On Price, Intrinsic Value, MBS, and Mark-to-Market

[CA renter]

Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

I’ll try to dig up old posts of mine to prove it.

Don’t ever accuse me of plagerism unless you know what you’re talking about!!! I’ve actually seen some of my posts from the HBB used, almost verbatim — paragraphs even — in newspapers just a couple of days after my posting. I never got any credit, but my point is to get information and a different perspective out to the public.

[CA renter]

Additionally, I’m not the first nor the only person who believes this.

Just because you disagree with it, does not mean that it was plagerized.

[CA renter]

Additionally, I’m not the first nor the only person who believes this.

Just because you disagree with it, does not mean that it was plagerized.

[CA renter]

Additionally, I’m not the first nor the only person who believes this.

Just because you disagree with it, does not mean that it was plagerized.

[CA renter]

Additionally, I’m not the first nor the only person who believes this.

Just because you disagree with it, does not mean that it was plagerized.

[CA renter]

Additionally, I’m not the first nor the only person who believes this.

Just because you disagree with it, does not mean that it was plagerized.

[CA renter]

spelling correction: plagiarism (sorry, I’m mad)

[CA renter]

spelling correction: plagiarism (sorry, I’m mad)

[CA renter]

spelling correction: plagiarism (sorry, I’m mad)

[CA renter]

spelling correction: plagiarism (sorry, I’m mad)

[CA renter]

spelling correction: plagiarism (sorry, I’m mad)

[davelj]

[quote=TheBreeze][quote=davelj]

Ok, let’s give every financial institution a year to sell all its assets (as opposed to a week). Who’s going to buy them?
[/quote]

No idea. Question about the banking system: My understanding is that banks can loan out at 10:1 against deposits. Is that correct? Is there a reason for the particular leverage ratio (whatever it is)? How do U.S. banks get to the 10:1 (or whatever) leverage ratio? Who do they borrow from? Is it just private parties generally? I know they can borrow from the Federal Reserve, but that’s not the normal SOP, correct?

Now, if a bank goes under, then the FDIC is on the hook for a percentage of the deposits. Does the FDIC have preference over the failed bank’s creditors in that they can sell off assets until the depositors are paid back and then the banks’s creditors get what’s left?

If you can point me to a good source that explains all this, I would appreciate it.

Dictionary.com defines insolvency as being “unable to satisfy creditors or discharge liabilities, either because liabilities exceed assets or because of inability to pay debts as they mature.” My understanding is that most of the insolvent financial institutions are insolvent because they can’t pay their debts due to the fact that they borrowed short and lent long. That is a failed business model. Let the institutions who did that fail. Surely you would agree that if a bank can’t pay debts as they mature, that they are insolvent?

I’m not sure about the “not all at once” thing. Who’s to say that’s not a better solution? Maybe that allows the system to rebuild sooner and more efficiently? It does seem like allowing a massive cascade of failures all at once could cause problems. However, I’m not sure that over-paying for bank assets (i.e, paying more than the ‘market’ would) is the solution.

As for the ‘agrarian society’ thing, you are a finance guy so I guess you think that the finance industry is the be-all-end-all. Some are thinking that portions of the finance industry could disappear completely with no ill effects:

[/quote]

Jesus H. Christ, Breeze. I want to try to be responsive and appreciate the inquisitiveness, but for the Love of God. I just can’t distill Banking 101 into a post. I can’t do it. Just as I’m sure you can’t distill whatever it is you do for a living into a post for my benefit. But I’ll try to hit a few things here…

First problem – and I don’t mean for this to sound as demeaning as it’s going to – but your first set of questions tells me that you don’t know the first thing about banking. Not even the most basic of basics. Which then gets me wondering what other things you don’t understand. Which is one of the reasons this discussion is so difficult. I assume based on your posts that you understand some particular fundamental concept only to discover that, in fact, you do not. Now, importantly, I’m quite sure that there are MANY things that you know 1000x better than I do. But we’re not discussing those things. We happen to be discussing what I work with intimately every single day.

So, moving beyond that unfortunate introduction, if you want to learn more about banking and the banking system there are many books out there with titles like “Fundamentals of Banking,” etc. I’m sure most of them will do an adequate job of passing along the fundamentals. I would point you to the book that I wrote some five years back on banking, but that would reveal my name, firm, etc., which from this site only Rich is privy to (he may even have a copy of my book – I can’t remember), which is how I’d like to keep things.

