Sunday, October 16, 2011

Bank Transfer Day Danger: Leverage

I'm thinking this morning about leverage. This is a financial thing, where you take the money you have, and use it as a base for loans.

For example, if you have $10 in cash, according to leverage rules you can borrow up to $100 out there. There are other rules involves - if it's a unsecured loan, the leverage ratio you're allowed to go with is something like 1:10 (with $10 you can borrow out $100), while for mortgages you can borrow out 1:20 (with $10 you can borrow out $2000).

The idea is that each loan has different risks - home ownership -is- was considered safe, so you could offer more loans based on it. Then again, that was when there was no such thing as "subprime", and even FHA loans (which are insured) were rarer. But "in the day" a mortgage required something like 20% down (so the owners had more cash riding on it, and it was easier to get their equity back).

Anyway. The issue here is that banks have kind of - well, screwed with the system. First by offering more subprime loans, which their leverage is closer to the 1:10 ratio. But that's where out friend bundling comes in, where the investment firms put together a bunch of mortgages and sold "shares" of those mortgages on the stock market. If you bundled enough "good" mortgages with "subprime" mortgages, the entire bundle could be considered "good" so the banks could still leverage the 1:20 ratio.

Which means they could be riskier with their money, which means when those subprimes crashed so went all of the money the banks had used to make those loans, hence why the financial system blew up.
There's a lot more to it than that, but there's the issue in a nutshell.

So why am I thinking about this? Because there's a growing movement of people pegging November 5th as "switch to a credit union" day. The idea here is that:

1. The big banks blew up the economy, so we want to take away their source of power: money.

2. Credit unions are membership owned, not stock market owned, so there's less incentive to take those crazy risks for profit.

3. Regional banks can be bought up by the bigger banks, whereas to buy up a credit union a big bank (like Bank of America) would have to totally redo the credit union's charter, and get the permission of most of the "stockholders" (aka - the credit union members) before they can do so.

Sounds like a great idea. Only - I'm worried.

I'm worried because I wonder just what the "big banks" will do as more and more of their cash deposits vanish. What happens to all of those loans that were made? They'll have to sell them off.
And the problem is there's still a lot of stuff that's toxic, especially all of these home loans that are being foreclosed upon. Now, in an ideal world, the big banks would go out of business, the deposits would be protected by the FDIC and transferred to another bank, the stockholders would lose out and next time form companies that don't take such risks.

I'll wait for the laughter to die down.

The downside of this is another wave of major financial collapse. The stock market alone would take a pounding, which means those pensions/retirement accounts would be even further reduced - and things are bad enough already. Not to say all of the layoffs as the big banks died (and my money says while they went on the CEO's and major executives would still get their nice golden parachutes).
But the other alternative is just as terrible: more bank bailouts. Before, the toxic assets were bought up by the Fed at nearly "paper value" - in other words, if the bank made a bad mortgage for $1,000,000 on a house that is now worth only $200,000, the bank got nearly $1,000,000 from the Fed as part of its toxic asset buy up (this was part fo the "save the financial system from itself" move - and wasn't accompanied by major hard new rules enforcing behavior. Nope - if anything, the financial system has spent millions lobbying congress not to touch them).

So if people take their money out of the banks en masse and put it elsewhere, my greatest fear is the US government will say "oh noes - Bank of America is going to die! Here, we'll buy your stuff at paper value. Granted, you leveraged $1 to become $20 (or more), so really you're making a massive profit, so it's canceling out all of the people who took money out of you, and now you're just as strong as before - but we can't let you special special too big to fail banks die!"

If it sounds like I'm saying "nothing might change if people take their money out", I kind of am. I hope not. What would be best is if the US government, instead of rescuing the big financial firms this time, broke them up into smaller parts, enforced hard regulations and took the financial system back about 30 years so they behave better, like they did between 1940 to about 1980 or so.

Yeah. I'm not confident that's going to happen.


Blossom Leang said...

What happened to the Final Fantasy XII walkthrough? :(

John Hummel said...

Gone, Ms. Blossom. It's all gone.