InvestorsFriend Inc. Newsletter September 28, 2008
The Banking Crisis – What’s at Stake Here?
The Banking Crisis could lead to much higher borrowing costs for individuals and businesses. It may mean that all of us find that our borrowing capacity is reduced.
The ability of companies to invest in new production could be reduced. The ability of individuals to invest in a house, or other major items may be reduced.
This could cause a deep world-wide recession.
The value of the U.S. dollar is also at stake.
What is potentially at stake then is the living standard of people all over the world.
Anyone who thinks that the “bail-out” package the U.S. government is proposing is merely a bail-out of fat-cat bankers is wrong. It is actually an attempt to bail-out the U.S. and the world from going into a very deep recession.
The U.S. government is expected to pass some kind of recue legislation in the next few days that could avert the recession.
The Banking Crisis – What Is It?
There are many aspects of this banking crisis. The most dramatic aspect has been bankruptcies and near-bankruptcies. There has been the bankruptcy of Lehman Brothers and the government take-over/rescue of Freddy Mac and Fannie Mae and AIG. Also the government seizure and sale of Washington Mutual.
Other aspects include dramatic increases in the “spreads” or the premium which large corporations pay to borrow money by issuing bonds to investors.
The United States deficit and debt is rising dramatically as it issued checks to people to stimulate the economy in the Spring and as it borrowed hundreds of billions to invest in Freddie and Fannie and AIG and proposes to borrow more.
The United States Money supply has increased as the Federal Reserve Bank purchased U.S. government treasury bonds from investors, in the process sending out checks (checks which represent in effect newly printed money) for these purchases that were deposited into banks (which is referred to as injecting liquidity into the banks). This increase in the money supply could cause inflation and could cause a drop in the U.S. dollar.
Over the course of this credit crisis we have seen the U.S. dollar at first continue to weaken quite dramatically. At its lowest it took U.S. $1.60 to buy one Euro. In recent weeks the U.S. dollar strengthened considerably to the point where it took only $1.40 to buy one Euro. Even more recently, the U.S. dollar has weakened again and it now takes $1.46 to buy one Euro. Most analysts expect the U.S. dollar to weaken, perhaps dramatically in the next few years due to the huge U.S. debt and its creation of money.
Other aspects of the credit crisis have been the stock market gyrating up and down. Also some corporate buy-outs have stalled in mid-course. There are many other ripple effects of this crisis.
The Banking Crisis Explained
To understand the Banking Crisis, you first need to understand how banks work.
The following is a simplified balance sheet for a simple savings and loan bank.
| Assets ($ millions) | Liabilities and Equity ($ millions) |
| Cash $40 |
Customer Deposits $900 |
| Loans & Mortgages Owed by Customers $960 |
Preferred Shares $40 |
| Common Equity $60 |
|
| Total Assets $1000 |
Total Liabilities & Equity $1000 |
The bank, of course, makes money by loaning out money.
Banks are highly leveraged. In this case the shareholders’ common equity is just $60 million and yet the bank has loaned out $960 million. That is a leverage of 16 times.
Why are banks so highly leveraged? Consider what would happen if this bank loaned out only 1 times its equity. In that case, if the borrower was paying 5.5% on the loan, then the return on shareholders equity would be 5.5% less the costs of running the bank and less income tax. The profit in that case would likely be under a 3% return on equity. Equity investors in banks want to make a lot more than 3% return on equity but borrowers don’t want to pay higher interest rates. The bank uses high leverage to increase its shareholder returns while loaning money at relatively low interest rates.
Banks raise some money from preferred shareholders who accept a lower return and who take less risk since they get their dividends before (in preference to) common shareholders. This provides some leverage.
But, the big leverage of banks is created by taking in depositor money.
In this example the Bank may pay 3% on deposits and lend out money at 5.5%, it makes a 2.5% spread (gross before expenses and taxes) on its depositors’ money.
The Income statement would look as follows (in millions):
The following is a simplified balance sheet for a simple savings and loan bank.
| Interest Collected on loans ($960*0.055) | $52.8 |
| Interest paid on deposits ($900 *0.03) | – 27.0<> |
| Net Interest Revenue to Bank | $25.8 |
| Costs of running Bank | – 8.1 |
| Profit Before Income Tax | $17.7 |
| Income tax at 30% | 3.3 |
| Preferred Share Dividends at 6% | – 2.4 |
| Net Income | $12.0 |
The bank here is quite profitable with a return on equity of 20% (12/60). Yet the return on assets is only 1.2% (12/1000). The bank has magnified its return some 17 fold by using high leverage. It makes money mostly by lending out depositors money, not by lending out its own money.
The higher the leverage of the bank, the higher its return on equity will be (assuming nothing goes wrong, more about that below). Bank regulators require banks to maintain a minimum level of capital (fancy word for shareholder equity). In this case the bank has 6% common equity and 4% preferred share equity for a total of 10% equity or capital.
So called Investment Banks like Lehman brothers were apparently not subject to the same leverage limitations and some of these banks leveraged themselves up 30 fold. That was basically an accident waiting to happen.
How Do Banks Get in Trouble?
