How Banks Work 1

Around 1997, while I was in Japan and the Japanese banks were having a hard time, I decided
that I should gain a better understanding about what was happening with the banks. In other
words, I decided to learn how banks work. This was not that hard — about an afternoon’s
worth of reading and head-scratching. Afterwards, it dawned on me that almost nobody else
understood how banks work — not politicians, not journalists, not economists, not wonky
think-tank types. Indeed, hardly anyone involved with resolving the problem with banks had
any idea how they worked.

Do you think this may have led to a failure to Identify the Problem? You bet it did.

There are some people who know how banks work. These include bankers, bankers’
accountants, and stock analysts. Unfortunately, none of these people have much of a
mouthpiece, and also they don’t know much about economics for the most part, so they often
have little influence on the policymaking process. Even if the bankers did try to explain the
situation to a policymaker, the policymaker probably would be completely unable to grasp
what they were talking about. (This is one reason why it’s nice to have a real banker as Finance
Minister or Treasury Secretary.) The result is that the policymaker tends to listen to journalists,
the IMF, economists and other such knuckleheads — people who don’t know diddly about
banks, and are therefore largely incapable of Identifying the Problem — because he can
understand what they are saying, even if it’s a load of crap.

He can understand it because it’s the same as what he’s reading in the media, which is where
the journalists quote the IMF, economists, think-tank types etc., producing a sort of Mirrored
Hall of Ignorance.

So, what we are going to do today is what I did back in 1997 — namely, take the public
financial statements of an actual real-life bank (we’ll use Wells Fargo), and figure out how the
company works. (For the pros who already do this every day, you might want to spend this
week at perezhilton.com instead.)

Download Wells Fargo’s 2006 Annual Report By Clicking on This Link

Ideally, print out the whole document.

Go to .pdf page 71 (printed page 69). This is the Consolidated Balance Sheet, the most
important page in the whole document.

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From this we can understand Wells Fargo’s business. In the Assets section, we find that it
holds $319 billion of loans. It also has $15 billion of cash (really short-term loans), $6 billion
of Fed Funds sold (sort of a short-term loan), $42 billion of securities available for sale
(probably mostly fixed-income securities, aka bonds, aka loans), and $33 billion of mortgages
held for sale (loans). Aside from some real estate and goodwill, basically Wells Fargo owns a
big pile of loans.

Where did it get the money that it loaned out? It borrowed it from others. On the Liabilities
side we find: $310 billion of deposits, $13 billion of short-term borrowings (from other banks
probably), some unpaid bills (accrued expenses and other liabilities) and another $87 billion of
long-term debt. So, on the liabilities side, we see that Wells Fargo also owes a big pile of money
to other people (mostly depositors). Do you see why I say that a bank deposit is really a loan
to a bank? It’s right there on the balance sheet, as money that Wells Fargo owes to you.

The difference between the assets and the liabilities is the Shareholder’s Equity, also known
as book value. Thus, if you own $10 of goodies and have $9 of debt, you have net equity of
$1.

So, a bank makes money by borrowing money from depositors, and then lending that money
out to borrowers. It makes an interest income from the loaned money (the assets) and then
pays interest on the borrowed money (the liabilities). The difference between the money
received and money paid is profit to the bank, and ultimately to the shareholders in the bank.

On .pdf page 44 is a table of interest received and paid on Wells Fargo’ loans and borrowings.

We see here that Wells Fargo gets an average of 7.79% from its loans (that’s your mortgage,
credit cards, business loans, etc.), and pays out an average of 2.96% on its borrowings (that’s
your savings accounts, checking, CDs etc.), producing a Net Interest Margin of 4.83%. (That’s
pretty good!)

This profit shows up in the income statement, the second most important item in the report.
It’s on .pdf page 70.

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3
Here we see the interest received ($32 billion) minus the interest paid ($12 billion) producing
net interest income of $20 billion. Then there is a provision for credit losses. Afterwards, Wells
Fargo declares $17.7 billion of net interest income. Then, there is is about $16 billion of
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noninterest income (mostly fees and charges, and don’t we all know about those), followed by
noninterest expenses of $20.7 billion, mostly salaries and other compensation. At the end of
the day, Wells Fargo made $12.7 billion before taxes, and $8.5 billion after taxes.

Quite a lot of work to make $8.5 billion, no? They had to carry a ginormous $481 billion
dollars of assets to make that relatively puny $8.5 billion in profit. That’s a ratio of 1.77%
(return on assets). Which is sort of low, you could say.

However, the shareholders did pretty well. The total amount of capital invested in the
company (crudely speaking) was $45.9 billion, the shareholders’ equity or book value. So, if
you had a $45.9 billion investment and got paid $8.5 billion in profit for just one year, that’s a
Return on Equity of 18.5%. Sort of like a bond that pays 18.5%. Juicy! That’s why there are
so many banks out there.

You can look at it this way: You start with $46 billion dollars. You borrow $436 billion dollars
and lend $481 billion dollars (approximately). You make a profit of $8.5 billion dollars.

Now, nowhere in this exercise does the bank “create money.” It borrows from one entity (the
depositor mostly) and loans to another. It is an intermediary. Nor does the bank “multiply
money.” Try asking a banker, “How much money did you multiply last year?” Huh?

The difference between the rather mediocre yield on loans (7.79%) and puny return on assets
(1.77%) and the splendid return on equity (18.5%) is due to leverage. We can see that the bank
is levered about 10:1, namely, it carries $481 billion of assets on a $46 billion capital base. This
is sort of like the homeowner with a 10% downpayment, who carries $500,000 of assets (the
house) on a $50,000 downpayment and a $450,000 mortgage. 10:1 leverage is pretty typical for
a bank, and has been determined over time to strike a nice balance between profitability and
resiliency.

Actual computation of “capital ratios” is rather more complex, and is found on .pdf page 116,
“Regulatory and Agency Capital Requirements.” Here we find that the regulatory capital ratio
is 12.50%, which is pretty close to our simple 10:1 (10%) ratio.

We will finish this week with one more point, namely “bank reserves.” Reserves are cash held
by the bank against withdrawals of deposits. We haven’t mentioned them, have we? Reserves
are noted on .pdf page 80. “Federal Reserve Board regulations require that each of our
subsidiary banks maintain reserve balances on deposits with the Federal Reserve Banks. The
average required reserve balance was $1.7 billion in 2006 and $1.4 billion in 2005.” Whoa! Are
you telling me that there is only $1.7 billion in reserves (plus a little vault cash) against $310
billion of deposits?

Waaah! Get my money out of there!

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Actually, this is quite common today. No bank wants to sit on reserves, which do not earn
interest. They loan out every penny they can, to collect interest income. This is possible today
because of the Federal Reserve, among other things. If a bank is facing withdrawals, it can get
the cash by a) selling something for cash, b) borrowing from another bank, or c) borrowing
from the Federal Reserve (via repos or the discount window). We won’t get into the issue of
liquidity shortage crises here, which were a systemwide shortage of reserves. This problem
doesn’t exist anymore, because of the Federal Reserve. To make a long story short, a bank like
Wells Fargo should never have a problem getting the cash to pay your withdrawal (“should
never” anyway). Maybe that “fractional reserve” stuff is meaningless when there is
effectively no reserve at all? You can see why I chuckle when people go on about that “fractional
reserve” nonsense. (The $15B of cash and due from banks could be considered a sort of
reserve.)

Now that we have an idea of how banks work in normal times, next week we will look at how
banks lose money.

You should keep poking around the annual report for more detail about how all the various
bits and pieces work. Spend a couple hours at it, if you can stand it. It’s complex, but
reasonably commonsensical (to the extent that any US bank was commonsensical in 2006!).

***

I rented Rollover (1981, Jane Fonda, Kris Kristofferson, Hume Cronyn. Fonda’s company
IPC produced.) from Netflix and watched it yesterday. It is a financial thriller that fictionalizes
the worldwide currency collapse that some people worried about in the late 1970s and very
early 1980s. Just the thing for today’s headlines, if you ask me.

Senior trader at Boro National Bank: “Gold just went over $2000!”

Head of trading at Boro National Bank: “It’ll be cheap by this evening.”

I love it!

Financial thrillers are pretty hard to get right, compared to car chases, gunfights and computer-
animated aliens, since they largely consist of people on the phone speaking in tongues.
Nevertheless, the characterizations are pretty interesting and I think this one hits pretty close
to the mark. Kris Kristofferson is a turnaround artist hired to save beleaguered Boro National
(think Jamie Dimon). Jane Fonda is the recently widowed wife of a chemical company mogul,
a high-society trophy (and former movie actress in the film) with ambitions to assume the
management of the chemical business via a Saudi-financed takeover of a Spanish chemical
plant . (Fonda married Ted Turner in 1991.) Hume Cronyn is the president of a major bank,
which is quietly helping the Saudis move out of paper currencies and into gold.

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I heard elsewhere that, in the last scene, the Hume Cronyn character leaves Midtown by
rooftop helicopter to a well-stocked bunker in the hills while demonstrations erupt in the
streets. However, in this version, he commits suicide. What — did he feel guilty or something?
Gimme a break.

