Banking Paralysis

Some of you could probably tell I've been intentionally avoiding posting on the economy specifically for a few weeks as I was waiting for the stimulus mess to sort itself out. I hoped to post something about President Obama's stimulus package in more detail, but, after following several publications over the last couple of months on the matter, determined there are enough sites out there to explain what the stimulus means to the "average Joe." But I would like to address a couple of items that have come up in conversations/emails. They are 1) What is taking the Banks so long to get their act together and 2) What does a Bank "Recap" mean?. So there's still lots of discussion around financial services. This discussion however, is different than the commentary six months ago. I'm not going to answer these questions in order, or even in one post, but instead lay out, basically, how banks work. Doing this, I think, will help give perspective to the ongoing financial paralysis. I apologize if this sound condescending, but I have no idea who is reading this blog so I will write to the least common denominator.

How Do Banks Make Money
You open a checking and/or savings account with the Bank and they pay you little to no interest. Then, they take your money and lend it out at say 6%. If the Bank pays you 2% on your savings account, they are making 4% on your money. More specifically, they pay you 2% on your savings account and lend your money to home buyers (in the form of a mortgage) for 6%.

What does it mean to "Securitize" a mortgage?
I wrote about this in an earlier post but will briefly summarize here. Let's say your mortgage is with Bank A for $200,000. You pay the bank say $1,500/mo for 30 years in exchange for the $200,000 up front (you're total payment is $540,000 over 30 years). But perhaps Bank B wants to buy your mortgage from Bank A. So Bank A sells the mortgage, for about $200,000. In this role, Bank A acts as an intermediary and only makes money off of closing fees. Your mortgage is now with Bank B, and they have claim to all future payments. Over the last several years Bank B would typically be an investment bank. Not only would they buy Bank A's mortgages, but they would buy mortgages from thousands of banks. Bank B bundles 1,000 (for example) mortgages together and divvies them out in slices of 10 (each slice has payments from 100 mortgages). This slice can now be called a security, or, a CDO (Collateralized Debt Obligation). The price that another bank would pay for this security is based on the perceived riskiness of the underlying payments, or, the credit worthiness of the borrower. At the time, none of the Banks anticipated the steep decline in housing prices.

Bank Capital
When borrowers began to default because they couldn't refinance their homes the Bank holding the CDO had to write the value of that CDO down accordingly based on mark-to-market (or fair value) accounting. The CDO is an asset to the bank that owns it. Future payment streams from mortgages are assets to banks. However, if the value of the Bank's investment was $10 million a year ago, it's now worth $2 million and they must take a $8 million dollar loss. That's what has been going on over the last year. Let's look at how that affects the Bank by providing an example.

Say you wanted to start a Bank and you were able to come up with $20 million dollars in cash from investors in exchange for equity (i.e. stock) in the bank. Then, you went and borrowed money in the form of Bonds for another $80 million. Now you have $100 million to "invest". Remember, with a bond, you pay the bondholder a set percentage each month, say 4%, of the face value of the bond and at the end of ten years you have to make a lump sum payment to the bondholder for the face amount of the bond (you would have thousands of Bondholders with individual bonds for $1,000 each paying 4%/yr). From the Bank's perspective, Bonds are liabilities. They represent a future obligation the Bank has to someone else. Then, with your $100 million, you go out and buy some CDO's that are paying you 6%. That's a great business model. Your CDO's are paying 2% more than you have to pay your bondholders. But if CDO's fall in value by 80% due to defaulting borrowers in the underlying mortgages, your $100 million of CDO's is now worth $20 million. Keep in mind, you still have to pay your bond holders. Now, your assets are less than your liabilities. Meaning, you don't have enough money coming in from your CDO's to pay your bondholders. The Bank is insolvent. I'm over-simplifying here, but you get the picture. This gets us to about Q3 of last year.

One Thing Exacerbates the Problem
There's a timing issue. You may have noticed at the onset that Banks borrow short and lend long (to use standard industry vernacular). A deposit is a short term liability to the bank, whereas a mortgage is a long term asset. At any point in time a Bank may only have 15-20% of all their deposits on hand in cash. Should depositors want to withdraw all their money at the same time the Bank would not be able to liquidate enough assets to pay their liabilities. This is one sort of "Bank Run." We know from the IndyMac fiasco last year, that all deposits are guaranteed by the FDIC up to $100,000. The problem lies in the fact that most Bank's short-term liabilities are not deposit accounts, and are not insured. To meet these obligations, Banks will typically borrow from other banks. But today, Banks are unwilling to lend to eachother because 1) they are worried the bank won't be solvent based on their exposure to CDO's and 2) they want to hang on to their own cash in case they have the same problem. So banks are just staring at eachother. Finally, a derivative product is to blame for the most recent stagnation--the dreaded Credit Default Swap.

Credit Default Swaps Explained
Back to bonds for a minute. If you want to buy a $100 Bond from JPMorgan you would pay JPM $100 (usually) and they would pay you a set interest rate, say 6% for 10 years, at which point they will pay you $100. You make $6/yr for 10 years and get your $100 dollars back, for a total of $160. Not bad, better than a 2% savings account. But there are two big risks. What if JPMorgan can't pay you back? What if interest rates go up and you're stuck at 6%? You could buy a Credit Default Swap for a few hundredths of a percentage point from an insurer to hedge the default risk (but you can't do much about interest rate risk). The insurer would step in and pay you off in the event the company you bought the bond from defaulted. Simply, they are insurance policies. But, since they're derivatives, the swap itself could be sold for a specific value. Let's make it a little more palpable.

Merrill Lynch owns a bond OR a CDO from Lehman Brothers. They do the sensible thing to protect themselves and buy a CDS to insure against a Lehman default. Since Lehman is a huge company, they go to AIG for the insurance and pay AIG .5%/mo in exchange for the coverage. See the problem? CDO's default, Lehman is insolvent, AIG can't make everyone whole (CDS' aren't regulated so "sellers" of the insurance don't have to have reserves). ML is stuck holding the bag. Whereas ML thought they would be made whole via AIG they are now stuck with major losses on their own assets and are themselves, insolvent Now holders of ML bonds or CDO's must mark down their assets and they are insolvent, triggering another payout by insurers of ML to those that had CDS on ML. And by the way, ML sold their own CDS to other Banks, which they will no longer be able to honor. This massive chain reaction is still playing out across the financial sector. A bank may look healthy but they may be depending on an insurance payment from an insolvent bank.


Hopefully I've been able to elucidate the current financial faceoff in a little more detail. AIG was bailed out because they were the largest sellers of CDS in the world. The government is still trying to figure out ways to either get these toxic CDO's and other mortgage backed securities off the Banks balance sheet, or provide additional capital to "Recap" the bank. Both of which I will treat in the next post.