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:

Assets
Cash and Equivalents 10%
Securities 10%
Loans 75%
Other assets 5%

Liabilities
Deposits 85%
FHLB borrowings 7%
Trust Preferred Securities 1%

Common Equity 7%

So, as you can see, the common equity is there to provide the capital foundation for the bank; the deposits are there to fund investments in loans and securities; and the cash and equivalents on the asset side are there to provide liquidity to depositors. George Bailey would be proud.

If a bank goes into receivership, the FDIC insurance fund covers all of the insured deposits. Yes, the FDIC is senior to ALL bank creditors under receivership. They only pay off the insured depositors. But here’s the problem, if the FDIC insurance fund runs out of funds – which it very wall may this time around – the govt (that’s us) will step in to bolster the fund to whatever degree is required. Then, theoretically, the govt will get paid back and the fund will be replenished by charging higher “insurance fees” on the surviving banks going forward (these fees are going up right now, and for good reason).

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.

I happen NOT to think that finance is the “be-all-end-all” of things, as you surmise. But as I’m in the middle of the financial world, I recognize that The Financial System is the foundation for the whole economic machine. It’s kind of like the engine in a car. It probably only represents 5%-10% of the value of the car itself. But without it, the car doesn’t move. I don’t think many folks have a good understanding of how all the parts fit together in our economy.

Your VC example is anecdotal… but you knew that. But I agree that the financial sector needs to shrink. In some areas, considerably. We need fewer brokers, hedge fund managers, PE managers (yeah, fewer folks like me!), traders, investment bankers, etc etc… and we’ll get there in time.

But having said all that, I don’t see major flaws at the core of The System. What I see are major problems that cropped up largely due to a lack of regulation. Specifically, our biggest problems are from:

(1) Securitization: Totally out of control. Regs should have required originators to keep a specified percentage of each deal’s equity and loans on balance sheet to reduce misaligned incentives.
(2) Off-balance sheet financing and Level III assets: Please, folks. If it’s financing it should go on the balance sheet. Period. If it’s a Level III asset and its value can only be determined through “unobservable inputs” then it shouldn’t be on a bank’s balance sheet in the first place. C’mon!
(3) Credit Default Swaps: Whose idea was it that this multi multi-trillion dollar market shouldn’t be centralized on an exchange and regulated? Oh yeah, among others… Alan Greenspan. Please!
(4) Allowable loan concentrations: Banks should have limits placed on how much concentration they can have in one loan classification (such as construction and land development). This is so fundamental…
(5) Leverage at the Big Banks: I already discussed this above. (BTW, for perspective, the largest banks have twice as much leverage as the smaller ones, on average. They also have the shittiest assets outside of construction and development.)

Had these five basic issues been addressed 10 years ago, and had Greenspan and his ilk not given away money post-9/11, I guarantee you we wouldn’t be in this mess today. But when the system is levered – as it is – a few regulatory failures can cause huge problems, as we’re witnessing.

Liquidity is what ultimately kills a bank. But the liquidity problem is always driven by two issues: (1) Loan concentrations, and (2) Leverage. If you concentrate in the wrong assets, you die. And if you have too much leverage at the wrong time, you die. Combine the two, and you die first.

I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.

[davelj]

[quote=TheBreeze][quote=davelj]

Ok, let’s give every financial institution a year to sell all its assets (as opposed to a week). Who’s going to buy them?
[/quote]

No idea. Question about the banking system: My understanding is that banks can loan out at 10:1 against deposits. Is that correct? Is there a reason for the particular leverage ratio (whatever it is)? How do U.S. banks get to the 10:1 (or whatever) leverage ratio? Who do they borrow from? Is it just private parties generally? I know they can borrow from the Federal Reserve, but that’s not the normal SOP, correct?

Now, if a bank goes under, then the FDIC is on the hook for a percentage of the deposits. Does the FDIC have preference over the failed bank’s creditors in that they can sell off assets until the depositors are paid back and then the banks’s creditors get what’s left?

If you can point me to a good source that explains all this, I would appreciate it.

Dictionary.com defines insolvency as being “unable to satisfy creditors or discharge liabilities, either because liabilities exceed assets or because of inability to pay debts as they mature.” My understanding is that most of the insolvent financial institutions are insolvent because they can’t pay their debts due to the fact that they borrowed short and lent long. That is a failed business model. Let the institutions who did that fail. Surely you would agree that if a bank can’t pay debts as they mature, that they are insolvent?