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How Banks Work 2: Shitting Like an Elephant

“Banks eat like a hummingbird … and shit like an elephant,” some bankers are known to say.

Well that is some macho he-man financial speak for sure! What does it mean? (And does it
help to pick up girls?)

First, review last week’s primer on How Banks Work. You will remember that our sample
bank, Wells Fargo, only made a return on assets of 1.77%. That’s not bad for a bank — better
than some German and Japanese banks — but, you have to admit, a 1.77% return doesn’t
exactly sound like an investment jackpot. On a pretax basis, it was 2.64%. That means that for
every dollar Wells Fargo lent out, it made a profit of $0.0264, and that’s before the government
takes their share. Over twelve months! That’s pretty skimpy. Sort of like the way a
hummingbird eats.

It also means that, if the value of Wells Fargo’s assets fall by only 2.64%, over twelve months
— for example if 2.64% of its loans become worthless — then the bank didn’t make a damn
cent. And, if the bank’s assets fall in value by, say, 5% or so, then that big 10:1 leverage kicks
in and the losses are enormous! Sort of like the way an elephant shits.

Since banks are the elephants of the economy, when they take a shit it’s not only the banks’
problem, it becomes everyone’s problem.

Remember, it’s the 10:1 leverage that turns the 1.77% return on assets into a 17.7% return on
equity. It works the other way as well. A 2% loss becomes a 20% hit to equity.

A bank’s assets are mostly loans. These loans have credit risk — sometimes they don’t get
paid back. (Do you think?) Or, they could be delinquent, or be partially paid back, or paid back
in full at a later date, or be restructured on new terms, or sold to a third party, or many other
things. Usually, the value of a loan doesn’t just collapse to zero. Many loans are collateralized,
for example. A mortgage is collateralized by a piece of property. Even if the homeowner stops
paying completely, the bank gets the house, and can sell the house. Banks are not allowed to
make a profit on the sale of a foreclosed property. They can only get back $1 for every dollar
they lend. (If there’s a profit, it goes to the previous owner.) However, it is not hard to see
that banks can often sell a foreclosed property for as much or more than they lent, so even if
the borrower goes bust, the bank might not take a loss at all.

If the bank sells the property and gets back $0.50 for every $1 it lent, then obviously the loss
is 50%. This is known as the recovery ratio. A 30% loss is a 70% recovery ratio.

There are other kinds of collateral as well, such as companies and their assets, which back
corporate loans.
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Auto loans are collateralized by the automobiles. If you can’t pay, your car gets “repossessed”
by the bank. Maybe they can sell the car for more than you owe on it. Maybe not.

Even an uncollateralized loan, like a credit card loan, might have some recovery value. The
loan could be sold to a credit collector, maybe for $0.05 or so. The collector then tries to make
a profit by squeezing $0.10 out of the deadbeat borrower.

Now, bankers know that some loans are going to go bad, at all times. Because of this, they set
aside “provisions” against loan losses. These provisions are added to the “allowance for loan
losses” or loan loss reserves, sort of like a piggy bank against the losses which are sure to come.
You can see these provisions on the income statement as a “provision for credit losses.” It
was $2.204 billion for Wells Fargo in 2006. Thus, Wells Fargo already has the first $2.204
billion of losses covered. Over time, this piggy bank is added to (via more provisions) and
subtracted from (via real, actual losses). We see on the balance sheet that, at the end of 2006,
there was $3.764 billion in Wells Fargo’s loan loss reserves piggy bank. Thus, Wells Fargo
could lose $3.764 billion and it wouldn’t even affect income.

This loan loss reserve is not very big. Since there were $319 billion in loans, it is only 1.18%.
Thus, the first 1.18% of losses are already covered by the loan loss reserve.

Provisions are recorded as an expense. So, they reduce net income. Since most banks are
publicly traded, the management has to answer to (typically impatient Wall Street)
shareholders. These shareholders usually like the biggest profits possible, as reported by
accountants on a quarterly basis. Thus, they like the smallest expenses possible. Thus, bank
managements tend to minimize provisions, in good times.

Also, in good times, the banks simply don’t have a lot of losses. When property values are
rising, and people are getting good jobs and making more money, and businesses are doing
well, usually borrowers can pay their loans. Even if they can’t, often recoveries are high,
because the collateralized assets (propety especially) are rising in value.

So, year after year, the bank recognizes that it doesn’t have a lot of loan losses. If losses have
been 1% of loans, year after year, why provision at 4%?

A bank could do this. The management could say: “Things aren’t always going to be so good.
In fact, the present situation looks dangerous. We’re cutting back on our lending to lower-
quality borrowers, and we’re going to start building up our loan loss reserves.” They could
take more money, each quarter, and put it in the loan loss reserves piggy bank. If everything
works out fine, the money is still there in the piggy bank. You can take it out again. This is
called “de-provisioning.” A privately-held bank might work this way. They could later say,
“Our provisioning for loan losses has proven to be overly conservative. This quarter, we
enjoyed a profit of $1 billion from de-provisioning.” (Since provisions are expenses, a de-
provisioning is a negative expense, or a profit.) However, such are the pressures on bank

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managements today that this sort of behavior is very unusual. Bigger provisions mean lower
profits, according to the standard accounting.

When the bad times hit — very predictable, but never predicted — then you have people
losing their jobs, businesses fail, and asset values fall. Default and delinquency shoot higher,
and recoveries plummet. Losses become huge. Last year’s provisions and loan loss reserves
don’t cut it anymore.

A bank has a duty to admit that loan quality has deteriorated, even before the actual, real losses
are known. For example, a bank might not know how much it actually loses on a mortgage
until the collateral property has been foreclosed and sold. This can take a year or more. When
a borrower stops making the payments, then you know right away that there’s a problem. The
accountants demand that the bank recognize this problem right away. They say: “Recoveries
are deteriorating badly. You need to raise the provision on these defaulted loans to 30%. Also,
the number of delinquent loans which go into default is rising. Provisions on delinquent loans
need to rise from 5% to 10%.” Which is to say, they make an estimate of how much the bank
will ultimately lose, which is $0.30 on the dollar for defaulted loans. The bank needs to put
aside this $0.30 right away in the provisions piggy bank, and write down the value of the asset
to $0.70. More provisions mean less profit, so profits decline, and maybe the bank is reported
to have made a loss.

In some cases, especially in large-size commercial loans where the bank monitors the financial
condition of the borrower closely, a bank may even declare a loan impaired (not worth its full
value) if the borrower (a company) has made all the loan payments, but is in deteriorating
financial health. The bank must provision against the risk that the company, some time in the
future, may default on the loan. A bank sets aside a “general provision,” but it may also set
aside provisions on specific loans, particularly large-size commercial loans.

These loans that the bank provisions against, particularly the ones with loan-specific
provisioning, are labeled “non-performing loans,” or just “bad loans” or “bad debt.” Now,
the funny thing is that many of these “bad debts” might be paid in full. This was particularly
the case in Japan. I recall that about 70% of all the “bad debts” at banks were loans to
companies that had made all the payments, but were suffering some difficulties. Which is not
too surprising in a recession, no? That’s why (see the FT op-ed I linked to last week) the
solution to Japan’s so-called “bad debt problem” was to cause the economy as a whole to
recover, via monetary reflation and tax cuts. If a loan to a company — which had made all its
debt payments — was simply recategorized from being a “loan at risk” (they were called “type
II” loans) to being a “regular performing loan”, then 70% of Japan’s “bad loans” would
vaporize. And, in an economic recovery fueled by reflation and tax cuts, this would be a very
natural thing. Maybe 1 in 10,000 non-bankers had figured this out, even though the banks
reported the statistics quarterly. Do you see why I say that it is important to understand how
banks work, and why I say that hardly anybody does?

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If they had read the banks’ financial statements, slowly and with curiosity, they would have
figured this out. Which tells me how many people actually read banks’ financial statements.
Which is why I insist that you do so, at least once in your life.

We’ll have more on how banks lose money next week.

***

Is the “tax rebate” just an advance on your 2008 tax refund? It appears that the $150 billion
“rebate” plan is, essentially, a loan on your regular 2008 (paid in 2009) tax refund. Most
people’s withholding is a little excessive, so they get a refund. Basically, the government is
paying your 2008 refund in advance! CNN reported this on their website as follows:

The package, which passed the Senate 81-16, will send rebate checks to 130 million
Americans in amounts of $300 to $600 for people who have an income between
$3,000 and $75,000, plus $300 per child. Couples earning up to $150,000 would get
$1,200.

The checks are an advance on next year’s refunds, and most, if not all of the
money, will be deducted from taxpayers’ refunds in 12 months’ time.
This was later modified to read:

Do I have to pay the rebate back?

No. And here’s why.

Your rebate is a one-time tax cut – an advance on a credit you’ll receive on your
2008 return.

It’s based on your 2007 income initially. If it turns out that your 2008 income and
number of children would have qualified you for a larger rebate than the one you
received, you’ll be sent the difference. If it turns out your 2008 income was lower
than in 2007 and you should have gotten a lower rebate, you get to keep the
difference.

