The Financial Services Industry: Risks and Opportunities in Turbulent Times

By Mary E. Schmidt
October 2008

PDF of article (9 Pages)

The U.S. financial system is in the midst of the most severe credit crisis in two generations. And this crisis — manifest in the bursting of real estate and credit bubbles — will likely exact a lasting toll on Minnesota’s financial services industry as well as Minnesota consumers and businesses (see sidebar).

Today’s crisis is rooted in the growing deregulation, globalization and consolidation of the financial services industry since the mid-1990s. Financial services — banks, capital markets and insurers — consolidated in order to achieve cost-effective economies of scale and scope, as well as to increase their product offerings to customers.

Nontraditional lenders also entered the fray (see sidebar). As the U.S. and other countries liberalized their finance systems during this period, banks, brokerage firms and insurance brokers integrated their services, pursued foreign markets and created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

The mortgage business in particular was transformed, shifting from a local transaction handled by the neighborhood bank to a global enterprise in which risk could be transferred and investors from almost anywhere could pool money to lend. Speculative real estate lending led to a real estate bubble that burst in 2007.

Financial services firms are important to Minnesota’s economy, accounting for 6,300 firms in total, mostly in the Twin Cities. Financial services accounts for 9 percent of Minnesota’s gross domestic product and 8 percent of all Minnesota jobs. Nearly 140,000 full-time and part- time workers are employed by banks, brokers and insurers. These employers pay higher than average Minnesota wages and have a higher than average share of highly skilled workers. This industry also has lower turnover and more full-time workers than other sectors.

Based on another measure, location quotient, the Twin Cities rank fourth in the nation behind New York, Boston and Philadelphia for concentration of financial services workers in a metropolitan area. The location quotient for financial services positions in the Twin Cities is 1.37, meaning the concentration of local employment in that sector is 1.37 times that of the nation as a whole.

The purpose of this article is to highlight the emerging trends and uncertainties that will drive the fortunes of Minnesota’s financial services firms over the next three to five years. The trends and risks are divided into three sections:

1. macro trends and challenges that emerge from the general geopolitical and macroeconomic environment in which all industries operate;
2. industry trends or uncertainties that are reshaping financial services specifically; and
3. operational trends and challenges that have become so intense that they may impact the strategic performance of financial services firms.

Banking

On a relative basis, 2007 was the worst year for U.S. bank stocks since at least 1970. And the severe slowdown in previously lucrative mortgages will degrade the banking sector’s future performance. [1] Industry-wide, $100 billion in debt-related losses were written off by commercial and investment banks by the end of 2007. [2] These figures take no account of losses that have spread to the credit card, auto and commercial property sectors. Nor do they recognize the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt. Two large insurance companies that have guaranteed buyers against losses on more than $1 trillion of bonds (MBIA and Ambac Financial Group carry municipal, corporate and mortgage debt) might be unable to keep their promise to pay investors if borrowers default on their debt. That could leave the buyers of the bonds — including many banks and pension funds — on the hook for untold billions of dollars in losses, shaking confidence in the financial system. [3]

Moreover, home foreclosures and defaults on home equity loans have surged to the highest levels this decade and are expected to accelerate in 2008, so banks will be counting fresh losses that could make them less able to lend. Banks that have suffered substantial capital losses will have to consolidate their balance sheets and avoid taking on additional risk.

Now that their houses are worth less and loans are harder to come by, hard-pressed Minnesota consumers are defaulting on credit card payments and other bills in skyrocketing numbers, and local banks and financial institutions are feeling the strain and tightening all sorts of lending.

For instance, Medina-based Polaris recently filed a lawsuit against the bank that provides revolving credit in the form of credit cards for buyers of Polaris ATVs, snowmobiles and other products, claiming that the bank unilaterally tightened underwriting standards for Polaris customers that would have slashed the loan-approval rate from 52 to 28 percent. [4] TCF Financial recently halted its federal student loan business when the bank was no longer able to resell student loans in financial markets.

In Minnesota default judgments imposed on debtors who failed to make consumer loan payments and then did not respond to lawsuits seeking to collect the money climbed to more than 36,000 in 2007, up 67 percent from 2006, according to state court administration.  [5]

Bad loans related to the troubled housing market and related industries — mostly outside the Minnesota market — pounded Twin Cities banks during 2007 and the first quarter of 2008. Minneapolis-based U.S. Bancorp reported a 9 percent decline in profit for 2007; first-quarter 2008 earnings fell 4 percent from losses stemming from the mortgage crunch. [6] San Francisco-based Wells Fargo & Co., which has a major presence in the Twin Cities, lost 22 percent of its market value in the last six months because of the credit crunch. TCF Financial Corp.’s first-quarter 2008 earnings fell 43 percent compared with a year earlier in part from rising reserves for loan losses.

