Rising Rates, Bank Deregulation, and More: This Week in the Financial Sector

There's been a lot of news this week that could potentially affect your financial-sector investments, as well as your future investment opportunities. In this episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matthew Frankel discuss tax legislation, banking regulations, and more.

A full transcript follows the video.

This video was recorded on Oct. 8, 2018.

Jason Moser: It's Monday, October 8th. Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. I'm your host, Jason Moser. On today's Financials show, we're going to talk about the S&P, we're going to talk about tax legislation, we're going to talk about bank regulations and people lying on their mortgages. Can't even believe that's happening. We'll take a look at Square (SQ -2.28%), we'll take a look at PayPal (PYPL 0.34%), of course, the week on Twitter, and we'll give you One to Watch. Let's just go ahead and get rolling right here. As always, joining me today is certified financial planner, Matt Frankel. Matt, it was a good week for both of our squads on Saturday. Your Gamecocks, tell me a little bit about that real quick. Who'd they beat?

Matt Frankel: We beat Missouri, and it was on a last-second field goal. It was a really exciting game to watch.

Moser: Yeah, and there were a few delays there with the weather, too. 

Frankel: Yeah, we had a thunder stormy day, which was kind of welcome, given all the heat we've been having.

Moser: It was nice to see, too, that my Wofford Terriers stuck it to Chattanooga. It ought to be a good week here for us. Let's go ahead and open this up. We're going to talk about the market last week, and it's bleeding into this week, it looks like. The S&P 500 last week posted its worst week in nearly a month. Gasp! Now, that really isn't the main story here. Anyone who knows us knows we don't invest based on what happened over the course of last month. But I think it leads to a more interesting discussion, based on what we talk about here on the Financials show. A lot of the blame was assigned to the rates forecast. We were talking last week about short-term interest rates vs. long-term interest rates. It sounds like with these short-term rates on the rise here, it also sounds like long-term rates are perhaps starting to catch up a little bit here. I think this is throwing a little bit of concern, perhaps, into the stock market here. 

Matt, when you see news like this, rates news as it pertains to the stock market in general, how do you invest in times like these? Perhaps it's a little bit more of an uncertain time. I would argue it's still certain, from the angle that rates really don't have anywhere to go but up. Does this change your investing philosophy at all?

Frankel: Well, not really over the long-term. But in the short-term, this does tend to affect different stocks in different ways. To name a couple of examples, we talk about banking, obviously, this is the Financials show. Banks, as I mentioned last week, tend to do better when longer-term interest rates start to rise. This affects the rates they get on things like, say, mortgages and auto loans. The spread between what they're bringing in on these long-term loans and paying out for deposits tends to get wider when long-term rates spike like they are right now, if you can really call 3.2 on the 10 year spike. Banks tend to see their profits rise, so you might see bank stocks outperform if this trend continues. 

On the other hand, high dividend stocks, like REITs, defensive sectors like utilities, tend to get hurt because their yields tend to look not as good in comparison to what investors could get from risk-free products like the 10-year and 30-year Treasuries. So, you'll see these stocks get under pressure and underperform in the short-term, as investors will start selling them, get out of those, in favor of lower-risk investments like long-term bonds that are now paying better. 

You'll see banks go up in price if the trend continues. You'll see the higher yield stocks go down in price. That creates some great buying opportunities in my opinion. I have a lot of high dividend stocks on my own radar. In the long run, it doesn't affect things. But in the short-term, it could definitely create some good opportunities.

Moser: Now, along with this news regarding the market, we also got some jobs data out last week. It looks like the unemployment rate has fallen to its lowest level since 1969. Which is great, right? We've really made a lot of progress on that front. It's good to see that we have a lot of people out there working. Wages grew by 2.8%, which was in line with expectations.

I think, to this point, at least, we've seen wage growth remain relatively stagnant. This kind of rolls into another story we wanted to talk about in regard to tax legislation. It was very interesting to see here that a new survey of 152 companies by executive recruitment firm Korn Ferry International revealed that of those 152 companies, only 14% were putting part of their tax cuts savings into base salary increases. A poll of 1,500 companies by Mercer showed that 4% are redirecting tax savings to budgets for bigger paychecks in the coming year. Then, a survey of more than 1,000 companies published by Aon plc, 99% said the tax cuts were not prompting them to increase minimum wages.

