Why Big Banks Hate Banking

10/27/2009 10:46 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

The stage is set for too-big-to-fail banks such as Citigroup and Bank of America to take on greater risks in pursuit of profits, counting on the US taxpayer to make good their losses.

There have been no obituaries. No eulogies. No burial services. But this quarter marks the death of traditional banking at the big money center banks.

Yes, we've seen amazing earnings reports from the likes of Goldman Sachs and JPMorgan Chase this quarter, but their profits came from things like trading. From everything, in fact, but what you and I—and certainly the preceding generation—called banking.

And it's exactly those huge profits from everything but banking that have put the final nail in the big banks as banks.

Goldman Sachs and JPMorgan Chase and maybe Bank of America and Citigroup, too, will survive as financial institutions. But they won't be banks.

The model for what these big financial institutions will be is laid out in the most recent quarterly earnings reports from Goldman Sachs and JPMorgan Chase. Goldman Sachs, for example, blew through Wall Street projections when it announced third quarter earnings of $5.25 a share, more than a dollar above the Wall Street consensus. Revenue climbed to $12.4 billion for the quarter, more than double Goldman's $6.04 billion in revenue in the third quarter of 2008.

Not bad for a recession, eh?

The Money Flow

Where did that revenue and ultimately those earnings come from? A lot of it—about $6 billion—came from trading fixed income, currency, and commodities. Revenue from equities trading came to $2.8 billion. And the company booked a gain of $1.3 billion from the stakes it owns in companies such as Industrial and Commercial Bank of China. Put that all together, and about $10 billion of the bank's $12.4 billion in revenue came from investing its own money or trading either for clients or with its own money.

What's surprising about JPMorgan Chase's results for the quarter is how similar they are to Goldman's, even though JPMorgan is a financial institution with a huge retail banking and credit card operation. Goldman Sachs converted to bank holding company status only last fall so it could gain access to cheap money from the Federal Reserve. It has a negligible retail banking presence.

Yet if you dig down a bit, JPMorgan Chase made its money this quarter in exactly the same way that Goldman did: From investment banking and trading.

Traditional Functions only a Fraction

Now, the bulk of JPMorgan Chase's $29 billion in revenue comes from traditional banking functions. Credit card services ($5 billion in revenue), retail financial services ($8 billion) and commercial banking ($1.5 billion) together make up half of the company's revenue.

But these traditional banking functions didn't make up anything like half of the company's $3.6 billion in net income for the quarter. Card services showed a $700 million loss. Retail financial services produced net income of just $7 million on that $8.2 billion in revenue. And commercial banking recorded net income of $341 million.

That's a net loss of $352 million from the traditional banking businesses that produced $14.5 billion of the company's $29 billion in revenue.

Contrast that performance to the $1.9 billion in net income produced from JPMorgan Chase's investment banking business on $7.5 billion in revenue. Of that revenue, $5 billion, up by $4.2 billion from the third quarter of 2008, came from fixed-income trading.

Fixed-income trading added more to JPMorgan Chase's bottom line than all of its traditional banking business.

NEXT: Can You Blame Them?

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Can You Blame Them?

The CEOs at our biggest financial institutions didn't get where they are by passing up profitable businesses to focus on money losers. Bet nobody at Goldman or JPMorgan is going into meetings to argue for putting less money into trading and more into credit cards or retail financial services, especially if they paid any attention to the results reported by their less fortunate big bank peers.

For example, Citigroup might have been able to offset some of the losses from its credit card business, just as JPMorgan Chase did, with higher revenues and bigger profits in investment banking and fixed-income trading—except that the company's fixed-income revenue plunged 18% in the quarter from the third quarter of 2008.

At Bank of America, it's hard to reach any other conclusion than that the bank would have been just fine if it did less traditional banking and more investment banking and trading. For the third quarter, the company lost $1 billion on credit cards and $1.6 billion on home loans and insurance. Global banking showed net income of just $40 million on $4.7 billion in revenue. Global markets, however, produced revenue of $5.8 billion. About $4.4 billion of that came from fixed income, currency, and commodity trading. Net income on that $5.8 billion in revenue was $2.2 billion.

If only the bank did more of that trading and less banking, it might not have reported an overall $1 billion loss.

Meanwhile, over at Wells Fargo...

