How Banks Are Making Money Now

 | Nov 29, 2012 | 1:00 PM EST  | Comments
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There are two basic ways in which banks create revenue, interest income and non-interest income. Interest income is what is commonly associated with banks. It is income derived from making, holding and servicing loans. Non-interest income comes principally from four areas: service fees, fiduciary activities, trading and loan sales.

The rescission of the Glass-Steagall Act by passage of the Gramm-Leach-Bliley Act of 1999 afforded banks the opportunity to expand into many more kinds of non-interest income activities, especially securities trading and insurance sales. This also started the institutional changes in the way banks and bank management operate.

The housing boom of the early 2000's also lead to an increase in bank affiliated mortgage brokerage operations and a focus on the origination of mortgage loans for sale to the mortgage backed securities packagers. The income derived from the sale of these mortgages is carried as non-interest income.

The steady decline in treasury yields, loan and deposit rates that has occurred since the housing bubble popped commensurate with increasingly more stringent loan qualification requirements and decreasing demand for loans has required banks to rely increasingly on non-interest income.

The most obvious evidence of this across all size banks has been the increase in service fees of all kinds. The largest institutions have also increasingly focused on trading activity, which also resulted in an increase in volatility from earnings associated with such activity as was evidenced most spectacularly with the $6B trading loss at JP Morgan earlier this year.

The increase in reliance upon trading activity and non-interest income, especially by the money centers, was then addressed by the Volcker Rule as a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed into law in January 2010 with restrictions on trading activities beginning to be phased in starting this past July.

Commensurate with these regulatory issues intended to steer banks back toward traditional activities the Fed was lowering the cost of debt capital to the banks to entice them to increase their lending and Congress created multiple loan modification programs to encourage banks to restructure their troubled loans and help to make them performing again.   

The lowering of the cost of debt capital also made it more profitable for banks to refinance their portfolio of loans and to increase their origination of new refinanced mortgages with the intention of selling them immediately to MBS packagers for a gain in non-interest income.

And indeed this is what has been happening so far this year with a substantial increase in such activity by the bulk of the banks in the U.S., those with assets of between $100 million and $50 billion, or about 70% of all banks.

These institutions, about 4,500 in total, have concentrated their activities on refinancing residential mortgages for sale to MBS packagers. The desire for such loans to back mortgage backed bonds is being driven by the search for yield by investors as interest rates are so low.

Non-interest income at banks derived from the sale of these loans has increased 300% this year to record highs, from about $1.8 billion in Q4 of 2011 to $5.6 billion in Q3 of this year.

About $3 billion of this has come from the mid-sized banks referenced above; and only about $2.6 billion from the money centers and national banks, the 35 largest institutions by asset size.

It is probable that the large institutions which are staffing up their mortgage operations now following the Fed's announced intention of buying $40 billion monthly in MBS's this past September will be the primary source for meeting the Feds demand in 2013.    

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