What has happened in the financial markets
What has happened in the financial markets
Banks are just money stores. They sell DEBT! Banks sell money by making loans and mortgages to people at an interest rate so that the people pay back more than they borrowed. They sell debt! Remeber that. It is in their best interests to put you in debt to them by any means possible. In that light, much of what they do makes much more sense.
Actually, you don’t exactly buy money but they do lease it. By offering various services, safeguards and payments, the bank gets people to put money into the bank’s inventory. The bank then makes payments to the depositors by giving them payments in the form of savings interest rates, free services and other benefits. They can afford to make these lease payments because the interest rate they get from their loans is much higher than they pay out for the use of the money they are loaning.
The pool of money that is deposited ends up being very large when compared to the amount that has been put out in loans. In fact there are laws that mandate that the bank must hold in reserve a very small pool of money to cover the normal fluctuations of deposits and withdrawals. It amounts to only 10% of the total amount of money they have lent out. This is called fractional banking.
While this small pool of deposited money is held by the bank, they try to make it earn more money by making investments. Some of this is in Treasury Bonds but mostly it is in things that people want to buy by borrowing money from the bank.
In this regard, this money bank operates like any other store. It has sales people (loan officers) that try to sell their inventory (debt) and inventory managers (asset managers) that try to attract more deposits from more people. The profit of the bank is made from making that small pool of deposited money earn additional income while it is in the banks control.
Now suppose that our economy is booming and lots of people are earning lots of money. They will want to put it into a bank for safekeeping and that makes the small pool of deposited money grow much larger. When the bank has millions of dollars just sitting in its vaults, not earning money on interest loans, then the bank is effectively losing money.
The response is to tell the sales staff to make more loans - this is, get more people into debt to the bank. The problem is that in a given community serviced by several banks and in a booming economy, there may actually be a shortage of people that want to borrow large sums of money. To entice borrowers, the bank will lower their interest rates and loan application standards. They don’t want to lose money, just get that initial sale, so, for mortgages, they offer a low rate for the first few years and then will raise the interest rate back up.
But again, the community is serviced by several banks and there are just so many mortgage loans that can be given out so the bank looks for other kinds of investments that can earn money. Most banks have a portfolio manager that handles the various Wall Street investments. But this is not the kind of investments that normal people make. A bank might have $300 billion in its pool of deposited money and it is not legal for them to put very large sums into one stock investment and it is not cost effective to make thousands of small (under $10 million) investments in stocks.
So the banks have come up with their own kind of investments. These are the kind of investments that you need billions of dollars before you are allowed to participate. One kind is to bundle all of your mortgages and sell them to another bank or investor. This had the effect of giving the bank an immediate return on its mortgage loans and the buyer gets its reward by gaining the long term high payoff that every mortgage pays. There are also tons of other weird and very complex “instruments” that banks use – like derivatives.
These high cost instruments cost billions of dollars and are valued based on their risk level. As with most investments, if the bank is willing to take on a little more risk, then the reward is potentially larger.
Ah but here is the problem. As the pool of deposited money gets larger, the bank is under pressure to get more of that money out into investments and earning profits for the bank. When they have tapped out the market for loans and investments at a safe and secure risk level, they are under pressure to change that acceptance level of risk and loan out at greater and greater risks. In this case, the risks may be that the collateral of the loan is not worth the value of the loan or it might mean that the derivative has a high risk if the economy fluctuates any.
In the great Savings and Loan Crisis of the late 1980’s and early 1990’s, that was just such a situation. A booming economy and the offer of high interest rate on deposits brought in billions of dollars. When the real estate boom of the 1980’s hit, the S&L’s wanted to make all that deposited money work for them. Deregulation had removed most of the normal safeguards allowing the S&L’s to invest in more than $160 billion of bad loans – mostly for real estate that was not worth the amount of the loan. The US government paid $128 billion to bail out the S&Ls.
Over the past 30 years, the baby boomers have put more than $7 trillion into various stock market, real estate and banking investments. Companies like Bear Stern took those deposits and made a lot of investments – mostly in the high risk derivatives. They were overextended and under-collateralized into high risk ventures that collapsed when the national economy took a dive.
One of the impacts of the baby boomers retiring is that they will be selling off their homes. Many have second homes or very large homes that they will not want to keep in retirement. The sale of these homes will oversupply the market and drive prices down – which is exactly what is happening right now.
That combined with the devaluation of the dollar on world markets and you can see why Bear Stern defaulted. But stand by, this is just the beginning. The sub-prime mortgage problem, the massive rise in bankruptcies and the devaluation of the dollar will combine with the real estate crash to make for one awful economy and any financial institution that took on a little more risk than was prudent will find themselves in big problems.
Unfortunately, that includes the federal government. The FED has a finite ability to manage these crisis situations. One is to lower their prime interest rate but it is now below 1.25 – the lowest since WWII – and if it goes much lower, the primary tool that the FED can use is gone. In addition, the FED has just paid out $160 billion to guarantee loans for the Bear Stern bailout. Since this is a federal guarantee, the buyer has very little risk and if they begin to falter, you can bet they will call in that guarantee.
There is no honest appraisal of the US economy that does not lead to the conclusion that we are headed for a major financial crisis in the next decade and it will be unlike anything we have ever seen before.