Spring in their step

Tax cuts and higher interest rates help boost banks’ earnings

America’s big six have their best quarter since the financial crisis


SO THIS is how normality feels. Between April 13th and April 18th America’s biggest banks reported a strong set of first-quarter earnings, with a helping hand from the taxman. Some are more profitable than they have been for years. They are paying billions to shareholders; regulatory reins are being loosened. Yet the stockmarket shrugged. On April 18th the S&P 500 index of banks’ share prices was 4.1% lower than at the start of reporting season.

Banks expected three main effects from the corporate-tax cut signed into law by President Donald Trump in December. The first was a write-down of deferred tax assets—past losses that could be set against future bills—which clobbered most lenders’ bottom lines in the fourth quarter but did no real damage. (Some, including Wells Fargo, carried deferred liabilities and hence recorded a gain.) The second was a permanent reduction in their tax bills. The third was a boost to business from a more lightly taxed America Inc.

The direct benefits of lower taxes are plain. Although pre-tax profits at the six biggest banks rose by $4.3bn, compared with the first quarter of 2017, taxes fell at five of them. (At the sixth, Goldman Sachs, the bill was unusually low a year ago because of a change in the treatment of employees’ shares and options.) Of a total increase in net profit of $5.4bn at those five, lower taxes accounted for $2.1bn. The ratio of tax to gross profit dropped by as much as nine percentage points (see chart).



Conclusive evidence on whether tax cuts will ginger up the whole economy will take longer to appear, although some bankers detect it already. Even so, the strong showing indicated more than merely a stroke of the presidential pen. JPMorgan Chase, America’s biggest bank, would have claimed a record profit even without lower taxes. Higher interest rates pushed its net interest income (the gap between lending revenues and borrowing costs) up by $1.1bn, or 9%.

As the Federal Reserve raises rates further, banks can expect more of that. Perky loan growth helped, too.

In investment banking, the brightest spot was in buying and selling shares. Choppier markets meant livelier trading after a quiet 2017. Revenues leapt by 38%, year on year, at Bank of America, Citigroup and Goldman Sachs and 25%-plus at JPMorgan Chase and Morgan Stanley. Trading of bonds, currencies and commodities was flatter—except at Goldman, where business rebounded by 23% after a poor start to last year. Revenues from advice and from underwriting new bond and share issues were mixed.

All this leaves America’s largest banks in rude health—the rudest, arguably, since the financial crisis a decade ago. The unweighted average return on equity for the biggest six in the first quarter was 13.1%. According to data from Bloomberg, it is at its highest since the crisis. Only Citigroup, at 9.7%, was below the 10% mark that investors regard as par. Bank of America cleared that hurdle for the first time in six and a half years. Goldman’s 15.4% was its best for five. Morgan Stanley’s 14.9% easily beat its self-effacing target.

Moreover, those returns are built on a much thicker equity base. The average ratio of common equity to risk-weighted assets, a key regulatory gauge of banks’ strength, is 12.5%, more than three times as high as at the end of 2007 (using an estimate by Autonomous Research). Lately, in fact, the ratio has declined slightly, as banks have returned money to shareholders and the Federal Reserve has felt confident enough to let them. Last June the Fed approved the big six’s plans to spend $72bn buying back shares over the next year, as well as increasing dividends.

The sky is not unblemished blue. Legal clouds linger over Wells Fargo, which may have to revise its earnings. Its net profit was the slowest-growing among the six. Regulators have offered to settle investigations of its sales of car insurance and some mortgages for $1bn. And a trade war would help no one. But big banks are once again getting used to sunshine.


Capitalism Can’t Work Without Losers

By Patrick Watson


Those who support free-market economics say it is the best, most efficient path to maximum prosperity for everyone.

In other words, everybody wins in a free market—not equally, but each person at least has the opportunity for a prosperous life.

I agree with all that, except the “everybody wins” part.

In fact, free markets don’t work well at all unless certain people lose. Otherwise the entire system fails and everyone loses. Which is happening right now.


