What banks do. And how we got in this mess

Last week, something happened which I never expected to see in my lifetime. There was a general run on the entire British banking system, something that hasn’t happened before, even in wartime. Ordinary people started moving their money around from bank to bank in fear that they might lose their cash. Millions of pound were flowing across the Irish sea for the safe haven of the Irish government’s 100% depositor guarantee. The banks were on the verge of losing public trust, and public trust is the one thing banks need to survive.

We are witnessing what the commentator Martin Wolf of the Financial Times, calls “the disintegration of the financial system”. But how did we get here? How did a few dodgy sub-prime mortgages in American inner cities lead to what is beginning to look like the collapse of capitalism? This is the great unanswered question in the midst of this extraordinary crisis, as banks explode one after the other across the world. We hear endless talk about “deleveraging” “derivatives” “collateralised debt obligation” “credit default swaps” most of which is completely incomprehensible - and very often designed to be. A lot of what has been going on is essentially fraudulent. But underlying it all the jargon is a fundamental truth about banking; that it is based on a kind of confidence trick

It's called "fractional reserve banking". Alone of commercial institutions, banks are allowed to create value out of nothing - they are allowed to lend out money they don’t have. To explain: at any one time a bank may have, say, a billion in assets, but it will have lent out at least ten billion. That ten billion will yield interest - interest on money the bank doesn’t actually own, that is not based on deposits in its accounts. Magic. Money for nothing. But this magic only works if the debtors the bank has lent to don’t default on their loans and that the savers who have placed deposits in a bank do not all try to take them out all at once. If they did, then the bank would rapidly become insolvent, because of the nine billion it has lent out that it never had in the first place. That’s what started to happen last week. The confidence trick began to fail.

Banking practice dates from medieval times when kings and aristocrats deposited their gold with goldsmiths for safe keeping. The goldsmiths noted that they owners didn’t all ask for all the precious metals back at the same time, so they started to lend it out. This is why, until very recently, bank notes “promised to pay the bearer” a sum of sterling silver. It was all based on precious metals. Not any more. Currency ceased to be linked to precious metals in 1971 when America abandoned the gold standard and ordained that, instead, the world should regard dollars as “good as gold” and use it as the universal medium of exchange. This is called “fiat” money, and some economists believe that it is the root of all evil because, with no intrinsic value, governments cannot resist printing more and more of it thus devaluing their currency.

Now, the prevailing view nowadays among economists is that central banks can maintain the value of their currencies by manipulating interest rates up or down to control inflation. But this depends on the willingness of the central banks to do so. It also depends on the wisdom and prudence of the banks who manufacture this magic stuff called credit. For the past twenty years, central banks have seen economic growth as more important than combating inflation, and banks have thrown prudence to the winds.

After the 1987 crash, central banks cut interest rates, and economic life resumed. Again in the late 1990s, after the Asian financial crisis and the near collapse of the hedge fund Long Term Capital Management, banks cut interest rates again. After the dot com crash in 2001, the US Federal Reserve followed by the Bank of England cut rates dramatically yet again, and kept them low for the next three years, stimulating house price bubbles in both countries. The central bankers made saving money a loser’s game. Interest rates were held below the rate of inflation, so anyone who saved actually lost money. The bankers knew perfectly what they were doing - the former Bank of England governor, Eddie George, told a Commons Select Committee two years ago that the housing boom was “unsustainable” but that he and Gordon Brown deliberately inflated it prevent a recession. Unfortunately, it got a bit out of hand.

The other problem with central banks always cutting interest rates was that this encourages the banks to stop behaving themselves. Huge institutions like Lehman Brothers and HBOS started to think they were invincible, masters of the universe, ‘too big to fail’. Banks like Halifax Bank of Scotland piled into property, believing that house prices would never fall, and if they did, the Bank of England would slash interest rates and house prices would rise again. Banks like Northern Rock stopped bothering about the boring business of attracting deposits from savers and started borrowing money on the international money markets to fund ever more ludicrous mortgage lending - such as their 125% “suicide” loans. Northern Rock was still selling these “Together” loans six months after it was nationalised.

This confidence that central banks would ride to the rescue led banks to take bigger and bigger risks. Instead of lending ten times the value of its underlying assets, investment banks like Lehmans started lending out thirty times asset value. This is called leverage, and allowed the hedge funds and private equity groups financed by Lehmans to go on buying sprees across corporate world. They were getting colossal quantities of almost free money. “Leveraged buy outs (LBOs)” became the name of the corporate game. Groups of investors would get together, target a company like AA, borrow to buy it, load it up with more debt, sell it, and move on. Hedge funds flipped multi-billion companies the way amateur property speculators in California flipped houses.

But it was all based on credit, and the dark side of credit is debt. All of this works only so long as the underlying assets retain their value. Using leverage seemed like free money. But when assets decline in value, the ugly side of debt appears in the form of “deleveraging”. If a bank has loaned out thirty times its assets, it has loaned out three trillion on the basis of only a hundred billion in reserves. If those assets lose half their value, the bank finds itself in the hole to the tune of one and a half trillion. Greatly oversimplified, this is what has happened in the last year. A class of complex paper assets called “securities”, based on the value of residential mortgages, started to lose value as US house prices started to slide. The banks suddenly stopped trading these mortgage backed securities because they were afraid of the potential losses that might show up if they did. These assets included the infamous sub-prime loans - fraudulently lent to Americans who couldn’t possibly pay - which were packaged up into “collateralised debt obligations” and sold on to other banks and governments who didn’t really know what they were buying.

