peer-to-peer lending, the next big banking innovation

the demise of the department store

The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion.  In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices.  Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.

The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.”  It has been underway for almost a half-century.

Consider what a bank does for a living:

in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%.  It uses the difference (the spread) to cover costs and make a profit.

money market funds

The first big disintermediation came in the 1970s, with money market funds.  These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations.  The entire spread, less expenses, goes to the money market shareholder.  So in normal times, money market funds pay considerably higher interest than banks.  The banks’ only advantage has been government deposit insurance.

The emergence of the money market fund produced a massive shift of customer deposits away from banks.

junk bonds

The second was  junk bond funds.  The first junk bonds were “fallen angels.”  That is, they were issued with low coupons by companies whose businesses subsequently deteriorated.  As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels).  Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.

As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today.  These bonds were direct competitors to the corporate lending operations of banks.  However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.

Again, there was a massive shift of profitable business away from banks.

peer-to-peer lending

We’re in the early days of a third big disintermediation.  Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.

As things stand now, P2P lenders are simply internet-based intermediaries.  They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee.  As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks.  In the junk bond case, though, the “department” quickly morphed into something else.  That could easily happen with P2P, as well.

What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.

More when IPO dates are closer.


new money market fund regulations

Yesterday, the SEC announced new rules for US money market funds, which in the aggregate hold $2.6 trillion in investors’ money.  Of that amount, two-thirds is in funds catering to institutions and high net worth individuals; one-third is in funds serving the mass market.

Why the need for new rules?  

Two reasons:

–today’s aggregate money market assets are large enough to be a risk to the overall financial system if something goes badly wrong, and

–the funds are typically sold as being just like bank deposits, only with higher yields.  However, like most Wall Street claims that  “x is just like y, only better,” it’s not really true.  The differences only become important in times of market stress, when normally sane people do crazy things, and when “yes, but…” is a sign for panic to begin.  So there’s a chance that “badly wrong” can happen.

The differences?    …bank deposits are backed by government insurance that insulates depositors from investment mistakes a bank may make.  Also, the Fed stands ready to rush boatloads of cash to a bank if withdrawals exceed the money a bank happens to have on hand.  Money market funds have neither.

Yet many holders are unaware that it’s possible for a money market fund’s net asset value to fall below the customary $1.00 per share, or that a fund might be overwhelmed by redemptions and forced to sell assets at bargain-basement prices to meet them.

the fix

Fixing this potential vulnerability has two parts:

–giving the finds the ability to halt or postpone redemptions during financial emergencies, and

–requiring funds to have floating net asset values, not the simple $1.00 a share.  This would mean marking each security to market every day.  …which would likely require hiring a third-party to price securities that didn’t trade on a given day.

The first of these would avoid the government having to step in the case of a run on a fund.  The second should reinforce that money market funds aren’t bank deposits.

the new rules

Of source, the organizations that sell money market funds have been strongly opposed to anything that would ruin their “just like…, but better…” sales pitch.  Their lobbying has blocked action for years.

So it should be no surprise that yesterday’s SEC action was a compromise measure:

–all funds will be able to postpone redemptions in time of emergency, but

–only funds that cater to big-money investors will have to maintain a variable NAV.

Personally, I don’t understand why money market funds that serve ordinary investors should be exempt from having to calculate a true daily NAV.  You’d think that this is the group that most needs to understand that the (remote) possibility of loss is one of the tradeoffs for getting a higher yield.  Arguably, sophisticated investors already know.  But the financial lobby is incredibly powerful in Washington, and this may have been the price for getting anything at all done.



regulating money market funds

In the aftermath of the financial crisis, the government has been considering the risks to financial stability posed, not only be banks but also by asset management firms.  As part of this effort, the SEC is about to set new regulations for money market funds this week.

what money market funds are

One of the most important economic (and stock market) trends of the past half-century has been the emergence of focused single-purpose entities to compete with large conglomerates.  In retail, specialty firms selling jewelry, toys, household goods or electronics have offered an alternative to department stores.

