Hedge post about "true sale," the hidden leverage of off-balance-sheet or OBS vehicles was the greatest subsidy of all, but I digress.
One of the biggest subsidies enjoyed by the zombie dance queens is the oligopoly control these banks exert over the secondary market for home mortgages. When a little bank makes a loan to help you buy a house it will often sell that mortgage to a federal agency to recoup its capital and be in a position to make another loan. (See “It’s a Wonderful Life” with Jimmy Stewart if you don’t follow me.) When the little bank or non-bank lender wants to do business with Fannie Mae, Freddie Mac or the FHA, however, it must sell its loan to one of the zombie dance queens, who pocket half of the profit on the loan for their trouble. This is just one of the structural subsidies blessed by Congress and the Fed that make large banks look more profitable than they truly are. In fact, the TBTF banks are not really profitable at all.
A veteran banker opined to this writer during the now defunct American Securitization Forum conference in Las Vegas in January 2013: "The day that Wachovia was acquired, the yields in the TBA market in US mortgages moved up 75 basis points. The strength of the US economy is competition, but not in mortgage finance. The smaller players lived on the bleeding edge of the mortgage market, but they were also far more efficient lenders than the large banks. Now, care of the Fed, we have a highly inefficient oligopoly in the US mortgage market that is built around the largest banks."
The subsidy to the TBTF banks for the mortgage market oligopoly must be worth at least $100 billion per year in fees earned from smaller banks, gain on sale into the TBA market and servicing. Let’s not forget that the Fed’s QE has handed the TBTF banks huge yield spread premiums on government guaranteed loans sold into the TBA market. Just look at the price for the on-the-run agency security and that gives you a rough idea of the premium earned by a bank selling loans into that market.
Fortunately for Elizabeth Warren and all of the other angry Calvinists in the audience, the new Basel III capital accord is going to force the largest banks out of the US mortgage market entirely. As I wrote yesterday in The Institutional Risk Analyst:
“As the abortive Basel III accord kicks in this year, look for the largest banks to start actively discouraging their personnel from originating all but the highest quality mortgage loans. Why? Three reasons: 1) B III capital rules for mortgage loans, 2) B III liquidity rules which force banks to hold only short-duration assets and 3) B III treatment of capital and accumulated other comprehensive income (AOCI). Taken together, these three pieces of Basel III will sharply curtail bank lending for real estate in the future. Get used to it.”
While housing and other government subsidized loans are significant sources of subsidy for banks, the biggest subsidy of all for the TBTF banks is the OTC derivatives markets. The lack of capital required in these transactions and other special dispensations from the Fed provide the zombie banks with unlimited leverage and almost no public scrutiny. The fact that OTC contracts are exempt from the automatic stay in bankruptcy is a huge subsidy. The bilateral market structure is another. All of these retrograde market configurations were supported by the Fed over the past several decades. And because Basel III is chasing the banks, large and small, out of the mortgage business, the importance of OTC derivatives to the largest banks will only grow. Let’s be conservative and figure that the subsidy for OTC derivatives is worth $100 billion annually.
The point of this exercise is to show that not only do banks receive huge subsidies from the federal government, but these subsidies are far greater than the stated income of the industry. While you can argue that the largest banks receive a disproportionate share of the flow of largesse from Washington, it is also fair to say that the entire industry is heavily subsidized. And keep in mind that the above points are only a partial list of the subsidies and other flows that allow the members of the banking industry to pretend to be profitable, risk-taking organizations in a free market economy. The reality, sad to say, is that banks in 21st Century America are government sponsored enterprises, effectively loan production offices working for FDR’s socialist utopia. Send your thank you notes to Paul Krugman at The New York Times.