That’s about where we stood at the time of the collapse of Northern Rock in August 2007. A general panic among banks froze interbank lending. Governments then stepped in, first to nationalise Northern Rock, then to pump billions of so called “liquidity” loans into the system. In essence, the Bank of England agreed to exchange valuable treasury bonds for dodgy mortgage assets. The banks could use these treasury bonds as a kind of currency, because everyone accepted their value was underwritten by the government - ie you and me.

But then something else happened. Huge Wall St investment banks like Bear Sterns started to discover their assets were declining even more rapidly than expected, and investors started withdrawing their funds from them, causing a kind of bank run. To prevent widespread defaults, the US government stepped in an forced a another bank JP Morgan to buy Bear at a fraction of its value. But this didn’t stop the contagion.

Within the space of six months all the big investment banks on Wall St had collapsed or been merged with other institutions in one of the greatest banking crashes of all time. Then the big mortgage banks started to go under, like IndyMac, Washington Mutual, Wachovia, HBOS, Bradford and Bingley. The two huge state supported US mortgage banks, responsible for $5 trillion in mortgages, Freddie Mac and Fannie Mae had to be nationalised, along with the world’s largest insurance company AIG. Banks which had handled hundreds of trillions of investments were finding that they were becoming insolvent almost overnight. Because fo the global reach of these companies, this became a crash even more severe than the series of banking failures that led to the Great Depression in the 1930s.

We are now reaching what might be called the terminal stage in this crisis. The contagion has spread through the entire banking structure of the West. It has moved from a crisis of liquidity, to a crisis of insolvency and finally to a crisis of confidence in the entire banking system. Suddenly, everyone wants their money out because no one trusts their banks. That essential trust that allowed the goldsmiths to lend on the basis of their borrowed gold, has begun to evaporate. To prevent Ireland’s banks going bust, the Taoiseach last week decided to guarantee all of the deposts in Irish banks, even though it would be impossible for the Irish government to pay up if everyone withdrew. Money is now flooding out of British banks to the Irish “safe haven” which is why Britain and the EU are furious at this unilateral action by the Irish. Meanwhile, European banks are now starting to explode, one by one.

So, what made the collapse quite so catastrophic that even hundreds of billions of liquidity loans were not enough to staunch the flow? Well, the answer appears to lie in what is called the “shadow banking system”. This refers to the unregulated dealing by banks in what are called “derivatives” - these are financial instruments which don’t have a value in themselves, but relate to a future value. Originally, derivatives were things like pork belly futures - essentially bets on the value of that year’s cull of hogs. But a hugely complex market evolved in the trading of derivatives called credit default swaps, which are like insurance policies taken out on corporate debt. In the space of five years the value of credit default swap contracts rose to $62 trillion, larger than the value of all the world’s stock markets. The bank of international settlement in Basel calculated that the total value of all derivatives in the world last year amounted to some $500 trillion dollars.

The market in these ‘over the counter’ derivatives is completely unregulated, and traders are allowed to make bets and enter into contracts without necessarily having assets to back them up. The derivatives banks thought they had removed the risk by using complex mathematical formulae which seemed to indicate that they could so finely calculate the likelihood of making a loss that they could insure against it. These derivatives and the mathematics underlying them were immensely complicated and very few people understand them. Indeed, it has emerged that the people who devised them didn’t understand them either because the whole derivatives pyramid is now collapsing.

But through all the confusion the simple essential fact is that banks have hugely over-lent, their assets are declining, debtors are defaulting and their losses, multiplied by complex derivatives and deleveraging, the losses have become almost incalculable. The banks have had to cut back their lending drastically to build up their capital reserves, and they are now appealing to governments for direct injections of capital. This is what the $700bn Troubled Asset Relief Programme was all about - using taxpayers money to try to shore up banking capital by buying their worthless assets. But the trouble with this scheme. devised by the former Goldman Sachs boss, Henry Paulson who is now US Treasury Secretary, is that no one really knows how big the losses of the banks are, because of this huge amorphous cloud of impenetrable derivatives contracts.

But the story isn’t over there. Not only did the banks lend too much, and binge on dodgy derivatives, they based most of their devilish formulae on a presumption that house prices always go up. Now, statistically speaking, this is arguably the case - over time, house prices have always risen in the long run. However, in the short run, the graph can be a very lumpy one, with rises and big falls. For some reason, the banks forgot this, and thought that the bubble in house prices that was ignited by the 2001 interest rate cuts, would continue forever.

This was utter madness. House prices are now falling to trend - which means to their historic values. This means a reduction of something like 30-50%, because the graph of prices always overshoots on the upside and downside. Look at any historical table of house prices and this is blindingly obvious - but for some reason the banks believed that the laws of economics had been suspended by their brilliant mathematics.

So now what happens? Well, as house prices continue to fall, as fall they must, the value of the assets in companies like HBOS will continue to be marked down. This is why LLoyds TSB shareholders are very reluctant to take on HBOS at any price, because it is stuffed with dodgy mortgages which are falling in value. The banks all hoped that by now the central banks would have cut interest rates and people would all have started buying houses again - and that is what the US and British governments are still hoping will happen. But it won’t and it can’t. House prices are simply too high and have to fall, even with cuts in interest rates. The banks know this, which is why they are refusing to lend unless people can put up large deposits.

This creates a vicious circle which can only be resolved by the assets being revalued. House prices must come down; the banks’ assets must be repriced; insolvent banks must be closed; interest rates must be recalibrated to encourage saving; consumers will have to stop borrowing to spend and everyone will have to start paying their debts. It’s a tall order, and governments across the world are in denial. But the only way out of this mess is some very hard medicine. The longer governments and banks put off swallowing it, the longer the slump will last.