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Dr. Kalinda Rose Stevenson
When Banks Go Broke
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The heart of the economic crisis right now is that the banks are unwilling to make loans. Even though governments are pouring money into the banking system, the banks are hanging onto the money.
The rescue program originally was sold to Congress and the public as a plan to buy mortgage-related loans from financial institutions. The goal was to remove troubled assets from those institutions’ books and inspire them to restart more normal lending operations.
Congress passed the massive and hard-fought legislation, and Bush signed it. The government raised the amount of bank deposits it insured. Billions of dollars of reserves have gone into banking systems in the U.S. and other countries. Yet credit, the economy’s lifeblood, has remained virtually frozen. “IMF warns of global financial meltdown” http://www.msnbc.msn.com/id/27129830/
Why are the banks so unwilling to lend? The heart of the current economic crisis is that banks are going broke. This is very different from the Monopoly Game, which is the most popular board game in the world. In Monopoly, a bank cannot go broke. In Monopoly, if the bank runs out of money, the banker can make more money by the simple act of writing an amount on a piece of paper.
But the global economy is not Monopoly. Banks around the world are going broke and being bought up by other banks. Banks are also being bought by governments, in an effort to stabilize the economic system that cannot function without banks.
Banks are in the middle of the economic system because they control the flow of money between creditors and debtors. At the same time, banks are also creditors and debtors themselves.
The economic system includes several types of banks, including central banks, national banks, commercial banks, and thrifts. These different types of banks have charters to serve different functions within the economic system, but the essential point is that the flow of money is controlled by banks.
The critical point is that the current economic crisis is not a money crisis. It is a credit crisis. Banks are cutting or canceling credit limits for home equity lines of credit. Banks are reducing credit card limits. Banks are extremely reluctant to make real estate mortgages.
But there is more to the credit freeze than the effect on consumers. The real crisis is the credit freeze for the banks themselves. This is a brief introduction to borrowing within the banking system, from No Money Limits For Real Estate Investors.
In the United States, the Fed is the central bank, which controls the amount of money in the economic system. The Fed is a shadowy institution, formerly called the Federal Reserve. The Fed is a strange hybrid of private banks with federal authority, but not really under government control. It operates mostly out of sight, to keep the money flowing between the extremely rich, the financial markets, the banks, and the consumers, all the while responding to political pressures, both nationally and internationally, and demands by the extremely rich to increase their wealth even more. It holds its meetings in private, making decisions that affect the economic well-being of all of us.The Fed has the power to increase or decrease the amount of money available in the economic system. They can do this by raising and lowering interest rates.
……When the Fed wants to increase the money in the money supply, it lowers the interest rates the commercial banks pay for borrowing money. When it wants to decrease the amount of money, it raises interest rates the commercial banks must pay. When there is too much money, the Fed begins to increase interest rates. This shrinks the amount of money in the system, and the shrinkage continues down to the amount of money available for you to borrow for your mortgage.
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Let’s say that the Fed pumps a billion dollars into the economy through the commercial banks. The commercial banks do what banks do. They loan out that money. By the time the commercial banks get through loaning the billion dollars, the commercial banks have created more money. Let’s say, five billion. And the commercial banks loan out the five billion to the “thrifts,” which are the savings banks, savings and loan banks, corporate banks, and credit unions. The thrifts take those five billion dollars and make loans, creating who knows how many more billion dollars. Chapter 9, “How Banks Use Debt To Create Money,” No Money Limits For Real Estate Investors.
The fact is, the banks don’t trust each other. Recent events have demonstrated how much the banking industry as a whole has thrown much of its traditional bankerly caution to the wind, not only providing credit that has mired millions of consumers in debt, but also plunged banks into massive debt.
For instance, Lehman Brothers failed because it carried a debt ratio of 35:1.
To keep profits growing, Lehman borrowed huge sums relative to its size. Its debts were about 35 times its capital, far higher than its peer group’s ratio. And it plunged heavily into real estate ventures that cratered.
Here’s how leverage works in reverse. When things go well, as they did until last year, Lehman is immensely profitable. If you borrow 35 times your capital and those investments rise only 1%, you’ve made 35% on your money. If, however, things move against you - as they did with Lehman - a 1% or 2% drop in the value of your assets puts your future in doubt. “How Financial Madness Overtook Wall Street”
http://www.time.com/time/business/article/0,8599,1842123-3,00.html
The banks that have failed have been debtors that could not repay their debts. This is why banks are so reluctant to make any loans. The credit squeeze is not primarily about you and me. It is about banks being unwilling to loan to other banks.
The actions being taken by governments around the world are an effort to stabilize the banks and induce the banks to start lending to other banks, as well as consumers.
The International Monetary Fund warned Saturday that debt-ridden banks were pushing the global financial system to the brink of meltdown and rich nations had so far failed to restore confidence. “IMF warns of global financial meltdown ” http://www.msnbc.msn.com/id/27129830/
The critical point is that the first priority of the IMF is to restore confidence in the banks about other banks.
Seized-up credit markets began to see the first small signs of easing Friday, but anxiety over the long-term prospects for recovery is keeping lenders mostly sidelined.
The overnight interbank lending rate, known as Libor, fell by half, suggesting that banks are becoming more willing to lend to each other in the very near term. The longer-term 3-month rate, however, continued to rise, hitting its highest level this year.
When banks show a willingness to lend to each other, it makes it easier for consumers and business to obtain loans. The financial crisis that caused Wall Street to buckle has spread around the globe, pushing panicky investors to sell stocks and sit on their capital.
“There is still an awful lot of fear driving this market and a preference to hoard cash rather than lend it out because you don’t know if you will get it back,” said Kim Rupert, fixed income analyst at Action Economics. “Credit freeze sees small cracks”
http://money.cnn.com/2008/10/10/markets/bondcenter/credit_markets/index.htm?postversion=2008101017
What we have seen so far is that the ”rescue” efforts by governments have involved pouring massive amounts of money into a banking system that is hoarding the money, from lack of confidence in the banking system itself.
Finance leaders from the world’s top economies, the Group of Seven, pledged Friday night to take steps to keep leading institutions afloat, unfreeze credit, ensure banks have enough capital to kick start lending and safeguard depositors’ funds and restart the secondary markets for mortgages and other securitized assets. “Global response” http://money.cnn.com/2008/10/11/news/economy/bush_group_of_seven/index.htm?postversion=2008101114
This credit crisis is by no means resolved, but already we see the direction that resolution will take—more government ownership of banks.
Bush did not mention any specific action that prompted his call. But Ireland recently moved to guarantee all bank deposits, triggering similar actions in Germany and other countries concerned that nervous depositors would move their bank accounts to Ireland.
The president barely referenced a significant new step from his administration - partial nationalization of some banks. After days of speculation this move was coming, Treasury Secretary Henry Paulson announced late Friday night that the government would buy part ownership in an array of American banks. “IMF warns of global financial meltdown” http://www.msnbc.msn.com/id/27129830/
So, at this point, it seems that the “bailout” or “rescue” plan, intended to buy mortgages, will be used to buy the banks themselves.
Dr. Kalinda Rose Stevenson
Find out more about the essential role of banks in the creation of money in No Money Limits For Real Estate Investors: Discover The Money-Making Secret In The Real Estate Game That Transforms Your Money Struggles Into Financial Abundance.
Award Winner of National Best Books 2007 Awards
Business: Real Estate Category
And Finalist in Business: Personal Finance Category
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