I’m not sure about the “not all at once” thing. Who’s to say that’s not a better solution? Maybe that allows the system to rebuild sooner and more efficiently? It does seem like allowing a massive cascade of failures all at once could cause problems. However, I’m not sure that over-paying for bank assets (i.e, paying more than the ‘market’ would) is the solution.

As for the ‘agrarian society’ thing, you are a finance guy so I guess you think that the finance industry is the be-all-end-all. Some are thinking that portions of the finance industry could disappear completely with no ill effects:

[/quote]

Jesus H. Christ, Breeze. I want to try to be responsive and appreciate the inquisitiveness, but for the Love of God. I just can’t distill Banking 101 into a post. I can’t do it. Just as I’m sure you can’t distill whatever it is you do for a living into a post for my benefit. But I’ll try to hit a few things here…

First problem – and I don’t mean for this to sound as demeaning as it’s going to – but your first set of questions tells me that you don’t know the first thing about banking. Not even the most basic of basics. Which then gets me wondering what other things you don’t understand. Which is one of the reasons this discussion is so difficult. I assume based on your posts that you understand some particular fundamental concept only to discover that, in fact, you do not. Now, importantly, I’m quite sure that there are MANY things that you know 1000x better than I do. But we’re not discussing those things. We happen to be discussing what I work with intimately every single day.

So, moving beyond that unfortunate introduction, if you want to learn more about banking and the banking system there are many books out there with titles like “Fundamentals of Banking,” etc. I’m sure most of them will do an adequate job of passing along the fundamentals. I would point you to the book that I wrote some five years back on banking, but that would reveal my name, firm, etc., which from this site only Rich is privy to (he may even have a copy of my book – I can’t remember), which is how I’d like to keep things.

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:

Assets
Cash and Equivalents 10%
Securities 10%
Loans 75%
Other assets 5%

Liabilities
Deposits 85%
FHLB borrowings 7%
Trust Preferred Securities 1%

Common Equity 7%

So, as you can see, the common equity is there to provide the capital foundation for the bank; the deposits are there to fund investments in loans and securities; and the cash and equivalents on the asset side are there to provide liquidity to depositors. George Bailey would be proud.

If a bank goes into receivership, the FDIC insurance fund covers all of the insured deposits. Yes, the FDIC is senior to ALL bank creditors under receivership. They only pay off the insured depositors. But here’s the problem, if the FDIC insurance fund runs out of funds – which it very wall may this time around – the govt (that’s us) will step in to bolster the fund to whatever degree is required. Then, theoretically, the govt will get paid back and the fund will be replenished by charging higher “insurance fees” on the surviving banks going forward (these fees are going up right now, and for good reason).

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.

I happen NOT to think that finance is the “be-all-end-all” of things, as you surmise. But as I’m in the middle of the financial world, I recognize that The Financial System is the foundation for the whole economic machine. It’s kind of like the engine in a car. It probably only represents 5%-10% of the value of the car itself. But without it, the car doesn’t move. I don’t think many folks have a good understanding of how all the parts fit together in our economy.

Your VC example is anecdotal… but you knew that. But I agree that the financial sector needs to shrink. In some areas, considerably. We need fewer brokers, hedge fund managers, PE managers (yeah, fewer folks like me!), traders, investment bankers, etc etc… and we’ll get there in time.

But having said all that, I don’t see major flaws at the core of The System. What I see are major problems that cropped up largely due to a lack of regulation. Specifically, our biggest problems are from:

(1) Securitization: Totally out of control. Regs should have required originators to keep a specified percentage of each deal’s equity and loans on balance sheet to reduce misaligned incentives.
(2) Off-balance sheet financing and Level III assets: Please, folks. If it’s financing it should go on the balance sheet. Period. If it’s a Level III asset and its value can only be determined through “unobservable inputs” then it shouldn’t be on a bank’s balance sheet in the first place. C’mon!
(3) Credit Default Swaps: Whose idea was it that this multi multi-trillion dollar market shouldn’t be centralized on an exchange and regulated? Oh yeah, among others… Alan Greenspan. Please!
(4) Allowable loan concentrations: Banks should have limits placed on how much concentration they can have in one loan classification (such as construction and land development). This is so fundamental…
(5) Leverage at the Big Banks: I already discussed this above. (BTW, for perspective, the largest banks have twice as much leverage as the smaller ones, on average. They also have the shittiest assets outside of construction and development.)

