Banking 101

I don't know much but I know a little. Here it goes.

I'm Jeff. I want to buy a house for $100,000. I don't have $100,000. The builder wants to sell me a house. The house costs $100,000.

I go to the bank and I say, "I need $100,000 to buy a house." The bank says, "OK, here's $100,000." I give the money to the builder, the builder gives me the house. I owe the bank $100,000.

The builder gets $100,000. He deposits the money in the same bank from which I borrowed the money. The bank is net loaned $100,000, got it back, and owns my house. Slowly I pay the bank for the value of my house and the bank makes interest.

That's not very profitable. So back to the builder. The bank only has to keep $10,000 of the builders $100,000 around. So my sister, Jan, says, "I want to buy a house. It costs $90,000." Jan goes to my bank, gets $90,000, pays the builder. Builder puts his money in the bank.

To recap:
Jeff - in debt for $100,000
Jan - in debt for $90,000
builder - +$190,000
bank - owns 2 houses, getting interest from Jeff and Jan.

That's not a bad business. The bank gets interest twice on essentially the same money. The bank owes the builder $190,000, but owns 2 houses worth $190,000. The bank gets about 5% per year on the $190,000 but is basically net zero in terms of assets. The bank must keep $19,000 on hand for the builder, so it can loan $171,000.

Wait a minute, where did all the money in the bank come from? How does it have money? It doesn't. It's using the builder's money. This is what they mean by leverage.
Builder: +$190,000
Jeff: -$100,000
Jan: -$90,000
bank: +$190,000 in deposits, -$190,000 in loans...so...
bank: owes the builder $190,000, owns 2 houses. If you took accounting, assets (2 houses) = liabilities (deposits)

The money came from Jeff and Jan. Now when farmer Joe wants a loan for $100,000, the cycle continues.

*****

What if my house is worth $50,000? I sell the house, I get $50,000, I still owe the bank, I file bankruptcy.

But the bank is worth less than zero. It owes the builder $190,000, but it owns two houses worth $140,000. Oops. If the builder wants his money, the bank closes and calls the FDIC.

That's big reason #1 why we are in this mess. But at least the builder is insured by the FDIC, so only the bank is at risk.

*****

Now, that would be the end of the story. However, some genius decided, "the bank doesn't need to own the house!." So it securitized the house. We thank Phil Gramm for this piece of legislation.

The bank, which is now an investment bank, puts the two houses together and says, "Here's $190,000 worth of houses. I'm going to sell 1000 bonds for $190 each. Other people can get the interest."

So someone out there was a very safe guaranteed 5% return on their money (pension fund, retiree, who knows). They give the bank $190,000, they get bonds with a 5% return a year.

Bank:
- owes builder $190,000
- has $190,000 in cash!!!!!

Bank is winning even more here! The bank gets fees from turning the houses into bonds, which is free money. This is an even better business! The bank gets fees from making the bonds and doesn't have to hold the houses. Less risk, free money, instant cash.

Now the bank:
- owes the builder $190,000
- owes the pension fund $190,000
- has $190,000 in cash from the builder
- has $190,000 in cash from the pension fund

Wow! It can loan twice as much!!! And doesn't have to worry about the houses...(allegedly). But the bank owes twice as much too. So if the price of the house falls, it will hurt twice as much.

*****

And that is the problem, multiplied by 30. Really, 30. The bank loaned out the same money twice in the first example. But it can do it 30 times if it wants. So instead of being on the hook for $200,000 from an original $100,000, the banks are on the hook for $3,000,000.

If the value of my house goes down, the bank and the pension fund are at risk. The bank has loaned that money out several times more than he would have before if he hadn't gotten the cash from the pension fund. What if 30 pension funds are at risk?

The bank needs assets to back up its loans. If it made 2 loans, it doesn't need as much to back up both. But what if it made 30 with the same money? One small move in the price of the house is much more devastating financially.

Now go read this:
http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print