Small and medium-sized community banks in Minnesota — more than 75 percent of all Minnesota banks have fewer than 10 branches — were also hit, together posting a 152 percent increase in the value of loan write-offs compared with the same period in 2006. [7] Twelve Minnesota banks reported negative net income for the first three quarters of 2007, many more than in the past four years. They were hurt by thin interest margins and a surge in housing-related loan defaults. Past due loans were more than double the previous year, so more bad loans are expected to be on the way . [8]

Industry observers are not predicting any collapses, but community banks are struggling to work through the housing construction recession. Six area community banks are among 20 in the U.S. most exposed to failing construction loans. The banks with good financial positions will be able to afford the losses from uncollectible debt. Lower long-term interest rates should see the bulk buyers, i.e., Minnesota’s large corporate clients, increasing their loan demand over the coming years.

Falling bank profits compounded by a weaker dollar may make some U.S. banks acquisition targets for foreign banks, including U.S. Bancorp, which looks attractive to prospective buyers who seek high-quality banks with little or no subprime-mortgage exposure. Hence, the industry’s consolidation trend is likely to continue, but fueled less by big banks that have too many problems to be out shopping and more by non-U.S. banks that can capitalize on the dollar’s weakness . [9]

Small and midsize community banks with solid portfolios and minimal exposure to the commercial real estate debacle will continue to present opportunities for consolidation, driven in part by banks that need to achieve economies of scale to afford technology that drives a large part of this industry . [10]

Technologies like mobile-phone banking and desktop deposit can be costly for banks to develop and maintain. The software and the expertise that banks need to comply with a growing list of rules and regulations also are expensive. The Internet will continue to affect banking practices as people grow more comfortable transacting financial matters online. Internet security is one of the biggest growth areas in the banking industry. Integration of technology with operations and strategy will be an ongoing operational challenge for the insurance industry as well.

Other trends already under way in the banking sector include tighter control on credit and changes in the way mortgages are financed. Banks that have lost billions because of bad mortgage debts are reverting to strict lending standards not seen in nearly 20 years . [11] In December 2007 the Federal Reserve, acknowledging that home mortgage lenders aggressively sold deceptive loans to borrowers who had little chance of repaying them, proposed a broad set of restrictions on high-cost loans for people with weak credit. New restrictions on appraisals have also been announced. Finally, state prosecutors are zeroing in on the way banks marketed, packaged and sold high-risk loans (see sidebar). The U.S. Congress and Treasury Department are scrutinizing practices and revisiting regulations across the entire array of commercial banks, Wall Street firms, hedge funds and nonbank financial institutions.

Capital Markets

In addition to banks, Minnesota businesses can access financial resources from capital markets. Capital markets refers to financial institutions that generate fees and commissions from investment banking, brokerage services and asset management. Trends in the capital markets segment include: growth of regulation and stricter oversight, debt and equity securitization, increasing global client base, and legal risks associated with underwriting subprime mortgage pools and products. There also will be robust demand for personal investment products as younger consumers save for retirement. Baby boomers will need other services as they retire and transition from savings accumulation services to savings payout services.

The capital markets sector is not immune to the subprime mortgage and credit crisis. Brokerage firms that packaged, sold and traded structured finance instruments, such as collateralized debt obligations (CDOs), made big profits along with the three credit-rating agencies — Moody’s, Standard & Poors and Fitch — that in a practical sense became responsible for passing judgment on the quality of the mortgages in each CDO. [12]

When the credit agencies downgraded some of this paper, certain commercial investors, such as retirement funds that cannot own non-investment-grade debt, were forced to sell in droves. Last year all three credit-rating agencies had to downgrade more than 5,000 mortgage securities, a tacit acknowledgement that the mortgage bubble was abetted by overly generous ratings. [13]

Critics of the Securities and Exchange Commission, the capital markets regulator, have called for policymakers to examine what went wrong, including the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages and the sale of high-risk securities to investors for whom they were unsuited. Critics say dramatic understaffing and conflicts of interest at the biggest ratings agencies also were factors in explaining how risk assessment mechanisms failed to flag problems earlier.

The losses associated with subprime risks and the credit crisis are affecting the bottom line of an untold number of companies, including insurers, mutual funds and investment banks. The credit crunch has prompted investment banks to cut back on loans to hedge funds, eliminating some clients and raising borrowing fees for others. Individual investors, pension funds and other institutions are now suing financial firms that were involved in the origination, packaging and sale of complex mortgage securities. The suits are premised on the claim by institutions that they lost tens of millions of dollars in funds that they were told would be largely invested in risk-free debt. [14]

In mid-April 2008 just such a securities lawsuit was filed against Wells Fargo, the largest bank operating in the Twin Cities and one of the largest employers in Minnesota, and its nonbank subsidiary, Wells Fargo Investments. [15]

A battle is now taking place over tightening supervision of the risk-management practices of investment banks, possibly putting limits on excessive leverage, and requiring them to keep higher cash reserves as a cushion against unexpected trading losses.