Photo: Getty Images


Forgetting the Lessons

Neel Kashkari, president of the Minneapolis Federal Reserve Bank, is often in the news because he dissents from the Fed’s rate-hike decisions. He previously worked at Goldman Sachs and PIMCO and was assistant Treasury secretary overseeing the crisis-era Troubled Asset Relief Program (TARP).
 
After running one of the top bailout programs, Kashkari now thinks the “too big to fail” banks are, well, too big and should be broken up. I imagine that makes for some interesting conversations with the banks in his district.
 
Kashkari went on a little rant at a Howard University event last month. Here are some quotes my Twitter pal Pedro da Costa reported for Business Insider.
 
• “We are forgetting the lessons of the 2008 crisis.”
 
• “The shareholders got bailed out. The boards of directors got bailed out. Management got bailed out. So from their perspective, there was no crisis.”
 
• “No other industry is levered like the banking industry. If we double the amount of equity banks have, we could go a long way toward resolving the problem that too-big-to-fail banks pose.”
 
• “If it were up to me, we’d be increasing banks’ leverage ratio, not decreasing it.”
 
Those last two comments are important. Banks profit mainly by lending money that was itself loaned to the bank by depositors and bondholders. This gives them leverage, which makes them vulnerable to losses when borrowers default.
 
As a result, there’s a constant tension. Bankers want more leverage so profits will be higher. Regulators want to allow less leverage so the banks are less likely to fail. They meet somewhere in the middle.
 
The Fed manages this balance and does a pretty good job of it... until something like 2008 happens.
 
But here’s the problem: Our bank-stability apparatus—the Fed, the FDIC, occasional bailouts—encourages banks and other lenders to take unwise risks because they know (or at least believe) they’ll get rescued.
 
And that brings us back to free markets and losers.


Photo: Getty Images


Hiding the Message

We heard a lot in the crisis, and still now, about people taking out loans they couldn’t afford.

Obviously, that’s a bad idea.

But every loan has two sides: borrower and lender. Both have responsibilities.

Just as borrowers shouldn’t overstretch, lenders shouldn’t over-lend. That’s partly how we get crises like 2008.

In theory, the free market imposes discipline on both sides. It certainly does for borrowers. Default on your mortgage and every future lender will either deny you credit or charge you much higher rates… and rightly so.

But on the lender side, responsibility for mistakes stays hidden. As Kashkari said, bank executives and directors who made bad decisions leading up to 2008 felt little punishment.

So, the system tacitly promotes irresponsible lending. The free-market way to prevent this is for irresponsible lenders to lose all their money. It would send other lenders a message: “Avoid doing what they did.”

Government bailouts keep that information from the people who need it. The result: an unstable banking system that builds up unsustainable debt and periodically implodes.


Photo: Getty Images


Raising Taxes

This isn’t just a US problem. An April 18 Financial Times story reported on some African countries slipping into a debt crisis. Here’s an excerpt:

With the number of countries already unable to service their debts doubling in the past year to eight, officials at the International Monetary Fund are urging all African countries to raise taxes to provide more scope for paying interest, which has increased to levels last experienced at the start of the century.

While we don’t know the details of these troubled loans, we can infer a few things.

First, it’s not new information that some African governments are unstable, corrupt, and have trouble servicing their debts. That has been the case for decades.

Second, anyone who lends money to those governments should know those risks and price their loans accordingly. These lenders apparently didn’t.

Whose fault is that? Not the borrowers’, and certainly not the citizens’ who the IMF now insists pay higher taxes so the lenders get their interest.

What should happen here is…

• IMF butt out, and

• Those lenders lose their money.

That would teach other lenders to require sustainable, realistic loan terms and interest rates. It would be short-term harder on the borrowers, but in the long run help free them from perpetual debt serfdom.

Don’t Blame Capitalism

Similar things happen in the US every day. I don’t think another banking crisis is imminent, but we’ll have one eventually.

When that crisis comes, some people will want to blame capitalism—but the real culprit will be the lenders’ lack of market discipline.

We could avoid this, or at least make it less painful, by taking the kind of steps Neel Kashkari recommends. But don’t hold your breath.