Now, it might look like the results from Wells Fargo violate this pattern. Wells Fargo reported record third quarter profits of $3.2 billion. And a good part of the credit for that number goes to hard work in its traditional banking business. Refinancing and modifying mortgages for hard-pressed homeowners isn't as exciting as battling currency trades across global time zones, but it is, finally, slowing the rate at which mortgages have to be charged off at Wells Fargo. That's no mean achievement given the size of the adjustable mortgage portfolio that Wells Fargo bought when it acquired Wachovia.

But in reality, the most you can say about Wells Fargo is that the jury is still out. Its entire third quarter profit of $3.2 billion is a result of a $3.6 billion gain that the bank made from hedging its mortgage servicing portfolio. Think of it as income from a single massive trade.

Now, maybe you think that what I'll call the Goldman Sachs model of banking is no big thing. Maybe you think it's been around forever.

What's really disturbing to me, however, is that the model is relatively new, even at Goldman Sachs, and current financial policy is pushing Goldman and JPMorgan Chase to even more extreme versions of the "bank as trader" model.

Trading from the Public's Pocket

In Thursday's Financial Times, columnist John Gapper took a look at the evolution of trading at Goldman. In the two years just before its 1999 initial public offering, when Goldman was still a private partnership—and any capital it risked came out of the pockets of Goldman partners—trading contributed about a third of its revenue. By 2006 and 2007, when a public Goldman was using money it raised in the public markets, trading revenue had climbed to two-thirds of Goldman's overall revenue. In the first nine months of 2009, when Goldman started using taxpayer money to take risks, trading revenue is up to 78% of revenue, Gapper figures.

It shouldn't exactly come as a surprise to you that Goldman Sachs is willing to put more capital at risk when the capital belongs to taxpayers (and, before that, to public investors) than when it belonged to Goldman partners.

And, of course, now that Goldman Sachs is a bank holding company, it can borrow some of that risk capital directly from the Federal Reserve.

MORE: How Much Risk Is Too Much?

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Interpreting Debt-to-Equity Ratios

Conversion to a bank holding company will limit the amount of leverage that Goldman Sachs can take in its business. It will have to keep more capital on hand and borrow less. In September 2008, when Goldman Sachs decided that the advantages of having access to the Federal Reserve outweighed the drawbacks, it had a debt-to-equity ratio of 22-to-1, meaning it had borrowed $22 in debt for every $1 in capital it had. Morgan Stanley, which converted to a bank holding company around the same time, had an even higher debt-to-equity ratio: 30-to-1.

Banks such as JPMorgan Chase, which face more stringent regulation (relatively) than investment banks, such as the pre-2008 Goldman Sachs, have a debt-to-equity ratio of 13-to-1 or so.

The lower ratios banks are allowed are supposed to make them safer. At least that's the theory.

But as we've just learned in this crisis, a low debt-to-equity ratio doesn't offer any protection against a bank making a bad loan. In fact, a lower debt-to-equity ratio could actually lead a bank to take on more risks in order to make up for the loss of leverage. If a relatively un-risky deal produces a modest profit, leverage of 30-to-1 can turn that modest profit into a huge gain. To make the same profit with half the leverage, a bank might have to take on two or more times the risk (as measured by what have turned out to be flawed models for calculating risk).

Ratcheting up the Risk

What's to stop a bank from taking on this higher level of risk and to encourage it to settle for the lower but more predictable and safer returns of lending to businesses and consumers is fear of loss. A bank will walk away from some risky deals because it is afraid of losing money.

Unless, of course, the bank believes that someone (cue the taxpayer as good fairy of last resort) will make up the losses. Then it's risk ho!

So let's see:

  • We've got a Goldman Sachs/JPMorgan Chase model that proves trading is superior to traditional banking
  • We've got low-cost borrowing from the Federal Reserve that comes with limits on leverage
  • And we've got a belief among the nation's biggest bankers that taxpayers will pick up the tab for any losses they take in chasing risk

And why would the CEO of any financial institution big enough to be a significant trader decide to be "just" a traditional banker?

We've built a very perverse set of incentives—with the help of lots of encouragement from the big money center banks themselves, their lobbyists, and alums such as former Treasury Secretary Henry Paulson—that logically add up to the end of banking as we know it for the nation's biggest banks.

Yes, we've saved the big banks. But we've destroyed banking at these companies.

Read More from Jim Jubak:

Time to Break up the Banks!
Citigroup and Bank of America Facing Heat from Washington

At the time of publication, Jim Jubak didn't own or control shares of any company mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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