Minnesota is home to many investment banks that engage in underwriting initial public offerings and secondary offerings, mergers and acquisitions, and corporate debt financing. The slumping economy and volatile credit markets took a toll on the number and pricing of large IPO deals across the country during the first quarter of 2008, but middle-market deals, worth $100 million to $1 billion that Twin Cities firms mostly specialize in, were up 3 percentage points from a year ago.  [16] Fewer and smaller deals mean less advising revenues for Twin Cities companies like Piper Jaffray & Co. and RBC Capital Markets.

Insurance

While profits have been realized through better pricing of products, insurance industry players have a number of sector threats on their radar screens, according to Ernst & Young. The firm said those threats were regulation and compliance issues, aging populations in the U.S. and other developed countries, emerging markets and new regulations arising from global warming.

For instance, insurers are seeing a dramatic shift in demand because of America’s aging population, and competitive battles are being fought for savings products that will appeal to the growing group of older consumers. As a result, according to Ernst & Young, a struggle is now emerging between insurance and asset management firms to deliver the innovative products that will meet the needs of baby boomers who transition from savings accumulation to income maintenance while balancing health care spending. [17]

The U.S. property insurance industry, which includes home, auto and commercial, reported a record profit of $44 billion in 2005, even after paying $41 billion in damages from Hurricane Katrina. The industry set another record for profit in 2006 at $64 billion, and 2007 looks to have been another lucrative year for both U.S. and Minnesota insurers.

Minnesota-based Travelers, which merged with the St. Paul Companies in 2004, became much more efficient in its ratio of claims expenses to premiums and shifted more costs burdens to the insured. What’s more, Travelers’ balance sheet has been nearly unscathed by the meltdown in the subprime mortgage markets, largely by holding only negligible amounts of subprime securities or commercial mortgage-backed securities.

Insurers make money from their returns from investments and premiums, and the slowing economy puts insurers at risk of continuing declines in premiums. After several years of clear profit trends for property insurers, a more pronounced competitive-price environment in 2008, coupled with smaller investment returns, could result in an erosion of underwriting margins for Minnesota property insurers.

Workforce Needs

Although possible recession, regulation and other risks identified in this article threaten profits at Minnesota financial services firms, most will likely weather the turbulence and remain competitive. The industry is fueled by productivity-enhancing technology and innovation and relies on Minnesota’s educated workforce. In fact, employment in financial services grew faster in Minnesota in the last decade than in the financial services industry nationwide. Moreover, firms throughout Minnesota benefit when knowledge workers from this industry seek jobs outside their industry.

While there are many cross-industry similarities, each of the financial services segments has different training requirements, workplace trends and future workforce issues.

Employment in Minnesota’s banking segment grew 17 percent between 2000 and 2007, reaching 57,411 employees (see Table 1). [18] Nationally, bank tellers account for 1 in 4 banking jobs, which require a high school diploma, are often part time (56 percent of tellers are part time in Minnesota) and will continue to be in demand because of high turnover. Other occupations in this segment require a post-secondary degree; often an advanced degree is desirable. Job vacancy rates in Minnesota’s banking establishments (fall 2007) were highest among computer systems analysts (5.4 percent), bill and account collectors (4.2 percent), and loan officers (2.7 percent).  [19]

Half of the people employed in the capital markets segment have college degrees, with post-graduate degrees rapidly becoming a prerequisite for employment. Competition in this industry is fierce for securities sales agents and managers, as well as trust professionals and investment advisers.

There were 20,900 Minnesotans employed in this segment in 2007, most of them in brokerage and investment banking. Currently, the job vacancy rates in Minnesota are the highest for personal financial advisers (6.9 percent), software engineers and applications (6.8 percent), and computer systems analysts (5.4 percent). [20] Reliance on personal retirement planning and estate planning is overtaking reliance on Social Security or company-sponsored pension plans. Meanwhile, corporate governance and financial rules are becoming more complex because of regulations. All these factors lead to a need for more seasoned professionals. When the baby boomer retirement cycle begins in earnest in two years, the industry could be caught short-handed with far fewer experienced candidates than jobs.  [21]

Employment in Minnesota’s insurance sector reached 57,276 in 2007. [22] Office and administrative occupations usually require a high school diploma, but college degrees are preferred for sales, managerial and professional jobs. Opportunities for advancement are relatively good in the insurance industry where office and administrative support workers can advance to higher paying claims-adjusting positions and entry-level underwriting jobs. As with banking and securities employers, insurance-related companies need IT workers as well as management analysts.

Table 2 provides vacancies and median wages for some of the most common financial services occupations in Minnesota.

