CHRIS WHALEN: We still haven't gotten back to where we were before 2008 in terms of equity returns for banks.

Well, credit is tomorrow's problem. Today's problem is liquidity. But I think right now, to me, the most interesting story in the top four is Citi.

I think we're headed into a choppy phase in terms of both credit costs and funding.

Hi, I'm Chris Whalen, Chairman of Whalen Global Advisors. I'm an investment banker and author. I work with banks, non-bank, financial institutions, mortgage banks, helping them raise money to finance operations. I also do some M&A and work on really strange mortgage assets with my friends at Ginnie Mae. So, that's how I spend my time when I'm not blogging or on Twitter.

How do US banks fund themselves?

Banks fund themselves in a variety of different ways. It really depends how big they are. If you're talking about a little bank below billion dollars in total assets, and that's most of the industry by the way, most of the deposits through checking account, small business deposits, things like that. The other big source for small banks is the Federal Home Loan Banks, because they can take a mortgage, let's say they give you a mortgage to buy a house. And they can finance that asset with the Home Loan Bank. So, it's a repurchase agreement. So, they sell it and they get funding, they go out and make another mortgage. They can also sell those mortgages to Fannie Mae or Freddie Mac, or whoever and they get their money back plus a little gain. And they go out and do it again. So, it's all about production, if you will, so like manufacturing assets.

The bigger banks have a lot more diversity in terms of funding. If you look at JP Morgan, or Goldman Sachs, most of their funding actually comes from Wall Street. It doesn't come from deposits. JP is about 50% deposits, Goldman Sachs around 15. Why? Well, Goldman's a broker dealer, they're an investment bank, that's what they do. And they're trying to build that bank. But compared to say, Key or US Bank, who are still 70%, 80% deposits, they have a big advantage over the "universal banks", who have to fund themselves on the street every day.

What's the difference between large and small US banks?

Well, if you think about the outlook for different financial institutions, you can separate them in a couple of groups. Smaller banks, and by that small, I mean anything below about 100 billion total assets. They're funded with deposits primarily. They really don't have Wall Street operations. They don't trade. They lend. They take deposits. They may have an off-balance sheet trust department, that kind of thing.

So, their rates are determined by Main Street, and they tend to move pretty slow. The funding costs for smaller banks rises less quickly than the big banks. You look at someone like Capital One, for example. It's a credit card business. There is a retail bank in there somewhere, but the credit card business is the biggest part of it. And they actually fund most of their broker deposits, which are expensive, but they can manage it every day. They can change that number every day. And it's a money market operation.

JPMorgan Chase, same thing, half the bank is deposits. The other half is from the bond market. So, each one of these banks has a different funding profile, the Wall Street banks tend to feel changes in Fed policy and market direction much more quickly, simply because they are very sensitive to those short term liabilities. And they have to go out and reprice like every 30 days. Your typical community bank is in a very different position. They know where their funding is, it's in their customers, and it recurs every 30 days. The mortgage payments, the payroll, everything else, that's your strength.

So, that's really the biggest difference in any of the non-banks who have to borrow their money from big banks. That's where they get the money. They have very limited sources other than that. So it's a chain, if you will. And the smaller community banks, will they lend to a non- bank? Not so much they'll lend to their customers. They'll lend to people that they actually know and have a certain size, but it's really the big banks that play the money market side of this of this game.

What's the trend in funding costs for US banks?

If you look at what the trends have been in funding costs for banks and interest rates, generally, you go back to the Financial Crisis. After the Financial Crisis, the Fed pushed the cost of funds for the banking industry down about 90%. And why did they do this? They did this to protect the banks, the banks are in the middle of writing off about $100 billion in bad loans. And they had to finance this.

So, the Fed deliberately reduced funding costs, at one point, they got down to about $11 billion per quarter for the whole industry. The industry is $15 trillion in assets. And normally on a quarterly basis, it would cost about $100 billion or so to finance everything. Goes down to $11 billion. So, what was happening there was savers were being taxed, essentially. And that money was being transferred to the equity holders of banks.

So, whereas in the '80s, and the '70s, probably 50%, 60% 70% of the money a bank made went to depositors and bondholders. Today, it's the other way around, at one point 90% of the cash flow earned by banks on interest was going to equity holders. So, we're rebalancing that now. But it's a structural thing. It has nothing to do with what the Fed does with interest rates or other policy measures. It's really a function of what they did to interest rates in 2009, 2010 and how that slowly now reversing.

