March 15, 2009

• Lives in the Balance

  Are you getting tired of hearing about the banking crisis?  The money crisis?  The mortgage crisis?  Are you getting tired of hearing someone’s opinion about it?  Are you tired of people “debating” by throwing big words at each other more designed to keep the viewer confused than to define and clarify the problems much less evaluate solutions?

  I think we all get it that the banking crisis affects ordinary people.  I don’t think any of us really get a sense of which government actions (or inactions) might be helping and which might be hurting.  I’m not going to try to persuade you to support one course or another, but I do want to explain some of the words we hear if we watch the news and hopefully shed light on what the debate is all about. 

  As I analyze a company for it’s financial strengths and weaknesses, I look at two documents (well, okay I look at a whole lot more, but these two are central).  I look at an income statement and I look at the balance sheet.  The current banking crisis is a crisis of the balance sheet.

  Let’s say I win a smallish lottery and I want to use my winnings to start a bank.  I have $10,000 of my own money.  I get a charter from the government and I’m in business.  The first thing I do is go to all my friends and tell them I’ll pay them 3% on the deposits they make into my bank.  Let’s say I have 9 friends, all of whom also have $10,000 so when they make their deposits.  My bank now has $100,000.

  Now my bank is losing money because I have to pay the people who have made deposits.  So I also go looking for people who have a need to borrow money.  I tell them that if they’d like a loan from me, I’d like to see some proof that they will have income to pay it back, I’d like to know that they have character to pay me back, and if they meet my criteria, I’ll loan them the money they need and they’ll pay me back, plus they’ll pay me 6% interest. 

  My balance sheet now has three entries. 

  The $90,000 which my friends deposited are called my LIABILITIES.  Those dollars are liabilities because my friends can come to me at any time to withdraw their money and I have to be ready to give it to them. 

  The $10,000 I put in is my EQUITY.  That’s the amount of money I have a right to draw out for myself. 

  Liability + Equity =  This is the amount of money I have to lend and they are both shown on the same side of the balance sheet.

  On the other side of my balance sheet is the money I’ve loaned out which I call my ASSETS.  The loans I’ve made are assets because they are paying me money, 6%.  The difference between the 6% I’m earning on my assets and the 3% I’m paying for my deposits is my profit which is added into my equity.  In my first day on the job as a banker, I met a guy, Joe, who wanted to borrow $100,000 to buy a house.  I loaned it to him and that’s my entry on the other side of the sheet.  

  So that’s the simplest balance sheet ever.  Three entries, Liability + Equity ($100,000) = Assets ($100,000).  And it all balances. 

  The most complicated bank in the world right now is Citigroup.  You can google Citigroup financial statement and find their balance sheet online.  They end their fiscal year on Dec. 31 and the top entries I googled show the balance sheet through 2007.  At that time Citigroup showed Liability (2,074,033,000,000) + Equity (113,598,000,000) = Assets (2,187,631,000,000).  Everything balances. 

  Now what happens when something goes wrong with an asset.  Say, Joe, who borrowed that $100,000 for the purchase of his house.  Six months later he comes back to me and says, “I’m sorry, I lost my job, I can’t repay the mortgage.”  When Joe and I made our agreement up front he pledged his house as collateral for his loan.  So now that he can’t pay his loan, I own his house.  In ordinary times, this isn’t a problem because the house has value, I sell the house to someone else, and I’m back in business.  But these aren’t ordinary times.

  There are literally millions of Joes out there who for one reason or another can’t pay their mortgage.  The supply of houses far exceeds the demand for houses.  And because of that I can’t sell the house for more than $80,000.  I have a balance sheet problem. 

  $10,000 + $90,000 = $80,000.

  If I sell the house now, I will be $20,000 in the hole.   I’d be bankrupt.  I’ve lost all of my equity plus I’ve lost $10,000 of the money that people deposited in my bank.  These assets which are worth less now than they were worth when I did the loan, are called Toxic Assets.  Though a lot of different people have weighed in with opinions about the banking crisis, the debate going forward is over this critical problem.  How are we going to deal with these toxic assets?

  1. Bad Bank – this is a concept used with some considerable success in Europe.  When a bank gets into trouble because of toxic assets, the Bad Bank buys the assets for just a little less than their face value but more than the market says they are worth.  The banks love this plan.  They lose a little, but they keep their bank and stay in business.  In essence, this is the Paulson plan as it was proposed last Fall.  Remember the title of that plan was “Toxic Asset Relief Plan”.  TARP as it was talked about and sold to Congress and the American Public was a Bad Bank Plan.  Those toxic assets would be purchased and HELD until some time in the future when the price of houses would rebound, then sold.  The taxpayer foots the cost for now, but gets money back in the end when the sale is made. 

  2. Another way we could deal with toxic assets is to wipe out the bank.  We say, sorry, you didn’t verify Joe’s income, you didn’t verify Joe’s assets, you loaned money based on a false appraisal so you loaned more money than the asset was worth and now Joe can’t pay, you screwed up – see you in bankruptcy court. 

  Remember that amount of money Citigroup shows as it’s liabilities?  The amount that depositors have in the bank?  If the bank’s assets are insufficient to cover the bank’s liabilities, then the bank is insolvent.  It’s technically bankrupt.  Some people are calling for exactly this option.  Let the banks fail, they say this is the way that markets regulate themselves and that the markets should be allowed to do just that.  

