Thursday, February 19, 2009

Our Ponzi Banking System

“Give me a lever big enough and a place to stand on and I will destroy the world.”

Oh, wait. That’s not exactly what Archimedes said. Of course, Archimedes never dreamed of the kind of ingenuity alchemy that would be practiced by our modern financial “wizards.” All they needed was a minuscule amount of capital and a lever arm so long it bent under its own weight.

I found a good intro. to bank leverage at Option ARMageddon. The first installment provides 2008 Q3 bank leverage calculations along with a discussion of how dangerous such leverage is. There are a couple of shorter follow-up posts here and here. The leverage calculations were recently updated for Q4 here. As the posts point out, these leverage numbers are likely to be conservative because they don’t account for “other assets” or off-balance sheet assets (e.g., special investment vehicles). Yet the numbers are still scary large.

In the “good” times, a bank with a 30x lever would make a 150% return on equity when its assets appreciated by just 5%. But now that the bill for this unsustainable leveraged credit bubble has come due, this same bank would be insolvent if its assets dropped by just 5%. And the collateral that is behind much of these assets has obviously fallen by far more than 5%. As these losses become actualized by the foreclosing housing market and a tanking economy, the pressure will mount on the bank to mark these assets to market (i.e., what the market is willing to pay for them today) instead of marking them to model (i.e., what the bank’s management optimistically thinks the assets would be worth in a stable and only slightly depressed market) thus exposing the bankruptcy of the bank’s business model. Since a 30x bank can only absorb a small portion of the losses, the rest of the losses must go elsewhere. And since the other big banks are also levered up with these tanking assets, they can’t deal with their own slop much less take on more slop.

This means that you (the taxpayers) get to bail out the guys who were getting crazy rich from the lever arm in the up years. You never saw any of these bonuses, of course, but you will certainly see the losses. They received the 30x profits but you’ll get much of the 30x losses. Our government will ensure this in order to avoid the cascading cross defaults that would result if these banks were to begin falling. When Lehman went down, the financial markets nearly ground to a catastrophic halt as Lehman’s levered losses threatened to bring down its numerous counterparties and credit default swaps (insurance contracts taken out on financial instruments such as bonds that pay out if and only if the instrument defaults) on Lehman’s debt were triggered that crushed AIG (which was also heavily leveraged with very little capital and huge credit default swap obligations). The government and the Fed had no choice but to jump in and stop this massive domino pattern from erupting (whether or not their actions were the best of the available options is another matter).

But as the latest numbers show, the banking system is still highly leveraged. The more the economy falls, the crappier these bank assets will become. It hardly looks like we’ve found the bottom yet. The scary scenario is this: the leveraged debt bubble is so big that even if the Fed prints money with both hands flailing, it still wouldn’t be enough to fill the credit black hole as it implodes. I don’t know how likely this is but the banks’ balance (and off-balance) sheets don’t inspire confidence.

Obviously there is nothing “free market” about a system predicated upon dumping huge economic externalities onto the rest of the economy and especially onto taxpayers (i.e., the banking version of an industry-wide pollution racket designed to lower the costs of production). The gains were all privatized while most of the risks and costs were socialized. Even apart from our fiat currency or the usual Fed manipulation of money and credit, the free market was dead in the banking sector years before the first bailout.

Bernie Madoff was a lightweight. Unlike our ponzi banking system, his puny $50B scheme was never a threat to bring down the entire world financial market.

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