Washblog

Is it time to think about the unthinkable? Is it time to think about major bank failures?

Let me give you a thought. A year ago, I posted a list of the Mortgage Dirty Dozen on this site and I predicted the unthinkable: that they would all be obliterated in the coming year.

.....I am beginning to believe that we are going to see some major bank failures, and we have to consider similar declines from the following stocks:

WaMu then heads the list of banks Cramer is suggesting may lose 75% to nearly 100% of their present value, if they follow suit behind REITs and mortgage brokers.

I think every one of these could fall like that dozen, which, by the way, were already way down and didn't seem like they could go lower!

Now, I know this is an unforgivable thought that any of these banks can just disappear, but it can no longer be taken off the table. The lower rates alone aren't going to save these guys. All of these banks need a multipart fix

Why does is Cramer having this "unforgivable thought"? I don't know so very much about finance. I'm a dilettante, no question. But when I read a story that sounds kind of extreme, I look for extremes in related areas - things that are really unexpected. When I read the words "margin call" and that margin call is being put on a unit of the Carlyle Group, it got my attention. The Carlyle Group is well-known enough to have become a recurring character in conspiracy theories. It's one of the most influential and well-connected money managing firms extant. So if even the smartest, richest guys on Wall Street are getting killed in this environment, that worries me. Not for them, obviously, but for whether it might confirm that strong language on the financial pages has some reality to it

And then you read this in the New York Times:

Not since the Depression has a larger share of Americans owed more on their homes than they are worth. With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3 percent of the total, are underwater. That is more than double the percentage just a year ago, according to a new estimate of the damage by Moody's Economy.com.

Administration officials say they still oppose any taxpayer bailout for either people who borrowed more than they could afford or banks that made foolish loans during the height of the speculative bubble in housing.

So the problem is of enormous magnitude and unfortunately the Bush Administration "Liquidationists" are still firmly in charge. Forget that term, maybe I'll have more about it in another post. In short they are the market ideologues who think that nothing the market does can do any damage, despite its being manipulated by charlatans.

So basically we are screwed if this thing starts to fall apart fast. (And if John McCain is elected, we are probably completely screwed.) No, of course we're not there yet, but when you look at the behavior of the Federal Reserve Bank you're not looking at people who are trying to soften a recession. You're looking at people who are trying to keep an economy from falling off a cliff - even if they don't admit that.

It's true that right now the numbers are only extraordinary from a financial-markets-watcher perspective. Yes, regular people are getting hurt, but the changes are not so generalized. The problem is that the speed and severity of the changes are very unusual AND the economic context in which they are happening suggests particular vulnerability.

Politicians can't talk about this yet. Understandably, responsibly, they don't want to "talk down" the markets - but mark my words: A package must be put together - right now, in Congress, and every campaign. That package must move VERY large amounts of private debt onto the US government's books, make corporate equity holders take a VERY large hit AND create mechanisms to get money flowing again when those private corporations refuse to lend. If such a package is not ready and the worst keeps happening we are headed towards something like the Depression.

[We should also hope to see even more cash from foreign governments coming in to prop up our banks. Dubai? Islamism, schmislamism - right now we LOVE Dubai.]

What do you care? How can you influence this stuff that seems so far above the heads of the average person? Frankly, it's just a question of asking questions. Politicians need an excuse to talk about this. As I say, they can't bring this subject up on their own. Smart leaders know about this, but they need to know that you want them to talk about it. And this stuff will need to grow a consensus fast, because it's going to take a lot of legislation passed very quickly.

Why? Right now the Fed is taking a stepwise process, although the steps are showing increasing desperation. But crises like these happen because of something now called the "cliff effect". In finance, that refers to a moment when too many people suddenly demand cash or collateral for the credit they've extended. Margin calls are something that can create a cliff effect. A bank run is an example of a cliff effect (depositors are, after all, lenders). Basically, when the amount of credit available drops below a certain threshold, suddenly debts threaten to become worthless, people stop lending, even less credit is available, more debts threaten to become worthless and so on.

The Bush Administration is populated by people who don't believe that the "cliff effect" can happen - even as it is happening. Once again, their total divorce from reality threatens us all.

