TL;DR Theatre Presents ZOMG WTF BANKING CRISIS, Act I: "Banking Ain't Rocket Science"
Good evening everyone and welcome to a very special edition of TL;DR Theatre, in which I'm going to present ZOMG WTF BANKING CRISIS, a play in two acts that attempts to explain the banking crisis we are currently facing. I've been doing a lot of reading and research on this, and though I don't have any formal education in business management, I do have years of experience modeling businesses in software and I have a pretty good grasp of financial basics. I think I understand what's going on, and so here it is.
This is Act 1, "Banking Ain't Rocket Science," and I'm going to talk about something extremely dull and boring but nevertheless very germane to the banking crisis. What might that be, I hear you ask?
In order to understand the banking crisis, you need to understand something that's actually quite boring: balance sheets. Balance sheets, and more specifically the ways the numbers on a balance sheet change, are a method of modeling a business on paper. If you already understand about balance sheets, feel free to skip down to where I start talking about toxic assets.
Let's start with a simple example. Let's say that I want to open the First Bank of Crossfire. I have $10 of my own money I'm investing, and I'm ready to go.
You can't do much with $10, so the first thing I need to do is get some investors. Banks get investors in two ways: by enticing in depositors, and by selling shares. Right now I don't want to share my bank with anyone, so I hit up my friends list. "Hey, guys, I'm opening a bank. If you deposit your money with me in this thing called a Savings Account, I'll pay you 3% interest every year." And because you guys are super cool, eventually I get $90 in deposits into savings accounts.
Now I have $100 in my bank: $10 of my money, and $90 of yours. But this kind of sucks, because I'm actually loosing money. I have to pay you guys interest, and that's going to have to come out of my pocket.
Fortunately, banks don't work like that. They make money by making loans and charging interest. So let's say along comes someone who is looking to buy a house for $100. I agree to lend this person a $100 mortgage if they agree to pay me 6% interest ever year.
Now I'm in business. I get 6% interest from the mortgage, 3% of which I pay to the savings accounts and 3% of which is profit. I can choose to pay myself that 3% as a nice tasty bonus. (*glances sideways at siliconshaman*) Or I can choose to re-invest the money as capital.
So let's draw up a balance sheet for the First National Bank of Crossfire. It looks like this:
Assets
Liabilities and Capital
Mortgage for $100
$10 capital
$90 in savings accounts
Total: $100
Total: $100
As you can see, you have $100 on the left side, and $100 on the right side, and that's why it's called a balance sheet: both sides must balance.
Now, there's some words on that balance sheet which I didn't explain yet, in the column headers: assets, liabilities, and capital. Generically, "capital" is any form of wealth that is employed to make more wealth. In this case, it refers to my $10 that I've invested in my bank to get things going. To my banking business, any money I owe--that is to say, the money contained in the savings accounts you super-cool people opened with the First Bank of Crossfire--are "liabilities." This is because I have to be able to pay you your money at a moment's notice; I am liable for that money. And to me, any money owed to me is an "asset," because I can count on it. Just like you guys can count on me to pay you your money. The Magic Formula for a balance sheet is Assets = Liabilities + Capital.
Balance sheets, along with a few other specific reports, constitute a company's financial statements (or simply financials). Publicly traded companies are required to publish their financial statements, and have strict legal requirements for them. If you google for, say, Citibank's financial statements, you'll find that they claim $1.5 trillion in assets as of last quarter.
Of course Citibank's balance sheet is much more complex than this. But at their core this is how banks work. They make money by leveraging money that's not theirs. This is the way banking has worked since...well, forever. And it works pretty well for 99% of the time.
But let's say that something goes wrong. Let's say that this person I lent the mortgage to stops paying me. I mean, he said he had a job, but I didn't really check, and he didn't have any money to make a down payment that I might be able to use to defray this hit to my financials, but I was so keen on getting into the banking business during the housing bubble that I went ahead and lent him the money anyway and now he's laid off and won't be paying me and, well, tough noogies.
In situations like this, the mortgage goes into foreclosure. This changes my balance sheet a bit, because now instead of a mortgage for $100 I have a house for $100. No big deal, right? Right.
