Tuesday, February 17, 2009

Run on the bank

I saw an interesting piece on the dailypaul.com about a deliberate bank run. Unfortunately, I don't see it working. Banks have built up reserves in the event of bank runs during this crisis. Plus, the Fed has an unlimited war chest thanks to basically no oversight by congress. If people decide to go through with this I support them. The only way to end the fractional reserve system is to not participate in it. I will be raising as much cash as I can over the next couple months because I just don't see my money as very safe in one of the large multinational banks.

This whole meltdown is scary because the system that we have is terribly flawed. Debt magnifies poor decisions. People have leveraged up to their eyeballs, more than 3:1 debt to equity throughout the system. Any mistakes that are made therefore come back 3x larger than they originally were. The real estate builder who took out 80% of the value in a speculative construction loan and loses out takes a big hit. He had $40,000 in equity built in on a $200,000 house. The $200,000 house falls 20% in value, like it has in the last year and he is wiped out. This is happening all over the country. Commercial RE developers and investors are being forced to lower rents to accommodate lower spending patterns. This lowers the Cash flow and value of the underlying. If the cash flow falls and the investors can't cover their debt service the lender calls the loan and equity is wiped out. The investors are poorer so they become less inclined to spend the big bucks they were spending this time last year, contributing even more to unemployment and falling prices.

The debt spiral is incredibly dangerous. The snowball becomes huge after only a couple losses. The Fed has tried to melt the snowball by flooding the market with liquidity without too much success. The damage was already done. Only a 3-4% loss at some investment banks was enough to start the toppling of financial markets. That 3-4% cascaded into 10% then into 20%. Who knows when it will end exactly. Banks throughout the world are insolvent (alive only through the trickery of accounting rules). They won't lend until they are sure they can recover all of the losses.

If every bank were to do a new appraisal on all the properties they owned, I think they would see loan to values (LTVs) well above what they would normally allow. Probably something above 90%, maybe 95%. As people are forced to sell assets they can no longer cover their debt service on, prices will fall even more, raising LTVs even higher. Forced selling is the bane of fractional reserve lending because it wipes out capital fast. Suddenly that $100 million capital base supporting $1.4 billion in loans gets wiped out because of 10 $10 million dollar deals or 20 $5 million dollar deals. Selling begets selling in forced liquidation destroying capital. At some point, when we all seem to think the world is ending, there will be the lucky (or smart) investor who kept enough cash to buy at the very bottom (see Jesse Livermore and the panic of 1907).

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