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The Real Reasons Behind The Crises Part II

By Andy Shaw | January 25, 2010

Originally posted 9th April 2009

What If We Were A Great Bank?

So let’s say we were a bank and we started out with say £2,000,000 of capital. So we started trading and we took in deposits and decided to loan out our deposits at a higher rate than the interest we were paying for the them. I’m not going to make this more complicated and discuss how as a bank we can create money against those deposits, so let’s just keep it simple and say that we loan out just the deposits that we take in. In which case we make our margin on the spread.

Let’s then say we take in £30,000,000 of deposits and we loan that money out. Our loan ratio is 15 (loans) to 1 (capital), which is apparently healthy. Now let’s say we go very conservative and we decide that we will only loan out at 70% ltv. We also decide that we want very low ratios of income and so we state that just 10% of someone’s income must cover the mortgage (ie very affordable) and we require a minimum credit score of 900 (max 999) – we are looking for only the best borrowers!

So now let’s look at us. We are in good shape, our loans are great and with no defaults we are making a good profit and our share price is going up. Life is easy! And, deservedly so, we are paying bonuses to the people who have generated this growth in our business (without the media spin it now looks different).

But then comes along mark to market – the property market is in decline and we have to re-evaluate our portfolio. Even though our loans are performing beautifully we have to re-evaluate them at today’s price. The property price has gone down in value by say 20%, so instead of us having loans on our balance sheet at 70% ltv, they are now at 90% ltv. So our company is now not as attractive as on paper our loans are higher risk. In reality they are not but on paper they look much more risky. So let’s say we have to mark the value down from £30,000,000 to £29,000,000. It’s bad but not too bad at first glance and it was the conservative thing to do, to avoid going to prison for not knowing something.

But where do we take this paper loss? Well against our £2,000,000 of capital, of course. So this transforms our 15 – 1 ratio (loans – capital) to 30 – 1, making us appear over-geared. This triggers off various alarms, the regulators are now very worried that we are way, way over exposed and are close to failure, so we are on the watch list.

We Have Now Become A Bad Bank, Yet We Have Done Nothing Wrong!

Our share price gets hit, we are now considered to be a bad credit risk, so we can’t borrow money anymore. Depositors see us as a bad risk so they do not want to deposit their money with us but worse still current creditors want to withdraw their money. Then the stock market shorters (people who bet on a stock price going down) come out to play and they drive our share price down because we look weak and on paper they are right, we are weak. In the real world of course we are fine but the real world has no place in mark to market – which is the very place it was supposed to be the most realistic.

So we are in real trouble. We are massively over-geared, but what went wrong? We have some great loans out there – none of them are late, none of them are even hinting towards repossession, we’ve been ultra careful. But because of the accounting rule of mark to market our world bears no resemblance to the real world.

Some of the world’s biggest financial institutions have gone through this and they have then had to try and sell their assets in a fire sale as very distressed sellers. Don’t forget they can’t lie about their value of course, because they could go to prison. So they are forced to de-lever at a time when everyone is wanting to sell and de-lever – which is the paradox of de-leveraging.

We Are Now Going To Have To Have A Fire Sale

There are two ways we can de-lever, we can increase capital – well who is going to lend to us right now, our stock price is down, the regulators have us on their watch list and we are in real trouble – or we can be forced to sell wonderfully performing assets at knock down unbelievable prices.

So we are a distressed seller in a market place where the only buyers want to buy at ridiculously low prices.First there were 15% discounts, then 35% and now all the way down to 88% discounts!

Side note: The land value of property is going to be worth an absolute minimum of 20 – 25%, so how the hell can the assets fall to 12%, if not done artificially? Which is why I said this was the second best money making scheme in history.

All of this happened when the bank has no bad loans, we have just lost our depositors money because of an accounting rule. What’s more, who else gets hurt when we sell at fire sale prices? Other banks of course, so not only are we dead but we are killing our peers off at the same time as they have to reduce their assets further because of mark to market, or go to prison. So give me all your money and assets or you can go to jail. As the Director of RBS said, this was a drive by shooting.

We Have Just Been The Victim Of A Robbery In Broad Daylight

So this brings us to the question of where all the money is going to and why I wrote the article about the second best money making scheme in history. Let’s say we were not a bank, but capital investors and I walked in and said how about this for a deal:

We can buy £1,000,000 of loans, none of which have ever been late. All the borrowers have credit scores above 900, their loan ratio is just 10% loan against income and the loan to value is just 50%! We can get a £1,000,000 basket of these loans for just £600,000!!! The deal of a lifetime!

So how much do we stand to make? Well, the average term for these loans will be at least seven years when we will get our £600,000 back. But we will not just get our money back, we will get the £400,000 discount as well, a nice little 66% return.

But wait – there is the interest on the money as well. Let’s say they were paying 6%, then that 6% was on £1,000,000, which on our £600,000 gives us a 10% return. So we are getting 10% a year plus a 66% bonus at the back end! This deal is too good to be true!

The Devil Is In The Detail

Well no, because of mark to market rules. Let’s say more banks are forced to sell this way then eventually even the assets we bought at a fire sale could be forced down further too and then we would be forced to sell. Which is why the credit markets are frozen! No-one wants to be left holding the bad asset. They all know the deals are unreal and hugely profitable but if they get caught because of mark to market then they will die just the same as Meryl Lynch did.