In finance, money market and junk bond mutual funds, have offered alternatives–to borrowers and savers alike–to commercial banks.

Money market funds have several important characteristics:

–they provide short-term, working capital-type loans to borrowers

–as mutual funds, they promise to accept daily subscriptions from savers and allow daily withdrawals in unlimited amounts

–they have typically offered higher yields than bank savings accounts–sometimes far higher yields

–they can offer the ability to write checks against deposits

–they promise, at least implicitly, to maintain net asset value at a stable $1 per share.  In other words, they promise that, like a bank deposit, you won’t lose any of the principal or interest you have in the fund

–because a money market fund is not a bank, its deposits are not government insured.  The “no loss” promise relies solely on the good will and financial strength of the investment company offering the product.

the risks

According to the Investment Company Institute, US money market funds currently hold $2.57 trillion in assets.  That’s a lot of money.

In times of stress, the warts in money market funds begin to show.

They come in two related varieties:

–as a practical matter, many funds are so large that they might not be able to meet redemptions if large numbers of shareholders lost faith in either the industry or a particular fund and headed for the exits,

–because money market funds compete with each other primarily on yield, inevitably someone (or more than one) will hold his nose and make a sketchy loan simply because the interest payments are high.  In a crisis, such loans may not be worth what a fund paid for them; in the worst case, the borrower will default.    In past crises, including 2008-09, there have been times when dud loans are big enough to make it questionable whether the real NAV of a given fund should still be $1.00 and not $.99.  These situations have typically been resolved by the management company that offers the fund buying the securities in question from its money market fund at face value.  But there’s no guarantee this will happen in the future.  And a single fund that “breaks the buck” by writing down assets in a crisis could easily spark an industry-wide panic.

new rules

This week the SEC is expected to issue new money market rules to meet these concerns.  They’ll include:

–many money market funds that don[‘t exclusively own Treasury securities will be required to have a floating NAV, and

–funds will have the ability to suspend redemptions in times of financial stress and/or impose withdrawal fees on those wishing to get their money back.

my take

I think new rules will have their greatest impact on the investment practices of money market funds.  They’re now generally regarded as a utility-like service that requires little investment skill or management oversight to run.  That will change.  No firm will want to be the first to impose withdrawal fees or suspend redemptions.  Certainly, no one will want to destroy their reputation for financial integrity by recording an NAV different from $1.00.  As a result, management oversight will increase and investing practices will become more conservative.

For all practical purposes, NAVs will remain stable at $1.00.

For savers, the FDIC insurance offered by bank deposits will become a bit more attractive.  Since, however, 2/3 of money market shares are held by institutions, I don’t think there will be a massive shift away from money market funds when the new rules take effect.

Madoff and JPMorgan Chase

another JP Morgan legal settlement

Yesterday JP Morgan and the federal government announced a deal.  The bank has agreed to pay fines of $2.6 billion and to reform its operating practices, in return for not being prosecuted for offenses relating to the Bernie Madoff Ponzi scheme.

Although the press reports are a bit confusing, the offenses seem to fall into two areas:

–Madoff routinely made transfers in and out of his accounts in excess of $10,000 a day.  Chase did not report these to the government as required by anti- money laundering statutes.  At least some of these transfers were rapid-fire movements from bank to bank, designed to allow Madoff to illegally collect interest on the deposits from more than one institution (“check kiting”).

–Parts of JP Morgan refused to invest the bank’s money with Madoff on the grounds that he was running a Ponzi scheme.  Other parts of JP Morgan happily continued to service Madoff, to buy his products, and to help sell them to others. Also, In the days just before Madoff’s arrest, JP Morgan withdrew most of its own money from Madoff, apparently because of fears of fraud.  The bank notified the UK government of this, but, oddly, not the US.

my take

To me, the plea deal is more evidence of a sea change in the attitude of regulators toward the financial industry since Mary Jo White became head of the SEC.  Long overdue.

