Financial Crisis 101: The Way it Works

Banking today in its most basic form is a really really simple idea. A bank takes in $1.00 in deposits, and is allowed to lend (this is approx) $0.30 of that dollar to the public. The rest has to sit in the bank vault as capital, just in case there are, ahem, problems. (See "It's a Wonderful Life", for George Bailey's version of this explanation.) As banking evolved, and I mean very recently, banks decided that they could make more money if they sold those loans (all the 30 cents' they lent) to someone else, so they could then lend out that same amount to someone else and make the fees on it, again. So they'd sell the loan at a discount to other firms, say investment firms or government-sponsored firms, creating what everybody on Wall Street loves, liquidity. Liquidity is simply exactly the same as that moment when you pay down your credit card, you're available credit goes up, you therefore have more liquidity, meaning you have more options. It's a good thing. So the banks have more liquidity, they lend again and again, always selling the loan quickly. Nothing wrong with this. Yet. Then along comes the day when someone realizes if they lend to folks who have a lower chance of fully paying back the loan, they can take a bigger fee upfront and justify it saying, hey you might stiff me. Now we're making some cash! And we're still selling those less secure loans off the books to other financial companies...think Fannie, Freddie, Lehman, etc. But it didn't stop there. The next step was someone saying let's change the traditional type of loan, call it an adjustable rate, a lot more people will qualify for loans now, yay! People will own homes, interest rates will be low, well at least until they adjust, and home prices will soar because everyone will want to be a homeowner. It'll create a seller's market. And these loans will still being sold to other financial companies. The prices of homes soared.This is like the Ginzu knives commercial. But wait, there's more. Then a few really edgy characters in the banking community decided to focus on subprime, the industry term for ‘weak-borrowers-that-probably-won't-pay-us-back-but-we're-not-scared-because-we'll-just-take-the-house-back-and -re-sell-it-and-recoup-our-loses.' And they lent them using the adjustable rate, so even if the economy stayed constant, once these mortgages adjusted to the higher rate, these borrowers were likely to default anyway. Oh, and these loans continued to be sold to other financial companies.I'm not going to even try to pinpoint the exact moment when the music stopped; suffice to say somewhere in 2006, some of these loans started going bad. Losses were accumulating, and here's where things really got sticky. The other financial companies decided to stop buying the loans from the banks making them. Oh, boy. The first jolt of panic was felt. Many banks had already started reigning in their lending to the subprime, but, they didn't shut it off! And that was critical. Countrywide and WaMu were most notable for this. So remember that $1.00 of deposit, and .30 cents can get lent, then rest in the vault just in case. When the ability to sell off these loans dried up, banks were left with more than they could hold on their own books, so that .30 cents became .50 cents, and senior executives went, holy shit, we have to raise capital to cover the .20 cents. They all went out and borrowed from each other, a very standard practice, and some even raised capital to cover it. Remember WaMu raised $7 billion back in the beginning of the year. Okay, phew. The banks raise the capital they need, and cross fingers that it isn't as bad as all that. Meanwhile the economy is going bad, the ability to sell loans made on houses has dried up, so banks scaled back all jumbo lending as well as subprime; jumbo loans is a defined term for all house loans over approx. $430,000. Why? Fannie and Freddie were still buying conventional home loans (loans under $430,000) from the banks, so the banks could still sell them and make money. That's when homes in the $400,000 to $900,000 started losing value. Not only had we hit the stall point, we tipped over and we started crashing.Home prices started falling fast in most places in the country. And the above cycle started to pick up tremendous speed. The velocity with which defaults were occurring, foreclosures were happening, was so fast and rapid, no one could even comment on how big the problem was...still can't. The final straw, in my opinion, the proverbial dagger through WaMu's heart, came the beginning of September, when consumers seemingly en masse decided to withdraw huge sums from the bank, a kind of organized run on a bank. Almost $17 billion dollars gone in about 15 days, and remember that means they have to either raise capital to cover the loans they have outstanding, or they get seized. They got seized. And then they got sold. Game over. Wachovia is now in the hot seat. Bank of America owns Merrill Lynch and Countrywide, and JP Morgan Chase owns WaMU. We are well on our way to having 4 or 5 national banking institutions as some speculate that Citibank will take Wachovia. Bottom line, liquidity has dried up from our markets. Only the truly well capitalized now have the money, the liquidity, to keep lending. Editor's note: Here is Part Two of this article: <a href="http://biznik.com/articles/financial-crisis-101-part-2-what-can-we-do">Financial Crisis 101: What Can We Do?</a> 2008-09-30T20:45:00Z

2008-10-01T15:09:10Z

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financial-crisis-101-the-way-it-works

2008-10-01T05:34:53Z

I am a 20 year banking veteran and a former consultant and small business banking expert to banks around the world. Read on for an explanation of what's happened in the financial markets.

Financial Crisis 101: The Way it Works

2009-02-24T09:46:16Z