Why Do Steven Spielberg and Matt Damon Still Exploit Malthusian Fears?

Dear Reader,

You might not be interested in economic theories, but economic theories are interested in you. False economic theories have made life hell for many millions of people, and some of our biggest celebrities seem committed to spreading these falsehoods to future generations.

I’m not talking about the obvious monsters—the fascists and communists who convinced nations that their policies would create utopian levels of prosperity and happiness, ending instead in mass murder. I’m thinking of well-intentioned people like Thomas Malthus, a genteel English clergyman and economics professor born in 1766.

By all accounts, Malthus was a kind and compassionate man who never sought personal political power. In 1798, his book, An Essay on the Principle of Population, set forth his theory that human populations, because they can increase exponentially, will inevitably outstrip resources.

Malthus wrote the book partly to counter the ideas of Nicolas de Condorcet, the French Enlightenment philosopher and mathematician who championed free markets, constitutionalism, and equal rights for women and all races.



Malthus apparently believed that Condorcet’s ideas, unconstrained by an intellectual class capable of controlling population and resources, would lead to catastrophic famine and conflict. Among those influenced by his views were people who interpreted Darwin’s work to mean that only the fittest cultures would survive the inevitable overpopulation.

The most proactive Malthusians, including Hitler, Stalin, and Mao, decided not to wait for overpopulation to arrive. Bryan Caplan, professor of economics at George Mason University and senior scholar at the Mercatus Center, shows how Hitler’s tome, Mein Kampf, explicitly cites overpopulation as a justification for his genocidal policies:

Malthusianism was Hitler's official argument for his greatest crimes. Germany's problem, in Hitler's own words:

The annual increase of population in Germany amounts to almost 900,000 souls. The difficulties of providing for this army of new citizens must grow from year to year and must finally lead to a catastrophe, unless ways and means are found which will forestall the danger of misery and hunger.

Given the historical record, you might think Malthusianism would have been repudiated long ago. Resource production has always outpaced population growth, thanks to scientific innovators and entrepreneurs. There have been famines in modern times, but their root cause has almost always been political conflict or corruption, not a shortage of food production capacity.

In the last few decades, exponential improvements in human conditions have become so obvious, it’s impossible to deny. Freedom-enabled innovation is lifting the world out of poverty into a new era while levels of pollutants are falling across the board. Birthrates are sub-replacement globally, and total world population is due to drop within a generation.

In fact, all net population growth now happens because improved healthcare is keeping people alive much longer. 

Academic demographers have known what’s going on for decades, but their data remains mostly unread. Slowly, however, word is getting out.

Swedish sociologist Hans Rosling was probably the most effective anti-Malthusian champion. Unfortunately, he is gone, but his videos on global progress and the end of overpopulation fears are still available.


 
More recently, Harvard psychologist Steven Pinker, HumanProgress.org, and others have taken up the baton.  

Right now, transformational technologies are emerging that will improve health and increase prosperity even further. El jefe John Mauldin is working on a book that attempts to describe this dawning era of abundance. 

Does that mean we have no problems? Obviously not. In fact, we still have one major Malthusian problem. This is not a problem that Malthus predicted, though. It’s a problem he helped cause.

For whatever reason, a lot of people, including influential artists and filmmakers, are drawn to the Malthusian vision of doom. This is a pity, because the biggest threat to the developed world today is the demographic deficit.

The aged population is larger than it has ever been and still growing. And since many Baby Boomers aren’t financially secure, the burden has fallen on an ever-shrinking population of younger people.

We’ve known this would happen since the 1930s, but Malthusians controlled the media bullhorn, so the average person never learned that the demographic pyramid was flipping. Though US fertility has been below the replacement birthrate since 1971, the establishment elite has never stopped sounding the overpopulation alarm and advocating lower birthrates.

Europe’s birthrates fell ahead of North America’s, so the problem is more obvious there.
 
Watch Germany to See What’s in Store for the United States

Germany’s Berlin Institute for Population and Development, an independent non-partisan research group and think tank, recently published a remarkable diagnosis of Europe’s future. Titled, “Is economic growth over?”, the report suggests that European policymakers should accept that the many decades of post-war economic growth are over, to be replaced by permanent secular stagnation.


