The Credit Crunch

A while since I posted, but I've been on holiday and since I came back I've been non stop having to deal with the symptoms of the financial crisis. It's certainly made me read and understand a lot more about economics. I'm still far from knowledgeable about it all.. but here are a few thoughts on the matter.

First to set the scenario:
Over the past year there has been increasing worry in the banking sector about the prescence of 'sub prime' loans in the system. In the USA in particular, the banks had been so eager to keep making profit they had loaned money to people to buy houses, where they had no hope of ever paying off the mortgage.

Instead of keeping this debt on their own books, these banks had packaged up these debts and sold them on to other international banks, while presumably downplaying the risk involved that the debtors would default.

Of course if the debtors defaulted, there was always the house left as collateral for the loan - i.e. the banks could reclaim the house, sell it on, and get back the money that was owed.

However, an added problem is that house prices in the US (and the UK) have been dropping. In many cases also it could prove nigh impossible to sell on the houses once the house buyer defaulted. This meant that there were an awful lot of 'sub prime' loans in the international banking system that were not worth a hell of a lot.

Of course the original home loaning banks didn't really care too much - they had sold the toxic debt on. After all, there seems to have been little regulation in this industry.

Throughout the last year worries about this problem have been spreading throughout the global banking system. Banks work by taking deposits from us, then investing most of that money themselves, by mechanisms such as providing home loans, or lending it on to other banks to invest, at an inter bank lending rate (LIBOR). They keep a little cash on hand, just in case some depositors come asking for their money back, but the vast majority is out there invested somehow, making the bank interest.

Now what has happened is that banks have become worried that their lending neighbour banks may have become contaminated with lots of worthless sub prime loans on their books. As far as I can see, the books of the banks are confidential, so there seems to be games of rumours and chinese whispers as to which banks have lots of their money tied up in these worthless loans.

The problem is, that if I lend money to a bank that has lots of toxic loans, and that bank runs into liquidity problems as a result of the toxic loans, then I'm not sure if I'll get my money back. Now consider that this applies for both me as a depositor, AND other banks in the inter bank lending market.

The banks really don't want to risk lending to each other because of this high risk, and thus the interbank lending rate (LIBOR) is sky high. However that means that the only way banks can make money and operate is through their own cash from depositors, and making loans etc themselves rather than via other banks.

This results in the banks having to offer very high interest rates because they are desperate for the cash from depositors, which effectively means that in the past few years they have become less and less tied to central bank (e.g. bank of england) lending rates, i.e. they are ignoring the moves that politicians make, because free market forces have taken over.

It also means that with this small amount of working capital the banks have to be VERY careful about who they loan it to (to make profit), AND they will only loan it at high rates of interest, as they need to make money to survive.

This means many businesses (particularly small ones) will apply to their bank for a loan to operate, and be refused. Businesses are thus having to downsize, or go under, from lack of loan money, and thus a lot of people are going to lose their jobs. This job loss stage is just beginning. When people lose their jobs, or are worried about their jobs, they cut back their spending, thus lowering the money made by other businesses, leading to more redundancies etc. The cycle continues and we have a recession.

But wait!! It's even more complicated than that. There is an extra 'BONUS' risk. This can be quite tricky to understand, so I'll say it slowly:

Banks are basically more advanced versions of the 'money lenders' in the temples in bible stories etc. The idea is that if you are rich, you can either hold onto your current wealth, or you can make it grow even bigger by lending it out temporarily to other people, but charging them 'interest' or a percentage for the privilege of having this lending.

Of course if you are going to do this, you need some kind of mafia scenario, where you have enforcers to beat up your clients because many of them are very unreliable and will need 'persuasion' to pay back your loans.

I digress ... anyway this was the initial system rich people, lent out their money and got it back with interest. A few years later some bright sparks came up with the concept of a bank. Instead of having a rich guy provide the capital, a company (the bank) would build a big vault to ward off robbers, then offer citizens the ability to deposit their cash in the bank (to keep it safe).

The citizens were happy, they could keep their cash safe (or safer) than under their mattress, and the banks had capital, some of which they could lend out and charge interest to other businesses, home buyers etc.

The above is a simple banking system. There is however a problem even with this system. Because the bank has invested much of it's capital, if all the savers came to the bank at once and demanded their money back, they couldn't have it!! The bank would suffer a liquidity crisis (a technical way of saying they didn't have the cash) as it was tied up in loans to other people / businesses.

This scenario is called a 'run' on a bank. Providing people have confidence in their bank, then on average only a small percentage of savers will be asking for money out on any day .. matched approximately by other savers putting money in. In this way providing the bank keeps a reasonable amount of it's capital in cash form (not invested), it can stay solvent.

But wait, here's the mad bit. At some point along the line banks stopped using hard cash e.g. coins etc to lend, and started using in effect 'I owe you' notes, for lending and mortgages etc.

Then some incredibly bright spark(!) invented what is called fractional reserve banking. If a saver deposited say 100 pounds into their account at the bank, the bank would (theoretically) have 100 pounds it could then invest and lend out to e.g. a homebuyer somewhere. This is very logical.