“If you were supposed to receive a larger payment than you did, you will get the
extra money,” said Treasury spokesman Andrew DeSouza. “If you received more
than what you should have gotten, you will not be penalized.”
This is more confusing, but it basically says the same thing. More commentary on the “phony
rebate” is here.
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MSN Money reports that: “It’s Not Really Free Money”

Remember, this is your money you’re getting back, and the rebate checks are
basically an advance on your 2009 refund. When similar rebates were sent out in
2001, said tax expert Mark Luscombe, “a lot of people were upset to see their (next)
refund reduced.”
Well, that’s pretty funny! Usually the government is a litte less sloppy than that. They should
have just recapitalized the banks. That might have accomplished something. Now, nothing
has changed except that even Subaverage Joe is aware that he is being governed by criminal
knuckleheads.

The halfpasthuman.com Web Bot project (see urbansurvival.com for more details) indicates a
“tax revolt” coming in the spring. Indeed, when a government loses all legitimacy it sometimes
finds that tax payments plummet. It happened in Argentina, for example, just before the
economic collapse in 2001. Americans, who like to think they’re “independent-minded” but
actually act like medieval serfs, would not normally be ones to simply not pay taxes. However,
this display of government arrogance, combined with the “just walk away” boom for all kinds
of financial obligations, might prove the Web Bot right in the end.

How Banks Work 3: More Elephant Poop

We saw that banks are highly leveraged, such that a relatively small loss, in comparison to total
assets or loans outstanding, can lead to a meaningful loss for the bank. Our example, Wells
Fargo, had a pretax return on assets of 2.64% ($12.7 billion in pretax profit), plus it had
provisioning of $2.204 billion, plus it had a bit of leftover provisioning such that it ended 2006
with $3.764 billion of provisions. Thus, its pre-provisioning profit was $14.9 billion, plus there
was $3.764 billion to start the year.

From this we see that Wells Fargo has enough profits to cover the first $14.9 billion of losses
in 2007, or about 3% of assets, assuming that base profitability stays about the same. As long
as losses didn’t exceed this figure, the net profit, as reported by accountants, would be
disappointing to equity investors, but the bank would basically be OK. The problem for banks
arises when losses exceed profits, or in other words there is a net loss.

(This also describes why banks like to spread their losses over several years, if possible.)

The shareholders’ equity, remember, was $45.9 billion. So let’s say Wells Fargo takes a loss of
5% of assets. Not real big, right? Just 5%. Since there were $481 billion of assets, that would
mean $24.05 billion. The pre-provisioning profit of $14.9 billion would be completely
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consumed, leaving a net loss of $9.15 billion. That loss would come out of the bank’s capital
base, leaving $45.9 billion – $9.15 billion = $36.75 billion. That $9.15 billion loss leads to a
20% decline in capital. Ouch!

Losing money is a bummer, but it is especially perilous when an entity is highly leveraged, like
a bank. Remember, there were $481 billion of assets, $435 billion of liabilities (mostly
deposits), and $45.9 billion of capital. Now, there are $481b-9.15b=$472 billion of assets, $435
billion of liabilities, and $37 billion of capital. The leverage of the bank has gone up from
$481:$46 or 10.4x to $472:$37 or 13x. Or, to put it another way, the depositors are looking at
the bank, which had a $46b “cushion” to pay back the depositors’ $435 billion, and the
“cushion” is now only $37 billion. If the capital base becomes too small, there could be a run
on the bank as depositors want to get paid back while the bank is still able to pay.

Thus, a bank that is making losses and has a shrinking capital base is at risk. What happens if
there is another loss next year? Because of this, the Bank for International Settlements requires
that a bank that is operating internationally (like most big banks) maintain an 8% capital ratio.
If the bank falls below this ratio, then no international settlements. No international
settlements = no international business. They compute the capital ratio a little differently than
the simple assets:capital ratio, but it is similar (it is actually risk assets:capital, which leaves out
some supposedly “no risk” assets like government bonds held to maturity). Wells Fargo’s BIS
capital ratio is on .pdf page 116.

We see here that the computed regulatory capital ratio is 12.50%. This is above the 8.0%
required for capital adequacy.

An international bank simply cannot allow its capital ratio to fall below 8%. It would have to
cease all international operations. A catastrophe. So, the risk is not really that the capital goes
to zero, the risk is that the capital goes to 8%. We see here that Wells Fargo has $51.4 billion
of capital (as it is calculated for regulatory purposes), and the 8% limit is $32.9 billion.

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Let’s think about this. In our example, we had a loss of $9.15 billion. So, if you take $51.4
billion – $9.15 billion, you get $42.25 billion. Which is only a bit above the $32.9 billion at
which you have real problems.

However, not only can a bank not fall below 8%, it can’t even get close to 8%! That’s why, on
the far right side, there is a requirement “to be well capitalized under the FDICIA prompt
corrective action provision”. In other words, if there is even a risk of falling below 8%, you
gotta start coming up with some solutions quick! This level is set at a 10% capital ratio.
Although it applies only to the Wells Fargo Bank N.A. subsidiary (about 79% of the
consolidated bank by capital), we see that this level is hit at $33.7 billion (from $40.6 billion),
which is a decline of only $6.9 billion! So, considering our $9.15 billion loss for the
consolidated bank, we see that this one single loss — a mere 5% decline in asset values — could
put Wells Fargo in a rather perilous financial position. (Proportionally speaking, 79% of $9.15
billion is $7.22 billion.) Especially with today’s capital requirements, there is only a little teeny
cushion between normal operations (12.50% capital ratio) and an emergency (10% capital
ratio).

That explains why so many banks have been running around for capital recently.

The BIS capital ratios were imposed in 1988, and are widely thought to be an attempt by U.S.
banks to suppress the international expansion of Japanese banks. Japanese banks were doing
very well in the late 1980s, while the US (and some European) banks were buckling under
huge losses in Latin America. The Japanese banks tended to have rather low capital ratios.
Why not? There were no capital requirements in those days. The BIS et. al. terrorized the
Japanese banks for years in the 1990s, and indeed one major Japanese bank (today’s Resona)
decided to withdraw from international activities.

***

At this point, I’d like to address a little different subject, which is “bad debts” at banks. Once
a loan has become an issue — for example, because some payments were missed — it becomes
a “bad debt.” We see from the example of a simple home mortgage that it can take years to
fully work out a bad debt, going from delinquency to default to foreclosure to the sale of the
collateral asset. Or, maybe the loan is restructured. “OK, I can see you really can’t pay the
original loan, so let’s make a deal. I’ll give you a special, fixed-rate loan at a low interest rate.
We can agree that you can’t pay $4,000 a month, but you can pay $2,000 a month, so let’s
make that the loan payment for now until the balance is paid off.” Banks can do this. They
can work out any sort of arrangement they like. And, a bank may conclude that this is a better
course of action than going through the legal foreclosure process. In other words, it gets more
of its money back this way. That’s good, right? (In fact, banks are doing just this sort of thing
right now, with some encouragement from the US Treasury.)

However, in both cases the loan is obviously an impaired loan, or a “bad loan.” In the first
case, the bank may have the loan for a couple years, until the foreclosure process is worked
14
out. In the second case, the bank may have the loan for the next 30 years. And then there is
the example from the Japanese case, of loans that are paid in full 100%, but are at some
elevated risk of default. This is true especially of corporate loans. Look, for example, at the
$240 billion or so of private-equity buyout loans on banks’ books today. I hear these have
been recently priced at $0.85 or so. Which is well below $1.00. Definitely impaired. However,
as far as I know they have all been paid in full. These sorts of loans are also often categorized
as “bad loans” as well.

Over time, there is some reckoning of “bad loans” on bank’s books, and it comes to some
colossal number like $300 billion. This is typically the face value of the loans. It is NOT a
measure of losses. These numbers are published in the newspapers, and everyone poops their
pants about the “bad loan problem”. What are we going to do about it?????

The first question is: why do we have to do anything about it at all? The banks
have already provisioned against the problem loans. These provisions may prove to be
inadequate, but on the other hand they may be more than adequate. The bank may find that
it set aside $0.30 in provisions for a problem loan, but they eventually get back $0.80 for the
loan, so there is a $0.10 latent profit! There is nothing wrong with letting banks work out their
problem loans themselves. After all, they are experts at this, right? This is their business.
Indeed, there are banks that own nothing but problem loans. They acquire problem loans for $0.70
and work them out for $0.80. (These are generally known as “asset management companies,”
but they do the same thing as regular banks’ problem loan departments.) The fact that these
banks own 100% “problem loans” is not a problem. They can be quite profitable.

Nevertheless, in the newspapers, on TV, among politicans and public policy types, there is
endless talk about the “problem loan” problem. These “$300 billion” of problem loans are
imagined to be some kind of financial time bomb waiting to go off. We better do something
before the “problem loan” time bomb goes off!!! Aaaaack!!!! After all, the “problem loans”
must be the problem or they wouldn’t be called “problem loans,” right?

Wrong.

