Tuesday, March 5, 2013

Insolvent Banks, Fractional Reserve Lending and FDIC

One interesting fact is that most banks are currently insolvent. There is also a lot of blame to go around for the financial crisis. But the banks should be the most responsible party. They use so-called fractional reserve lending (FRL), which created inflation during the bubble years and is creating deflation now. FRL increases leverage. It was the banks' monster revenue generator and now is causing them tremendous pain.

Now, there is no need to worry if you are under FDIC limit, but without FDIC I would be very worried about my money.

So here is how fractional reserve lending works. Banks can lend money while holding only fraction of the amount in reserves. Doesn't sound scary? It is.

Imagine you have $1,000 and keep it in your wallet or at home without spending it. So you have the $1,000 and it is safe and secure (unless you get robbed or have a fire, etc.)

Now imagine you take your $1,000 to the bank and assume that the bank will put your $1,000 in a safe. You feel that your money is safe and secure. But this is not what is happening.

The bank uses FRL to keep the fraction of your money in its reserves and lends the rest out. So, assuming the reserve requirement is 10%, the bank keeps $100 and lends $900 to someone to buy a car, a house or simply to spend using his/her credit card.

Let's assume the person who got the $900 in question is Joe and he got it as a part of the loan to buy a bike. So Joe turns around and gives $900 to the seller, whose name is Jim. Jim takes $900 and deposits into a bank (the same as yours or the other bank). The bank keeps 10% ($90) as a reserve and lends $810 to Nancy as a part of the loan to buy a house. She spends $810 on the house (among with more money from other depositors) and the seller (Karl) takes $810 to the bank (again, among with more money from other depositors).

The process repeats many times over. So, as a result, we now have almost $9,000 extra dollars going through the economy, generating inflation. BTW, I use the Austrian economic definition of inflation as the expansion of the amount of money and credit. Prices (e.g. CPI) follow, so generally inflation causes prices to go up and deflation causes them to go down.

Compare the two outcomes (money at home or at the bank with no FRL vs. money at the bank with FRL). Instead of 0 money going into economy, you end up with almost $9,000, which is not only higher than the original 0, it is much higher than the $1,000 that really exists.

So, the lower the reserve requirement, the more credit is created and that causes prices of assets (along with food, oil, etc.) to go up. Housing bubble anyone?

The assets are used as collateral to obtain ever larger loans as the asset values grow like mushrooms. Banks are using tons of money and everyone is happy. The age of prosperity has arrived. Until the music stops. If the value of the collateral starts going down, the process works in reverse. As the value of the house goes down 20%, the bank has to make provisions for losses (even if the owner is still paying) or record losses (if the owner defaulted and the house is foreclosed upon and resold).

What if all houses loose 30% and the default rates on credit cards, auto loans and other debt increase to 10% (for simplicity's sake, lets assume that the weighted average of losses is 20%)? The banks in aggregate loose 20% of the $9,000, which is $1,800. $1,800 is obviously more than the original $1,000. So now banks have to come up with money from somewhere. Banks have excess capital - money collected from creditors when banks issue bonds or from shareholders when the bank sells stock (shares of the bank) during an IPO or a secondary offering.

So the bank's shareholders and creditors have to loose $1,800 so that you can get your $1,000 back.

Let's not forget that the losses create a contraction of credit because every $1,800 lost reduces credit in the system by almost $16,200. This is deflation. This also causes "credit crunch". Deflation causes additional declines in prices of houses and other items used for collateral, triggering more losses. This is called positive feedback loop (very frequently incorrectly called "negative" feedback loop; "positive" or "negative" does not refer to "good" or "bad", but to whether the feedback is amplifying or counteracting the original change).

So housing prices fall more, banks loose more money and at some point become insolvent (liabilities exceed assets). But the government cannot allow this to happen. It allows banks to engage in accounting fraud known as suspension of mark-to-market rules. This allows banks to pretend that the loans they made are still worth close to 100% of the money loaned, even if the loan is delinquent (until the foreclosure or/and a foreclosure resale happens). This is one of the reasons you hear about people not paying the mortgage yet not yet being foreclosed upon. The banks don't want to take a loss.

The government takes taxpayers' money and injects capital into banks thinking that through the "magic" of FRL the injected money will be magnified and credit expansion makes everything better. Since for every $1,000 of extra capital (be it your deposit or government injection) there will be approx. $9,000 of loans made (using our 10% reserve requirement), things should be great again. But they aren't. The banks are not lending as much because of the above-mentioned positive feedback loop of falling asset prices and deflation. And consumers are not borrowing due to poor economy, falling asset prices and deflation.

BTW, the "bailout"/capital injection is not a giveaway. The government expects the repayment at some point, with interest. So, provided this happens, this is not bad for taxpayers. But this is not good of the bank or its depositors. Because the bank is still insolvent. The money given by the government solved nothing, but just delayed the inevitable. There is a hope that banks will be able to "earn" their way to solvency. Whether this happens remains to be seen.

A lot of banks went belly-up for this very reason. FRL allowed them to lend money they didn't own. If you lend out $900 and owe $1000 to the depositor and only keep $100, a loss up to $900 can occur. Any loss has to be taken by the bank using the bank's excess capital. Shareholders or bondholders of the bank must take losses until the bank has no excess capital anymore and becomes insolvent.

But the government didn't want the bank bondholders and equity holders to take losses they rightfully deserved to take.

The major banks used the suspension of mark to market accounting to report fake "profits" in the beginning of 2009, causing their stock prices to go up. When the prices went up, they held secondary offerings to sell new shares of stock to get money from "investors" to use for future losses. Still, this doesn't make them solvent.

Some say we are "saved" by Bernanke, Paulson and Geitner. Unfortunately, nothing is further from truth.

Absent FDIC insurance, which is backed by the faith and credit of US government, I would not put any money in any bank. Even though the government cannot afford to have a major run on the bank and therefore would probably protect depositors to some extent, this is a major risk.

FDIC is running out of money, but can borrow from the US Treasury and can increase fees it charges banks.

With FDIC, I would not put more than the FDIC limit in any of the bank accounts. 

One more thing is certain: we are following the path of Japan to "lost decade(s)", deflation and zombie banks.

Disclaimer: The above is not an investment advise or guidance. It is not intended as an investment advice or guidance, nor is it offered as such. It is solely the personal opinion of the writer, who is NOT an investment counselor/professional.

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