Had these five basic issues been addressed 10 years ago, and had Greenspan and his ilk not given away money post-9/11, I guarantee you we wouldn’t be in this mess today. But when the system is levered – as it is – a few regulatory failures can cause huge problems, as we’re witnessing.

Liquidity is what ultimately kills a bank. But the liquidity problem is always driven by two issues: (1) Loan concentrations, and (2) Leverage. If you concentrate in the wrong assets, you die. And if you have too much leverage at the wrong time, you die. Combine the two, and you die first.

I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.

[davelj]

[quote=TheBreeze][quote=davelj]

Ok, let’s give every financial institution a year to sell all its assets (as opposed to a week). Who’s going to buy them?
[/quote]

No idea. Question about the banking system: My understanding is that banks can loan out at 10:1 against deposits. Is that correct? Is there a reason for the particular leverage ratio (whatever it is)? How do U.S. banks get to the 10:1 (or whatever) leverage ratio? Who do they borrow from? Is it just private parties generally? I know they can borrow from the Federal Reserve, but that’s not the normal SOP, correct?

Now, if a bank goes under, then the FDIC is on the hook for a percentage of the deposits. Does the FDIC have preference over the failed bank’s creditors in that they can sell off assets until the depositors are paid back and then the banks’s creditors get what’s left?

If you can point me to a good source that explains all this, I would appreciate it.

Dictionary.com defines insolvency as being “unable to satisfy creditors or discharge liabilities, either because liabilities exceed assets or because of inability to pay debts as they mature.” My understanding is that most of the insolvent financial institutions are insolvent because they can’t pay their debts due to the fact that they borrowed short and lent long. That is a failed business model. Let the institutions who did that fail. Surely you would agree that if a bank can’t pay debts as they mature, that they are insolvent?

I’m not sure about the “not all at once” thing. Who’s to say that’s not a better solution? Maybe that allows the system to rebuild sooner and more efficiently? It does seem like allowing a massive cascade of failures all at once could cause problems. However, I’m not sure that over-paying for bank assets (i.e, paying more than the ‘market’ would) is the solution.

As for the ‘agrarian society’ thing, you are a finance guy so I guess you think that the finance industry is the be-all-end-all. Some are thinking that portions of the finance industry could disappear completely with no ill effects:

[/quote]

Jesus H. Christ, Breeze. I want to try to be responsive and appreciate the inquisitiveness, but for the Love of God. I just can’t distill Banking 101 into a post. I can’t do it. Just as I’m sure you can’t distill whatever it is you do for a living into a post for my benefit. But I’ll try to hit a few things here…

First problem – and I don’t mean for this to sound as demeaning as it’s going to – but your first set of questions tells me that you don’t know the first thing about banking. Not even the most basic of basics. Which then gets me wondering what other things you don’t understand. Which is one of the reasons this discussion is so difficult. I assume based on your posts that you understand some particular fundamental concept only to discover that, in fact, you do not. Now, importantly, I’m quite sure that there are MANY things that you know 1000x better than I do. But we’re not discussing those things. We happen to be discussing what I work with intimately every single day.

So, moving beyond that unfortunate introduction, if you want to learn more about banking and the banking system there are many books out there with titles like “Fundamentals of Banking,” etc. I’m sure most of them will do an adequate job of passing along the fundamentals. I would point you to the book that I wrote some five years back on banking, but that would reveal my name, firm, etc., which from this site only Rich is privy to (he may even have a copy of my book – I can’t remember), which is how I’d like to keep things.

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:

Assets
Cash and Equivalents 10%
Securities 10%
Loans 75%
Other assets 5%

Liabilities
Deposits 85%
FHLB borrowings 7%
Trust Preferred Securities 1%

Common Equity 7%

So, as you can see, the common equity is there to provide the capital foundation for the bank; the deposits are there to fund investments in loans and securities; and the cash and equivalents on the asset side are there to provide liquidity to depositors. George Bailey would be proud.

