Frank: A Breakup Story
Sometimes it's hard to say goodbye. Other times it is not. This is the latter.
For a brief moment, imagine you have an acquaintance who you’ve known for some time. Let’s call him Frank. You met Frank 18 years ago and it has always been a generally cordial relationship between the two of you. We’ll stop short of calling Frank a “friend” because the relationship resulted more from a business arrangement rather than genuine personal interactions.
On that business arrangement, Frank is fine. There are other people in your life who can do what Frank does but you’ve stuck with Frank because he hasn’t done anything to justify leaving him. In the beginning, Frank does what you ask without kicking or screaming and that’s good enough. Your confidence in Frank through the years has been so solid that it leads to four distinctly different arrangements between the two of you. In some instances, you are buying from Frank and but in others Frank is buying from you.
Then something changes. And Frank starts getting a little bit unreasonable. You’ve still never had a serious disagreement but you can sense it heading that direction. Unfortunately, things start deteriorating somewhat quickly:
In year 13 you cancel one of the services Frank is providing because it’s simply uncompetitive.
In year 15 you try to renegotiate an agreement when the market changes. You give him several chances, but Frank ultimately refuses to adjust so you move on and he loses that part of your business entirely.
In year 17 Frank is again on the wrong side of a major market shift. Rather than leaving Frank outright, you ask him if he can offer a rate in line with the competition and he won’t budge.
In year 18, with just two business arrangements remaining, an increasingly desperate Frank starts getting a little aggressive and charges you for something that had previously been free for the entire existence of the relationship.
You probably don’t want to do business much longer with Frank at this point, no? Maybe some context would help. I have a Frank. What I’ve just presented is a personified version of my relationship with Bank of America BAC 0.00%↑ dating back to when I opened my checking and savings accounts as a freshman in college.
In year 13 I canceled my credit card because the rewards structure wasn’t cutting it and I didn’t need the credit line.
In year 15 we refinanced our mortgage with a different lender because BofA was 100 bps worse than the offer I ultimately took from a competitor.
In year 17 I asked for something resembling a yield on my savings. BofA couldn’t offer me better than 0.01%. The US 2-year was already well over 3% by that point, for what it’s worth.
Then in year 18 (this year) I noticed a $12 monthly maintenance fee in my BofA checking account for the first time.
At this point, I’ve had enough of Frank… I mean Bank. What’s interesting is BofA knows it. And I know that they know because they keep calling. Why? Because I triggered the maintenance fee by drawing down the accounts and lending that capital to a firm that is treating it better. Now Frank wants it back or he’s going to charge me just to keep an account open - which is fundamentally no different than a negative interest rate when real rates are positive. This is not a winning strategy. Yet they keep calling anyway…
Bank of America thinks it can potentially get this cash back because it owns Merrill Lynch. You see, even though Bank of America refuses to give me a yield on a savings account that I already have, they think they can get me to open up a brokerage account with Merrill Lynch so they can give me the money market sweep and call it square.
No.
Fidelity has that capital now because Fidelity doesn’t make me jump through hoops to earn on my savings. And this illustrates a larger problem for Bank of America and other institutions like it. I’m sure there’s a banking regulation story here that makes my account too expensive to keep open below a certain threshold. But I think this is also about the ZIRP (zero interest rate policy) era. Coupled with a broad lack of financial literacy from the public, ZIRP has obfuscated who the boss and who the customer is in this current business arrangement with Frank.
As I see it, when BofA decided to stop earning interest on my home mortgage, the bank officially turned into the customer. Bank of America is borrowing my money. What do they do with it? They lend it to the government. The issue for Frank is I can just lend the government my money directly and keep the yield all to myself. I don’t need to let Frank do it on my behalf and then keep all of the interest to himself.
We don’t care about this dynamic so much when Fed Funds is at zero. But that ain’t the case anymore. If the savings account has no yield, it might as well be held in physical paper - that way there’s no third party risk. And that’s ultimately the Achilles heal with banking. The deposits aren’t just sitting in a vault. The deposits are borrowed by a third party so the bank can earn a yield.
