Why Banks Are in Trouble

The media reports that all mortgage defaults in the U.S. amount to approximately 1.5 or 2% of all outstanding mortgages. That doesn’t sound like much, so why is it a problem?

Banks’ leverage is 30 times – meaning that for every dollar they have, they can loan out $30. Therefore, if a bank uses its full capacity to give out loans, and then just 4% of all oustanding loans default, the bank will be wiped out. (If you have no cash on hand, how can you loan out anything?) The more loans/mortgages are in default, the less the bank can loan out, because it now has less money to leverage against.

And then it goes like this: less cash on hand -> less able to loan out -> less able to make money on the loan interest.

This is a simple explanation for the people like me, with only basic understanding of banks and credit. If I made a mistake here, please correct.

4 Comments

  1. ducati998

    Kat,

    Banks are indeed leveraged as high as 30x, however the mechanism is slightly different.

    Banks that take DEPOSITS and lend against the deposits can only leverage 10x this is due to fractional lending. If combined with due diligence on credit risk, then generally they are not a problem. In point of fact most of the deposit based Banks are in *reasonable* capital ratio condition.

    The problem lies with banks that sell short/lend long; viz. they access the wholesale money markets for capital, then securitizing and selling the resultant loans in MBS. With the credit markets no longer accessible, and MBS markets closed until further notice, Banks holding unsold inventory of a falling market value are in deep doo-doo.

    Hence the Federal Reserve stepping up to the plate to save their arses [again] Citi, the proverbial poster child of every banking crisis since 1934 is at the forefront once again.

    This mechanism allowed the Banks to leverage to 30x and higher once you take SIV’s into account + credit revolvers that don’t even appear on ANY Balance Sheet [until drawn down] thus making Banks even riskier than they appear.

    jog on
    duc

  2. Thanks, Duc.

    I read somewhere that leverage is 9x or 10x, but it sounded like it was the case in the past. So it’s still the rule, but only for loans against the deposits.

    Banks sound even scarier than I thought. (I’m very late to the party but want to short some of them, MER for example.)

    Would you be buying any banks now, or is it too early? I remember you said that some regionals look good already, but what about big ones? Again, I’m not looking to go long any banks, I want to short them.

    Just wondering if you think the worst is behind us. There seems to be a lot more people thinking that this time it really is the bottom and the market is forward-looking, and all those things…

  3. ducati998

    Kat,

    I have bought banks, although Convertible Preferred rather than common stock, a diversified list via a Convertible Preferred Mutual Fund.

    There will be lots of volatility in the banks, but that makes them difficult to trade on price.

    The worst is behind us, as soon as the Fed. stepped up and backed them, it was pretty much assured *most* will survive. Bear Stearns an obvious exception.

    I wouldn’t be short the banks, you’re far too late to the party I think.

    jog on
    duc

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