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Floyd Norris on the Financial Sector

He writes:

As Bank Profits Grew, Warning Signs Went Unheeded: The banks were doing a lot better than they should have been doing.... There were signs that banks were either lying about their results or were taking large risks that were not fully disclosed, but investors were oblivious.... Consider how banks make money. They pay low rates on short-term deposits and charge higher rates on long-term loans. So they love what are known as positively sloped yield curves. And they like to see big credit spreads.... By that light, nothing was going right in 2006 and early this year. The yield curve was inverted, or at best flat. And credit spreads were at historic lows.... And yet the bank stocks were buoyant, and so were reported profits....

Instead of being suspicious, many analysts believed that banks had found a new way to prosper. Making a loan and keeping it on the balance sheet until it was repaid was so old-fashioned. It was far better to collect fees for arranging transactions and passing on the risk to others. We did not ask why passing on risks should be so profitable to the risk-passers. In reality, it was not. In recent weeks, we have learned of many risks the banks kept. Not only did we not understand them, but there is every indication that senior managements did not either....

There were many other funny ways to bolster profits, like specialized investment vehicles, or SIVs. These creatures bought those C.D.O. securities, paying for them with money borrowed in the commercial paper market. Just like banks, the SIVs borrowed short and lent long. The spreads might be thin, but they could employ leverage to make narrow margins go a long way. The SIVs did not have much capital, but so long as everyone believed in C.D.O.’s, they did not need it. The banks that set up the vehicles swore they had no continuing interest in them, and so they also vanished from any balance sheet that investors could see. Now they are costing banks money to prop them up.

Jamie Dimon, the chief executive of JPMorgan Chase, told investors this week that “SIVs don’t have a business purpose” and “will go the way of the dinosaur.” Will they take the securitization system with them? The answer to that question may be crucial in determining how soon the financial system recovers...

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