Borrow from me at 4%, lend it out at 5%, and keep the spread? No problem. Borrow from me at at 0%, lend it out at 5%, and keep the spread? I’m afraid my answer is no. I’m taking my money back. Which is bad for Frank because it means he has to sell the collateral that is backing my deposits. This is basically what happened back in March. Banks collateralized short term deposits with long dated treasuries. The duration mismatch isn’t an issue as long as interest rates stay low…. buuuuut they didn’t…
Again, rates rising is what caused the regional bank crisis back in March. To assume that rising rates are only impacting just a handful of poorly managed smaller regional banks would probably be a mistake. Higher rates appear to even be a problem for Frank. Who I’m told is “too big to fail,” if such things exist. Frank has problems. But you’d never know it from looking at the headlines.
Headline shot
Last paragraph chaser
Unrealized bond losses in the bank’s held-to-maturity portfolio widened to $131 billion in the third quarter, compared to $116 billion for same period a year ago. Such losses aren’t recognized in earnings because the bank plans to hold the bonds until they are paid off.
How lovely. Our $131 billion in losses are not actually losses because we’re not selling. Now here’s where it gets really interesting; $106 billion of those unrealized losses are mortgage backed securities. This is still theoretically a really big problem if things start breaking to a larger degree in the macro but the reason all of those MBS are underwater is because the rates are well below current market. As long as the mortgages don’t go delinquent, Frank is fine. Since the rates on those deals are so low, delinquency risk may not actually be that high to be totally honest. But we don’t know for sure and a bad recession could certainly change things.
But back to the breakup for a moment; basically, if Frank and I came to an agreement on that refi in 2020 that I wanted, this paper loss would be even worse for Bank of America. Fortunately (I guess) for both of us, somebody else bought my debt at a preposterous rate and Frank dodged a bullet. But now there is no debt servicing obligation helping to keep my deposits with BofA and that presents a different kind of problem. Because something on Frank’s sheet has to get liquidated to cover the capital flight. I doubt I’m the only one. It’s going to be fascinating to watch.
Recommendations
I haven’t shared any recommended links in a while but this seems a fine time to offer up some goodies. These are some “content pieces” that I think are really worth your time this weekend:
Read
“The subprime attention bubble” by Adam Singer via
is really well done and weaves together some well articulated points about the attention economy. I highly recommend it:
Adam touches on the failings of the attention economy a few different ways. But I think he really hit the nail on the head with his commentary on this video of a 25 year old having a literal temper tantrum about not making six figures right out of college on a marketing degree. Looking past the obvious “make your coffee at home” joke, all I can say is this: fellow young parents, we really have to do a better job of helping our kids manage expectations.
Quick note: on the attention economy, I wrote a somewhat similar critique back in January. It’s archived, but I’ve taken down the paywall just for this weekend for those of you who showed up to Heretic Speculator more recently:
Watch
Simplify Asset Management recently held a gathering with some of the top financial minds in the business. This fireside chat between Mike Green and Danielle Dimartino Booth is terrific and probably one of the best finance conversations I’ve watched this year:
Mike is often on the other side of the table during interviews so it was interesting to watch him sit back and pose the questions. He did a nice job and Dannielle’s perspective on the internal struggles at the Federal Reserve is really insightful. Question posed to Fed staffers: Why don’t you use the headline CPI? Answer:
If we used headline CPI, all of our models would break.
Delicious. I can’t imagine why people are so upset about the inflation that Paul Krugman swears isn’t actually there…
Listen
NEVER ENOUGH by Daniel Caesar. I think I’ve run through this full album four or five times this week.
I really like Daniel Caesar. For me, his neo-soul sound is familiar and new all at the same time. But I wouldn’t say I’m a fan the way I am of someone like Nas.
Speaking of which, I’ve been so busy listening to Nas’ seemingly quarterly album releases that I didn’t even know Daniel Caesar released a full length project in April this year. But after listening to NEVER ENOUGH, I can honestly say I haven’t reacted to an album like this since probably Channel Orange by Frank Ocean. Just wonderfully all over the place. I couldn’t get enough of it this week.
Favorite cuts: Valentina, Toronto 2014, Pain is Inevitable, Superpowers
I hope you guys enjoy the recommendations and have a wonderful weekend!
Disclaimer: I’m not an investment advisor.