Decisions, decisions
The way to make money investing in a back book is to value it higher than the market. Current uncertainty makes the latter harder than the former. In some ways it can be easier to predict the future than the past.
Capital Thinking · Issue #813 · View online
Big banks and insurance companies are a thing of the past.
Not in the way that fintech founders think (that’s a topic for another note). Rather, their balance sheets reflect decisions that were taken long ago, sometimes a very long time ago.
Front Book, Back Book: A Framework for Understanding Financial Companies
Marc Rubenstein | Net Interest:
Warren Buffett has often spoken about the ‘long tail’ business that Berkshire Hathaway writes — policies generating claims that often take many years to resolve. In his 1985 shareholder letter he told how an advertisement placed in an insurance weekly had garnered US$50 million of premiums.
But he warned:
“Hold the applause: it’s all long-tail business and it will be at least five years before we know whether this marketing success was also an underwriting success.”
It’s the same at banks.
The average life of a mortgage in the UK is seven years. A mortgage underwritten in between bouts of the Harlem Shake will still be on a bank’s balance sheet today.
Even an investment bank trafficking in liquid securities can end up with assets lodged on its balance sheet. This time last year Deutsche Bank set up a special unit to ring-fence such assets that it wanted rid of — the average life of a portfolio of interest rate derivatives in there was eight years.
As a benchmark for how long eight years is, it’s worth remembering that Deutsche Bank has had four CEOs in that time.
As banks and insurance companies get older, they accumulate a larger ‘back book’ of business. A large back book has advantages.
A financial company doesn’t have to start all over again on 1 January each year. Before it even opens its doors it can bank on a stream of income coming in (although a stream of charge offs or claims could very well go the other way). Unlike other businesses a back book makes money during the night and over the weekend.
It’s a melting ice cube of course, the asset won’t stick around forever, but as long as it was priced correctly, the back book can provide a stable stream of earnings to finance new business growth.
Problems arise however, when pricing on the back book is off.
Berkshire Hathaway’s reinsurance business General Re suffered a big loss in 2001 because of this, in the aftermath of 9/11.
“it did not reserve correctly…and therefore severely miscalculated the cost of the product it was selling. Not knowing your costs will cause problems in any business. In long-tail reinsurance, where years of unawareness will promote and prolong severe underpricing, ignorance of true costs is dynamite.”
Just as no-one priced in the possibility of large-scale terrorism losses in 2001, no-one priced in the possibility of pandemic losses in 2020. Lloyd’s of London estimates that insurance industry losses will exceed US$100 billion this year. That’s around twice what 9/11 cost (US$40 billion or US$55 billion in today’s money).
Again, it’s the same at banks.
They are expected to incur significant loan losses over the next year or so from customers unable to pay back pre-pandemic loans. The Bank of England estimates that UK banks alone could suffer £80 billion of credit losses as a result of the pandemic.
The possibility of incurring losses on back books makes them a very capital intensive enterprise for financial companies. [1] But they’re pretty cheap to maintain, so the operating expenditure associated with them is quite low.
Front books are the opposite. It’s quite expensive to win new business, but not much incremental capital is required to do it. This means financial companies consist of two discrete businesses:
- A back book, representing the past — high capital intensity, high operating margin
- A front book, representing the future — low capital intensity, low operating margin
Financial services isn’t the only industry to have evolved this way. It’s just that the financial industry’s back book is much bigger.
Consolidate the gross assets of S&P 500 companies and financials make up over half the total in spite of making up only an eighth of the constituents (and a tenth of the market cap, but that’s another story).
Other sectors have finessed the back book model.
The genius of SaaS is to have created a back book with low capital intensity and high margin. But the origins can be traced back to financial services.
This week Tren Griffin tweeted:
“The microeconomics of a software as a service (SaaS) business evolved from cable and mobile. John Malone invented what is the most common business model for SaaS.”
John Malone, in turn, borrowed heavily from real estate:
“The concept that cable television looked more like real estate than it did manufacturing was always obvious…to me, anyway. And I think the financial markets really didn’t have a model for cable, because the industry was a small, startup industry with no real following. Coming out of that period of the ’70s, the industry needed some model, some metric how the market could value us. We decided…to go on a cash flow metric very much like real estate.”
Cleaving apart the businesses
In spite of their high operating margins, high capital intensity can crush back book returns. McKinsey estimates that the provision of balance sheet and fulfillment functions that constitute their back book make banks a 6% return on equity (ROE).
The front book meanwhile, consisting of origination, sales, distribution and other customer-facing activities, makes them a 22% ROE. Any gap of that magnitude is going to attract arbitrage and the way to effect it is to cleave the businesses apart.
As Jim Barksdale said,
“In business, there are two ways to make money. You can bundle, or you can unbundle.”
In financial services this really got going via the process of securitisation in the 1980’s, with the US mortgage market the epicentre.
The people who originated mortgages no longer had to be the same as the ones who serviced them, and the people who serviced them no longer had to be the same as the ones who underwrote them.
Michael Lewis wrote about it in his classic, Liar’s Poker:
“thrifts became traders and traders thrifts.”
Marc Rubinstein
Photo credit: Toa Heftiba on Unsplash