On the one hand, I'm not actually terribly surprised by this. I think that when these corporate tax rates initially were cut, when we saw this legislation go through, the big question was the Wall Street vs. Main Street dilemma there. There are two very different sides of the coin. What may be good for Main Street isn't always going to be the best for Wall Street, and vice versa. I think what we've seen here is a lot of share buybacks, some dividend increases here. That's great for Wall Street. It doesn't seem like it's playing out for Main Street so much yet. I guess I wonder, can we expect things to get better for Main Street? Or are we going to see just more of the same?

Frankel: You have to understand the reason that this is happening in the way it is. As you mentioned, buybacks are at a record high. The reason is that buybacks don't really add to corporate expenses. Buybacks don't eat at the profit margins. Increasing minimum wage that you're paying to employees has the effect of increasing your labor costs, and in turn making your company look less profitable. If you just take all that money and shove it into buybacks, your profit margins stay the same and it's good for shareholders in the long run, not necessarily for employees.

Now, this move is good for Main Street in the sense that people's 401(K)'s have never been higher. A lot of buybacks, over time, will increase the inherent value of the shares you own, or your 401(K) indirectly owns. It can be good for Main Street that way. But until companies have more incentive to direct their tax cut savings into wage growth as opposed to dividends and buybacks, I really foresee more of the same.

Moser: We've seen a lot of companies offer up those one-time bonuses. I think that was very headline-driven. Right as this legislation was passed, we saw a lot of these companies come out praising it and immediately offering these $1,000 bonuses to all of their employees. A nice thing. No one would ever turn down money. You have to remember, though, that's a one-time deal. There's a tax implication there. And, again, one and done. I'm certain that wouldn't create the same incentive as a nice boost to the paycheck over a longer stretch there.

I thought of two things as we were reading through these stories here. No. 1, we know that Amazon recently went ahead and decided they're going to raise their minimum wage for their employees. I think that's a little bit of hardball they're playing. They're really telling their competitors at this point, "OK, you guys need to follow suit." And their competitors can't really follow suit, because the economics don't make nearly as much sense for them because Amazon is so much bigger. Another thing I thought of, though, and I'd love to get your opinion on this, I've always thought that while a lot of these changes may not flow down to Main Street as much as they help out Wall Street, we participate as investors. As investors, it's nice to have that. We benefit from Main Street and Wall Street, because we work, and we also invest. I feel like, at least if you start investing, then you will at least benefit from stuff like this. But, what about if a company said, "Instead of offering up this $1,000 one-time bonus, why not structure something around an equity grant that vests over a certain period of time?" Maybe it's two, three, four years. I just feel like that's an opportunity, No. 1, to educate your employees more about the benefits of owning equities; and No. 2, it certainly gives you a workforce that's a little bit more incentivized to stick around for a while and work as hard as they can to try to boost that share price. What do you think about that?

Frankel: Yeah, I'd definitely like to see some kind of more employee-friendly use of the tax funds. In my mind, it's all about creating incentives. If there was an incentive for companies to do like you just suggested, I think we would see more of that. Shareholders hate seeing profit margins go down. By using the tax cuts to incentivize employees, it inherently makes your profit margins go down. Amazon's profits are probably going to take a hit as a result of increasing their wages. There's nothing shareholders hate more than a bad quarterly report. And unfortunately, if there was a tax credit to offset some of the cost of higher wages, we might see something like that happen. But until then, I don't know. I hope I'm wrong. I'd love to see more wage growth. It's good for everybody.

Moser: Yeah, no doubt. Let's talk for a minute here, there's some information out here recently from the Federal Reserve, they are going to try to broaden the number of banks receiving regulatory relief. This is ultimately going to change, potentially, how it defines a big bank. The thing that caught my eye with this article, first and foremost, was the fact that they're looking to change some of these regulations to make it easier for banks to lend money, which is obviously a very important factor in the banking business model. That's how they make their money, it's all about lending it out. 

Now, I read this, and then I also read an article that was talking about how more people are lying on their mortgage applications this year than last. Mortgage fraud risk jumped more than 12% year over year at the end of the second quarter, according to CoreLogic. They say that one in every 109 mortgage applications is estimated to have indications of fraud. 

Now, we know that one of the big catalysts behind our financial crisis years ago was the fact that you didn't really have to do much of anything to get a loan to buy a house, much less five houses. Banks got called on that eventually. There was a lot of bad behavior in how they were lending money to people who probably shouldn't have been borrowing it in the first place. It became contagious and really set us back a number of years there. Do you really feel like there's an opportunity here for banks? Do you feel like they can walk that thin line into relaxing some of these regulations without causing housing crisis 2.0?