Unless the market value of the house drops. As we all know the housing market bubble has burst in a big way. So this house, which was $100, is now only worth $95. And now my balance sheet is out of balance. And it has to balance, or, well, it won't be a "balance sheet."
So what do I do? Well, I can't reduce my liabilities (the savings accounts) because you guys were good enough to trust me with your money and I have to be able to pay you at a moment's notice. So that money has to come out of my capital. Poof. With the stroke of a pen, I've lost $5 of my investment. I've lost half my money.
In reality, the situation is even worse. The housing bubble, as I said, has burst in a big way. The loss in value of these houses has been 10%, 20%, even 50% of the original market value. They have gone from being assets to being toxic assets. Toxic assets are assets that behave like liabilities, but are still reported as assets. They eat up capital, and when the capital is gone, they start eating up the other stuff on that side of the balance sheet. In our example, that would be your money in your savings accounts, my friends. My money goes first, because I want to protect yours as much as I can, but when all my capital is gone, your investments are next.
So I come up with a plan. "Don't worry, friends," I tell you. "I'm not going to sell the house. I'm going to keep it on my books, because I just KNOW that the housing market is going to recover. And furthermore, because the market is illiquid, that is to say I can't sell the house for its face value, I can't even determine what it's really worth. But eventually the market will recover, and I'll be able to sell the house, and everything will be copacetic. Trust me." And here I would give you a big smile.
This is, perhaps unsurprisingly, exactly what bankers are saying, according to David Biem, a professor at Columbia Business School and an ex-banker himself. "Most often the bankers say, 'Well it's not as bad as that.' For example, in the current crisis, many banks hold these so-called toxic assets whose quoted prices are down around 20 or 30% of their face value and the bankers say, 'I'm just sure it's worth more than that, I don't want to mark it to market.'"
The phrase "mark it to market" means to valuate an asset at its market value. In our very simple case of the First Bank of Crossfire, it would mean marking the house at $50 instead of $100 or even $95, which would not only wipe me out financially, but take a goodly portion of your guys' money as well. Sucks to be us, huh?
Yeah, it sure does. Because banking experts and economists right now estimate that more than a thousand banks are in this exact situation, including many of the largest banks in the banking system. They owe more money than they have, and there's a word for that: they are insolvent.
In fact, if you ask Jeremy Siegel, the so-called Wizard of Wharton (of the Wharton Business School) how many banks are in this situation, he'll tell you, "I don't know how many but I think there might be on a current market value, and again I think the market may be overdiscouting some of these, but probably, I wouldn't be surprised if Citi and Bank of America really at current value of their assets don't cover the depositors and the bondholders and would wipe out shareholders equity, and there could be others too."
Let's pause and take that in, shall we? Citibank and Bank of America are the two largest banks in the United states, and Siegel is saying their assets are too small to cover their liabilities. The losses would wipe out their capital, and there's still not enough left to pay all the depositors and other people who lent them money.
I should point out right now that normal peoples' savings and checking deposits are insured by the FDIC for up to $250,000. But banks rely heavily on investors, who invest millions and even billions of dollars, and those investments aren't insured. If the bank goes under, these investors lose their money, and the consequences of that will ripple around the world.
Now, Citibank and Bank of America both claim solvency, and for the most part the government and regulators are agreeing. The government agrees with Citibank and Bank of America that the housing market will recover, and everything will be fine, probably sometime quite soon.
And maybe it will. But right now the stock market does not agree. Currently, Citibank claims on its balance sheet capital in the amount of $150 billion. But if you look at its total stock value, it's at less than $10 billion. So the stock market says Citibank is worth less than its stated capital by fifteen times, and that doesn't even address the liabilities.
We're basically seeing two different interpretations of reality. Who is right? Citibank, or the stock market?
This is a very important question because what you think needs to be done about the crisis depends on which side you buy into...and I mean "buy into" quite literally, because guess who's going to pay for all of this! You get three guesses and the first two don't count and I'll even give you a hint: it ain't the Easter Bunny.