 
The following paragraphs are from the press release announcing the study:

“In order to boost economic growth, governments and central banks are resorting to classic economic policy instruments, such as publicly-funded investment programs or low interest rates”, [Dr. Reiner Klingholz, Director of the Berlin Institute for Population and Development] explains. “Tackling structural problems using cyclical economic instruments is futile. Debt will only grow further as a result.”

The problem is that state, business and society rely on steady growth. Klingholz: “In our current organisational form, the state is dependent on economic growth to service its debts or to maintain efficient social systems for an aging society.” The economy likewise depends on growth. Without growth, businesses need to lower their profit expectations and investment needs and anticipate that technological progress will continue to slow down. This threatens jobs. Increasing unemployment, coupled with a weak economy, may undermine people’s trust in the promise that they are going to be better off than preceding generations. What helped democracies emerge and survive in the past is the broad distribution of wealth. A stagnating economy poses hitherto unknown challenges.

 
What an understatement. We are at a turning point in history. A demographic transformation unlike any seen in history is happening right now, and we need to understand what it means for investors and the public in general.

Low birthrates and a rapidly aging population are suffocating economic growth and creating enormous political schisms. This is obvious in Europe but just dawning on North Americans. The policy and investment models that worked during the post-war growth era are already failing, and the problem will get worse.

How ironic that the West, which created the innovations responsible for raising the world’s standard of living, has embraced Malthusian pessimism. The solution, as I’ve said before, is not more centralized control. It is more innovation, especially in healthcare.

We can solve the financial problems that are killing economic growth by shifting older people out of the dependency column and into the productive column. We can revitalize the West by making the old more youthful and delaying aging for everybody.

We can, and we will. Unfortunately, media and popular culture are not helping.

Two recent big-budget movies, Matt Damon’s Downsizing and Steven Spielberg’s Ready Player One, both depend on the tired, discredited boogeyman of overpopulation to drive their plotlines. A few years ago, Damon starred in a similar dystopian movie named Elysium.

It’s impossible for me to watch any of them. Once I am asked to accept the premise that the world is facing catastrophic overpopulation and wealth inequality, my ability to suspend disbelief fails. Malthus has done enough mischief already, I can’t watch hectoring entertainers continue his work.

 Fake Markets Produce A Fake Economy

Automtaic Earth’s Raúl Ilargi Meijer just posted an essential essay on the world’s financial markets – or what used to be the world’s financial markets. Here’s an excerpt:

“[Price discovery] is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers”, says Wikipedia.  
Perhaps not a perfect definition, but it’ll do. They add: “The futures and options market serve all important functions of price discovery.” 
What follows from this is that markets need price discovery as much as price discovery needs markets. They are two sides of the same coin. Markets are the mechanism that makes price discovery possible, and vice versa. Functioning markets, that is. 
Given the interdependence between the two, we must conclude that when there is no price discovery, there are no functioning markets. And a market that doesn’t function is not a market at all. Also, if you don’t have functioning markets, you have no investors. Who’s going to spend money purchasing things they can’t determine the value of? (I know: oh, wait..) 
Ergo: we must wonder why everyone in the financial world, and the media, is still talking about ‘the markets’ (stocks, bonds et al) as if they still existed. Is it because they think there still is price discovery? Or do they think that even without price discovery, you can still have functioning markets? Or is their idea that a market is still a market even if it doesn’t function? 
Or is it because they once started out as ‘investors’ or finance journalists, bankers or politicians, and wouldn’t know what to call themselves now, or simply can’t be bothered to think about such trivial matters? 
Doesn’t a little warning voice pop up, somewhere in the back of their minds, in the middle of a sweaty sleepless night, that says perhaps they shouldn’t get this one wrong? Because if you think about, and treat, a ‘thing’, as something that it’s not at all, don’t you run the risk of getting it awfully wrong? 
A cow is not a dinner table; but both have four legs. And “Art is Art, isn’t it? Still, on the other hand, water is water. And east is east and west is west and if you take cranberries and stew them like applesauce they taste much more like prunes than rhubarb does. Now you tell me what you know”. And when you base million, billion, trillion dollar decisions, often involving other people’s money, on such misconceptions, don’t you play with fire -or worse? 
This may seem like pure semantics without much practical value, but I don’t think it is. I think it’s essential. What comes to mind is René Magritte’s painting “La Trahison des Images”, better known as “Ceci n’est pas une pipe”, (The Treachery of Images – this is not a pipe). People now understand -better- what he meant, but they were plenty confused in the late 1920s when he painted it. 
An image of a pipe is not a pipe. In Magritte’s words: “The famous pipe! How people reproached me for it! And yet, could you stuff my pipe? No, it’s just a representation, is it not? So if I had written on my picture ‘This is a pipe’, I’d have been lying!”. 
But isn’t that what the entire financial community is doing today? Sure, they’re making money right now, but that doesn’t mean there are actual markets. They don’t have to go through “the process of determining the price of an asset in the marketplace..” I.e. they don’t have to check if the pipe is a real pipe, or just a picture of one. 