There is, at this point, typically a great failure to identify the problem. The problem is usually
not “problem loans.” That was the problem. That time bomb already went off. Banks
have already paid for that problem via provisions. The real problem is usually … loans that are
not yet classified as a “problem.” These might include, for example, super-crappy loans which
will become a problem in the future, like last year’s CDOs and subprime lending. However,
once “problem loans” become a headline issue, nobody is making these kinds of “future
problem loans” anymore. The other problem is more-or-less OK loans, which would become a
problem in the future if the economy continues to deteriorate. To solve this problem, you have
to do what you can to foster a strong economy, which must include:

Low Taxes

15
Stable Money

Also, this helps the “problem loans” already existing. The “problem” of problem loans is not
really the face value, but the recovery. In an improving economy, a bank might eventually get
back $0.90 for its “problem loan,” while in a deteriorating economy it might get back $0.50 or
even $0.20.

It is often imagined that this “$300 billion of bad debts” means that someone is going to have
to pay $300 billion to make the bad debts disappear. This is nonsense. The real losses might
be more like $300 billion * $0.20, or $60 billion, and the banks have already paid this via
provisions. Sometimes this myth assumes such power that even bank stock analysts make this
mistake! “Ohhhh, Bank A is going to dispose of $10 billion in bad debt. Bank A’s book value
will therefore decline by $10 billion!!!” Actually, Bank A might have provisioned the debt at
$0.30. Then, considering that the economy is now recovering nicely, maybe it sells the debt
for $0.80. So, it then deprovisions by $0.10. On $10 billion of debt, that is a $1 billion profit!

Second, taking bad debts “off banks’ books” (often through the sale of a loan) doesn’t make
the bad debt disappear. It just moves it to another bank’s books, or to some other owner.
Whoever owns the loan, they will manage it in whatever way they feel will bring the most
overall profit or recovery. This might take many years, even decades. It might make perfect
sense to hold onto the loan for a long time, until the economy and asset values recover.
Consider, for example, Wilbur Ross, who bought the bank debt on bankrupt auto parts maker
Collins and Aikman. He probably bought it for about $0.90 or so. Marty Whitman was a big
holder of the subordinated debt, which originally traded for about $0.60. It may well turn out
that Wilbur Ross will end up owning all of Collins and Aikman, and it may well turn out that
this investment will be worth not only $0.90, but many multiples of that as the auto industry
recovers. This process may take many years.

It is also imagined that this “$300 billion of bad debts” is some horrible drag on the economy.
Now, it is probably true that the “$300 billion of bad debts” represents the effects of some horrible
drag on the economy, like tax hikes or monetary instability. Or, it might just be an artifact of
total financial silliness previously. It is often the case that more stringent lending standards
(which often follow the emergence of bad debts) will result in some economic slowdown.
However, “bad debts” don’t really cause a drag on the economy themselves. I mentioned that
the US banks had enormous bad debts from lending in Latin America in the 1980s. Also, there
were the S&Ls, which were very much loaded with bad debts in the 1980s. Neither caused a
drag on the economy, which did very well during that time.

I mentioned that some “bad debts” might be restructured loans. Is paying $2000 a month
rather than $4000 a month a “drag on the economy?” And how about those loans that are paid
in full but are considered to be at some risk? How is that a drag on the economy? Remember,
these “loans at risk” can constitute the majority of “problem loans.”

16
How Banks Work 4: Banks and the Economy
Last week, we talked about how credit losses lead to shrinkage of the bank’s capital base.
Typically, when banks have capital impairment (losses), there is much hue and cry that lending
will shrink as a result, leading to recession. This is based on a very simple multiplication: banks
typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their
capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must
also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements
mandate that large banks not get too far out of line regarding these ratios.

Oh my GAAAD! Horror! We’re doomed!!!!

But banks don’t really work like that. This is a subset of a broader group of theories, that an
economy can be managed by a sort of mechanical top-down monetarist approach. The
“money multiplier” was another of these ideas, as is the old “MV=PT” theory which actually
dates from the 17th century, if not earlier. They are all based on the idea that there is some
amount of “money” (or capital), and everyone jumps up and down like puppets depending on
this one quantity variable. Thus, if banks have capital, then they create loans according to some
sort of inevitable mechanical multiplication function, and if they don’t have capital then loans
shrink by the same inevitable mechanical multiplication function.

The world doesn’t work like this at all. Just think of why borrowers and lenders get together
in the first place. The borrower thinks: “If I borrow this money, then I can invest in an asset
(or business) that, over time, will produce an effective return on capital greater than the rate
of interest on the debt, and I’ll make a profit.” OK, that’s a little technical, but the basic story
is that the borrower sees an opportunity to put capital to use. The lender is thinking almost
the same thing: “If I lend this money, I can enjoy a return on assets (the interest on the loan,
minus credit risk) greater than the interest paid on my borrowing (which is the interest paid to
depositors mostly), and thus enjoy a profit.” In other words, it’s a win-win situation, as it
would have to be or nobody would do it voluntarily.

If such win-win situations exist, then the financial system will naturally tend to find a way to
make it happen. For example, what if there was a borrower who had some great uses for
capital, but had a hard time borrowing? They would look around for a lender, and be willing
to pay a decent interest rate. They could look all over the world. They aren’t limited to US
lenders. (In 2006, I was making some loans to companies in China, while others in the firm
17
were making loans to small companies in Mexico and Venezuela. They paid very well.) The
entity that made this loan would probably do pretty well, also. The lender would thus be
profitable. Capital chases the profit. Thus more capital would be directed at this sort of
lending, and the banking system would expand.

To take a more specific example, what if there were lots of wonderful loan opportunities, but
banks today are unable to take advantage of them because of impaired capital? Well, they could
then raise some more capital, which is exactly what they are doing. “We need capital to take
advantage of this wonderful situation. If you buy an equity stake in our bank, we are sure you
will enjoy a wonderful return on equity.” Investment floods into the sector. This has been
happening in a big way in Eastern Europe, where Western European banks are investing
hugely. This is also an argument behind the sovereign wealth funds’ recent investments in big
US banks. “Well, they’re having a hard time now, but they have fantastic franchises and have
proven to be very profitable in the past. We’ll bet on a winning horse, and when the situation
turns around and there are more lending opportunities, the bank will make good money again.”
Or something like that.

Or, a competitor could arise. “Bank A is flat on its back due to crappy lending in the past.
Nobody wants to invest in Bank A because they are such losers. However, Bank A is missing
all kinds of wonderful lending opportunities as a result. I’ll step in and eat Bank A’s lunch!
And you can join me, just invest in my new bank.” Warren Buffet is doing something like this
by challenging the monoline insurers’ core municipal bond insurance business. Thus the total
capital of the system increases, in response to the excellent returns on capital provided by the
abundance of win-win lending opportunities.

To summarize, lending is not driven by capital, rather capital is driven by opportunities in the lending
business. Probably every businessman understands this, as it is true not only of banks but of
practically any industry.

A good example of this appeared in Japan. In the 1990s, we were hearing the same baloney
about how banks couldn’t lend because they didn’t have enough capital, and if there was more
capital, then banks would lend more, and the economy would recover. There was a major
failed bank called Long Term Credit Bank of Japan. The government thought it would use
this bank as an experiment. They effectively nationalized the bank and sold it to some foreign
(US mostly) investors, who effectively made a new bank out of it. (The new bank is called
Shinsei Bank, which means “New Life”. Poetic bank names were very popular in the 1990s in
Japan.) Now there was a brand-new fully-capitalized bank without all the bad-loan difficulties
of the other major banks. Plus, this brand-new bank had (supposedly) best-quality
management, namely those New York sharpies who were going to show us all the most
sophisticated pratices in the financial industry. This new bank would then make all the loans
that the other banks “couldn’t” make, because they were capital impaired. With more loans,
the economy would recover.

Right?
18
Wrong. Actually, at the time, there was very little demand for borrowing, because of the poor
economy. The poor economy was caused, in large part, by monetary instability in the form of
horrible deflation, plus various tax hikes. Debt is very painful in a monetary deflation. Most
of the healthier companies had all the debt they wanted, and more, and didn’t see many
expansion opportunities (requiring more borrowing) in the environment of unstable
money and high taxes. Most of the weaker companies nobody wanted to lend to, nor did they
want to borrow either, as they were spending all their time trying to figure out ways to escape
the burden of their past debts. In fact, the existing large banks were, at the time, searching
very hard for good lending opportunities, from which they could make the profit to pay for
their losses on their existing bad debts, and not finding many. All of this was represented in very
low interest rates (high prices), for both government and good-quality corporate debt, which
shows an excess of buyers (lenders) compared to sellers (borrowers).

So, what happened to Shinsei Bank? For the first couple years, it didn’t do a thing. The lending
market was, in fact, very competitive, and virtually all the demand for debt was satisfied at very
good prices for the borrower (low interest rates), and rather poor terms for the lender (narrow
net interest margin and low profitability). Later on, as the monetary issue was resolved
(reflation), investment opportunities arose again, and both banks and borrowers got together
to take advantage of them.

The New York sharpies still made out very well, however, mostly because of cushy terms given
to them from the government. So, in the end, the real opportunity was not in the wonderful
lending opportunities. The real opportunity was the chance to get a very cushy deal from the
Japanese government. And how did they get this cushy deal? Because of the idea that there would be
some wonderful lending boom and economic recovery if the government gave them a cushy deal.