The finance and insurance industry is projected to grow in the Twin Cities by 11.8 percent between 2004 and 2014, adding about 12,723 new jobs. This is just below the Twin Cities’ average employment growth rate of 13 percent.  [23] However, employment growth may be slow in 2008 and 2009 as fallout continues from the subprime and credit crises.

In Minnesota the impact is evident in mortgage-related jobs. Developments in the state to date include a shedding of 30 percent of Residential Capital’s employees and a decrease from 4,000 to 1,600 registered mortgage brokers. [24] Overall, mortgage and non-mortgage loan brokers have been particularly hard hit by the recent downturn in the housing market.

In Minnesota, employment in the finance and insurance industry is down 1,000 jobs since 2005. Losses were highest in the Twin Cities (down 1,900 jobs) followed by northeast Minnesota (down 240 jobs) and the southwest region (down 160 jobs). Employment grew in the southeast section of the state (up 240 jobs), central (up 111 jobs) and northwest (up 43 jobs). [25]

Even with tightening of credit, charge-offs and lower profits, Minnesota financial employers have continued to hire. They report difficulty finding accountants, credit analysts, loan officers, trust managers and sufficiently skilled information technology professionals. They also report difficulty finding workers with good soft skills, analytical/critical and bilingual abilities, as well as sales acumen.

Without these customer service skills, banks and insurers will not be able to attract and retain customers and, thus, maintain revenues. Simply, financial services employers will continue to seek educated workers holding high school to post-graduate credentials. Moreover, companies throughout the economy will continue to hire their own in-house financial professionals.

 [1] According to the FDIC, profits at 8,560 FDIC-insured banks dropped $9.4 billion or 24.7 percent. Minneapolis-St. Paul Business Journal, Dec. 28, 2007. Delinquencies and loan losses were up in all loan categories, not just residential mortgage loans. Federal Reserve Bank of Minnesota.
[2] New York Times, Jan. 13, 2008.
[3] The head of New York hedge fund Pershing Square predicts that the two companies might lose $24 billion on complex mortgage investments they have guaranteed. Such losses would cause a chain reaction of losses at some of Wall Street’s biggest banks, as well as raise borrowing costs for states and municipalities. New York Times, Jan. 24, 2008.
[4] Minneapolis/St. Paul Business Journal, April 25, 2008.
[5] The data do not include mortgage foreclosure cases. The Center for Responsible Lending estimates that almost 39,000 homes will be lost to foreclosure in Minnesota in 2008 and 2009. StarTribune, Feb. 24, 2008, and March 16, 2008.
[6] Yahoo! Finance. April 14, 2008.
[7] This figure excludes U.S. Bancorp, which would skew the data with its size. Wells Fargo & Co. was not included because it is based in San Francisco. TCF Bank was included in this figure. Minneapolis/St. Paul Business Journal, December 2007.
[8] Minneapolis/St. Paul Business Journal, Dec. 7, 2007.
[9] Minnesota-based U.S. Bancorp is the nation’s sixth-largest bank by market value. It has the highest rate of return on assets, a gauge of efficiency, and a relatively small 28 percent of its loan portfolio in real estate. It also adds a high percentage of revenue from nonbank business fees, such as for payment services, payment processing and corporate trusts. Finance and Commerce, Dec. 28, 2007.
[10] St. Paul Pioneer Press, April 25, 2008.
[11] StarTribune, March 21, 2008.
[12] From 2002 to 2006 Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance deals. New York Times, April 27, 2008.
[13] New York Times, April 27, 2008.
[14] A study published by the Stanford Law School and Cornerstone Research on Jan. 3, 2008, found that the number of securities lawsuits filed in 2007 increased 43 percent from the year before. The study attributed the increase to the subprime crisis. The total number of lawsuits, 166, still remains at historic lows. New York Times, Jan. 4, 2008.
[15] St. Paul Pioneer Press, April 21, 2008.
[16] Star Tribune, April 28, 2008.
[17] Strategic Business Risk 2008, Ernst & Young.
[18] DEED: LMI: Quarterly Census of Employment and Wages (QCEW).
[19] DEED: LMI: Occupational Employment Statistics (OES).
[20] DEED: LMI: Job Vacancy Survey (JVS).
[21] Minneapolis/St. Paul Business Journal, April 18, 2008.
[22] DEED: LMI: QCEW.
[23] DEED: LMI: QCEW.
[24] In addition to the slowdown in mortgages, the number of registered mortgage brokers was also impacted by new regulations and fees in the state. Minneapolis Star Tribune, Oct. 18, 2007.
[25] DEED: LMI: Industry Fact Sheet. Updated 4/07. Available online at http://www.deed.state.mn.us/facts/PDFs/FinanceInsuranceFactsheet3-2.pdf.

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