Frankel: Yes and no. I'm all for deregulation when it's done responsibly. We've already seen some bank deregulation happen recently. We talked about this a few episodes back. They raised the threshold for what's considered a systematically important financial institution all the way from $50 billion in assets to $250 billion. That's a big leap. This is a whole subset of banks that's going to save a ton of money in regulatory expenses. This action by the Fed could do the same. It also reduces capital requirements. It's too early to tell because we don't know the details of how much it could reduce capital requirements. I don't really see them rolling it back to the pre-crisis levels, but that's just me. I hope I'm right about that. 

As far as the mortgage fraud thing, one out of every 109, that's definitely an uptick, but that's not enough to set off housing crisis 2.0. The thing to point out with that is, most of the fraud we're seeing is income-related, meaning people getting fake pay stubs and things to make it look like they can afford a house more than they really can. We're not seeing credit score fraud. Your credit history is really tough to fake. The big difference between before the financial crisis and now is, like you said, anybody could get a mortgage. Right now, the credit standards are still relatively high. Those are set by Fannie Mae and Freddie Mac for the majority of homebuyers. Until you see that really start to relax, which we haven't yet, I don't think we're in danger of housing crisis 2.0 

Now, having said that, these two things, the deregulation combined with an uptick in mortgage fraud, could definitely cause an uptick in mortgage defaults, which could hurt the housing market. I don't see it as housing crisis 2.0 yet. But I'm definitely watching for warning signs that it's heading in that direction.

Moser: Yeah, I agree with you. I'm all for deregulation, as long as it makes sense. I think there's a responsible way to go about it. When you're talking about banks and their role in our economy, and housing's role in our economy, obviously, there needs to be some form of regulation there. Yeah, it seems like we just need to keep an eye out for potential signs. 

Between a perhaps inflated housing market, I tell you, what really makes me a little nervous is that amount of student debt that's still outstanding, and how that's going to affect the generations to come and their ability to spend and save. Then, to your point about the difficulty of getting a mortgage, I will say, I've noticed a big difference. From the first house that my wife and I bought back in 2005 to the house that we bought last year, they really put us through the ringer there in getting the loan, and we both have very good credit histories. Hopefully, that won't change very much. We'll certainly need to keep an eye on that. 

Man, I was thinking, we're going to have to solicit our listeners here. We may have to throw a poll out on Twitter. We're talking Square and PayPal. It seems like every week, we've got something in regard to these companies. I'm thinking maybe we need a This Week in the War on Cash segment or something like that. Maybe we'll put a little poll out there on Twitter and see what people think about that.

Today, let's talk about Square. A couple of things out there. One thing, I'd seen they were dabbling in this and it was probably going to become something they would pursue. They're now letting customers pay in installments. They've essentially introduced a new payment option for their small business partners, in order to let customers pay for larger purchases in monthly installments. Larger purchases, I believe the number qualifies anywhere from $250 to $10,000. It's not like just anybody can do it whenever they want. You have to actually be able to qualify for it. But it does sound like yet another option Square is offering its merchant partners. Sounds like they're giving them that option in order to be able to really meet their customers' demands wherever and however they need.

Frankel: Yeah, definitely. I have mixed feelings about this move. For one, it's a long-awaited first step into consumer lending for Square. When we were talking about the Square Cash app, we mentioned that's one of their big, long-tail opportunities, to eventually monetize that base with loans. On the other hand, what they're doing is essentially what most store credit cards do with their 0% financing offers. To be clear, Square's isn't always 0%. It ranges from 0-24% APR depending on the credit profile of the borrowers. But my point is, with store credit cards, those are some of the highest default rates in the credit card industry. If you look at say, Synchrony Bank, which is a big issuer of store credit cards, their default rate is about twice what AmEx's is. So, this adds a big element of credit risk to Square, which I think is why you saw a little bit of a negative reaction in the stock after they announced this. 

But in the long run, I think this is really good for the business. It adds an element of risk, but it's definitely welcome news to people like me, who have wanted to see them dip their toes into the consumer lending space.

Moser: As a shareholder, I see what you're saying there. I saw the news and I wasn't quite sure how to feel about it at first. It does add that element of risk that so many companies before have not executed as well on. But I think also, the encouraging part is, at least with Square, most everything they do is built on the data that they get from their hardware and software systems that their merchants use. Assuming that they are doing what they say they're doing, and using this data to make these decisions, perhaps that is going to prove to be a bet that pays off down the road. Certainly, it's a very long-term oriented type of bet there.