One day the bank managers met up with themselves, and decided, they were reliable fellows - why not increase their potential to make profit, by allowing themselves to lend out MORE money than they had in deposits!! i.e. when a depositor gave them 100 pounds, this wasn't going to make them much interest on investments, so instead they would invest that 100, but also conjure up 900 from thin air, and invest that too!!

After all these notes they were issuing for mortages etc were only IOUs, they could write anything they wanted on them. And they were reliable sorts these bankers, providing everyone paid their loans back, then they would make 10x the profit, and no one would suspect a thing!!

So fractional reserve banking is kind of like a con trick, except it has become accepted as the conventional way of doing banking. That is because, in most cases, it works ... it applies 'leverage' and makes 10x the profit from the same amount of depositors money.

However this con can multiply the problems caused when a bank runs into trouble. In normal businesses, when they run into trouble, they go into administration, and the administrators split up the assets of the company that are left, sell them off and split the money left among the people that the company owes money.

But with a bank, most of the debts that the bank has, it made with IOUs, they were never backed by real money!! That means when a bank goes under, in many cases the IOUs will become almost worthless. This means that in a risky climate, banks are incredibly risky things to lend your money too.

And this is what is happening, the whole banking network is built on the fraction reserve 'con' trick, so the banks are incredibly wary of lending money to each other just in case one of them goes down. And if one goes down any banks that have lent money to it will suddenly find themselves a lot worse off, and in a position where they could go down. And then again any banks which rely on this second bank get taken down, and the cycle continues. The danger is that the whole banking system can fall over like a stack of dominos.

This is essentially as I understand it what happened in the wall street crash of 1929 and the following depression of the 1930s. Very large numbers of banks collapsed, millions of people lost their savings, and lots of businesses went under and their was massive unemployment.

The US government at the time believed strongly in the free market capitalist system 'to the end', and thus didn't provide any help when this situation occurred. It saw it as the 'weak banks' being taken out leaving only the fittest still standing.

Of course it doesn't actually always work like that. And they neglected to realise that the knock on effect of this would be a collapse of the rest of the economy, as everything in capitalism depends on the banking system, ie. banking is the backbone on which everything else lays. If the banking system goes, your whole system of society is at risk (you can end up with anarchy, everyone for themselves).

This time round the scenario is very similar. Most people have been unaware of the risks involved here, they are too busy watching 'big brother', or seeing what madonna or kylie are up to, they aren't 'interested' in financial matters. It reminds me of that scene in constantine, where keanu asks the woman 'do you believe in the devil?', 'no' she replies. 'Well he believes in you!'. It doesn't matter whether people have any interest in the financial system, they still are wholely dependent on it for practically everything in their lives.

This time round most casual observers make the same comments and mistakes that were made in the 1929 crash. 'It's the banks fault, let them go down'. Of course the stack of dominos would result, and the world could fall into the abyss. Quite frightening that these are also voters.

Luckily those making the decisions (well some of them) are a bit more versed in the hazards and the knock on effects. We stand on the edge of the precipice. As far as the governments are concerned they want to maintain the status quo. On the surface the problem is one of confidence. They want to restore confidence. Confidence on the one hand to depositors, in order to prevent runs on the banks. And confidence on the other hand to the banks so they will lend to each other, and hence make them more able to provide loans to businesses and homeowners that keep the economies of the world ticking.

The latest plan used by gordon brown, alistair darling, and now being followed to some extent in many countries, is to address these problems by providing capital (to prevent liquidity problems) and to provide guarantees to inter bank lending, to get the banks lending to each other. It is in effect trying to provide a giant band aid to the current banking structure / status quo.

Of course, because of the fractional reserve banking system, the figures involved are enormous, but hey the tax payers have no choice, they elected their governments... Besides it's just going on the countries own debts (they each seem to have made some kind of international 'tab', another con perhaps?). And the argument is that if it works, it's only a loan because it's a 'guarantee' and insurance against the bank lending, everything should work smoothly. Shouldn't it?

Well now we are beginning to see the signs. The plan was accounced around a week ago in the UK, and rather more recently in other countries. The FTSE / dow jones etc all jumped on the news of the global 'bailout' for the banks. But now it is falling again. People are beginning to realise that the problems of trust are more endemic and are being very hard to solve .. they will probably take years to return to normal levels of trust (and I doubt they will without some kind of modifications to current systems).

The inter bank lending rate (LIBOR) in the uk at least hasn't responded as gordon brown / darling would have hoped. In short they still aren't lending. We are still on the edge of precipice. And what's more, many of the governments have 'shot their load'. They don't have infinite finance. They can't carry on pumping billions and trillions to prop up the banking system indefinitely. And the bad debts of lehman brothers are going to be looked at shortly. What other institutions might go down as a result of this? What will be the knock on effects of several european banks going down, in iceland, in britain, in france, in germany etc. What were the interlinks? Will the stack of dominos start to fall?

Interesting times!