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How Banks Make (and Lose) Money

Who’s Doing What These Days

Early in March, Citigroup made big news when it reported profits for the first two months of the year. The seemingly dramatic turnaround helped to lift the entire market, but the news really shouldn’t have been so stunning. Citi, and other banks, have been generating profits recently because they’ve been able to capitalize on the most basic banking transactions: They received low-cost capital (in this case, free from taxpayers) and then loaned money against it for a fee. In banking this is known as the carry trade, and it’s the easiest transaction in finance.

Forecasting a turnaround for financial stocks these days is an impossible task, especially because we still don’t know the ultimate value of the securities held on bank balance sheets. But recent events at least afford us the opportunity to take a closer look at financial companies and how they make their dough.
After years of consolidation, most of the big financial companies that call themselves banks aren’t traditional banks at all — they’re merger and acquisition advisers, securities brokers and investment managers, all under one roof. JPMorgan Chase does traditional retail banking, private money management and Wall Street deal-making as well as trade securities for its own accounts. So it would be a mistake to buy or sell the stock based solely on the performance of its retail branches.
After the Glass-Steagall Act that kept commercial banks out of investment banking activities was repealed in 1999, the financial sector turned truly complex. Traditional banks got into investment banking and everyone entered investment management. Most public banks do a little bit of everything these days. Their activities can be broadly defined as traditional banking (lending and retail services) investment banking (deal-making) and money management (for themselves and others).
Banks that are mostly lending institutions, such as Hudson City Bancorp, try to raise capital as cheaply as possible and then lend against it. The capital can be deposits, for which they pay interest, or it could be investment securities such as government or corporate bonds. The idea is to lend more than the capital costs. That’s why Citi has had such an easy time so far this year — those billions from the government were free.
Banks have figured out how to further profit from making loans by getting into securitization. In this process, loans are packaged into portfolios and then sold to institutional investors and hedge funds. The bank gets a fee for designing these loan portfolios, commissions for selling them and in some cases an annual fee for managing the assets.
These portfolios, known as asset-backed, mortgage-backed securities or commercial-mortgage-backed securities, are at the heart of our current problems. Banks issued them to meet demand from large investors. When those investors disappeared, banks were stuck with these securities. If the banks sell the vehicles at depressed prices, they risk insolvency. But if they hold onto them, they risk taking huge losses as the underlying loans fail to perform.
Securitization is where commercial banks and investment banks intersect. Investment banks don’t focus so much on lending. Instead, they make money advising on mergers and acquisitions, underwriting debt and equity offerings, and investing the bank’s capital through the proprietary trading desk.
The prop desk is where investment banks meet asset managers. JPMorgan Chase, Bank of America and Goldman Sachs all compete with the pure investment managers such as Legg Mason and T. Rowe Price. In this business, they take in annual fees for managing other people’s money. Goldman focuses on high-net-worth investors and institutions. JPMorgan is also traditionally a high-net-worth manager, but its merger with Chase has given it more exposure to small investors. These businesses are mostly about gathering assets, and they tend to suffer during bear markets.
In the wake of the financial crisis, there’s much talk about new government regulations that will restrict bank activities. The industry seems to be headed toward a great simplification, with banks getting back to the basics of relationship lending, boutique investment banks focusing on a few areas where their bankers have expertise and asset managers struggling to regain investors’ trust.
This suggests that in the future, financial stocks won’t provide quite the frothy growth they did during the ’90s and early part of this decade.

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