As we approach the end of the quarter, I thought I’d try something different. No feature essay this week; rather a review of many of the themes we’ve discussed since Net Interest was launched in May 2020. We’ve picked up a lot of new readers along the way, so consider this a round-up of Net Interest so far, with pointers back to the original posts.
I’ve got to say, it has been quite a ride. When I started writing, fresh from a bout of coronavirus in Spring last year, I had no idea how much I would learn through the process. I’d written before, of course. In the first part of my career, I would write investment research and send it out to a few thousand people under the Credit Suisse banner, or whatever banner hung above my door at the time. The Credit Suisse salesforce would promote it, and its value in the market would be determined by some mix of my credibility, theirs, and our mutual employer’s. The process put quite some leverage behind the thoughts of a moderately intelligent but inexperienced 28 year old; whatever he said, instantly became what Credit Suisse [a 150 year-old globally active financial institution that employs tens of thousands of people] said.
Then, in the second part of my career, I would write internal investment memos for circulation within the hedge fund where I was an analyst. Here, leverage came not from the firm’s platform, but from the capital that was allocated to my recommendations. Later, as a portfolio manager, I would write quarterly investor letters, where leverage came from the net fund flows they might attract.
Now, there’s no investment punchline to Net Interest – that entails regulatory hoops so it’s best I leave that last mile to you – but it’s an alternative way to air ideas to any I’ve used in the past. And doing it at a weekly cadence provides a high rate of feedback. I’m lucky that my 15,000+ readers comprise some of the smartest operators, investors and analysts of financial services from around the world. The insights and connections you provide me feed right back into the process – thank you.
So, let’s get to it: key themes so far.
Top post: Financing the American Home
When I published Financing the American Home in November last year, I never imagined it would become my most-read post. As a non American, I struggle to understand that most American of products – the 30-year fixed-rate fully prepayable mortgage, but I thought this would be a niche curiosity to itch. It seems that perhaps many Americans don’t recognise how special a product it is either. The prepayment part makes it a great deal for the borrower yet it places so much risk on the lender that a permanent government backstop is needed.
That backstop has provided a huge windfall since interest rates were brought down in response to Covid. Last year saw record mortgage origination activity in the US – $3.8 trillion of mortgages were originated, of which $2.4 trillion represented homeowners exercising their prepayment option.
The backstop is maintained by Government Sponsored Entities Fannie Mae and Freddie Mac. Their mobilisation was an ingenious way for policymakers to intervene in a market without it looking like direct intervention. (The US employs indirect credit as a policy tool much more extensively than other countries, where direct intervention has a different political hue.) But their government ownership is not strictly sustainable. Last year’s piece speculated on whether the government would privatise them, but this remains a very slow process. Much faster to come to the market are those companies processing mortgage originations at the front end. Over the past nine months, four non-bank mortgage originators have become public via IPO and SPAC, creating a bigger traded mortgage sector than at any time since the financial crisis. We’ve looked at two of these companies over the months – Rocket and United Wholesale Mortgage. Their bet is they’re able to concentrate a highly fragmented market.
The Policy Triangle
Any analysis of financial services requires an understanding of regulatory trends. I’ve said before that regulation is the invisible asymptote of growth for financial startups. Below a certain threshold of size compliance costs remain low and frankly, regulators don’t care very much. Above that threshold and those things no longer apply.
Policymakers’ relationship with the industry is highly complex. On the one hand, the power shift which had already tilted towards policymakers in the aftermath of the financial crisis moved further in that direction after Covid. Capital requirements had been put in place to cover all shades of risk. Although a pandemic wasn’t explicitly covered, its broad economic consequences were; yet policymakers nevertheless intervened to block dividends. The good news for bank investors is that policymakers are now in retreat: this week the Fed announced it is lifting limits on capital return on 30 June. But the overhang of precedent remains. In Europe, banks can resume normal dividend payouts from 1 October, but a third-wave and delayed vaccination roll-out could provide a setback. Meanwhile, the European Central Bank is asking for a greater say on personnel appointments at banks, retaining micro-oversight that way. As we discussed in Banks vs Fintech: A Coronastory and in The End of Banking, private sector banks have morphed into policy banks in many countries around the world.
On the other hand, financial regulators are conscious that their wards don’t anymore play on a level playing field with technology companies. It’s a theme we addressed in The Policy Triangle. Traditionally, financial regulators have governed to a simple trade-off: financial stability versus competition. Different regulators take a different view on how they manage that trade-off and their position can shift over time. At one extreme, Canada has a history of sound financial stability but it also has a banking oligopoly.
Now, however, competition is emerging from outside the regulated financial sector. Nothing new there – regulators have learned to live with shadow banks – but technology companies introduce a new element into the trade-off that financial regulators haven’t had to deal with before: data. Last week, the Bank for International Settlements published a briefing note which concludes, “Big tech risks have not yet been fully captured by regulations, and a rethinking of the policy approach is needed.”
