Occam's Razor

Banking is another one of these activities that to an outsider unschooled in finance seems a bit mysterious. Just how is it that you can put your money in a bank, know that it is safe and somehow your money will grow?

We understand that if we were to put our money in our mattress, it would not be particularly safe. If no one knew it was in our mattress then at least it would be safe but most of us cannot take the chance that it will be discovered. However, even if we kept our savings in our mattress, the money would not grow. In fact, over time it would be worth less because in most countries inflation is an unpleasant reality. If you want to keep your money safe, it is better to put it in some sort of financial fortress where it is hard for anyone other than you to get the money out and where it is always safe: a bank.

You would expect that if your goal was to safeguard your money the bank would charge you money for the privilege of banking it, rather than the other way around. After all, if you have a million dollars in gold bullion you do not want to find that it mysteriously disappeared one day. Instead, it is just the opposite. We give the banks our money and somehow they manage to give us some modest amount of interest for letting them guard it. (Granted, with the many fees banks are charging these days, it may negate some or all of your interest.)

Most of us understand on that our money rarely sits in a vault somewhere. Instead, it goes to someone else who doesn’t have enough of it to meet his or her needs. Over time, debtors repay the principle to the bank with a fee for use of the money. At least some portion of the money earned goes back into our account as interest. The bank gets the rest. So it sure seems like a symbiotic relationship. Your money is protected. Both you and the bank are more prosperous as a result.

As we relearned recently though, money you put in a bank is about as safe as the U.S. dollar. The dollar is not backed up with gold and silver. As you may have learned from my last post, the real value of the dollar is that it is a representation in the faith that the U.S. government will be around in the future and the idiots will not be running it. The crisis of confidence that is painfully underway is a crisis of confidence in the United States government. It would be charitable to say our government was asleep at the switch these last eight years. In fact, it was worse than that. Our crisis of confidence was not a result of a lack of competence, but rather faith in a financial ideology and the free market that was misplaced. In short, the ideologues, not the idiots, were running the asylum, practicing some weird sort of Zen-like financial alchemy. The only gold they were producing was fool’s gold.

In some ways, a bank is like the federal government because in reality the proportion of its assets in cash is rather small. The vast majority of its assets are in loans to other people and businesses. Its job is to stay solvent and make sure it does not give out the money to just anyone, but only to people who are creditworthy. If it has confidence that the people it gives money to will repay the loans on time, it can stay solvent, maybe turn a profit and throw some small change into your account as interest.

Banks sell trust. That is why bank names so often have trustworthy names, like First Fidelity Bank. That is why bankers tend to look and dress soberly. They hope it will make you think they are sober people. They want you to believe that their bank will be around and will only lend prudently. Just in case they do not, because they are a bank, they are required to pay a fee to the FDIC that insures your accounts up to $100,000 (well, $250,000 temporarily under the Wall Street bailout legislation). As we learned though, the money banks paid into the FDIC looked like it might not be big enough to handle a major run on the banks. That is when the FDIC petitioned Congress to stand behind it. Congress passed a bank bailout and hopefully the crisis is contained. What has not happened, and would be more devastating than a nuclear strike, would be if our creditors lost financial faith in our government. Fortunately, we are not there yet.

One problem is that banks can have an embarrassment of assets. This happened quite a bit during the last eight years. The Federal Reserve, primarily under its former chairman Alan Greenspan, had this notion that the economy needed low interest rates, providing inflation did not go up precipitously. With interest rates low, the message was that it was okay to borrow more money than you could comfortably afford. Therefore, we did. In fact, those low interest rates may have been something of a facade. Most of the time, low interest rates were offset by higher prices, particularly for commodities like homes and automobiles. With interest rates so low though, we could and often did supersize our financial dreams, buying bigger homes, fancier cars and upscale furnishings. At some level, this made sense. Because historically low interest rates have been an aberration, it made some sense to purchase these items because interest rates were lower. Low bank interest rates also gave us more incentive to buy stocks, on the assumption they would offer higher returns. Otherwise, the effect felt like stuffing your money into your mattress.

All this purchasing through debt had the consequence of causing the economy to grow. This growth was real in the short term, but artificial in the long term. Growth financed by shaky debt generated more growth financed by shaky debt. One effect is that all this purchasing caused a lot of economic activity, which resulted in many dollars ending up at institutions like your neighboring bank.

In general, banks do not like to keep assets in their vault. They would rather loan the money out to someone else and collect the interest on the money, making their bank more profitable. We Americans were glad to borrow this money, but so much growth was happening so fast, particularly in places like China, that creditors became a bit desperate. They did not want to figuratively put money in their mattresses. They wanted it to grow too. Unfortunately, there was a dearth of borrowers. Wall Street rode to the rescue by creating new investment vehicles. Specifically it invented the sub-prime mortgage-backed security, which bundled high-risk securities into one large package for which shares were sold. Even though these individual loans were riskier, buyers of these securities thought they were protected because the risk was spread out among a larger number of loans. As long as too many debtors did not default at once, all was well.

It was a foolhardy mistake driven by need and greed. Risky borrowers proved why they are risky and defaulted in large numbers as soon as the economy got a bit shaky (and much of it was caused by rapidly rising oil prices). Sub-prime mortgage backed securities became like a pin puncturing a balloon. Moreover, all the complex financial instruments created to take the risk out of risky ventures also proved to be risky. Insurance giants like AIG did not expect everyone to make massive claims at once.

These financial mistakes trickled down perhaps even to your local bank, which in trying to find places for the rush of incoming money may have also invested in shady financial instruments. Some of these banks, like WaMu, you now own, at least partially, as a taxpayer.

Let us hope that next time we do not let new ideologues run the asylum.