 
What killed price discovery, and thereby markets? Central banks did. What they did post-2008 is two-fold: they bought many, many trillions in ‘assets’, mortgage-backed securities, sovereign bonds, corporate bonds, etc., often at elevated prices. It’s hard to gauge how much exactly, but it’s in the $20+ trillion range. Just so all these things wouldn’t be sold at prices markets might value them at after going through that terrible process of ‘price discovery’. 
Secondly, of course, central banks yanked down interest rates. Until they arrived at ultra low interest rates (even negative ones), which have led to ultra low yields and the perception of ultra low volatility, ultra low risk, ultra low fear, which in turn contributed to ultra low savings (in which increasing household debt also plays a major role). As a consequence of which we have ultra high prices for stocks, housing, crypto(?), and I’m sure I still forget a number of causes and effects. 
People wanting to buy a home are under the impression they can get “more home for their buck” because rates are so low, which in turn drives up home prices, which means the next buyers pay a lot more than they would have otherwise, and get “less home for their buck”. In the same vein, ultra-low rates allow for companies to borrow on the cheap to buy back their own stock, which leads to surging stock prices, which means ‘investors’ pay more per share. 
Numbers of the S&P 500 and its peers across the world are still being reported, but what do they really represent? Other than what central banks and financial institutions have bought and sold? There’s no way of knowing. If you buy a stock, or a bond, or a home, you no longer have a means of finding out what they are truly worth. 
Their value is determined by central banks printing debt out of thin air, not by what it has cost to build a home, or by what a company has added to its value through hard work or investment in labor, knowledge or infrastructure. These things have been rendered meaningless. 
Central banks determine what anything is worth. The problem is, that is a trap. And your money risks being stuck in that trap. Because you’re not getting any return on your savings, you want to ‘invest’ in something, anything, that will get you that return. And the only guidance you have left is what central banks purchase. That is a much poorer guidance than an actual market place. The one thing you can be sure of is that you’re paying more for ‘assets’ -probably much more- than you would have had central banks remained on the sidelines… 
And I know you’ve heard this before, and I know central banks bought us 10 years of respite. But it was all fake, it was all just a picture of a pipe. They had to pile on insane amounts of debt on your heads, kill off your pension systems and make markets a meaningless term, to achieve that respite. 
They had to kill the markets to create the illusion that there still were markets. With the implied promise that they would be able to get out when they had ‘restored growth’. 
But you can’t buy growth. And yet that is the only trick they have up their sleeves, and the only thing the emperor is wearing. Next up: a rabbit and a hat. And a pipe. And then the lights go out and someone shouts “FIRE!”.

This is really the central theme of today’s world. What used to be markets have become something else. And that something else no longer performs the single most important task that exists within capitalism – helping people figure out where to invest.

Without markets’ price signaling mechanism the world’s wealth creators and preservers are flying blind, making the typical mistakes of someone operating without crucial pieces of information. The resulting malinvestment is piling up like underbrush in a forest where fires have been suppressed for too long. And when a fire does break out it will be one for the history books.