If a bank goes into receivership, the FDIC insurance fund covers all of the insured deposits. Yes, the FDIC is senior to ALL bank creditors under receivership. They only pay off the insured depositors. But here’s the problem, if the FDIC insurance fund runs out of funds – which it very wall may this time around – the govt (that’s us) will step in to bolster the fund to whatever degree is required. Then, theoretically, the govt will get paid back and the fund will be replenished by charging higher “insurance fees” on the surviving banks going forward (these fees are going up right now, and for good reason).

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.

I happen NOT to think that finance is the “be-all-end-all” of things, as you surmise. But as I’m in the middle of the financial world, I recognize that The Financial System is the foundation for the whole economic machine. It’s kind of like the engine in a car. It probably only represents 5%-10% of the value of the car itself. But without it, the car doesn’t move. I don’t think many folks have a good understanding of how all the parts fit together in our economy.

Your VC example is anecdotal… but you knew that. But I agree that the financial sector needs to shrink. In some areas, considerably. We need fewer brokers, hedge fund managers, PE managers (yeah, fewer folks like me!), traders, investment bankers, etc etc… and we’ll get there in time.

But having said all that, I don’t see major flaws at the core of The System. What I see are major problems that cropped up largely due to a lack of regulation. Specifically, our biggest problems are from:

(1) Securitization: Totally out of control. Regs should have required originators to keep a specified percentage of each deal’s equity and loans on balance sheet to reduce misaligned incentives.
(2) Off-balance sheet financing and Level III assets: Please, folks. If it’s financing it should go on the balance sheet. Period. If it’s a Level III asset and its value can only be determined through “unobservable inputs” then it shouldn’t be on a bank’s balance sheet in the first place. C’mon!
(3) Credit Default Swaps: Whose idea was it that this multi multi-trillion dollar market shouldn’t be centralized on an exchange and regulated? Oh yeah, among others… Alan Greenspan. Please!
(4) Allowable loan concentrations: Banks should have limits placed on how much concentration they can have in one loan classification (such as construction and land development). This is so fundamental…
(5) Leverage at the Big Banks: I already discussed this above. (BTW, for perspective, the largest banks have twice as much leverage as the smaller ones, on average. They also have the shittiest assets outside of construction and development.)

Had these five basic issues been addressed 10 years ago, and had Greenspan and his ilk not given away money post-9/11, I guarantee you we wouldn’t be in this mess today. But when the system is levered – as it is – a few regulatory failures can cause huge problems, as we’re witnessing.

Liquidity is what ultimately kills a bank. But the liquidity problem is always driven by two issues: (1) Loan concentrations, and (2) Leverage. If you concentrate in the wrong assets, you die. And if you have too much leverage at the wrong time, you die. Combine the two, and you die first.

I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.

[davelj]

[quote=TheBreeze][quote=davelj]

Ok, let’s give every financial institution a year to sell all its assets (as opposed to a week). Who’s going to buy them?
[/quote]

No idea. Question about the banking system: My understanding is that banks can loan out at 10:1 against deposits. Is that correct? Is there a reason for the particular leverage ratio (whatever it is)? How do U.S. banks get to the 10:1 (or whatever) leverage ratio? Who do they borrow from? Is it just private parties generally? I know they can borrow from the Federal Reserve, but that’s not the normal SOP, correct?

Now, if a bank goes under, then the FDIC is on the hook for a percentage of the deposits. Does the FDIC have preference over the failed bank’s creditors in that they can sell off assets until the depositors are paid back and then the banks’s creditors get what’s left?

If you can point me to a good source that explains all this, I would appreciate it.

Dictionary.com defines insolvency as being “unable to satisfy creditors or discharge liabilities, either because liabilities exceed assets or because of inability to pay debts as they mature.” My understanding is that most of the insolvent financial institutions are insolvent because they can’t pay their debts due to the fact that they borrowed short and lent long. That is a failed business model. Let the institutions who did that fail. Surely you would agree that if a bank can’t pay debts as they mature, that they are insolvent?

I’m not sure about the “not all at once” thing. Who’s to say that’s not a better solution? Maybe that allows the system to rebuild sooner and more efficiently? It does seem like allowing a massive cascade of failures all at once could cause problems. However, I’m not sure that over-paying for bank assets (i.e, paying more than the ‘market’ would) is the solution.

