Banks are very fragile things – here is why - December 2010

Dear Clients and Friends,

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I plan to write from time to time (four to eight times a year) about issues which I feel might interest my clients and friends.

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And now here comes the first article which is all about banks.

Best wishes,

Christoph Schnelle
Adv Dip.FS (FP) EPA Acc Level 2

Banks are very fragile things – here is why

Have you ever wondered why there is so much fuss about banks in the papers and why countries like Ireland prefer to bail out their banks and go bankrupt in the process rather than let their banks fail? The reason is that banks are very frail businesses and when they fail they take down many other businesses with them because banks always owe a huge amount of money.

That is also why Germany prefers to bail out Ireland rather than let Ireland go broke. If Irish banks fail, their creditors – many German banks – will be in big difficulties.

Let me tell you a story:

Imagine you are worth $300,000 in cash and you only earn enough to live on, no more. How much could you borrow to buy a house? If you are not prepared to lie, you could borrow as much as can be serviced by the house’s rent, which is about $250,000, i.e. you could buy a house for $510,000 plus $40,000 in expenses.

If you are prepared to lie about your income you could take out a low doc loan with mortgage insurance where you can borrow up to 70% of the value of the house, or about $560,000, i.e. you could buy a house for about $800,000, taking $60,000 for expenses to purchase the house.

If things go well, an $800,000 house will give you a bigger capital gain than a $510,000 house. However, you are much more likely to run out of money with the $800,000 house than with the $510,000 house.

If you were a bank, your situation would be very different even if you are still only worth $300,000. You could borrow between $6 and $15 million – yes, really – and buy houses from that money or lend that money to other people and you are allowed to promise every one of your lenders that they will get their money back whenever they want to.

Even better, once you bought $6 million in houses, one year later you could revalue them by an employee of yours to $7 million and now you have made a profit of $1 million and are worth $1.3 million and you can borrow altogether $26 million and a year later revalue your $26 million of houses to $30 million and now you are worth $5.3 million….

This is what happened to the banking system up to 2007. The banks didn’t buy houses but something much worse – they lent those $26 million from the previous paragraph to many poor Americans – who would never be able to repay those loans – for those Americans to buy houses.

We all know what happened next, those Americans couldn’t service their loans and we got the global financial crisis.

We didn’t have this problem in Australia because our regulators didn’t allow the banks to participate. Instead it was a lot of local councils that were caught lending to insolvent Americans and they lost their money but the main consequence in this case is more potholes on the roads, nothing worse.

As you can see from the above story, banks are very fragile institutions and in constant danger of going broke. Governments have tried to deal with this fragility by giving open or hidden guarantees to their biggest banks. For example, in Australia the big four banks are officially not guaranteed by the government but if one of them would go broke the government would almost certainly step in and rescue that bank.

Another consequence is that regulators are telling banks that they can’t borrow so much any more. A bank that is worth $300,000 will only be able to borrow $2.5 - $4 million, not $6 to $15 million. This leads to another problem: If as a bank you borrow and lend a lot of money and things are going well, the management earns a lot in bonuses. If that same bank can suddenly only lend half as much, then management will earn a lot less but will still be used to the higher earnings from the past. It seems that we will see a lot of banks trying to raise their rates, fees and charges wherever they can to preserve as much as possible from the old profits.

There is no simple solution to the fragility of banks – it is part of their design and banks play a useful and important role in our economy. However, it is very helpful for an investor to be aware of this frailness because banks play a big role in the investment area and most of their advertising is based on their solidity, financial strength and sturdiness. As an adviser I always need to look at how a bank failure would impact any of my investment recommendations.

This message was sent by Christoph Schnelle of In Your Interest Financial Planning.
Click here to email me or phone us on 1300 889 657.