In my experience, in every company there’s a tension between politically powerful senior managers who are identified with, and benefit from, the revenues generated by someone like Madoff and the relatively junior researchers who understand the facts better and are more aware of what the law requires.  The former can put up immense resistance to fixing problems.  Their allies can simply refuse to act on, or even to read, the case for a different course of action.

I’ve seen some of the Madoff sales materials.  They assert that phenomenally high returns are to be had with virtually no risk.  No explanation of how this is possible, just a simple appeal to greed.

Current media coverage is highly favorable to government investigators.  What seems to be forgotten is that Harry Markopolos, a financial analyst whistleblower with very detailed evidence of the Madoff Ponzi scheme, repeatedly showed up at SEC offices from 2000 onward to present his case.  He was ignored every time.  (Markopolos was asked by his boss to create a clone of Madoff.  He soon realized that there were periods where no assets delivered the returns Madoff claimed.)

The most elementary checks of the phony documentation Madoff prepared would have revealed the fraud.  But in their periodic inspections, the SEC appears to have checked virtually nothing.  Madoff himself commented on how easy the SEC was to fool.

bank investigations finally beginning

Until recently, one of the key aspects of the financial wrongdoing that led to the Great Recession, one bemoaned by mid-level investigators/regulators, has been that virtually no one has been prosecuted.  This contrasts sharply with what occurred during the savings and loan collapse of the early 1980s and the junk bond debacle later in that decade.

One obvious difference between the latter and today is that the perpetrators in the former instances were tiny fish in the financial pond–either owners of small S&Ls or the rogue financier Michael Milken, who worked for the US subsidiary of a Belgian bank.  No one systematically important.  No big sources of political patronage.

Just what any cynic would have thought.

But what appears to be proving most important, in my view, is who is serving as head of the SEC.

President Obama’s appointment in 2008 to chair the regulatory agency was Mary Shapiro. Her previous job?   …head of the National Association of Securities Dealers, now known as FINRA (Financial Industry Regulatory Authority), the trade group representing the investment banking industry.  In other words, Ms. Shapiro was the chief publicist/lobbyist for the big commercial/investment banks.  According to Wikipedia, FINRA paid her $9 million in her final year in that post.  Talk about the fox guarding the henhouse.

Now that Ms. Shapiro has been replaced by a tough veteran prosecutor, Mary Jo White, investigations are suddenly far more extensive.  And the SEC efforts now have teeth.  No more consent decrees without admission of criminal behavior.  And it’s finally ok to investigate the systematically important banks.

I think this new effort to clean up Wall Street is a huge plus for all portfolio investors, and particularly for individuals like us.

A perverse part of me just can’t accept a gift horse, though.  I keep wondering what led to Mr. Obama’s change of heart.  I’m thinking that the contrast between Shapiro and White (Elisse Walter, another FINRA alumna, served as SEC chairperson for a few months between the two) is so great that there must have been a reason.  Could Mr. Obama just have been that clueless?  Does he no longer need political donations?  I can’t imagine what.  Any thoughts?


US banks since the repeal of Glass Steagall

In the 1930s, Congress passed a series of laws, collectively known as Glass Steagall, that barred commercial banks from engaging in brokerage/investment banking activities.  The rationale:  the linking of banking and brokerage in one company had spawned abuses that had a big hand in causing the Great Depression.

Fast-forward to the late 1990s.  Glass Steagall was gradually rolled back and then discarded. The rationale advanced by bank lobbyists in Washington?  …commercial banks were older, wiser and better-managed.  Banks also needed to expand their size and activities to compete successfully with the “universal” banks of the EU, which already were allowed to combine commercial and investment banking under one roof.

How’s that been working for us?

Well, in the decade-plus since, the new domestic “universal” banks:

–destroyed the mortgage market through wild speculative lending and widespread misrepresentation of the poor character of the mortgages they subsequently bundled up and sold off to others.  Voilà!   …the Great Recession.  (Perversely, though, the American banks caused near-fatal wounds to their EU rivals, who were the eventual “dumb money” buyers of much of the sketchy mortgage-backed paper.)

–last year, regulators began investigating the big banks for illegally colluding to manipulate short-term interest rates through LIBOR (the London Interbank Offered Rate).

