Understanding Panic

You know we are in trouble when even Bush can’t dumb it down just how messed up the financial systems are. When I explain to people the business of banking I get a range of epiphanies from “oh, so this is supposed to happen” to “that’s just not fair“

Truth is, not only is it right, it is the very definition and spirit of the American way and capitalism itself. In a nutshell:

Financial prosperity of a capitalist system is dependant on volume always increasing. More credit extensions, more sales, more deposits, more loans, more taxpayers more people. In effect, your very social security benefits and retirement are dependant on there being enough suckers in the workforce making deposits between the age you retire and the age you drop dead. The profitability of the banking system is dependant on ever-expanding credit, with ever-expanding deposits followed by ever-expanding loans. Believe it or not, the bank business profits do not come from your personalized check orders every 5-7 years.

So how do banks make money? In United States we have what is called a fractional reserve banking system under which the central bank sets the reserve rate, or the amount of money the bank is required to keep in reserve to meet the demands of daily withdrawals and other business. So every time you make a deposit into a bank you are not dropping a pile of gold coins which then goes into the back of the bank to be loaded onto a horse drawn carriage and pulled across the dusty planes of Texas. What you are actually doing is making a loan to the bank expecting a full repayment. What the bank does is set aside the reserve rate (let’s say 10% of the deposit) and use the remaining 90% of the deposit for a commercial loan to someone else. They in turn take the loan and deposit it into the bank and the process repeats – save 10%, loan out 90% and so on.

The profitability of the banking industry is tied to the loans it makes. As it makes these loans it then packages them up and sells them to another financial institution which is the designated backer of such loans. Freddie Mac and Fannie Mae, two names you’ve heard a lot about, were the designated backers or purchasers of such loans.

Here is where things get ugly. During the Clinton years there was a huge push for financial institutions to deregulate the process of who backs loans, how and when. It established a deregulated quazi-market under which the loan packages could be traded almost like stocks and the companies that purchased these securities had to mark them to market – that is, the values of these loans had to be adjusted on the books to what their real value was. So long as the housing prices appreciated in value, so would the value of these loan packages and the more money that was loaned out for housing, regardless of whether the borrower was able to repay the loan, the better it looked for the financial institutions because the value of their books kept on going up. It’s like holding a stock that perpetually increases in value.

You know what happened next 🙂 As the housing bubble popped folks holding these loan packages could not get rid of them fast enough. They piled up at Fannie Mae and Freddie Mac as well as at some of the largest brokerages in the world which served as a medium for these transactions. As they could no longer sell and offload these loans, and as their value started to fall through the ground, so did the company.

Sure, that’s ugly. But here is the really messed up part:

Remember the 10% (or currently sanctioned amount) that the bank has to hold in reserve to meet daily withdrawals and regular business operations? Yeah, that works great if everyone doesn’t try to take their money out at the same time.

If more than the 10% of the deposits get called in the bank has to liquidate some assets (i.e., the $30,000 loan it extended to a college kid so he can rice out his Scion sC and put spinners on it) and as more stuff heads for liquidation so does the bank – it fails, just like any other business, because it is unable to meet its financial obligations.

In fact, this is how the Great Depression started, people started a run on banks so their money wouldn’t disappear. In part this gave birth to FDIC, the federally insured deposit accounts and so on. Psst. Did you know that a bank can actually temporarily suspend withdrawals and keep you from your money? What is the first thing you are thinking about right now? I’ve got bills to pay, time to get some ca$h. This is called a bank run.

So what are we bailing out?

The $700 billion dollar package being debated in Washington DC is to help back the loans that are considered insolvent. You’ve read that right: We are being asked to shell out $700 billion to cover the repayment of loans that the banks deem impossible to collect. The dude behind this proposal? Henry “Hank” Paulson, former CEO of Goldman Sachs that presided over the company while the current deregulation took place and made it possible for the ridiculous loans to be traded around, current United States Treasury Secretary and board member of IMF, whose job is to support regulation of financial markets and financial health of the United States of America. What he is asking for is $700 billion to spot the bad decisions made by him that eventually lead to the problems we have now.

And you know what – you’re going to pay it. 🙂

Here is the bottom line: The reason there is a panic right now and you haven’t heard anything about this for years is due to the fact that there is a huge bank run underway in United States. As this is going on, the banks are refusing to issue loans no matter how good and solvent the loan may be. The banks are concerned about the massive debt they have on books that they are not sure they will be able to collect, so they are refusing to extend any credit because they need to keep the bank operations going.

Back to the financial prosperity of a capitalist system and how it impacts even us – even Karl Palachuk, recession blindfolded and cork 2″ in his ears, is unable to ignore this one. If you do HaaS and depend on readily available credit and ability to pay off the infrastructure purchases over time you might find your next big purchase and next big financing deal declined for no apparent reason. We are a nation that depends on readily availability of huge sums of money to make business deals happen without having 100% asset solvency (ie, cash on hand to buy stuff).

The $700 billion is going, in part, to keep things going as they have been going and effectively forgive the massive near criminal greed of bank executives, and it will be approved and go through because the financial prosperity of our system depends on our ability to overindulge and pass the bill off to the next sucker in line.

So long as the line of suckers is perpetual and we can print funny money to get a free pass whenever we are called on the inherent flaws of our society, the American dream lives on.

Only in America and God Bless America.