As for the ‘agrarian society’ thing, you are a finance guy so I guess you think that the finance industry is the be-all-end-all. Some are thinking that portions of the finance industry could disappear completely with no ill effects:

[/quote]

Jesus H. Christ, Breeze. I want to try to be responsive and appreciate the inquisitiveness, but for the Love of God. I just can’t distill Banking 101 into a post. I can’t do it. Just as I’m sure you can’t distill whatever it is you do for a living into a post for my benefit. But I’ll try to hit a few things here…

First problem – and I don’t mean for this to sound as demeaning as it’s going to – but your first set of questions tells me that you don’t know the first thing about banking. Not even the most basic of basics. Which then gets me wondering what other things you don’t understand. Which is one of the reasons this discussion is so difficult. I assume based on your posts that you understand some particular fundamental concept only to discover that, in fact, you do not. Now, importantly, I’m quite sure that there are MANY things that you know 1000x better than I do. But we’re not discussing those things. We happen to be discussing what I work with intimately every single day.

So, moving beyond that unfortunate introduction, if you want to learn more about banking and the banking system there are many books out there with titles like “Fundamentals of Banking,” etc. I’m sure most of them will do an adequate job of passing along the fundamentals. I would point you to the book that I wrote some five years back on banking, but that would reveal my name, firm, etc., which from this site only Rich is privy to (he may even have a copy of my book – I can’t remember), which is how I’d like to keep things.

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:

Assets
Cash and Equivalents 10%
Securities 10%
Loans 75%
Other assets 5%

Liabilities
Deposits 85%
FHLB borrowings 7%
Trust Preferred Securities 1%

Common Equity 7%

So, as you can see, the common equity is there to provide the capital foundation for the bank; the deposits are there to fund investments in loans and securities; and the cash and equivalents on the asset side are there to provide liquidity to depositors. George Bailey would be proud.

If a bank goes into receivership, the FDIC insurance fund covers all of the insured deposits. Yes, the FDIC is senior to ALL bank creditors under receivership. They only pay off the insured depositors. But here’s the problem, if the FDIC insurance fund runs out of funds – which it very wall may this time around – the govt (that’s us) will step in to bolster the fund to whatever degree is required. Then, theoretically, the govt will get paid back and the fund will be replenished by charging higher “insurance fees” on the surviving banks going forward (these fees are going up right now, and for good reason).

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.

I happen NOT to think that finance is the “be-all-end-all” of things, as you surmise. But as I’m in the middle of the financial world, I recognize that The Financial System is the foundation for the whole economic machine. It’s kind of like the engine in a car. It probably only represents 5%-10% of the value of the car itself. But without it, the car doesn’t move. I don’t think many folks have a good understanding of how all the parts fit together in our economy.

Your VC example is anecdotal… but you knew that. But I agree that the financial sector needs to shrink. In some areas, considerably. We need fewer brokers, hedge fund managers, PE managers (yeah, fewer folks like me!), traders, investment bankers, etc etc… and we’ll get there in time.

But having said all that, I don’t see major flaws at the core of The System. What I see are major problems that cropped up largely due to a lack of regulation. Specifically, our biggest problems are from:

(1) Securitization: Totally out of control. Regs should have required originators to keep a specified percentage of each deal’s equity and loans on balance sheet to reduce misaligned incentives.
(2) Off-balance sheet financing and Level III assets: Please, folks. If it’s financing it should go on the balance sheet. Period. If it’s a Level III asset and its value can only be determined through “unobservable inputs” then it shouldn’t be on a bank’s balance sheet in the first place. C’mon!
(3) Credit Default Swaps: Whose idea was it that this multi multi-trillion dollar market shouldn’t be centralized on an exchange and regulated? Oh yeah, among others… Alan Greenspan. Please!
(4) Allowable loan concentrations: Banks should have limits placed on how much concentration they can have in one loan classification (such as construction and land development). This is so fundamental…
(5) Leverage at the Big Banks: I already discussed this above. (BTW, for perspective, the largest banks have twice as much leverage as the smaller ones, on average. They also have the shittiest assets outside of construction and development.)

Had these five basic issues been addressed 10 years ago, and had Greenspan and his ilk not given away money post-9/11, I guarantee you we wouldn’t be in this mess today. But when the system is levered – as it is – a few regulatory failures can cause huge problems, as we’re witnessing.

Liquidity is what ultimately kills a bank. But the liquidity problem is always driven by two issues: (1) Loan concentrations, and (2) Leverage. If you concentrate in the wrong assets, you die. And if you have too much leverage at the wrong time, you die. Combine the two, and you die first.

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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