More on the so called “bailout"

OK so at least two blog readers felt my last post was incomplete. It was, even though it was over 500 words, and I was kind of venting, but I’ll try to add another couple of cents Well, more like 1,000 words.

I think the banking industry is one of the easiest to understand and most universally accessed industry, yet maybe least understood. An old banking axiom is “in at 3, out at 6, out by 3” referring to interest rates on deposits and loans, respectively, and then a jab at bankers’ hours.

A friend once worked as a bank teller. He told me that customers often said and did silly things. The best story was a dude that brought in about $50 in change and small bills. He gave it all to the teller, requesting the largest bills possible. OK, so far, so good. I can see why you might do this. But then he deposited the bigger bills into his savings account. When my friend asked why he had gone to the trouble of the currency exchange, motioning to the pile of change the customer said, “I don’t want that in my account.”

I think people don’t want to think about is the fact that the money they have “in” a bank is not really there. The bank lends it out. That’s what they do. That is how they earn money to pay you interest. That is why a “run on the bank” is not only bad, but it doesn’t work. The money is not there. Sure, banks are required to keep some of their depositors‘ money in cash at the bank, which should be sufficient if any single depositor wants to cash out, or maybe any 100 depositors, but not everyone.

So where is the money? Well, they lent it to businesses and individuals, who often use it to buy houses or cars. The loans for homes and cars are usually collateralized, meaning that if the borrower cannot meet the loan’s terms, the bank instead gets the home or the car. So what’s the problem? Well, suppose there is and economic slowdown which results in high unemployment and a lot of people cannot pay back their loans? Way more than you predicted. This slow-down might also spook depositors and they want their money back. But the bank doesn’t have all your money. They have some of it, and a bunch of valid loans, and a bunch of foreclosed homes and repossessed cars. Why doesn’t the bank just sell the homes and cars, to get my money back? They try, believe me.

But remember that economic slowdown that caused all the defaults? The same thing is making people reticent to buy, so who are they going to sell to? The price falls, and at some price someone will buy.

Imagine the quandary the bank is in. Say for example, that they have $1 million in deposits and assume they must keep 20% of this amount on premises for fickle or short-term depositors. That leaves $800,000 to lend out and make money. Let’s say that some dude want to buy a million dollar home, and he has $200,000 to put down. He has a good job and good credit so you take a chance. The bank will earn 7% interest, or $56,000 a year. They are paying depositors 2%, or $20,000, so this could be a good thing. (I know, $36,000 a year doesn’t sound like a lot, but banks are a lot bigger than my simplistic model. Add a few zeros to the back of all the numbers.)

OK, unforeseen economic slow down, dude loses his job and cannot find work. He cannot make payments. Big problem for him, but the bank is OK, right? They only lent him $800K and he’d repaid $100K, so they just need to recover $700K, right? Its a million dollar home for crying out loud, so they foreclose and evict the unfortunate one, and try selling the home. They even list it at $900K, foreclosure sale! But no one buys it. $800K? Nope. $700K? Still no buyer. $600K? At this price they would take a big loss, they would have lost some of the depositors’ money, which they would have to make up somewhere else. No bonuses for bank employees, and maybe even pay cuts and layoffs.

But still the bank needs to sell the property. When depositors come to get money you can’t give them a few shingles and a rain gutter. $400K? OK, at that price someone is willing to buy the house, and they have $80,00 cash, but are having a hard time getting a mortgage for the other $320K since all banks are having the same problem as you.. Can you help? Can you lend it to them?

See the problem?

It begins to affect everyone. People can’t borrow money. Sometimes they can’t withdraw their own money. That is why the government is stepping in. Basically the idea is that if everyone chips in (tax payers) we can buy up those $400K homes and restore some confidence in the banking system. The action does nothing to directly impact the sagging economy, but without their action the economy will be like an ungreased engine, screeching to a grinding halt. At least that is the fear.

So, who is getting “bailed out” and why should taxpayers have to pay for it? The idea is that we are, that’s why.

Will it work? I don’t know. Could there be a better way? Undoubtedly. Do I know what that way is? No clue. I do know that we probably wouldn’t have the problem if we, as a society, lived better within our means. I know that if my bank called and said, “We’re having some liquidity issues. Can you repay your mortgage today?” I would have to tell them no.