Now, we also have seen today Square shares are in the tank. That is because of a little news we saw earlier that, frankly, I don't think is all that big of a deal. What do you think?

Frankel: What happened was CEO Jack Dorsey exercised some options at the end of the day Friday and sold about 103,000 shares of Square. He got between $95-$98, I want to say, for his shares. Generally, when a CEO starts unloading shares, it's a negative. But the company put out a press release. It's very important to remember this was a pre-planned sale. They stress that it does not reflect how Dorsey feels about the company or the stock's valuation or anything to that effect. 

Generally, when this happens, we consider this a buying opportunity. It's generally, in the long-term, in the long context of things, a non-event. It's down about 11% today. We were just talking before this that if we were allowed to buy some today, we might. Don't panic and sell. That's the last thing you want to do.

Moser: Yeah. I feel like that old Peter Lynch saying, there are a million reasons to sell and really only one reason to buy. I never hold selling against anyone, because that's part of compensation. And as a planned sale, it matters even less. I've always found insider selling to be much more of a non-event than I think a lot of the financial headlines would have you believe. And, jeez, if we didn't have these trading restrictions, I certainly would be thinking very, very long and hard about adding to my position. And I still may. You never know, maybe I'll shut up about Square for the rest of the week here, so I can at least have the choice.

I also saw, we were talking about this before taping, the NBA team the Phoenix Suns and PayPal have announced a multi-year of global partnership where PayPal is going to be the official patch of the Phoenix Suns. Not only that, but the Phoenix Suns' organization is going to integrate PayPal payments solutions in virtually every facet of their organization, for games, tickets, concessions, all of this stuff. This really is playing into that trend where people less and less want to worry about carrying cash, and they want to be able to just make that purchase with their phone. It's a lot safer. It's a lot easier. I kind of like this move, don't you?

Frankel: Yeah. It seems like it's a big race between all these fintech companies to see who can build the ecosystem the fastest, who can eliminate the need for cash in the most places. Like you said, if you're watching a Phoenix Suns game at the arena, PayPal is it. It's a head to head competition and maybe Square Cash's surpassing Venmo for a number of downloads scared PayPal into making themselves a little more visible to the public.

Moser: Yeah. I think it's also worth noting that whenever we talk about these things, I don't view this as a zero-sum game. I don't think we're looking at just one horse that we need to bet on here. Whether it's PayPal or Square, I'm certain there's going to be another concept that comes up. Stripe, obviously, is out there. They're not a public company, but Stripe is obviously performing very well. They continue to raise capital to build that business out. I just think it's a fascinating opportunity there. A lot of different ways you can win it. I think that's really what the war on cash basket was about in the first place. 

So, yeah, listeners, keep a look out there. Maybe we'll get a poll out there on Twitter. I want to ask you, what do you think? Should we have a This Week in the War on Cash segment for the shows going forward? I'm sure we'll always have a surplus of news to choose from these four businesses. 

Matt, let's take a little break from the specific world of finance. You were in town here last week at The Fool HQ for a couple of days for our annual Writers' summit, for lack of a better word there. All of these writers, all of that great stuff we see on fool.com every day, all of you guys and girls, y'all were here last week to share best practices and tips and whatnot. No. 1, tell me a little bit about your trip here. Did you get to go somewhere to eat that really stood out? Or what?

Frankel: A bunch of the writers and a few of the in-house people, we all went to the new MGM National Harbor after the conference.

Moser: Oh, right! Did you get any gambling in?

Frankel: A few of us did. I don't know if you've been there yet. It's a really neat place if you're ever in the D.C. area. Great restaurants in there. We all hit Shake Shack after we were done gambling.

Moser: Very nice! I haven't had a chance to get over there yet. I feel like I really need to, but I don't really have a big gambling bone. Maybe I'll get over there for a show or something. Give our listeners a couple of ideas, some of your favorite takeaways from the conference here. What were some of the things that you took away from the conference that you feel like we need to know about?

Frankel: Hearing from a lot of the writers, especially those who have been there a lot longer than me, and who have followed The Foolish investing strategy through the years, how well they've done. Some of our writers are the best testimonials to how well the system works. I heard from a few who bought Netflix when it was worth about 1/ 100th of what it's worth now, just because Tom and David Gardner were recommending it so heavily. They did what they said and held it throughout the years, through the ups and downs, didn't pay attention to market noise. Some bought before the financial crisis even. Stay the course is the biggest takeaway I learned. I mean, I haven't been here since before the financial crisis, but a lot of our writers have. It's kind of inspiring to see how well it works and how it's actually changed people's lives.

