Real Time Economics (WSJ Blog) – Like The Phoenix, U.S. Finance Profits Soar

Not too long ago, during the depths of the global crisis, the finance industry was on the brink of collapse. How times have changed. Friday’s revisions to U.S. gross domestic product contained news on fourth-quarter profits. Top-line, or pretax, operating profits economywide hit a record high at the end of 2010. All of the gain was in the financial sector. During the darkest days of the financial crisis, when Lehman Brothers and Washington Mutual went belly up and the U.S. government had to bail out other institutions, the finance sector reported an annualized loss of $65.2 billion in the fourth quarter of 2008. It was the only quarterly loss recorded in the government data. Since then, the sector has come roaring back. The GDP report shows finance profits jumped to $426.5 billion. While profits haven’t returned to their high levels of 2006, the gain in finance profits last quarter more than offset a drop in profits posted by nonfinancial domestic industries. After rising like the Phoenix, the financial industry now accounts for about 30% of all operating profits. That’s an amazing share given that the sector accounts for less than 10% of the value added in the economy.

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Comment: As the chart below shows, profits at financial companies accounted for 28.72% of all corporate profits at the end of 2010.  The rise in financial profitability relative to all other corporate profits should not shock anyone considering the Federal Reserve’s mission to keep the yield curve artificially steep.  As we said in 2009:

As the yield curve rises, financial sector companies make more money relative to non-financial companies.  As the yield curve falls the financial companies lag behind.  The exception to this rule is the latest period which shows a big divergence between financial sector profitability and the shape of the yield curve.  This can be explained by the huge write-downs by financial companies over the last two years.  But notice the record steep yield curve has caused financial sector profitability to bounce back sharply in the last three quarters.

Before the huge write-downs the financial sector was regularly generating 30%, 35% and even 40% of all corporate profits, an astounding number.  This is especially notable when compared to its longer history as shows in the second chart below.

Prior to the end of Federal Reserve Regulation Q (which set limits on interest rates) and other financial deregulation of the early 1980s, financial sector profits rarely topped 20% of all corporate profits (thick black line, second chart).  Since the 1980s, they have rarely been below 20%.

Sum it up and the most important driver of all American corporate profitability could be the shape of the yield curve.  The biggest driver of the yield curve is government manipulation of the front-end Federal Reserve Policy.

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Click on chart for larger image

Category: Earnings, Think Tank

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