But when that financial hurricane hits, entire parts of the financial system have to be shifted to stronger hands and deeper pockets - and that means government. This will prove an object lesson to those who blather on about how little government can do and how the private sector is all-powerful. I hope the lesson is not too expensive. But if plans aren't made, it will be.

  Update [2008-3-10 21:37:53 by dlaw]: I just read this little piece of ugliness. The headline:

[Fed numbers show] home owners' equity as a percentage of household real estate [to have dropped to] 47.9%, the lowest on record. Going back 20+ years, this number was as high as 68.2% in 1986. In other words, for the first time ever, banks/lender own more [of the value in] houses in America than the folks who live there do.

Banks are being forced - and will be forced harder - to own - (or administer as creditors) more of the real estate in America than they have any idea what to do with - or any desire to own. Banks want to lend, not foreclose and own. In addition, this huge sum of real estate they don't even want in the first place will become less valuable as this all happens. This is going to take significant government intervention, maybe at the state level as well.

To understand this, I had to remember that sort of backwards accounting banks use. For all the dollars deposited in a bank, the bank must have "assets" - loans (plus a small amount of cash - the required reserve ratio or RRR) - to balance those deposits out . In bank accounting, deposits are "liabilities" because they represent cash the bank may have to come up with at any given time. The payments on the loans - the assets - keep cash flowing positively.

AND HERE IS THE INFORMATIVE COMIC SLIDESHOW I PROMISED

Banks also have capital of their own and they need enough to offset the risks inherent in their loans (assets) - that is, in case they don't get paid back or the value of their assets drop.

Usually, banks have quite a bit more capital than they need and the past years have been pretty good for banks. Plenty of them are in reasonably good shape.

However, banks have found themselves in an odd position just lately. What they had been doing is getting rid of loans - especially mortgages - by packaging them into securities, selling the securities for cash and then lending out that cash again. This was supposed to take the loans "off their books", so if people didn't pay back the loans the banks weren't hurt - they had already sold those loans for cash and it was all somebody else's problem.

The idea was that if Americans, say, started defaulting on mortgages it was no longer the bank's problem. Some fat cat Belgian mutual fund manager or French insurance company or German bank took the hit. They had bought these loans and too bad for them. And that did happen. The system worked.

But it's not so simple, because WaMu had started acting more like a mortgage broker than a typical bank and, basically. It now seems that as WaMu's volume of loans became huger and huger, the average quality plummeted at the same time. At some point, WaMu and others could not and now cannot get these off their books fast enough - or even at all.

And even for more typical banks, the huge, complicated "secondary market" in these loan-based securities (and securities made of these securities and based on all this stuff) sort of "closed the loop" and put the risk of these loans back on the banks who thought they were safe from that risk.

And what that all means is the the loan "assets" in banking system - particularly banks like WaMu - are very suddenly worth a lot less than they used to be. But the banks, of course, still have the same liability to their depositors. And this is very bad situation. Yes, the FDIC will insure the vast majority of depositors, but we don't ever want to get to that point on a large scale. We're way closer than we should be and unfortunately WaMu is sort of leading the way right now.

Update [2008-7-22 15:12:28 by dlaw]: IndyMac! If you look at the Wikipedia article I reference above, please note the bottom of the paragraph labeled "Decline". But what does it all mean? Well, here's what I think it means: $18 billion in deposits X 37% Brokered Deposits (CDs and such) = About $6 Billion in Brokered Deposits (for convenience) I know, you're already falling asleep, but hang on just three more sentences. June 30, IndyMac is no longered allowed to gather Brokered Deposits (Forget why - you want to read more? No, so trust me.) So as $6 billion in CDs and the like mature at about a $500 million a month, IndyMac loses about $500 million a month in deposits. But why would that have happened? Turns out that IndyMac was forced to own not only its own crap mortgages, but also its own crap Mortgage-Backed Securities. When Moody's and S&P downgraded those securities, IndyMac found itself in a sudden capital crisis. They fell below "well capitalized" at the stroke of a pen and when they did, they were screwed.