–recently, a similar investigation has been opened up to look at illegal bank collusion in foreign currency markets.  According to the Wall Street Journal, so many bank senior currency traders have been suspended that too few honest traders (not an oxymoron, but close) may be left for global currency trading to function smoothly.

–reportedly, more investigations will be opened for other bank commodities trading, notably oil.



Wow!  I find this all hard to take in.  I have several reactions.

The first is that, either by accident or design, these investigations are only being launched after the worst of the financial crisis is over–meaning that the banks can withstand the financial and reputational shocks these inquiries are causing without triggering panic withdrawals by depositors.

The downsizing of the banks, now underway, probably still has a long way to go.  The best and the brightest younger minds will search for jobs elsewhere, fearing the industry taint may be deep and more enduring.

Despite the financial industry’s enormous political clout in Washington, continuing scandals argue that further legal restrictions on banks’ activities are probably inevitable.

This all suggests to me that big money-center banks will be uninteresting investments for a considerable time to come.

As a citizen, the banking mess is appalling.

As an investor, the current situation suits me fine.  I’ve never understood banks,  I’ve never been willing to do the work needed to see what’s going on underneath the covers–although I’m sure I would never have guessed the extent of the criminality they’ve been involved in.

In a practical sense, the banking scandals mean I can focus my attention on IT and Consumer Discretionary as sources for individual stock ideas, without worrying that Financials will move to the head of the pack.

What makes this important is that Financials account for a big chunk of the index.

As the S&P 500 stands today, the largest sector by market weight is IT at 17.7% of the index.  Financials (16%) is second.  Healthcare is #3 (13%).  Consumer Discretionary (12.5%) is #4.  Together, these four sectors make up about half the index.  Being able to ignore/underweight one of them with a high degree of confidence is a big deal.

Wal-Mart and banking: the Bluebird card

the “unbanked” or “underbanked” population

About a quarter of all Americans are either “unbanked”–that is, they don’t use conventional banking services at all–or “underbanked,”  meaning they may have either a checking or savings account but regularly use check cashing stores, pawn shops and other non-traditional banking services.  About 8% of the population is in the unbanked column, about 17% is underbanked.  (You can find more details in this PSI post.  The situation hasn’t changed since I wrote it.)

Why no bank accounts?  

The un/under population finds conventional banking services too expensive and bank locations not  convenient.  Of course, until very recently banks have been totally uninterested in this market segment, despite frequent Congressional prodding to be friendlier.

The situation has long been a problem/challenge/opportunity for WMT, because a large chunk of its customers fall into the un/under category.  There are two aspects to this:

–lacking a checking account or a debit card, the un/under generally find it hard to make money transactions, and

–if we estimate (read: make up a number) that conventional banking services cost at minimum $500 a year, then check cashing stores et al can (and do) charge $400 a year and still be a bargain.  Not good for un/unders, but basic microeconomics.

That’s not all.  Forbes has a good recent article on exploitative “celebrity” prepaid cards, which can end up costing a bundle.

That’s all cash that could otherwise be spent in WMT stores.

WMT can’t be a bank

Years ago it tried.  Despite the company’s unique position to serve the un/under community, furious lobbying both by banks and other retailers caused Washington to deny WMT’s banking application.

it’s turning to AMX for a prepaid card…

…one that will have very low fees.

The card, called Bluebird and bearing the American Express name, will be sold both by AMX online and in WMT stores.  It doesn’t require that you have a checking/savings account;  you just load cash into the card and use it.

WMT should benefit in several ways:

–its un/under customers will have more money to spend

–the service will doubtless make them more loyal to WMT

–it may attract new traffic to its stores, and

–WMT will presumably get a ton of information about card users shopping habits.

investment implications?

I’m not sure that, by itself, the Bluebird card is a reason to buy WMT shares.  They’ve already performed very well recently as domestic economic recovery has gradually widened to include ordinary Americans.  But as one of a number of positive measures from new management, Bluebird has put WMT back on my radar screen.