That is one reason why we see these arguments again and again during these “bad debt” events.
The economists at the big brokerage houses blah blah about it constantly. Some of the
economists are aware of the scam (a little bit), but most are just useful idiots. At the end of
the day, they act like amoebas that swim toward a source of sugar. (If they weren’t idiots, they
wouldn’t be useful.) The useful idiots understand, at some limbic level, that if they talk the
blah blah, they keep getting paid. The journalists pick up on it and magnify it. (Most journalists
have an inferiority complex, making them unwilling to challenge anyone who makes more
than they do, which is about everybody, and amount to badly paid useful idiots.) After years
and years of this blah blah, the politicians relent.

Probably the scammers themselves (in this case the foreign investors) believe the story. Why
not? They aren’t economists either, but they can smell a good deal, and if they can also Play
an Important Part in the Revival of the Japanese Financial System, well, that’s fine too, and
maybe they’ll get an honorary degree or something out of it.

And who is pushing this idea today? Why, it’s the economists of Goldman Sachs! I am soooo
surprised!

19
$2 trillion lending crunch seen Goldman Sachs economist says mounting credit losses could
force banks to significantly scale back their lending.

Are we prepping the waters here for another cushy deal from the government? Maybe? It
might be a different sort of cushy deal. More like a “save our asses by taking our bad debt off
our hands, or lending will contract by $2 trillion!!!” cushy deal.

Bank of America Asks Congress for a $739 Billion Bank Bailout

Well, that’s enough for this week. We are going to be talking about banks around here for a
while longer, I can tell.

***

A reader asked a question via email, and I thought the answer got at some interesting ponts
that other people might also want to think about. This is fairly complex stuff. I touched on
this before, but it’s worth chewing over a bit more.

Q: I did some rudimentary analysis of the monetary base published by the St. Louis Fed and
found that the year – over – year growth rate (of the base) is slowing rather dramatically. While
I don’t think the monetary base per se tells you much about how the Fed is managing the
dollar, it does make me wonder if they’re on to something, more so than they let on, and being
contradictory to their statements that they are trying to increase liquidity to help the credit
markets. If they are targeting base money, they’re not reducing the base fast enough given
what oil, gold, and the dollar are telling us.

Can you help me with my analysis?

20
A: They might be fibbing about the monetary base numbers. But, let’s assume the numbers
are correct.

The Fed can’t really target the monetary base, so long as it has an interest rate targeting
mechanism. Maybe they can sort of bend things in a certain direction, but the rate target will
take precedence.

I interpret the low, or even negative, base money growth as evidence of a rather dramatic
decline in demand for dollars worldwide. The monetary base is about 90% paper bills, and
about 70% of this circulates internationally (perhaps more). If people no longer wish to hold
these dollar bills, preferring euros instead for example (euro base money has been growing
quickly), then the bills tend to end up at banks, and if banks don’t want them (they have no
use for them unless someone comes and takes them off their hands) then they tend to be
redeemed at the Treasury for electronic bank reserves, which are another form of base money.
These electronic reserves are then lent out, which tends to reduce the interbank lending rate
(Fed funds rate), and then the Fed compensates one way or another by selling some assets (or
buying fewer), so that the overall monetary base contracts or has slow growth.

Thus, rather than a proactive attempt to support the currency, I see this low base growth as a
symptom of the dollar being used less internationally. Although the interest-rate targeting
mechanism does reduce the base somewhat in response to this decline in demand, as per the
mechanism outlined above, it does not do so adequately enough to fully support the currency’s
value. Thus, the overall result of the decline in demand is a decline in currency value.

That’s how I see it. The relationship between monetary base growth and currency value is a
lot looser than most people think. You can have a very quickly growing monetary base (Russia
for example) with a strong currency, and a low-growth base with a declining currency (like the
dollar). You can see that Russia’s monetary base growth is high because the currency is strong,
and the dollar is weak, and thus people are dumping their dollars and doing business in rubles
instead.

It is fairly typical to see the monetary base grow rather slowly in inflationary times, in
comparison to the decline in currency value. I used the example of the 1970s, when the USD
base grew about 110% during the decade but the value of the dollar fell by about a factor of
20, or 95%. When inflation is a problem, then a) international holders often dump the
currency, and b) the opportunity cost (interest rate) of holding paper currency increases, so
people hold less of it, preferring interest-paying money market accounts etc. for their “cash”.
Thus we see in Japan in the 1990s for example decent growth in the monetary base, as people
saw no penalty in holding large amounts of paper bills vs bank accounts paying 0% with some
risk of default.
“Liquidity” as it is popularly imagined, is somewhat different than the monetary base. Today,
the Fed is tending to support the credit functions of weak banks. Let’s say that Countrywide
Financial has to borrow from the Fed because nobody else will lend to it. Thus, the Fed lends
$50 billion to Countrywide (hypothetically). However, this means that someone else doesn’t
21
lend $50 billion to Countrywide, and thus has $50 billion to lend somewhere else. This tends
to depress the interbank rate, and the Fed compensates for this via its interest rate targeting
mechanism. Thus the net addition to the monetary base might be closer to zero.

There was no “shortage of liquidity” in the early 1930s. As long as systemwide funds are
adequate (ie interbank interest rates are tolerably low), then banks have no problem
borrowing if their credit is good. Some banks’ credit wasn’t good, and nobody would lend to them,
and thus they blew up. The idea was that the Fed would allow banks to make these decisions
among themselves. It was later thought that, in a crisis situation, the Fed should be more
lenient for reasons we can easily imagine, to prevent systemic failure. In practice, this means
the Fed (or other government agency like today’s FHLB) would make direct loans to banks
that other banks wouldn’t make loans to. This could be through the discount window, term-
auction facility, or simply via repos with shaky institutions. The Fed is doing all these things
now, providing “liquidity” to banks that would have trouble borrowing otherwise. (For a bank,
it is not just borrowing, but borrowing at a rate that doesn’t result in a negative carry.)

Hope this helps.

***

One last thing here, especially for our college-age readers. Here’s the secret of How to Be
Right All the Time.

Are you ready? This is important.

Admit you are wrong all the time.

In economics especially, everyone is wrong a lot of the time. Not only about the future, but
also about the past. I change my mind all the time. I say “I used to think this, but then this
other thing came to my attention, and I thought about it, and now I think this instead.”
Nobody cares much. This is the process of learning. If you keep at it, you might not only learn
things that are new to you personally … you might learn things that hardly anyone has ever
discovered before. Indeed, so many economists (and other sorts as well) are so convinced that
they must never change their mind, that they get stuck with some loser idea for decades, or the rest
of their life. They are easy to surpass, because they aren’t going anywhere. They got stuck in
the mud in their late 20s. If you keep dropping these old ideas, you will be so far ahead of
everyone else that it will appear to them that you are right all the time.

Many of you will surpass me. You will learn everything I know by the age of 30, and then go
on from there. I am looking forward to that.

How Banks Work 5: Selling Loans

22
In our previous discussions about how banks work, we noted that the presence or quantity of
impaired loans on banks’ balance sheets tends to get way more attention than it deserves. The
problem is generally not loans that have already had issues, but rather the flow of new bad
loans, in other words the continuing deterioration of credit conditions, which typically reflects
broader economic factors that banks themselves can’t do much about. Thus, rather than
having bankers do something about their bad loans, it is best for politicians to do something
about the economy.

This can help even those loans that have already had issues, as an improving economy can
increase recoveries for loans, or allow borrowers to become current on their payments, thus
reducing banks’ losses.

Usually there is a pretty clear economic impairment — very often high or rising taxes, or
monetary instability — which can be solved by a policy change. The present situation is
somewhat different. There have always been credit busts, but the present one is rather special
both in its extremity and extent around the world. (I have heard that, to some extent, the US
housing boom in 2001-2002 was centrally engineered to compensate for the recession of that
time — and I’m not talking about the Fed funds rate target alone.) Thus, the present situation
is a bit of an exception to the general rules I’m presenting here. The government should do
what it can to promote economic health, via a better tax system or monetary stability, or at the
very least not make things worse. However, to the extent that the present situation does not
reflect broader economic issues (high or rising taxes, or monetary instability), then the sloppy
lenders and the sloppy borrowers have to take their losses. There is a responsibility for the
government to keep this process from getting too far out of hand, which is why I focused on
bank recapitalization a few weeks ago.

We’re now hearing that our little adventure in Iraq may end up costing the US taxpayer in the
neighborhood of $2.4 trillion, or more (probably). Thus, the government has more than
enough resources to take care of the banking system, if necessary, if it wasn’t expending those
resources to blow stuff up and kill people in the desert.

