But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
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As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:
Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable.Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
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I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.
In your original post in this thread, you said this:
[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
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Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.
You also said:
[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
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May be the selling is continuing because the value of the underlying collateral is continuing to decline?
[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
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No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.
That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.
