Banks' business model is NONSENSE

As we already know, most bank stocks are suffering from this slow down in mortgage underwriting and anything related to it (RMBS, CDOs, CLOs, CMOs....good stuffs). Anyway, this got me thinking about the banks and why I would almost NEVER invest in one.

Banks generate profit by borrowing money and lending it out. So if a bank borrows at 5% and lend the money out at 7%, it would make 2% on the capital.

Lets take a simple example:

Neighborhood Bank (NB) receive financing from deposit ($50), short term and long term credit facilities ($42) and issued equity ($8 - 8% capital requirement). The bank total capital is $100 ($92 liability + $8 equity). And the average cost of capital is 5%. So every year, the bank has to pay $5 to its investors. The bank will take this $100 and lend it out to Neighborhood Business Corp. and charge 7%. The bank will receive $7 and pay out $5, netting out $2 each year. This extra profit would go to the equity holder, so the equity holder is rewarded handsomely (100% ROE). Obviously in this example, we didn't factor in administrative cost and such, if we did, the equity holder of the bank would probably make about $15-20% ROE. Not too shabby.

The bank essentially is a over leveraged corporation (92% debt 8% equity). Now imagine the bank has to pay its administration expenses and other fix costs. A typical bank probably has net interest of 1.5%, so to cover its fixed costs, they need a HUGE capital base. And if part of their assets (portfolios of loans) start to go bad- the first loss would hit the equity holder. So the equity holder is essentially investing in an over leverage corporation that allow them to invest a small amount and make what it seem to be a significant gain - because of small initial investment.

This is what is happening to the banks now. Some of the banks might even trade "under" book value. The reason is simple: the book value of the bank is simply A - L = E. The problem is the market value of the Asset can be significantly different from the book value asset- so when a bank is trading below book value- it doesn't necessarily means that its cheap.

On top of that, the banks can buy "insurance" or credit derivatives on its loan portfolios. By doing so, they can lower their capital requirement- further allowing them to leverage up over 92%. Since most banks do over leveraged, they would face capital squeeze when the market value of their assets go down the drain... which is exactly what is happening now. In a sense, the banks are always walking on a thin line with equity holders at risk. That and a huge capital base that require to run the bank- make it a very unattractive business for me to invest in. Now, if we are talking about investment banks and brokers....that's a different story....