This is the real reason why Meryl Lynch went under – they bought billions of dollars worth of loans at 60 cents on the dollar, but the market value went down. So they then had to sell at 22 cents on the dollar for these terrific assets. What was worse for them, they only got 5 cents in cash and the other 17 cents was a loan!

So the buyer who bought those loans which will pay out £1,000,000 in 7 years, actually put down £50,000 cash and took a loan off Meryl Lynch for £170,000. What an outstanding return, does anyone think that the government are not profiting from this? This is why AIG had to be bought out, Lehman Brothers, Indymac bank – the list goes on and on.

The Knight In Shinning Armour

So in steps the Fed with a $700 billion loan, out of kindness, to buy assets at a dangerous 60 cents on the dollar. Ie, they are paying too much for them but in doing so they create a few things.

Firstly, a 66% return on their investment of borrowed money. Pretty cool by anyone’s standards, especially seeing as they do not have the problem the banks have of actually getting to the 7 year pay out in one piece (which is what every other financial institution has the problem of doing). Their problem is that they need the assets to be worth that much in 7 years. So they make 10% per annum when they are only paying 2 – 4% on their bonds. So the Fed make a nice spread as well.

As I have said before this is a great money making scheme for the Fed. But when I wrote that I wondered if the Fed had had nearly enough and history has proved my instincts right – they enjoyed this feast and didn’t want it to end for a while.

This was such a good deal for them they wanted to make more and more and just how long could they keep going before the world collapsed… Well now that the Fed have had a good fill, they are about to relax the mark to market rules and allow other players to enter the game.

So now they are finally trying to stimulate the game at the level of 60 cents on the dollar, that way they make enough and the world doesn’t come crashing down. Remember the $700 billion was passed in October last year? So they kept the feast going for 6 months and came up with various reasons why they couldn’t use this money to bail out the banks.

Shortly it will be down to when the other financiers around the world notice this wonderful worm dangling on the fishing line and whether or not they can resist it. Afterall, the Fed are offering non-recourse loans to tempt them back into this market. This removes the borrower’s risk and could unfreeze the market.

The trouble is that no-one trusts them and who is to say there will not be another round of musical chairs and the purchasers at 60 cents on the dollar will not end up the way of Meryl Lynch and now of course the Bank of America is suffering because of its purchase. However, the Fed has now said that they are a buyer at a reasonable price, so this means that they may be able to tempt the private market back in, as they will think we’ll, I may lose a little bit of money if I have to sell to the Fed, but the upside is now enormous and only a small downside. This is a very smart play for the Fed as I said several months ago, they have to create a market otherwise they will not realise their gains in the future.

Is $700 Billion Enough?

So is this new $700 billion going to be enough? Well that depends on how it is spent and what assets are grouped into the ‘distressed’ group. Afterall if this $700 billion was just to buy out sub-prime loans then there is only around $1 trillion in total, so they could just pay cash and be left with change of 60 cents on the dollar. So they are talking about a much bigger market.

What’s more let us look at those loans and group all the sub-prime, option arms and Alt-A loans together. Let’s go crazy and say 20% will default across the board (12 – 15% is expected). Well it’s almost impossible to lose money on this deal then buying at 60 cents on the dollar.

Possible Conclusions

So this could actually re-inflate the bubble for the US and the UK, or it could just put a floor on the market very quickly. I’m not saying it will, I’m just saying that it could right now as we need to see how things gradually unfold. However, right now I would say that the credit markets could potentially unfreeze and eventually that will trickle down into a need to lend to support the property market.

Why? Because just like the Fed the new buyers of the mortgage backed securities (MBS) need the markets to be worth at least what they are now so that they can collect on their 10% per annum and their 66% profit in 7 years. Now in that time the market value of MBS’s will recover and so they will not be able to make as many significant gains anymore. They know they will have to keep the market afloat, so it will be in their interests to keep it funded with new loans under the protection of the Fed and the Bank of England, who will step in if there is a problem and buy at reasonable prices – and of course each time they do buy one of these assets at knock down prices the world will thank them for it and they will rob from the rich and give it to the people who badly manage their country’s money.

All this means that instead of playing the game out and going down the deflationary spiral, there is a good chance that they may get to re-inflate the game and start playing it once more. Well, at least that is their plan.

As for me, I think their plan is a little suspect to say the least but then so is most government intervention when you get to finally unravel it. I think from our point of view a sweet spot will start to appear where we will be able to get some long term fixed rates to capitalise on the current low rates and I think that new products will become available as soon as the banks stop having to worry about their capital ratios. This could happen this year and we should start to see the banks return to the market within the next six months.

However, I still think we are in a depression and this will take several years to play out. The other problem is that if their plan does succeed then we will have probably put off today so that our children will pay later.

As always we will simply have to find the opportunities that are hidden within the rubble.

Best wishes


PS I had a realisation a little deeper the other day when I was discussing conspiracy theories with Alison. She said that her problem with them was that she didn’t want to believe that anyone could do something so horrible. It was at this point that I realised something – she was letting her own opinion affect her judgement as to whether something is likely or not. She had let her emotions guide her – what possible use would they be! The difference I have When looking at markets, property prices, currency movements and government conspiracies, is that I don’t care what I want to believe – that is totally irrelevant to me. All that matters to me is what is likely to be right and I ignore what my emotions would have me believe, as how do they help me when I evaluate something?

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