Moser: I think that's probably one of the bigger hurdles we face in our jobs day to day, helping people to believe in that. It's easier said than done. I think that once you've had a little success in doing it, it becomes a lot easier, kind of like adding to your winners. But, yeah, that's great stuff. Well, I'm looking forward to getting you back here soon.

Frankel: I didn't know everybody in the office was going to be off on Friday, so I've still never met Jason in person. Just so listeners know.

Moser: [laughs] Half the office was gone for Unsick day, and I was in an office locked up talking stocks for a report we have coming out here very soon. It was a busy week for some, maybe not as busy for all. But, yeah, the timing just didn't work out, but I know we'll get you back here soon.

This week on Twitter, @ZachFergie tweeted me last week. He said, "These cashiers at this Shake Shack in LAX Airport keep announcing credit and debit only, no cash, sorry, like it isn't 2018." He added a little #WarOnCash there. He was just making the point that, hey, so many places are just getting rid of the cash option and just going credit, debit, mobile payments. It's just so much work for these businesses to manage cash. You have to count it, you have to balance it, you have to take it to the bank, you have to make sure it's right. I mean, it just takes up a lot of unnecessary time. I just appreciate you, ZachFergie, for sending that out there. One of the big reasons why we love all of those fintech companies, those PayPals and Squares, and even MasterCards and Visas, they're really adopting to a new cashless economy there. 

Alright, Matt, we've got earnings season kicking in here. Friday marks the big start. That's when the big banks announce. We've got a number of them announcing Friday morning. We figured we would narrow down our playing field for the One to Watch this week and choose some of these banks that are going to announce earnings on Friday. Hit me with you One to Watch this week. 

Frankel: Obviously, I'll be watching all of the big banks reporting earnings. But Wells Fargo (WFC 2.74%) is one that I really have my eye on, just because their last quarterly report was so terrible. Last quarter, they missed expectations. I don't really pay too much attention to expectations, as we've said on the show. But their revenue dropped almost 3% year over year. Their deposit base is down 2%. The big takeaway is, as of the end of last quarter, there were no signs that their scandals and whatever have really begun to get into the past yet. So, I'm looking for that. 

I'm also looking for anything management might have to say about the Federal Reserve's penalty that they put on the bank. Wells Fargo is not allowed to grow right now, and we really don't have a clear timetable of when that might be lifted. So, any kind of color that management wants to give on that, I'll be looking for. Basically, I'm hoping to see that Wells Fargo's report isn't quite as horrible as last time. I don't have terribly high expectations, though.

Moser: [laughs] Yeah, it seems like they've got some cultural issues there they've really got to figure out it. I just keep on waiting for yet another shoe to drop.

Frankel: Someone at the writers' conference had a great quote on Wells Fargo. They said, "Wells Fargo is a great bank, aside from their fraud."

Moser: [laughs] And that really is the crux of it, right? You don't really want to bank with a bank that you don't trust.

Frankel: Yeah. I don't want to name names, but that that person really summed it up well. 

Moser: And the ticker for Wells Fargo?

Frankel: WFC.

Moser: OK, great! I'm going to go with JPMorgan Chase (JPM 2.51%), ticker JPM. I've always been a big fan of Jamie Dimon. If one reason is enough to invest in this business, I think he's it. So, I feel really good about him being there at the helm. Not afraid to speak his mind, either, on the calls, I'll tell you. He can be a little entertaining at times, too. The company is making a strong push into digital. Last quarter, they reported 31.7 million active mobile customers, which I think is actually kind of amazing. I'm not sure that I know anybody who is one of those active mobile customers, but hey, I guess they're out there. They have a very healthy yield, very well-capitalized bank. I think that's going to continue to be the case.

They do continue to buy back shares. Shares right now trading a little bit more than 2X tangible book value. I don't know that really is the borrow where they like to repurchase as much as possible. But, again, I think that of all of the big banks, this is the big bank that I would want to own first, so looking forward to that earnings call on Friday. 

Matt, as always, I appreciate you joining us!f

Frankel: Anytime! It's always fun to be here!

Moser: We'll catch you next week, and you can give us a little bit on what you're looking out there for the money show that you're going to be heading to the following week, I believe, right?

Frankel: My agenda is really shaping up nicely.

Moser: Good! That's good for listeners. They'll have a lot of good stuff to listen to. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. The show is produced by Austin Morgan. For Matt Frankel, I'm Jason Moser. Thanks for listening! We'll see you next week!