In 2008, the real estate bubble burst. The culprits were many, but one of the main transgressors was the financial sector.
Banks were allowed, and sometimes even encouraged, to give mortgages with no money down and to less creditworthy recipients. From there, the mortgages were packaged into collateralized mortgage obligations (CMO), which receive cash flow as borrowers repay the loans. The mortgages act as collateral for the securities and many were rated highly due the mix of highly rated mortgages being combined with lower rated mortgages. Morgan Stanley and Merrill Lynch were hard hit during and after the crisis as their large holdings of CMOs hit their balance sheets.
As a result of the financial crisis, 25 banks closed or went bankrupt in 2008, 140 banks in 2009 and 157 banks in 2010. Lehman Brothers (LEH), the largest bankruptcy in history, was a global financial firm that collapsed in September 2008. Bear Stearns, a global investment bank, was sold to JP Morgan (JPM) to prevent further damage to the economy and Bank of America (BAC) agreed to acquire Merrill Lynch in September 2008. For a broader view of how these takeovers, mergers and bankruptcies occurred and how the Fed helped, watch HBO’s “Too Big to Fail.”
Barney Frank, a member of the House of Representatives at the time, stated before the crisis that Fannie Mae and Freddie Mac (put into conservatorship in September 2008 due to insolvency) were in good shape. When the Bush administration proposed tighter regulation on Fannie and Freddie, Frank complained that the administration was more concerned about financial safety than about housing.
After the crisis, Frank claimed, “The private sector got us into this mess.” In response, Frank, the Financial Services Committee chairman, and Chris Dodd, a member of the Senate Banking Committee, introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Dodd-Frank, as it is commonly called, required bank holding companies with more than $50 million in assets to abide by stringent capital and liquidity standards. It also created the Financial Stability Oversight Council for coordinating regulation of larger, “systematically important” (read “too big to fail”) banks.
During the crisis, a few financial leaders stood strong; Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JP Morgan come to mind. When I heard Blankfein was retiring by year-end, my first thought was of his leadership during the crisis. The fear being that once the leaders who navigated us through the crisis successfully were gone, we would end up back where we started.
As with any boom and bust, regulation goes from too lax to too tight. As the current administration takes hold, we enter a climate promoting tax reform, deregulation in energy, and lightening regulation in financials. In an article in Wednesday’s Wall Street Journal, ’Financial Deregulation Throws Fuel on Already-Hot Economy,’ author Greg Ip references Congress’s move to “exempt medium-size banks from the stricter standards found in the 2010 Dodd Frank.” It is a milestone because it is the first proposed easing of capital requirements since the crisis.
Even with the higher regulations, Wells Fargo (WFC) still ran into issues with its sales practices. The Consumer Financial Protection Bureau (CFPB) levied a $1 billion fine against the financial firm in the largest fine imposed by the agency in its history. Wells Fargo broke the law by overcharging customers for mortgage extensions and adding insurance costs and fees to borrowers’ car loans. This is after a $185 million fine by the CPFB due to Wells Fargo’s widespread practice of opening unauthorized deposit and credit card accounts. It is corporate culture and not regulation that exposes and/or drives companies’ ethics.
Less regulation leads to lower costs and better earnings. Lower taxes lead to better after-tax earnings. To add to the growth possibilities, financials are typically the best performing sector in a rising rate environment. CDs are paid a fixed rate over a fixed term so even though rates are rising, banks still pay the lower rate on term deposits until they mature. Interest costs on customer deposits (checking and savings accounts) are paid very little and rates rise slowly. Banks tend to benefit from a stronger economy with higher loan activity.
In short, many positives are coming for the financial sector. The question is whether they can navigate successfully for higher earnings and margins without the risk of overextending themselves into another crisis.
*Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector. Past performance is no guarantee of future results.
