More comments on banking

My mom, who actually has a business administration degree unlike me who just reads blogs, chimed in with this, and I agree where there is an opinion:

At one time, income from home mortgages were considered a slow but steady income for banks. They didn't bundle them and sell them to investment banks, they kept them to themselves. You borrowed money from your local bank for a mortgage, you paid all of your notes to that same bank. This business of combining/bundling groups of mortgages and selling them to another bank, then to an investment firm to another investment firm is a fairly new innovation (and where I personally think most of the problems came in). Plus, in the 70's, banks had to show most of their overall interest income on home loans on their income tax in the first year of the loan. When Dad and I went to the banks [to buy a mobile home], the State Bank turned us down because they would have to show 1/2 of the total interest income on the loan on that year's income tax even though we wanted to finance for 7 years. (I don't know what the fraction is today.) The National Bank okayed the loan. Thus, if we had defaulted on the loan after 3 years, they bank would have lost money on the interest we didn't pay, and would have lost money to the government because they would have paid income tax on money they never collected when we defaulted.

This is interesting to me given the regulations were more strict regarding the income tax.

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BTW, one thing I forgot to mention. When the loans are "collateralized" (basically, turned into bonds), they go off the balance sheet. This is a point of huge controversy right now.

http://en.wikipedia.org/wiki/Off-balance-sheet

So, in Banking 101, the houses are owned by...um...Who has the title? It's like a stock at that point. If I log onto my brokerage and buy stock, I don't get the paper. It's in my account. They hold it for me.

Enron did a lot of stuff similar to this. So a rule was instituted called the "mark to market" rule. If you have assets, you have to price it at what it would sell at today, not what it was originally priced or anything like that.

This is a huge problem. House prices go down, values of the bonds go down, banks need more capital to back up all the loans they have made.

http://www.bloomberg.com/apps/news?pid=20601009&sid=a4O4VjK.fX5Q
http://money.howstuffworks.com/cooking-books3.htm

So, let me put it like this. Shares of stock are worth whatever they are at that moment. If I buy stock at $10 and 2 days later the stock is trading for $5, I can't really pretend it's worth $10. This is the cause of margin calls and what not - what the stock is worth at that moment.

Many banks have these bonds around (they own them, they couldn't sell some of them, whatever), but the bonds were moved "into a brokerage account." See the problem? The banks are saying, "I have these bonds in a brokerage account and they were worth X." However if they tried to sell them, they would be worth much much much less. If they are worth less, they have to get more money to back up their deposits, all kinds of problems happen.

That's the simplified form. The banks basically have an account holding stuff that's worthless. But, the banks are stating it's worth more.

Or think of it like this. I have a house. I think it's worth a million. The house next door sold for $1 million last year, but now it's selling for $750,000. How much is my house worth? If I was a bank, I would say a million because that's how much I bought it for and I claim I can sell it for that. The market says it's worth less.

The banks are worth less than they say. That's bad. That's why people like Nouriel Roubini are stating the banks are essentially insolvent.

Hopefully that made some sense since I'm half asleep right now...