Bank Crashes for Dummies

John McCain is among many Americans who just a year ago would have said that the Economy is not our strongest suit. We don’t pretend to understand the strange alchemy that surrounds our investment banking system. But lately the news has been full of talking heads with very dour looks and talk of massive “write downs” and “margin calls” and “credit crisis” and “bail out”. Somebody by the name of Bear Sterns just got a lot of money, our money. Some of us are wondering just why they needed it, and why “we” gave it to them.

Banking 101 – The mortgage loan

In an egg shell: Bank has money. Bank lends money for a house. Bank gets house as collateral. That’s a mortgage loan.

In the old world, the bank makes monthly income from interest payments plus gets the capital back to lend again. They even used to service their own loans, but that’s another story.

Or, in the modern world,

The bank sells the loan to an investor (at a profit). The bank now has cash again, and looks to loan it out again.

Its not who you are, its how you look.

A while back, the banks figured out a legal way to bundle up mortgage (and other) loans in closed packages with solid sounding names like Structured Investment Vehicles (SIV) and Collateralized Debt Obligations (CDO). Then they sold them as if they were safe bonds but with a much higher rate of return. It is probably not a big surprise they were pretty easy to sell. As a matter of fact, they could sell everything they could put on the market. They were making money hand over fist at it too.

Of course, they were not actually as safe as bonds. They were mortgage loans. Many of them sub prime loans. And since everyone knows that some percentage of loans don’t get paid back, they don’t really have as good of a return as they look like. Sub prime loans in particular have a higher interest rate because they have a higher default rate.

In other words, they packed up plain chicken eggs in pretty boxes and called them Fertile Purebred Amherst (FPA) eggs, and Silver Plated Easter (SPE) eggs. It was difficult to see what was actually in the boxes, but the price was good so no one really looked.

Something’s rotten in that vehicle.

But wait, there’s more. Not only were the boxes full of plain chicken eggs, but as chicken eggs go, these weren’t so good. With housing prices heading for the stratosphere, and an unlimited market for their innovatively packaged loans, the banks totally lost the concept of due diligence. “Due Diligence” in this case means bothering to see if the barrower had any chance to repay the loan.

Banks were “aggressively” selling loans, real estate agents and builders were “aggressively” selling houses, buyers were unrealistic about what they could afford, investors were clamoring to get in on the profits, and loan brokers were very willing to put anything on paper to make the deal work. Many of the loans are so far from reasonable that no government help, loan counseling or help from Bank of Dad is going save them. There’s a pile of rotten eggs in those boxes.

Circle Lending

It gets even worse. Among the really big buyers of these gussied up rotten eggs were the investment banks themselves. You see, although they surely had at least an idea of what was really in the box, if they traded to each other with a wink and a nod, they could keep putting the rotten eggs on the books as solid assets. Against which they could, and did, borrow so they could make more loans and make more money.

The arrival of “someday”

Eventually, some of those rotten eggs started to stink. Unrealistic home prices finally took a dive. With no room left to refinance, mortgage defaults began to rise and investors were noticing the smell. Soon everyone was getting an idea of what was really in those boxes. When the news says some big bank just “wrote down” a gazillion dollars in assets that was a bank fessing up to the rotten eggs. At best, it means they can’t borrow any more against the assets. At worst, the people who lent money against those assets want all the money back. “Now”. That’s what happened to Bear Sterns.

If that wasn’t enough, now that investors have figured out what’s in those fancy boxes they are not so eager to buy them. Even if the banks sell them as plain chicken eggs, and promise there are not rotten ones, well, the investors aren’t buying it. Not the story, or the eggs. That previously unlimited market for mortgage backed securities all dried up.

It also means the banks don’t have the cash to lend out. Not to businesses, not to each other, not even to solid working folk with a decent down payment. The oft referred to “credit crisis”.

And it means that some of these banks might have more debt then assets. Like homeowners that borrowed against the entire inflated value of their houses, some banks borrowed against the entire inflated value of their portfolios. For those who’s houses were severely over inflated and who borrowed every dollar they could get someone to lend them, and who then spent every one of those dollars on giant CEO bonuses, making more loans and dubious investments (oh, that was the banks, not the homeowners) . . .

Well, for some of the banks, this will mean losing their house. In other words, some banks are looking to fail.

If you are not familiar with the consequences of major bank failures, goggle “The Great Depression”. That is why our government just put a huge stack of taxpayer money on the line to bail out Bear Sterns and support the whole pile of egg painting fools. A complicated and expensive bail out and we are only just beginning to get an idea of how big and bad it is.

There's the story in an egg basket.

Or is that a hand basket?