What's the trend in interest income for US banks?

Well, interestingly, the trend in interest income during this extraordinary period that the Fed engineered was pretty good. They maintain their spread because their cost of funds were so low. They were still making money on loans. And the break that they made on loans fell more slowly than the cost of funds. So, they got a big gift from the Fed.

The Fed also started paying interest on what we call excess reserves, deposits at the Fed. That gave them another $10 billion a quarter of income. But now, we've been seeing the cost of funds really for the past two and a half years galloping long 50%, 60%, 70% annual rates have increased. And it's starting to slow now. But that's coming right out of bank income.

So, last quarter, as we have predicted about a year ago, income for banks, net interest income actually fell. And it's now we're going to flatten out and probably go down a little bit simply because some markets are not repricing loans. In other words, banks can't make more money on their loans as their cost of funds is going up.

Well, why is that? Because banks are competing with everybody. The competition for both funding on the deposit side of the balance sheet and for loans is intense, especially for larger banks. They're competing with pension funds and private equity funds, and anybody could think of, all chasing the same assets. So, it's hard for JP Morgan or any of these commercial lenders to get an extra quarter point on a loan when that customer can just walk cross the street and do better. It's extremely a competitive market right now.

But unfortunately, the cost of funds is going to still go up. It's about $55 billion per quarter now. I think it's going to go up to $70 or $80 billion easily in this cycle. The interesting thing is over the long term, if you go back 30 years, banks were actually making less money per dollar of assets. And this is a wasting effect of interest rates slowly in a secular sense going down. And it's troublesome because you want banks to be profitable. The reason US banks cleaned up the mess so easily in 2009, 2010 is because they made money. You look at Europe, the banks there don't make money. And that's why they can't clean things up. It's a big difference.

Where are non-bank financial institutions competing?

If you look at the competitive landscape for banks, especially larger banks, they are head to head with insurance companies, pension funds, private equity, Blackstone, BlackRock, Apollo, whoever. Commercial real estate, for example. That's an asset to the insurance company will finance for an investor and keep, they're not even going to sell it in the securities market, they just keep it because they like real estate, they like that kind of asset. So, a Citibank, JP Morgan, if you look at what they actually make on real estate lending, it's pretty bad. Their best book in the entire bank is consumer. That's where they make their money.

You've seen non-banks and investors get into auto lending. Auto lending has doubled since 2008. It's the fastest growing asset class. You've also seen banks get out of residential mortgages in a big way, the sales of residential mortgage has been cut in half in the past five years. They just don't want the risk.

So, the competitive landscape is such that there are certain kinds of commercial lending that banks make the most money on, where if you're Citi Bank or Capital One, you got a credit card book, deals on that are very good, but with more risk, because you can see defaults go up. And then all the other consumer stuff, residential mortgages, it's a loss leader. The banks don't really make money on that.

So, if you think about it, they have to focus on commercial lending, that's their most profitable category. And as they get bigger, the big banks run into the big non-banks who want to steal that asset from them. The smaller banks have better pricing power. If you look at say, BB&T, or any of the smaller banks below that level, they'll be a point and point and have better yield on their loan book than a large bank. And it's simply because of competition for big assets.

Because think about it Citibank, do they care about a half million dollar loan? No. They're looking for billions of dollars at a time because it takes the same resources to process each one. So, you might as well go for the big ones. And the other thing to keep in mind is most banks, a fifth of their book runs off every year. So, they have to go replace those loans. And then they have to go make new ones if they want growth. That's the tough part.

A smaller bank, or like Bank of America, who keeps a lot of 30-year mortgages on their books, they have an average life of 10 years. So, a very different situation, less than 10% of their book is running off every year. But if you're Citibank, it's like 25% might and they have to run fast to keep up with that.