  If Citibank is bankrupt, the American taxpayer is on the hook because the Federal Deposit Insurance Corp (that’s us) has guaranteed depositors up to $250,000 each that they won’t lose their money.  At Citigroup alone that’s close to a trillion dollars.  But even worse than the taxpayer being on the hook for the insured deposits, is the fact that “institutional investors” and other big companies who have their money in Citigroup would lose.  Institutional investors means mutual funds, IRA accounts, money markets … the money that Americans are relying on for retirement.  Companies who bank millions of dollars with Citigroup would not be insured and would lose everything.  Allowing Citigroup to fail means that in addition hundreds and possibly even thousands of small, medium, and large businesses  would have their capital wiped out, they would also fail. 

  Then the cost to the tax payer becomes the cost of life in the Great Depression – we have 20% unemployment or higher, and a whole generation lost to that giant flushing sound.  Economists are concerned that not only the largest banks, but potentially hundreds across the country are potentially insolvent.  (I’ll come back to this question further down.) The fear is that if even one of the biggest banks goes down, all the rest will follow in a cascade of failure that would not only crash the US Economy, but would ripple around the globe. 

  3. The third main proposal is that we nationalize the banks.  This is the policy preferred and implemented by the International Monetary Fund around the world.  We are not the first country to get into a banking crisis.  The IMF says that the longer the crisis is allowed to continue, the more costly it will become.  So their recommendation is nationalize as early as possible.  Use government money to bring the balance sheet even (which if the banks fail we will have to do anyway) and then as soon as they are stable, we sell them back into private hands.  There have been countries who successfully employed this strategy and only owned the banks in question for a matter of hours.  It’s a big hit to the taxpayer, but it’s a known hit, it ends the crisis, and we can get back to economics as usual on Monday morning. 

  Bankers hate this solution.  They lose control of their banks, they lose their jobs, they lose their big bonuses.  As a tax payer, I kind of like this plan.  I figure this is the only plan in which the bankers feel as much pain as I do.  I’m angry that they loaned so much money to people who obviously can’t repay their loans.  So I want them to suffer too. 

  4. The final option under debate is somewhere in the middle.  In this option instead of pouring a trillion into Citigroup, a trillion into Wells Fargo, a trillion into B of A … as they all go bankrupt, or we nationalize them, we pour a few billion into them to shore up the balance sheet.  We implement rules and regulations that say things like, “in exchange for taking public money, you will limit executive pay, you’ll go to a lending process where you verify the borrowers’ assets down to the last penny and you look at his credit history all the way back to 4th grade when he borrowed that dime from Jennifer for his milk money.  You’ll imporve the rigor of teh appraisal process and you won’t ever ever ever lend 100% of the value of a home (that way if the price of homes does fall, there’s at least a small cushion to protect the bank from losses.”

  This last option is the plan the Obama Administration has come up with.  Some economists fear that its not enough and that we are postponing the inevitable.  They are saying that the Toxic Assets on the balance sheet are more toxic than the banks are representing.  If the money that’s being poured in only brings the balance sheet into balance, or worse, if it doesn’t balance it, there’s no money to lend and businesses will continue to fail or down-size which hurts domestic production which means that the toxic assets become more toxic as more people lose their jobs and home prices continue to fall. 

  But there are other economists who side with the banks and say that the situation really isn’t as bad as it looks on CNN, the assets held by the banks do have value and if we just give them time, they will appreciate back to a level that allows the bank to sell them for enough to cover liabilities and the crisis is over. 

  The biggest unknown in the whole mess is the value of these toxic assets, just how toxic are they.  That one piece of data would tell us in an instant whether the banks truly are insolvent.  Banks are saying it’s not that bad, economists and the market are saying that they fear its far far worse than the banks have been willing to admit. (We can figure out what the market thinks by looking at the price being paid for Citigroup stock.  They have 113 million shares of stock outstanding.  On Friday, Citigroup stock closed at $1.74 per share = $196,620,000.  Compare that to the balance sheet which says that the stock-holder equity is $113 Billion and you can see the problem.  The market thinks that if Citigroup had to pay all its stockholders today, those stockholders wouldn’t get much of anything.)

  And that’s where part 2 of the Obama plan comes in.  The nation’s 19 largest banks have been given until the end of April to complete a collateral “stress test”.  This means that they are to evaulate their assets under certain assumptions, (unemployment rates, falling housing prices, etc) and determine whether or not they would be continue to be solvent under these asumptions.  If they aren’t, they would have 6 months to either raise their capital elsewhere, or the Government would step in and purchase (Nationalize) a certain percentage of the bank.  

  There is room for debate on all these questions.  I’m sure we all have an opinion about what might work and what the impact of failure would be on ourselves and our families.  What I hope is not that I’ve convinced you, as indeed I have not attempted to convince you, which plan is the best for America.  What I hope is that I’ve explained the options well enough that with a little more research you’d feel confident to let your Congressional Representatives and Senators know what you are hoping they will do. 

  * * * * * * * * * *

  Money Savers:

  In the midst of the national preoccupation with getting a good deal – have you changed anything about your own spending habits?  Are you saving money now in ways you weren’t a year ago?

  Here’s what I’ve changed recently:

  Cancelled cable television, signed up for basic Netflix plan.  Monetary savings = $50 per month and ironically, I think I’m watching more television programming now.  I like that there are no commercials, I can see an hour long program in 40 minutes.

  Staying out of bookstores.  I have only bought two books since Christmas, a couple of discounted paperbacks at Walmart which I’ve read, loaned to a friend and will put in a care package for troops in Afghanistan soon. 

  Brown-bagging my lunch.  I’ve slipped on that one lately, been going out to lunch with my friends.  But I grocery shopped this morning and I’m set now for two weeks of lunch in a ziploc bag/box in my Tinkerbell lunchbox. 

  What are you doing?

  • 3:42 pm
  • 8 Comments