Typically, as bad loans at banks pile up, there is a suggestion that they “solve the bad loan
problem” by selling the loans. This doesn’t make the bad loans disappear, of course, it merely
transfers their ownership. As far as the broader economy is concerned, it generally matters
little who owns the loan. (These days, most borrowers probably don’t even know who owns
their loan.) As loan losses mount, banks’ capital bases become strained. There are two
immediate ways to deal with this: get more capital, or shrink the balance sheet, possibly by
selling loans. But, a bank could just as well sell performing loans rather than non-performing.
What difference does it make? Indeed, a bank might be better off selling some “good” loans
for $1.02, when the bank thinks there might be problems that will make their ultimate value
more like $0.96, instead of selling some “bad” loans for $0.20, when their ultimate value might
be $0.65. Indeed, to sell “bad” loans for a deep discount can create more losses for a bank. If
a loan is on the books at $0.65, and this is a reasonable figure for ultimate value, but the bank

23
sells it for $0.20, then the bank has to take an additional $0.45 loss on the loan, which means
more capital impairment.

If a bank can sell good loans to others, then it can continue to make loans, and thus we see
that the bank’s capital base is not really a restraint on lending. Indeed, banks have been getting
more and more into this business model over the past twenty years, packaging loans and
passing them along to other investors in the form of asset-backed securities, etc.

We can also see that, if there is a buyer for a loan (good or bad), then in effect more capital
comes into the banking system. It may not be on banks’ balance sheets, but effectively there
is some entity willing to make loans, and that entity has capital.

Typically, banks recognize that in an environment where there is lots of supply of impaired
loans, but not very many buyers, they are better off holding the $0.65 loan and getting $0.65
for it eventually, or even $0.50, rather than selling it off for $0.20 and taking another $0.45
loss. That’s when you start to hear the economists of the big brokerages start to make all sorts
of arguments that banks need to “take care of the bad loan problem” by selling off their bad
loans en masse. Of course the journalists pick up on it, and the politicians start to hear this
from everywhere that “banks could take care of the bad loan problem, but they are being
stubborn and holding on to them.”

This is often driven by the fact that it is quite a wonderful business to buy a $0.65 loan for
$0.20. So, the bad-loan vulture investors start to have private conversations with the
politicians, about how they could Do Wonderful Things for the National Economy if the
stubborn banks would Just Solve the Bad Loan Problem by selling off their bad loans. Often,
the politicians relent and actually force banks, through legislation if necessary, to liquidate their
inventories of bad loans. Since all the banks are then selling all at once, as mandated by the
government, the supply of loans is extreme, and there are not very many buyers, certainly very
few domestic buyers, but only the foreign vulture-type investors who have been quietly
encouraging this whole process. The banks thus sell the $0.65 loans to the vulture types for
$0.20, or $0.10 or $0.02 or whatever. This causes catastrophic losses to the banking industry,
at which point the banks themselves are then bought out by other foreign vulture investors,
including the big banks of the U.S. or Europe. Thus, the process of economic colonization
continues.

Now, selling a loan simply changes ownership. It doesn’t make the bad loan disappear. The
loan still needs to be “worked out” in some way, which can take several years. The original
bank might have been very careful about this process. They have a multi-year relationship with
the borrower. They understand the business, the possibilities, the markets, and so forth. They
make careful plans to get the $0.65 value out of the loan, or maybe more than $0.65. The new
foreign vulture investor is often a lot sloppier about this process. If they bought the loan for
$0.10, it doesn’t really matter if they get $0.20 or $0.30 for it. Either one is a huge profit. They
like to do thinks quick and sloppy, book the profits, collect their bonuses, and buy another
house in Sun Valley. This liquidation itself often has rather poor economic consequences.
24
The foreign vulture investor types probably haven’t really thought all this out. Maybe some of
them have. Most probably believe the myth that “taking care of the bad loan problem” is the
path to economic recovery. They would rather not think about it too much. That could be
inconvenient. In the end, they’ll say anything, and believe anything, if it helps them buy a $0.65
loan for $0.02.

***

One concept that is blowing up in people’s faces right now is that of “mark to market.”
Experienced investors know that, often, “market” prices diverge to an extreme extent from
underlying value. They assume that the market is wrong all the time. The only questions
are: is the market wrong enough to be useful to me, and can I come to a reasonable
determination of how wrong it is? Often, markets are very wrong, but it is difficult to tell how
they are wrong. For example, the market price of Google is probably grossly different than its
actual economic value over the next thirty years. However, it may be hard to say just how
wrong the market is, or even the direction in which it is wrong! It takes experience in investing
to become an experienced investor. Most people, as they do for any topic that comes their
way, look for the consensus. A market price appears to be a consensus, although that may not
actually be the case at all. Maybe the reason that security A is falling in price is due to the
selling of Fund X. Maybe the selling in Fund X is due to redemptions from investors, caused
by Fund X’s losses in security B. It may have nothing at all to do with security A. In any case,
the fact that most people consider a market price to be a consensus creates a consensus that
the market price is a consensus.

Hedge funds and the like are in the mark-to-market business. It’s the game they play. If they
buy WMT at $15 and it goes to $10, then they deal with that on that basis, even if WMT stock
is really worth $80.

That’s why we see, for example, that it is very difficult to use lots of leverage in stocks
(excepting some hedged strategies), because of the daily volatility of stock markets. Just try to
buy-and-hold the S&P 500 at 3x leverage. You would be liquidated on the first 15% decline.
However, private-equity firms regularly use 4x or 5x leverage, because they are subject to the
underlying business, and its cashflows, rather than the silly market.And these are individual
companies. The S&P 500, as a whole, due to diversification, has much more stable operating
characteristics than virtually all individual companies.

However, there are more and more companies, which are really operating companies rather
than investment funds, that are being treated like investment funds. This is getting dangerous.
Take the strange example of Thornburg Mortgage. This is basically a mortgage bank, which
makes loans to upper-income homebuyers. Their clientele is gold-plated. Here is the average
borrower:

47 years old
$435,000 annual income
25
 High FICO
$656,000 mortgage
LTV 67%

Thornburg has had total, cumulative credit losses of $174,000 in the last ten years — on a $30
billion book! At present, only 78 of 38,000 loans (0.2%) are 60 days delinquent. It made $286
million in 2006. Thus, it could take a loss of $286 million, and still be in reasonably good shape.
If it took a total loss on all 78 of its delinquent loans (not likely as they are well collateralized),
that would cost about $50m. Operationally, Thornburg looks fine.

However, Thornburg has become a victim of the “mark to market” mentality. The “market”
has said that loans like Thornburg’s are worth perhaps $0.95. These “losses” made
Thornburg’s balance sheet look iffy. Some of Thornburg’s lenders demanded that Thornburg
sell some of its loans to reduce leverage. Thornburg was thus forced to sell $22 billion of its
mortgages for about $0.95, resulting in a realized $1.1 billion loss. Instead of just sitting on the
mortgages, all of which were paid in full, and maybe, perhaps, experiencing such a disaster that
it recovered only $0.95 on its mortgages, Thornburg ended up taking an actual cash loss in the
market! And, because of the selling of Thornburg and others like them, the market price fell
further! Producing even more problems for Thornburg!

Let’s think about what would have to happen for Thornburg to actually take a 5% loss on its
loan portfolio. Let’s assume that the price of the houses that serves as collateral for Thornburg
falls by a whopping 50%. Remember, the LTV is 67%. So, if the house was originally appraised
at $1m, then there would be about a $670,000 mortgage on it. (Which is just about in line with
the actual figures.) Then, if the market value of the house fell by 50%, the house could be sold
for $500,000. Remember, this is an average, not just the single worst house in the bunch. Thus,
Thornburg would have a $670,000 mortgage and a $500,000 house, for a loss of $170,000.
That would be about a 25% loss on a $670,000 mortgage. Now, people don’t just stop paying
their mortgages just because their house is worth less than before. Certainly not people making
$435,000 a year. But let’s say there is mass job loss among these borrowers. 20% of them lose
their jobs and are unable to pay their mortgage. 20% — that is a huge figure. That’s 6,707
mortgages — compared to 78 presently. And, none of these 20% has any other assets that
could be used to pay off the mortgage. (Remember, these people are making $435,000 a year.)
It’s just a total disaster — which doesn’t really happen in real life. Some of the borrowers pay
the mortgage by selling their yacht, or their vacation house, or some stocks, or their third and
fourth cars, or whatever. Or the loan terms are changed so the monthly payments are less, so
the borrower keeps paying and there is only a partial loss. Or maybe they get another job. But
if all these terrible things happened, the loss would be about 25% * 20%, or 5%. Or $1.1
billion. And, that would be spread out over a couple years, so that the losses could be matched
against income from performing debts. You can see why Thornburg has had so few realized
losses over the years. It takes absolute Armageddon for them to suffer a 5% loss.

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And what happened to the people who bought mortgages from Thornburg? After all, if the
mortgages were basically OK, then they should have done well, right? No — they blew up
too!

Peloton Partners Asset Sale

These were smart guys — and they bought best-quality mortgages, like those of Thornburg.
They bought with only 5x leverage, which is about half that of a normal bank. However, with
all the other sellers hitting the market — Thornburg-like entities — prices collapsed further
in February. Now Peloton has to sell, into the collapsing market, causing — you guessed it —
more problems for Thornburg.

Thornburg is now in default. It may go bankrupt and be liquidated.