Tune in for the Act II of ZOMG WTF BANKING CRISIS, "I Can Has Bailaut Nao?" in which I'll explain what our choices are for dealing with this situation, and explain as best I can what the Obama administration is actually doing (as near as I understand it), and why.
This is TL;DR Theatre signing off, wishing you a safe and pleasant tomorrow.
This is Act 1, "Banking Ain't Rocket Science," and I'm going to talk about something extremely dull and boring but nevertheless very germane to the banking crisis. What might that be, I hear you ask?
In order to understand the banking crisis, you need to understand something that's actually quite boring: balance sheets. Balance sheets, and more specifically the ways the numbers on a balance sheet change, are a method of modeling a business on paper. If you already understand about balance sheets, feel free to skip down to where I start talking about toxic assets.
Let's start with a simple example. Let's say that I want to open the First Bank of Crossfire. I have $10 of my own money I'm investing, and I'm ready to go.
You can't do much with $10, so the first thing I need to do is get some investors. Banks get investors in two ways: by enticing in depositors, and by selling shares. Right now I don't want to share my bank with anyone, so I hit up my friends list. "Hey, guys, I'm opening a bank. If you deposit your money with me in this thing called a Savings Account, I'll pay you 3% interest every year." And because you guys are super cool, eventually I get $90 in deposits into savings accounts.
Now I have $100 in my bank: $10 of my money, and $90 of yours. But this kind of sucks, because I'm actually loosing money. I have to pay you guys interest, and that's going to have to come out of my pocket.
Fortunately, banks don't work like that. They make money by making loans and charging interest. So let's say along comes someone who is looking to buy a house for $100. I agree to lend this person a $100 mortgage if they agree to pay me 6% interest ever year.
Now I'm in business. I get 6% interest from the mortgage, 3% of which I pay to the savings accounts and 3% of which is profit. I can choose to pay myself that 3% as a nice tasty bonus. (*glances sideways at siliconshaman*) Or I can choose to re-invest the money as capital.
So let's draw up a balance sheet for the First National Bank of Crossfire. It looks like this:
Assets
Liabilities and Capital
Mortgage for $100
$10 capital
$90 in savings accounts
Total: $100
Total: $100
As you can see, you have $100 on the left side, and $100 on the right side, and that's why it's called a balance sheet: both sides must balance.
Now, there's some words on that balance sheet which I didn't explain yet, in the column headers: assets, liabilities, and capital. Generically, "capital" is any form of wealth that is employed to make more wealth. In this case, it refers to my $10 that I've invested in my bank to get things going. To my banking business, any money I owe--that is to say, the money contained in the savings accounts you super-cool people opened with the First Bank of Crossfire--are "liabilities." This is because I have to be able to pay you your money at a moment's notice; I am liable for that money. And to me, any money owed to me is an "asset," because I can count on it. Just like you guys can count on me to pay you your money. The Magic Formula for a balance sheet is Assets = Liabilities + Capital.
Balance sheets, along with a few other specific reports, constitute a company's financial statements (or simply financials). Publicly traded companies are required to publish their financial statements, and have strict legal requirements for them. If you google for, say, Citibank's financial statements, you'll find that they claim $1.5 trillion in assets as of last quarter.
Of course Citibank's balance sheet is much more complex than this. But at their core this is how banks work. They make money by leveraging money that's not theirs. This is the way banking has worked since...well, forever. And it works pretty well for 99% of the time.
But let's say that something goes wrong. Let's say that this person I lent the mortgage to stops paying me. I mean, he said he had a job, but I didn't really check, and he didn't have any money to make a down payment that I might be able to use to defray this hit to my financials, but I was so keen on getting into the banking business during the housing bubble that I went ahead and lent him the money anyway and now he's laid off and won't be paying me and, well, tough noogies.
In situations like this, the mortgage goes into foreclosure. This changes my balance sheet a bit, because now instead of a mortgage for $100 I have a house for $100. No big deal, right? Right.
Unless the market value of the house drops. As we all know the housing market bubble has burst in a big way. So this house, which was $100, is now only worth $95. And now my balance sheet is out of balance. And it has to balance, or, well, it won't be a "balance sheet."