Consider what would happen if this bank made bad loans and had to “write-off” 6% of its loans as non-collectible. 6% of its loans is $58 million. This Bank could wipe out its entire common equity if just over 6% of its loans were unpaid. Banks cannot afford for very many of their customers to default on their loans. Banks have to be very careful who they lend money to. In lending large amounts for mortgages, banks tend to (or at least they used to) insist on the customer having a good income to be able to repay the bank AND insist on the house being worth more than the mortgage AND they insist that the borrower have a good credit rating. These three factors together insure that many banks lose no more than about 1% of loans to bad debt
At the heart of the banking problem in the U.S. was that these rules were not followed. Sub-prime loans were given (by definition) to sub-prime borrowers. Losses on mortgage loans have started to jump and are projected to jump much higher. The problem is 1. Banks made loans to people not likely to be able to repay and 2. A percentage of those people are indeed failing to repay.
When you have a situation where 10% of the mortgages that a bank issued may not be repaid and where the bank only runs with about 6% equity, we clearly have a recipe for bankruptcy of the bank.
Another way that banks can get in trouble is if too many depositors come and take their money out. Our bank above has only 4% of its assets in ready cash. In normal circumstances that is plenty to fund any depositors who happen to take their money out. However, if it is rumored that a bank is losing its equity and headed for insolvency, then there will be a run on the bank. In this case the bank will not have sufficient cash on hand. The deposits have been loaned out as mortgages. If the bank can’t borrow to fund the withdrawals (perhaps by borrowing from the Fed or another bank) it must soon shut its doors.
When you look at the balance sheet of our bank above, the wonder is not how banks run into trouble but instead is how they ever kept out of trouble with their massive leverage. By-the-way, this massive leverage associated with an equity level of about 10% (counting common equity, preferred equity and bond capital) is a level that has often been referred to in the industry as “more than adequate” (read more than legally required) capitalization (yeah right, any first-year accounting student would beg to differ).
Securitization Explained
Our simple bank above would make money on a mortgage over the years as the interest was paid by the homeowner. However in recent years “smart” people on Wall Street convinced the simple banks that there was a better and faster way to make money. Instead of waiting 20 years to collect interest on a mortgage, they could gather a large number of mortgages together and sell these to investors. This was called “securitization” (turned an illiquid mortgage receivable into a security to be sold to investors). The investors would accept a lower interest rate and the bank would make a fast profit by selling the mortgages. The bank could then recycle the money by giving out more mortgages, which would then be securitized and recycled again. In affect this was an added leverage. It allowed a bank to offer more mortgages without having to have more deposit money or more invested capital.
Amazingly enough, credit rating agencies found a way to rate these securitization investments as AAA – virtually risk free. They did this by dividing the mortgages into different slices for different investors. A high risk slice at the bottom (with a much lower credit rating) would absorb all the risk of defaults. This protected the slices above and allowed the high credit rating.
Traditionally banks that held mortgages for 20 years until they were repaid were careful about who they lent to. With securitization the mortgages were being hived off to investors. Banks soon became a lot less careful about who was given a mortgage.
During a time of rising house prices, few people default in their mortgage. (If a borrower is in trouble he can sell the house at a profit rather than default on the mortgage). During this time the Wall Street bankers refined their assumptions to reflect the fact that the percentage of defaults on mortgages were very low. Based on this experience they calculated that the probability of say 5% of mortgages ever defaulting was effectively zero.
By 2007 house prices were starting to fall and this caused more people to default on their mortgages (why pay a mortgage that is larger than the value of your house?). It became apparent that calculations that suggested we could never get large default rates on montages were horribly wrong. In fact some categories of sub-prime mortgages were suddenly defaulting at rates of 20% or higher.
Eventually, as defaults mounted, the investors who had been buying the mortgages from the banks stopped investing, or demanded huge interest rates. Today, most banks will find that if they want to sell their mortgages to raise cash, they will have to do so at a loss. In this situation the bank is very vulnerable. If depositors sense the bank is weak, they rush in to withdraw money. The bank may then be forced to sell off mortgages at a loss to raise cash. In this scenario the bank can quickly wipe out its equity capital and then will be seized by government regulators.
Who is Getting Bailed-Out Here?
The proposed bail-out would allow the U.S. government to set up a fund to purchase such things as mortgages that investors are no longer buying. If these mortgages are purchased at their current depressed market values, then this would be no bail-out at all. For a bank to be offered the ability to sell off assets at 50 cents on the dollar is not much a bail-out. Especially not when you consider that banks are highly leveraged and it only takes a loss to 5 to 10% of the asset values (much less 50%) to bankrupt a typical bank. To be a true bail-out, I believe the fund will have to purchase mortgages at something much closer to their original face value, not at 50 cents on the dollar.
There is a lot of rhetoric and mis-understanding about the bail-out.
Many people are opposed to a bail-out because the bank executives were paid millions and this mess is their own fault. That is true, but it remains true whether there is a bail-out or not. The executives will mostly keep the million they have made, with or without the bail-out. What a bail-out might do is prevent further bank collapses. If people are concerned about high bonuses for bankers, then perhaps the government or the banks needs to go after these people and demand the bonuses back on the grounds that they were never earned in the first place. That is a separate issue from whether or not the bail-out should proceed.