Operationally, everything is fine. People are paying their mortgages on time. However, due to
today’s rather extreme allegiance to the “mark to market” concept, entities are blowing up
right and left.

How Banks Work 6: Liquidity Crises and

Bank Runs
What has the Fed been doing recently? A little hard to understand, right? The technicalities
tend to get brushed into generalizations. It was a “bailout.” They’re “printing money.” And so
forth.

The problem faced by a number of financial entities recently — banks, brokers, SIVs, Carlyle
Capital, etc. — has been the equivalent of a “bank run.” These entities borrow lots and lots
of money. Remember our look at Wells Fargo’s balance sheet.

A lot of that money has a short maturity. Lenders can ask for it back on short notice. Zero
notice in the case of demand deposits, and typically under a year for a lot of other sorts of
lending. Let’s say you’re a bank. Your lender says, “gimme my money back.” You have to give
the money back, or you are in default and on your way to bankruptcy. The thing is, you don’t
actually have any money. Remember Wells Fargo’s teeny weeny reserve? All you have is a huge
pile of assets, primarily loans. What do you do? Usually this is no big problem. A bank like
Wells Fargo is considered to be a good credit. Wells Fargo just borrows the money from
someone else. They borrow from Lender B and pay back Lender A. The total amount of
borrowing on the balance sheet doesn’t change. This happens constantly in the day-to-day
activities of banks.

This is why a modern bank apparently doesn’t need “reserves.” They can borrow on a
moment’s notice.

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However, let’s say word gets around that a certain bank is maybe not such a good credit.
Lender B starts to think “hey, if I loan Bank A some money, then Lender A is getting all their
money back. But, I might not get all my money back. In fact, if Bank A declares bankruptcy,
I might have to spend the next two years at the county courthouse to get my money back.
That might be unpleasant.”

Lender B starts to think that maybe they would end up a bagholder.

So, maybe Lender B says “OK Bank A, I’ll tell you what. You have to pay me an extra 100
bps per annum for the money.” And, since Lender B is not the only lender with concerns,
Bank A pays the 100 bps.

Now what do we have? The net interest margin contracts. Remember that the pretax return
on assets was only about 2.5%. So, if you give Lender B an extra 100 bps (1%), and all of your
funding costs also rise by 100 bps, then your return on assets falls to about 1.5%, which is a
pretty big haircut (40%). At the same time, you may be facing credit losses (which is why
Lender B is asking for the extra 100 bps in the first place), so profitability looks even worse.
This is one way a bank can get into trouble, simply by paying a little more for funding due to
perceived credit risk. In this case, a bank may decline over a period of years.

Maybe Bank A is in a little more trouble. Lender A wants its money back, but Lender B (or
other potential lenders) say: “Hmmm, sorry. We’re not doing that anymore. If something goes
wrong, I could lose my job.” Pretty much all the decision-makers in a bank are functionaries
climbing the corporate ladder. It’s not their money. They do whatever they perceive to be the
highest-probability route to the next rung on the corporate ladder. One month, that might be
making 30-year NINJA mortgages with no money down. In fact, if they didn’t make these
mortgages, they would have been kicked off the corporate ladder. “Our loan production isn’t
keeping pace with Bank B! Shareholders are getting antsy. Who is responsible?” The next
month, they won’t make a collateralized short-term loan to an international blue-chip financial
institution with public accounting. “If you end up a bagholder one more time, outta here!”
Considering the NINJA loans owned by Bank A, this might be a good idea, come to think of
it.

Now Bank A has a real problem. Lender A wants their money back, but there is no Lender B.
This is somewhat like a “bank run” of yore, but it is taking place mostly at the institutional
level. ABCP issued by an SIV is maturing, but nobody wants any new ABCP issued by this
SIV. What to do?

One thing Bank A can do is sell assets. In normal times, usually this is easy to do. Markets are
“liquid,” meaning that a bank can easily find a buyer for a reasonable price for its assets. When
there is only one Bank A with problems, and lots of other banks that are fine, everything is
OK. The problem today is that there are lots of Bank As, and SIVs, and collapsing hedge
funds, and so forth. Plus, a lot of this stuff is complicated. As in, really really complicated. What’s
in this packaged mortgage stuff? People used to rely on the rating agencies, who had big staffs
28
with special training to understand all the complications of structured finance, on top of all
the complications of mortgage lending. Unfortunately, now everybody has figured out that the
rating agencies’ ratings are totally fictitious.

Everybody wants to sell. Nobody wants to buy — unless the price is good enough that you
can say: “OK, can’t lose on this one.” Let’s say you’re buying some best-quality mortgages for
$0.90. We saw last week that it takes a neutron bomb going off in Palos Verdes (a super-
wealthy neighborhood in Los Angeles) to make a 5% loss on best-quality mortgages. Maybe
their economic value is $0.99. If you buy at $0.90, you’re getting paid perhaps a 7.2% yield
(6.5%/0.90). You’re borrowing at 3.50% from your prime broker. (Fed funds plus 50 bps is a
common borrowing rate for investment funds. The Fed funds rate is literally the rate that
banks borrow at for the short term, so the bank is making a 0.50% spread by lending to you.)
At a modest 5:1 leverage (like 20% down for a house, and since mortgages are collateralized
by houses, it’s sort of like buying a house in a sense), that’s a yield of 7.2%+ 4*(7.2%-
3.5%)=22%. Nice! And then, when the market normalizes and you can sell the mortages for
$0.99, that’s a 10% capital gain as well, or a 50% capital gain at 5x leverage. If that takes 12
months, you’re looking at 50% capgain plus 22% yield for a total return of 72%. Honey!

Time to trade up that yacht!

And they would deserve it. A good fund manager is one who can take some abstract
information like “Thornburg Mortgage Series 27 MBS $0.90 asked on $757 million face” (I
think that’s about right — I’m not a fixed-income guy) and see: “72% return in 12 months
with low risk.” It’s a rare skill, one that takes great training and discipline.

The problem is, some entities that thought they couldn’t lose, at the price they were buying
and the modest leverage they had, lost big. Like Peloton Partners. Even though paying $0.90
for an asset that probably has an economic value of $0.99 looks good on paper, a lot of
potential buyers are wedded to the mark-to-market convention. If they get a great deal at $0.90,
but someone gets an even better deal at $0.85, then they have a 5.5% capital loss ($0.85/$0.90
-1) on a mark-to-market basis. At 5x leverage that is a 28% capital loss. In a single month
(February). If you report that to your investors, a 28% down month, they all tell you that they
are giving 30 days notice for redemption on March 31. Plus, the fund’s prime broker is getting
nervous. These guys lost 28% in a month! And now, instead of having $5 of mortgages and
$1 of capital (5:1 leverage), they now have $4.72 of mortgages and $0.72 of capital, or leverage
of 6.6x. So the prime broker says: “5:1 leverage didn’t work so well. You’re going to have to
take your leverage down to 4:1.” In effect, a margin call. The fund managers see 30% of their
capital leaving (redemptions), and demands for leverage at 4:1. 30% of $0.72 is $0.22, so they
have $0.50 of capital left. 4x $0.50 is $2.00. They own $4.72 of mortgages. Now they have to
sell $2.72/$4.72 or 58% of their entire holdings. Remember, everyone else is trying to sell too.
The last transaction was at $0.85. Where are the bids for 58% of your entire holdings, for a
quick sale? At $0.80. Instant fund annihilation. (Not to mention that the guy who bought at
$0.85 is going to have some ‘splainin to do.) Leverage is super-nasty when you get on the
wrong side of it, especially in a mark-to-market situation.
29
Other funds look at this, and think about it, and decide that the thing to do is to take no
leverage whatsoever. So they buy the stuff at $0.80. They’re getting paid about a 8.125% yield
(6.5%/0.80), and could have a capital gain of 25% as the value goes back to $1.00. Over a 12
month period, that’s a total return of 33.125%. Which isn’t 72%, but you have to admit, that
doesn’t suck a bit. Very super safe. No margin calls. The problem is, they can only buy a little
bit, because they aren’t using leverage.

You can see why buyers are a bit nervous here. But back to Bank A. They’re trying to sell.
Normally, they’d be able to sell at $0.99, the economic value, even in a recession (in which the
economic value is impaired). If there wasn’t a recession, they’d get $1.00 or maybe $1.02. (The
mortage broker business — like Countrywide Financial — was built on lending $1.00 and
selling the loan for $1.02. This is a lot of fun on big volume.) The bid is at $0.85, or $0.80.
Don’t want to sell there. They would have to revalue the entire loan book at $0.80, if they are
subject to mark-to-market accounting themselves. Or maybe there isn’t a bid at all, and you’d
have to hire someone to make phone calls to find a buyer. So, they do nothing. The market is
“frozen.”

Nevertheless, Lender A wants their dough, so it’s off to the Lender of Last Resort, the central
bank. And, since I would really like to get at least a little exercise this week, that will be the
topic for our next installment in this series.

How Banks Work 7: The Lender of Last

Resort
Last week, we talked about what happens when a bank, or a similarly levered financial entity
like a brokerage, SIV, certain types of hedge funds, etc., has a “bank run.” In other words,
lenders (depositors) want their money back. The bank has to either borrow from someone
else, or sell assets.