All Companies Were Startups Once
Over the months we’ve looked at the roots of many established financial companies. They were all startups once. Citigroup burst onto the burgeoning Manhattan scene in 1812 (Citi Never Sleeps); Goldman Sachs in 1869 (Reinventing Goldman Sachs). German banks Deutsche and Commerz were set up in 1870 to help the German economy catch up with its more industrialised rivals (The German Bank Paradox). Case studies from the recent past include Visa, founded in 1958 (Dee Hock, the Father of Fintech) and ETrade, founded in 1982 (Party Like It’s 1999: From ETrade to eToro).
The more recent two are perhaps the more relevant through which to look at the latest crop of financial startups (although Square founder, Jim McKelvey, cites Bank of America and its founder, AP Giannini, as an inspiration). ETrade achieved success by offering customers a faster product at a cheaper price than they were getting from full service brokers. Yet throughout its life as a public company, it continually battled fee erosion until Robinhood and others came along and eroded fees completely.
Visa, by contrast, always retained pricing power as part of an effective duopoly. But it wasn’t always meant to be like this. Founder Dee Hock wanted to see more networks created: “Exchanging authorization information and monetary value in the form of electronic particles ought to be a highly decentralized, competitive business. Trying to design and impose a single, monolithic system on such an essential ﬂow of information seemed absurd.” Visa’s disruption may ultimately come from the kind of decentralized exchange that crypto allows. In which case, Facebook’s Big Diem may be its Robinhood.
The Truth in Fraud
Finance companies have a unique relationship with fraud. They are at the same time victims of it, vehicles for it and occasional perpetrators of it. So they are a rich source of content at Net Interest. Back in September, Dan Davies, author of the book Lying for Money, wrote a guest post about the Parmalat fraud that was perpetrated between 1990 and 2003. The US edition of his book was published this month and I strongly recommend it.
Within the financial sector, we’ve had Wirecard of course. Munich prosecutors were told this week that the fraud there may have been going on for ten years before the company imploded. And although it hasn’t been labelled a fraud yet, we’ve discussed Greensill a lot in Net Interest, drawing some parallels with Wirecard in our initial piece in July (Supply Chain Finance: Greensill and the Stillbirth of a New Asset Class).
Dan points out that “exponential growth is a bad drug to get addicted to.” He suggests that in the Parmalat case, the motivation was a pathological desire for growth. Greensill, too, wanted to grow beyond what the market for reverse factoring could support. One of the red flags we highlighted back in July was the rate of loan growth in Greensill’s German banking operation. In tech, growth is usually good; in finance less so, so any finance company trying to pass itself off as a tech company warrants special care.
The New Power Brokers
When I was in college, it was widely agreed that Masters of the Universe worked at investment banks. Slowly, though, power shifted. Today most financial market power rests not with them but at global exchange firms. Originally these exchange firms were mostly owned by the banks but the banks set them loose. We brought these ideas together in The New Power Brokers.
Exchange groups draw power from three sources. First, they control clearing. Since the financial crisis, trading activity that banks may have conducted directly with clients has been routed into clearing houses. With the notable exception of the DTCC (which we wrote about in WTF is DTCC: The Story of Clearing), most clearing houses are owned by exchanges.
Second, they control data. In Plumbing the World’s Markets: The Story of ICE, we quoted ICE CEO Jeff Sprecher: “And so largely, my business, my company is a database operator.” Controlling the data allows exchanges to commoditise its complement: trade execution. According to Sprecher: “We don't break out execution, but I don't think there's any money, I think, and we may even lose money on execution if we were to really allocate costs. And how do we make the money? Data, listings, connectivity, information… everything around the execution is where we make money.”
Third, they create the benchmark indices that underpin trillions of dollars of passively-managed assets. This is a theme we picked up in The Business of Benchmarking. Originally, newspapers took on this role in equities; banks in fixed income. Global exchange groups (and some independents like S&P and MSCI) consolidated a lot of it. Standards are normally a public good, but when they are privately owned, the payoff is monopolistically good.
Banks are long past regret, but it’s worth noting how much value has been created by the assets they’ve set loose.
Along the way, we’ve explored specific fintech firms in some depth. These include:
They all operate in different segments, so it’s difficult to draw parallels between them. However, the consumer facing ones do seem to be converging on a similar model – the one employed by Ant Group in China. Once the customers are on the platform, ramp up the cross-sell. It makes sense of course given the high cost of customer acquisition. But it ultimately leads to more competitive markets.
If there’s a financial company you are keen to see more work on, let me know and I will add it to my list!
The Story So Far
Finally, to round out the story so far, several posts capture the way I think about financials. These include:
I look forward to sharing many more insights with you in the weeks to come. None next week though, because of the public holiday. In the meantime, please do continue sharing Net Interest – it means a lot.