Where are net interest margins heading? I think investors, when we talk about net interest income, a lot of investors have this programmed response in their head. They think, well, interest rates are going up, in other words, the 10-Year Bond, Fed Funds, all of that. That doesn't necessarily translate into the banker being able to make more money on his loan book, or really even on agency securities. Most banks over the last two years have moved from being liability sensitive, in other words, they were focused on their funding costs, to being more asset sensitive. And ironically, last Thanksgiving, when the 10-Year Bond was at 3.25%, they weren't buying it. Now, they're buying it at 2%. And it just shows you that the volatility that the Fed has put into the market with all of these extraordinary measures has made it really hard to manage a bank. So, people see rates falling, and they're like, oh, funding costs are going to go down. No, because the short end of the yield curve is still propped up around 2%, 2.5%, that's not going to change. See, the thing you're going to do is understand about banks and investors, if rates fall too much, they just won't lend money. It's not worth their time. They'd rather just keep the cash. So, there's a very fine balance that the Fed has to strike, because if you really drove rates down to zero, I think the economy would die. And banks too. Anybody with leverage would be advantaged and all the savers, which includes banks, they would be losers. What rate of return are banks getting? The industry's rate of return right now is a little over 1% on assets, about 12%, 13% on equity. Historically, that's low. We still haven't gotten back to where we were before 2008 in terms of equity returns for banks. And that's even after the tax bill. The tax bill effectively increased the amount the banks payout to their shareholders. And even with that, we still haven't gotten back to where we were in 2007, 2006. So, pricing is the biggest issue facing banks today. Do they have to compete for funding? Yes, of course they do. But the question is, what are they going to do with the funding? Right now, loans in the US are growing about 5% a year, which sounds like a lot. But that doesn't necessarily translate into great profitability for the banks. And the question is, how much capital do you have to put up against it? So, if I make a commercial loan, $8 for every $100 worth the loan, that's what we call 100% risk weight. Mortgages, 50%, $4, and so on. So, their calculus for the bank is not just how much do I make on the loan? But how much capital do I have to put behind it? Because ultimately, the risk adjusted returns are what mattered for banks. What can you say about credit quality? Well, credit is tomorrow's problem. Today's problem is liquidity. And that's the reason that the Fed stopped the runoff on their balance sheet this week. They had to say, the squeeze on liquidity is too great, we're starting to see problems. And you had had a couple of hiccups in the past several months with some non-banks and some funds that were seeing runs. Credit, we'll see in a couple of years. Because the problem with what the Fed did was it made asset prices go up, so credit looks great. Every time there was a default in a building or a house, they just sell the collateral, and they make money. In fact, the default rate on multifamily housing financed by banks for the past five years has been negative, because in the rare event, there was actually a default, they sell a building and they make money, they pay off the full amount of the loan. So, that's not normal. And so, as we come back, and we normalize these relationships, we're going to start to see the real cost of credit. Because right now, if you look at the numbers, credit has no cost. When was the last time that was? 2005. So, we're replaying the tape again, it'll be different this time, it always is, but I don't think we can escape a bit of an uptick in credit costs say 18, two years out, especially for consumers. Because during this period, you've had junk come the market gets finance like it's A paper, and it's just not the case. What role does the slope of the yield curve play? The slope of the yield curves discussed a lot, you hear everybody going on and on about the fact that the medium and long maturities are lower than say anything from Fed Funds out to two or three years. And that's because of the Fed. The signal that people take from that is that a recession is coming. And in the old days, of 10, 15, 20 years ago, when rates were higher, it certainly did function that way. Now, I'm not so sure. There's such a demand for US Treasuries all over the world that when you see the bond rally the way it did from Thanksgiving to now, point in the quarter in seven months. I'm just not sure what it's telling us anymore. It may not mean that we have a recession, it may mean that people are flying from other markets and they'd rather hold our paper. People keep saying, oh, the Chinese are going to stop buying our bonds. Well, who cares? If the Chinese stop buying our bonds tomorrow, I got news for the Bank of Japan and Norinchukin Bank, one of the biggest banks in that country would buy it all. They would just say ship it in right now. And so, you have to realize that the market dynamics have changed when it comes to interest rate, both for what that means for the economy and what it means for financial institutions. Do you have any regulatory concerns? I think my biggest concern about regulation is that we've done too much in some cases. And the different regulators don't know what the other is doing. In other words, we don't have a holistic perspective from the Fed and the other agencies, it says, what do we want to achieve? Because if you're trying to have growth, you need lending. That's the only way an economy grows is if you have leverage. So, for example, we're not building enough homes, it's clear that we're not building enough housing to satisfy demand. But banks have been told not to do construction lending, they've cut the leverage by a third. So, whereas in the past, you could get a construction loan and finance three houses, now you could finance two with the same amount of capital. So, you're a builder, that slows things down. So, I think that we have to try and harmonize and tune the regulatory. So, we're not providing blockages that are unnecessary. In other words, we're hurting ourselves. And it's very much the case with the Fed. The Fed market out the money markets and credit robs us of indicators that