If nobody wants to loan them money, and they can’t sell assets effectively, then they go to the
Lender of Last Resort, the central bank.

This is actually close to central banks’ original purpose. They were never intended to
manipulate interest rates and manage currencies. That is something that happened later, after
the Great Depression, when economists convinced themselves that manipulating interest rates
and fooling with currencies would be helpful.

Central banking was originally developed, in the mid-19th century, to alleviate the liquidity-
shortage crisis. This was accomplished by making loans, effectively increasing the supply of
base money. The characteristic symptom of a systemic liquidity-shortage crisis is high
interbank interest rates. Very high. Typically over 10%, when 3% might be a normal figure,
30
and often above 40% during the crisis. Today, central banks’ interest rate targeting
mechanisms effectively keep something like that from occurring, so the classic 19th century-
style liquidity crisis doesn’t really exist any more. You can read about it in Chapter 8 of my
book. 1907 was the last liquidity-shortage crisis in the U.S. Interbank rates went over 100%
— for best quality credits.

The risk of having to pay such a high penalty rate, or perhaps not having access at all to funds,
is the reason that banks held much larger reserves in those days, on the order of 10% of
deposits. Banks today can accomplish a similar thing by holding very liquid securities, such as
Treasury bonds or perhaps deposits/loans with other banks.

Central banks haven’t really used direct lending for many decades. They discovered that they
could keep interest rates from spiking via open market operations. This was done in conjuction
with the gold standard, but it was on the slippery slope to interest rate manipulation and
floating currencies. The advantage of the old system of direct lending was that there was
typically a rather harsh penalty interest rate, of 10% perhaps. Banks would only borrow at that
rate in dire circumstances. And, when things settled down, they quickly paid the money back.
This is the “self-cancelling commercial bill of credit” you sometimes read about in old
economic discussions. The involvement of the central bank in the monetary system was rare,
brief and self-reversing.

One advantage of the system of open market operations is that it leaves questions of solvency
to the market. The central bank can buy a Treasury bond, paying for it by “printing money.”
The money from this sale typically ends up at a bank — although, you should notice that the
money was not directly given to a bank. It was given to the seller of the bond, in trade for the
bond. This additional base money is often lent out on the interbank market, thus creating a
tendency toward lower interest rates. However, who is it lent to? That is up to the receiving
bank to decide. To someone solvent, presumably, rather that to an insolvent entity.

An entity can remain in business even if it is insolvent, if someone keeps lending them money.
You can probably identify many households with that characteristic. The bankrupt S&Ls, like
those of Texas, stayed in business for years in the 1980s because FDIC deposit insurance kept
people from withdrawing their deposits.

The central bank was never meant to prop up weak institutions. Sometimes it is difficult for a
lay person to recognize the difference between bank illiquidity and insolvency, but bankers
understand well. Typically, an institution will be weak for months or years, due to deteriorating
asset quality (bad loans etc.), before they suffer the final collapse in liquidity (“bank run”).

Thus, in the Great Depression, banks which were weak — those that had made too many real
estate loans during the Florida property bubble for example — were expected to go under.
After all, they didn’t know they were in the Great Depression. That label was applied many
years later.

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After the Great Depression, it was determined that the government should have some role in
preventing a “systemic collapse.” Probably they should have “prevented” it by not hiking taxes
to the moon. Central banks were not supposed to be government agencies, but rather
something like a banking industry association, or simply a dominant commercial bank like the
Bank of England was. Since central banks were already in existence to “make loans to banks,”
to serve as a “lender of last resort”, etc. etc., this new government role was laid upon the
existing central bank organization.

I am not particularly opposed to government support of the financial system to prevent

“systemic collapse.” (I put it in quotes because it is complicated to define or describe, but
everyone knows what I’m talking about.) Typically, as in Japan or the U.K. recently, or in many
other countries with banking problems, this has taken the form of a direct government loan
to the bank. In the U.S., however, people seem to look to the Federal Reserve for this role. By
making a loan to the bank, the government acts as the Lender B we described last week. Note
that this is a loan. It is supposed to be paid back, just like a commercial loan. If it is not paid
back, the bank is bankrupt just as if it defaulted on a commercial borrowing. Thus, ideally,
“taxpayers” get all their money back. The government’s role is to step in when fears of
insolvency prevent a significant financial institution from finding another lender. The
government turns something of a blind eye to asset deterioration, in recognition of the risk of
“systemic collapse.” In the midst of high drama, it is hard to tell what assets are worth anyway.
The Fed, via its discount window lending and other such direct facilities (we seem to get a new
one every week these days), is also able to turn a blind eye to asset deterioration. This isn’t
really “nationalization” either, as the government doesn’t have any ownership in the bank
(equity). The bank would be nationalized, at least partially, if the government recapitalized it.
However, even this is not really a “bailout” in the sense of free money. Existing shareholders
would be diluted, and likely take a loss overall.

This lending doesn’t really do much for insolvency, alas. Lending affects the Liabilities side of
the balance sheet, but not the Assets side. If assets are deteriorating, lending can’t help.
However, it prevents a fire sale of assets, and also takes care of short-term liquidity issues,
which alleviates the “systemic” risk. If the bank has troubles but manages to right itself, it
eventually pays back the goverment loan and continues as a regular bank. If the bank is unable
to right itself, then it has an “orderly liquidation” or perhaps a sale and merger with another
entity.

The Fed has invented many different types of “loans,” including repo agreements and various
swaps. They generally function much like loans, however.

Unlike the government, or other commercial entities, the Fed actually creates fresh money
when it makes a loan. In many cases, this fresh money is likely “sterilized” via the interest-rate
targeting mechanism, so that overall base money doesn’t necessarily change much. In effect,
the Fed’s assets show an increase in lending, and a decrease in securities related to open-market
operations, mostly government bonds. Indeed, the recent swap facility accomplishes this
rather directly. Roughly 50% of the Fed’s capacity to make direct loans/swaps/repos/etc. has
32
apparently been used thus far, for a total of $400 billion of such activities on an $800 billion-
ish balance sheet. The Fed can’t exceed its $800 billion-ish without resorting to direct money-
printing. It would be rather exciting if we got that far.

All in all, I don’t think the Fed has done anything particularly unseemly thus far regarding its
lending activities. Probably a rather good job, given the situation. The problem is that, while
doing so, the Fed is allowing the currency to become a big problem. Also, the Federal
government should at least ready itself to take a bigger role, perhaps by recapitalizing financial
institutions, or by making additional loans if the Fed’s capacity to do so is exhausted.

Notice that we haven’t once mentioned either interest rate manipulation or changes in
currency value. The Lender of Last Resort function is independent of these later functions,
which didn’t really come to full bloom until after 1971. Thus, we see that the role of the
government/central bank (it should really be the government instead of the central bank) in
preventing “systemic collapse” does not require a floating currency or interest rate
manipulation, or even a central bank. Nor are these functions contrary to a gold standard. A
gold standard just keeps the value of the currency stable. That’s all it does.

Later, we will talk about floating currencies and interest rate manipulations, and how those are
also outgrowths of the Great Depression.

***

Bailout Watch: If there’s anything happening that most resembles a “bailout,” it is the defacto
nationalization of Fannie Mae and Freddie Mac last week. Fannie and Freddie plan on buying
$200B up to “trillions” of mortgage paper. Doug Noland of prudentbear.com has the details.
Like other closet Mogambo fans, he seems to share a fondness for Dramatic Capitalization!

http://www.safehaven.com/article-9751.htm

***

People talk about the S&L “bailout.” S&Ls weren’t “bailed out.” They were liquidated.
However, the depositors were FDIC guaranteed, up to a certain point. Thus, the depositors
got their money back. It was the depositors that were bailed out. There was a lot of thievery
and fraud going on at the time too, mostly within the government (and the Bushies were
heavily involved), to pocket a piece of this bailout for themselves. Then, the S&L assets were
liquidated. This was another great chance for certain insiders to make a bucket of easy money.
They just sold themselves loans/assets that were worth perhaps $0.50 or $0.20 for $0.02. I
believe they even got easy government financing to buy these loans. Thus, they had $0.02, but
bought $5.00 of loans for $0.20, using 10x leverage. This is pretty much like hitting the lottery,
except that no luck is involved. Bankruptcy and liquidation are great times to make a lot of
money, without much risk, when nobody is noticing.

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***

Interesting little essay on similar themes here:

The Shadow of the Depression and the Lesson the ’70s

***

Nice series of articles on naked shorting of smallcap stocks, by the CEO of Overstock.com,
Patrick Byrne. This is some serious research by a smart guy, who has experienced this first
hand.

http://community.overstock.com/deepcaptureblog/

***

Meanwhile, back at the ranch … MBIA and Ambac are still without plan or rescue (although
Ambac has a little more capital), and the housing/mortgage market continues to deteriorate.
Now, we’re starting to get economic issues like job loss and declining revenues. I think that
this year, the housing market is going to start seeing some “give up.” Prices are still way too
high. We could get a “dislocation” to the downside.

The Subprime Crisis is Just Starting

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