To the extent that the Federal Deposit Insurance Company could end up losing money on failed banks, the bail-out may be a bail-out of the government itself.
Consider who is definitely not getting bailed out. Shareholders and (likely) bond investors in Lehman’s and Washington Mutual have lost 100% of their money. Washington Mutual depositors are not losing anything. Shareholders in Fannie and Freddie and AIG appear to have been wiped out. There is no bail-out for them. The shares of many banks are down in the range of 80%. That money is lost. Any bail-out will lift bank share prices, but it will not come close to recovering the huge drops in the shares of banks. Therefore, bank shareholders in general are not getting much of a bail-out, except shareholders who bought at the lows.
It has been pointed out that the homeowners who cannot pay their mortgages are not getting bailed out. They will still owe the full amount of the mortgage. Perhaps a more sensible plan would be for the government to subsidize these mortgages. This is problematic in that it rewards the behavior of these deadbeats at the expense of their neighbors who actually repaid their mortgages.
“Ordinary” voters are up in arms about what they think is a bail-out of fat-cats. They should also perhaps be angry at all those people who are failing to pay their mortgages. Those people are equally at fault equally with the banks. If people pay their mortgages this whole crises goes away.
What is the Cost of the Bail-Out?
If the U.S. government takes $700 billion and buys distressed mortgages the cost will not be $700 billion. Not unless they plan to then forgive all these mortgages. In fact many analysts expect that the government would make a profit on this and there will be no cost. If the government buys mortgages at 70 cents on the dollar (which unfortunately would not really help the banks), they may find that they eventually collect 90 cents and they make a profit.
A Socialist America?
It has often been said that a free and prosperous economy depends on the following three pillars:
1. Democracy, the people choose their government
2. The Right to Own Property
3. The Rule of Law (Allows freedom from criminal acts and enforces contracts)
In recent weeks the American government has trampled all over points 2. and 3.
Fannie Mae and Freddy Mac were taken under government control. The government will provide very significant financial support. The government also gave it self an option to own 80% of the shares and ordered the companies to be largely wound down over a period of years. The shareholders had no say in this. Some bond investors may lose their money and it is not clear if they have recourse in the courts. AIG was seized and with no shareholder vote. The government is providing a loan of $85 billion (at some 10% interest rate) the government helped itself to 80% of the equity shares of AIG. I believe in these cases the Boards of directors were involved in approving the governments actions.
Washington Mutual was snatched on a Thursday evening, apparently with no immediate prior contact with the Directors, the executives or much less the shareholders. Shareholders will lose everything. Bond investors at the Holding company level will also apparently lose everything. Washington Mutual Thrift was immediately sold at a fire sale price. The company was given no opportunity to operate under bankruptcy protection and seek a higher offer for the Thrift.
This is very strange behavior indeed in a country that views itself as a land of freedom.
The Role of Accounting Regulators
I strongly believe that accounting regulators will have to accept some blame in this crises. For many years we have been hearing about companies using off-balance sheet liabilities. The very purpose of a balance sheet is to list assets and liabilities. The notion of off-balance sheet liabilities as allowed by accounting regulators was a corrupt and unethical concept from the very start. We can call it institutionalized corruption. It take s place on a wide scale. It is condoned and “everyone” is doing it. But it was still corrupt and unethical from the start.
Should there Be A Bail-Out?
I don’t know the answer to that. Perhaps in the absence of a bail-out the market would soon correct itself. The banks could issue new equity. The government could commit to loaning (not giving) money to banks and assure people that their deposits are safe. Perhaps the government could help homeowners pay off their mortgages (this also solves the problem for the banks).
As an investor my selfish answer would be that I want them to go ahead and pass some king of legislation immediately to restore some confidence in the markets.
How to Invest Now
2008 has not been a fun time to be an investor. And things could get worse. But ultimately the best time to invest is always after the market has tumbled and not when it has risen to an unsustainable peak.
However, investors should clearly be cautious.
Companies with debt and little or no profits or free cash flow are clearly at risk of bankruptcy. In good times, companies that are not making money can often borrow money until better times arrive. Today such a company may be pushed quickly into bankruptcy.
Investors should focus on quality companies with lower debts and with strong cash flows. There are companies like that which are now available at attractive prices.
Most investors will want to keep some money in cash. Investors will also be more careful where their cash is. If an investment is guaranteed, an investor will want to ask, guaranteed by whom? and how strong is the company making the guarantee.
Investors will want to be aware that corporate bonds are now more risky. Bonds with lower credit ratings are at risk of default. Such defaults have been rare in the past decade or so but are starting to occur more often. This will continue.
There are and there will continue to be some exceptional bargains emerging from the carnage. Some investors will spot these and invest a significant amount of money and will greatly increase their wealth as a result. Other investments will look like great bargains but in fact will be on their way to zero. Careful analysis and caution is warranted.
END
Shawn Allen, President
InvestorsFriend Inc.
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