Wednesday, 8 October 2008

So Whats actually happening?

A few friends have asked me to try and explain all the "financial stuff" so here goes, I add that this is my understanding of whats happening and may well be complete nonsense, but hey its my nonsense and its got to be better than the spin we are getting from Gordon and Darling.

Right,,, The fractional reserve system of banking means a bank can take a deposit of £1 and lend it out (effectively) more than once.

So, if everyone walked into a bank on the same day and tried to withdraw their deposits, the bank would not be able to pay them back.

They have to keep a certain level of cash available to meet the demands of savers for cash. (Capital Adequacy)

The more banks lend, the more money they make. When they had no more money to lend, they created packages of debt - like Mortgage Backed Securities and Collateralized Debt Obligations.

(So, if they had lent 100 million out via 1000 mortgages (of 100k each) that were paying 5.5% interest - they would package these mortgages together and provide them as security for a loan from another bank.)

They then lent that money out again - and they all packaged up debt and sold it to each other (or used it as collateral).

Within these packages of debt, risky loans (high Loan to Values and high salary multiples) were included with lower risk loans.

In this way the banks got around the capital adequacy rules that say 'you must always keep x% in cash to allow for savers demanding their money back'.The result, eventually when the housing market started falling, was that banks suddenly stopped trusting each other.

Bank A would say to itself 'what is the real value of the security that Bank B is offering ... they're offering a MBS with a face value of 100 million that pays 5.5% but, are the properties backing that MBS actually worth a 100 million, are the loans inside it all 'good' loans or is it full of high risk loans (like Northern Rock used to make).

So, Bank A stopped lending to Bank B ... and Bank C, D, E etc - in fact all banks - because the whole system of packaging up and re-selling debt had become so complicated that no-one knew what the real position of any other bank was.

Were they sitting on lots of bad debts or not? Were the assets enough to back the loans they were offering as security or not.

So, the banks stopped lending to each other. As they had long ago used up all the lending they could make based on the money you and I deposit in them .. they basically stopped lending.

They certainly stopped risky lending. Now you needed a big deposit and a lower salary multiple to get a mortgage.

And, of course, this made it worse because this causes house prices to fall further - reducing the value of all the MBSs and CDOs flying around the system - making the banks even more reluctant to lend to each other.

So, the banking system begins to freeze. And their share prices fall through the floor. And, when this happens, the rating of their debt is reduced by the people who decide whether a company's credit worthyness is AA, A, etc and, as this happens, other banks become even more reluctant to lend to them.So, the spiral down continues.
Until, and unless, the government can put enough money into the system for the banks to start lending to each other again. So that is what the 500 billion bailout or is it 750 billion bailout from Alistair today...... will it work? NO!
Why wont it work?
Ill have to do another log to explain why not, but it has not worked in America and we are a few months/weeks behind them in this crisis!

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