So what do I do? Well, I can't reduce my liabilities (the savings accounts) because you guys were good enough to trust me with your money and I have to be able to pay you at a moment's notice. So that money has to come out of my capital. Poof. With the stroke of a pen, I've lost $5 of my investment. I've lost half my money.
In reality, the situation is even worse. The housing bubble, as I said, has burst in a big way. The loss in value of these houses has been 10%, 20%, even 50% of the original market value. They have gone from being assets to being toxic assets. Toxic assets are assets that behave like liabilities, but are still reported as assets. They eat up capital, and when the capital is gone, they start eating up the other stuff on that side of the balance sheet. In our example, that would be your money in your savings accounts, my friends. My money goes first, because I want to protect yours as much as I can, but when all my capital is gone, your investments are next.
So I come up with a plan. "Don't worry, friends," I tell you. "I'm not going to sell the house. I'm going to keep it on my books, because I just KNOW that the housing market is going to recover. And furthermore, because the market is illiquid, that is to say I can't sell the house for its face value, I can't even determine what it's really worth. But eventually the market will recover, and I'll be able to sell the house, and everything will be copacetic. Trust me." And here I would give you a big smile.
This is, perhaps unsurprisingly, exactly what bankers are saying, according to David Biem, a professor at Columbia Business School and an ex-banker himself. "Most often the bankers say, 'Well it's not as bad as that.' For example, in the current crisis, many banks hold these so-called toxic assets whose quoted prices are down around 20 or 30% of their face value and the bankers say, 'I'm just sure it's worth more than that, I don't want to mark it to market.'"
The phrase "mark it to market" means to valuate an asset at its market value. In our very simple case of the First Bank of Crossfire, it would mean marking the house at $50 instead of $100 or even $95, which would not only wipe me out financially, but take a goodly portion of your guys' money as well. Sucks to be us, huh?
Yeah, it sure does. Because banking experts and economists right now estimate that more than a thousand banks are in this exact situation, including many of the largest banks in the banking system. They owe more money than they have, and there's a word for that: they are insolvent.
In fact, if you ask Jeremy Siegel, the so-called Wizard of Wharton (of the Wharton Business School) how many banks are in this situation, he'll tell you, "I don't know how many but I think there might be on a current market value, and again I think the market may be overdiscouting some of these, but probably, I wouldn't be surprised if Citi and Bank of America really at current value of their assets don't cover the depositors and the bondholders and would wipe out shareholders equity, and there could be others too."
Let's pause and take that in, shall we? Citibank and Bank of America are the two largest banks in the United states, and Siegel is saying their assets are too small to cover their liabilities. The losses would wipe out their capital, and there's still not enough left to pay all the depositors and other people who lent them money.
I should point out right now that normal peoples' savings and checking deposits are insured by the FDIC for up to $250,000. But banks rely heavily on investors, who invest millions and even billions of dollars, and those investments aren't insured. If the bank goes under, these investors lose their money, and the consequences of that will ripple around the world.
Now, Citibank and Bank of America both claim solvency, and for the most part the government and regulators are agreeing. The government agrees with Citibank and Bank of America that the housing market will recover, and everything will be fine, probably sometime quite soon.
And maybe it will. But right now the stock market does not agree. Currently, Citibank claims on its balance sheet capital in the amount of $150 billion. But if you look at its total stock value, it's at less than $10 billion. So the stock market says Citibank is worth less than its stated capital by fifteen times, and that doesn't even address the liabilities.
We're basically seeing two different interpretations of reality. Who is right? Citibank, or the stock market?
This is a very important question because what you think needs to be done about the crisis depends on which side you buy into...and I mean "buy into" quite literally, because guess who's going to pay for all of this! You get three guesses and the first two don't count and I'll even give you a hint: it ain't the Easter Bunny.
Tune in for the Act II of ZOMG WTF BANKING CRISIS, "I Can Has Bailaut Nao?" in which I'll explain what our choices are for dealing with this situation, and explain as best I can what the Obama administration is actually doing (as near as I understand it), and why.
This is TL;DR Theatre signing off, wishing you a safe and pleasant tomorrow.