by Calculated Risk on 4/26/2009 11:57:00 AM

Note: I took some short cuts to make this simple - think of this conceptually. I'm intentionally mixing financial institutions. For commercial banks, the FDIC stopped the bank run by upping the FDIC insurance. For investment banks, the Fed provided the liquidity. Please think of this conceptually or I'll have to write 100 pages ...

This post looks at a bank balance sheet and a liquidity crisis. In a subsequent post, I'll look at a solvency crisis and two possible solutions.

A special hat tip to This American Life’s Alex Blumberg and NPR’s Adam Davidson who presents some of the same ideas (although I'm going to go further). Here is the website for their presentation.

Click on graph for larger image in new window.

If you watch the Planet Money presentation, they explain the basics of a bank from a balance sheet perspective. It doesn't matter if the left scale is in dollars or billions of dollars - the structure is the same.

Capital is the amount of money investors put into the bank plus any retained earnings. Liabilities is the money the bank borrows from depositors or other sources. And assets are loans that the bank makes (and a little cash and other assets). (see Alex and Adam's presentation to make this clear).

The balance is: Assets = Capital + Liabilities

Banks make money by lending at a higher rate than they borrow. In the Planet Money example, the banks borrowed at 3%, loaned the money at 6%, for a spread of 3%. The difference between 6% and 3% is called the "net interest spread".

Banks report something a little different called the "net interest margin". The difference between the "spread" and the "margin" is because not all assets are loans (some might be held as cash for regulatory reasons). Net Interest Margin (NIM) is the interest earned, minus the interest paid, divided by total assets. As an example, Wells Fargo just reported a net interest margin of "approximately 4.1 percent".

Now look at how profitable a bank could be. If this bank had $100 billion in assets, and a NIM of 4.1% that would be $4.1 billion in annual profits before expenses and charge-offs - on just $10 billion in capital (Note: The diagram shows 10-to-1 leverage; many banks were levered 30-to-1 or more).

Of course the bank has expenses (all those nice buildings and employees) - and there are always charge-offs for loans that don't get repaid, even in good times. For reference, the Federal Reserve tracks the charge-offs by loan category here.

Banks have two main risks: interest rate risks and credit risks. Since banks mostly borrow short and lend long, they are exposed to increases in short term interest rates, and this would lead to lower NIMs. The credit risk is that too many of those assets will go bad (more on credit risks in the next post).

Not all liabilities are the same. The second diagram shows three categories of liabilities: 1) Long term bank debt, 2) commercial paper (called CP, this is less than 270 days duration, and usually much shorter), and 3) FDIC insured deposits.

Each category has advantages and disadvantages.

Commercial paper is usually the lowest interest rate, but it is the shortest duration and has the highest interest risk. Usually the bank pays the highest interest rate on long term debt, but there is no interest risk for the duration of the security. Most banks have a mix of liabilities.

Now imagine the bank starts reporting higher than expected credit losses - or at least depositors believe the bank will start reporting huge loses.

Here the bank has lost $5 billion, and the capital has been cut in half.

Fearing further losses, the commercial paper (CP) investors run for the hills and refuse to reinvest again when their short term paper matures.

The FDIC insured depositors run (or amble) towards the hills too. A classic bank run.

The long term debt holders are stuck. They can sell in the market, but at a lower price - and that doesn't impact the bank's balance sheet (OK, there are some accounting issues here that I will ignore).

To stop the bank run, the FDIC stepped up and increased the guarantee on FDIC insured assets to $250 thousand. But this did nothing for the commercial paper investors.

Next the Fed steps in and replaces the commercial paper liability as it matures.

If this was just a panic, and the bank was actually fine, the commercial paper investors would return (or the bank could sell more long term debt), and the Fed would be replaced by private debt.

However this is not just a liquidity crisis, and the Fed is still providing liquidity to the banks.

This doesn't work long term because the Fed requires the banks to over collateralize any money borrowed from the Fed. As the long term debt starts to mature, those investors will follow the commercial paper investors to the hills - and the Fed will have to provide more and more liquidity. And eventually there will not be enough collateral to borrow from the Fed. Here is an example of the Collateral Margins Table for the discount window.

Next I'll discuss the solvency issues (not as easy to fix).

by Calculated Risk on 4/26/2009 10:15:00 AM

From the Cincinnati Enquirer: Nobel-winning economist speaks at UC (ht Jonathan)

The country may experience some economic growth in the latter half of this year, but don't expect the rate of job losses to abate anytime soon, noted economist and recent Nobel Prize laureate Paul Krugman told an audience of economists and area business leaders Friday at the University of Cincinnati.
...
"There are two kinds of recessions that are bad - those that take place because of financial crises, and those that are synchronized around the world," he said. "In both cases, the recessions tend to last longer and be deeper. Right now, we've got both going on."

And from a separate interview with the Enquirer:

Q: What will it take to pull out of this crisis?

Krugman: I'm in the camp that really worries about the L-shaped recession. We level off but we don't get the recovery. We hope it isn't, but it has all the markings of it. This looks like the kind of slump that has all the markings of where normal recovery forces are very, very weak.

It's hard to see where recovery comes from. Almost always the way a country recovers from a financial crisis is with an export boom. The problem is that we have a global crisis this time. So who are we going to export to, unless we find another planet to take our stuff?

by Calculated Risk on 4/26/2009 01:15:00 AM

The Economist cover story is titled A glimmer of hope? and cautions: "The worst thing for the world economy would be to assume the worst is over"

Click on cover for larger image in new window.

[W]elcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced—that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths.
emphasis added

by Calculated Risk on 4/26/2009 12:04:00 AM

Just an open thread for discussion ... this story is concerning:

From the NY Times: Students Fall Ill in New York, and Swine Flu Is Likely Cause

Tests show that eight students at a Queens high school are likely to have contracted the human swine flu virus that has struck Mexico and a small number of other people in the United States, health officials in New York City said yesterday.

The students were among about 100 at St. Francis Preparatory School in Fresh Meadows who became sick in the last few days, said Dr. Thomas R. Frieden, New York City’s health commissioner.

“All the cases were mild, no child was hospitalized, no child was seriously ill,” Dr. Frieden said.

by Calculated Risk on 4/25/2009 06:25:00 PM

Last night, economist Joseph Stiglitz, investor Bill Ackman (Pershing Square), and NY Times journalist Andrew Ross Sorkin discussed toxic assets with Charlie Rose. The entire discussion isn't available yet, but here is a short excerpt: