How Banks Work 2: Shitting Like an Elephant

How Banks Work 2: Shitting Like an Elephant

February 10, 2008


“Banks eat like a hummingbird … and shit like an elephant,” some bankers are known to say.

Well that is some macho he-man financial speak for sure! What does it mean? (And does it help to pick up girls?)

First, review last week’s primer on How Banks Work. You will remember that our sample bank, Wells Fargo, only made a return on assets of 1.77%. That’s not bad for a bank — better than some German and Japanese banks — but, you have to admit, a 1.77% return doesn’t exactly sound like an investment jackpot. On a pretax basis, it was 2.64%. That means that for every dollar Wells Fargo lent out, it made a profit of $0.0264, and that’s before the government takes their share. Over twelve months! That’s pretty skimpy. Sort of like the way a hummingbird eats.

It also means that, if the value of Wells Fargo’s assets fall by only 2.64%, over twelve months — for example if 2.64% of its loans become worthless — then the bank didn’t make a damn cent. And, if the bank’s assets fall in value by, say, 5% or so, then that big 10:1 leverage kicks in and the losses are enormous! Sort of like the way an elephant shits.

Since banks are the elephants of the economy, when they take a shit it’s not only the banks’ problem, it becomes everyone’s problem.

Remember, it’s the 10:1 leverage that turns the 1.77% return on assets into a 17.7% return on equity. It works the other way as well. A 2% loss becomes a 20% hit to equity.

A bank’s assets are mostly loans. These loans have credit risk — sometimes they don’t get paid back. (Do you think?) Or, they could be delinquent, or be partially paid back, or paid back in full at a later date, or be restructured on new terms, or sold to a third party, or many other things. Usually, the value of a loan doesn’t just collapse to zero. Many loans are collateralized, for example. A mortgage is collateralized by a piece of property. Even if the homeowner stops paying completely, the bank gets the house, and can sell the house. Banks are not allowed to make a profit on the sale of a foreclosed property. They can only get back $1 for every dollar they lend. (If there’s a profit, it goes to the previous owner.) However, it is not hard to see that banks can often sell a foreclosed property for as much or more than they lent, so even if the borrower goes bust, the bank might not take a loss at all.

If the bank sells the property and gets back $0.50 for every $1 it lent, then obviously the loss is 50%. This is known as the recovery ratio. A 30% loss is a 70% recovery ratio.

There are other kinds of collateral as well, such as companies and their assets, which back corporate loans.

Auto loans are collateralized by the automobiles. If you can’t pay, your car gets “repossessed” by the bank. Maybe they can sell the car for more than you owe on it. Maybe not.

Even an uncollateralized loan, like a credit card loan, might have some recovery value. The loan could be sold to a credit collector, maybe for $0.05 or so. The collector then tries to make a profit by squeezing $0.10 out of the deadbeat borrower.

Now, bankers know that some loans are going to go bad, at all times. Because of this, they set aside “provisions” against loan losses. These provisions are added to the “allowance for loan losses” or loan loss reserves, sort of like a piggy bank against the losses which are sure to come. You can see these provisions on the income statement as a “provision for credit losses.” It was $2.204 billion for Wells Fargo in 2006. Thus, Wells Fargo already has the first $2.204 billion of losses covered. Over time, this piggy bank is added to (via more provisions) and subtracted from (via real, actual losses). We see on the balance sheet that, at the end of 2006, there was $3.764 billion in Wells Fargo’s loan loss reserves piggy bank. Thus, Wells Fargo could lose $3.764 billion and it wouldn’t even affect income.

This loan loss reserve is not very big. Since there were $319 billion in loans, it is only 1.18%. Thus, the first 1.18% of losses are already covered by the loan loss reserve.

Provisions are recorded as an expense. So, they reduce net income. Since most banks are publicly traded, the management has to answer to (typically impatient Wall Street) shareholders. These shareholders usually like the biggest profits possible, as reported by accountants on a quarterly basis. Thus, they like the smallest expenses possible. Thus, bank managements tend to minimize provisions, in good times.

Also, in good times, the banks simply don’t have a lot of losses. When property values are rising, and people are getting good jobs and making more money, and businesses are doing well, usually borrowers can pay their loans. Even if they can’t, often recoveries are high, because the collateralized assets (propety especially) are rising in value.

So, year after year, the bank recognizes that it doesn’t have a lot of loan losses. If losses have been 1% of loans, year after year, why provision at 4%?

A bank could do this. The management could say: “Things aren’t always going to be so good. In fact, the present situation looks dangerous. We’re cutting back on our lending to lower-quality borrowers, and we’re going to start building up our loan loss reserves.” They could take more money, each quarter, and put it in the loan loss reserves piggy bank. If everything works out fine, the money is still there in the piggy bank. You can take it out again. This is called “de-provisioning.” A privately-held bank might work this way. They could later say, “Our provisioning for loan losses has proven to be overly conservative. This quarter, we enjoyed a profit of $1 billion from de-provisioning.” (Since provisions are expenses, a de-provisioning is a negative expense, or a profit.) However, such are the pressures on bank managements today that this sort of behavior is very unusual. Bigger provisions mean lower profits, according to the standard accounting.

When the bad times hit — very predictable, but never predicted — then you have people losing their jobs, businesses fail, and asset values fall. Default and delinquency shoot higher, and recoveries plummet. Losses become huge. Last year’s provisions and loan loss reserves don’t cut it anymore.

A bank has a duty to admit that loan quality has deteriorated, even before the actual, real losses are known. For example, a bank might not know how much it actually loses on a mortgage until the collateral property has been foreclosed and sold. This can take a year or more. When a borrower stops making the payments, then you know right away that there’s a problem. The accountants demand that the bank recognize this problem right away. They say: “Recoveries are deteriorating badly. You need to raise the provision on these defaulted loans to 30%. Also, the number of delinquent loans which go into default is rising. Provisions on delinquent loans need to rise from 5% to 10%.” Which is to say, they make an estimate of how much the bank will ultimately lose, which is $0.30 on the dollar for defaulted loans. The bank needs to put aside this $0.30 right away in the provisions piggy bank, and write down the value of the asset to $0.70. More provisions mean less profit, so profits decline, and maybe the bank is reported to have made a loss.

In some cases, especially in large-size commercial loans where the bank monitors the financial condition of the borrower closely, a bank may even declare a loan impaired (not worth its full value) if the borrower (a company) has made all the loan payments, but is in deteriorating financial health. The bank must provision against the risk that the company, some time in the future, may default on the loan. A bank sets aside a “general provision,” but it may also set aside provisions on specific loans, particularly large-size commercial loans.

These loans that the bank provisions against, particularly the ones with loan-specific provisioning, are labeled “non-performing loans,” or just “bad loans” or “bad debt.” Now, the funny thing is that many of these “bad debts” might be paid in full. This was particularly the case in Japan. I recall that about 70% of all the “bad debts” at banks were loans to companies that had made all the payments, but were suffering some difficulties. Which is not too surprising in a recession, no? That’s why (see the FT op-ed I linked to last week) the solution to Japan’s so-called “bad debt problem” was to cause the economy as a whole to recover, via monetary reflation and tax cuts. If a loan to a company — which had made all its debt payments — was simply recategorized from being a “loan at risk” (they were called “type II” loans) to being a “regular performing loan”, then 70% of Japan’s “bad loans” would vaporize. And, in an economic recovery fueled by reflation and tax cuts, this would be a very natural thing. Maybe 1 in 10,000 non-bankers had figured this out, even though the banks reported the statistics quarterly. Do you see why I say that it is important to understand how banks work, and why I say that hardly anybody does?

If they had read the banks’ financial statements, slowly and with curiosity, they would have figured this out. Which tells me how many people actually read banks’ financial statements. Which is why I insist that you do so, at least once in your life.

We’ll have more on how banks lose money next week.

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Is the “tax rebate” just an advance on your 2008 tax refund? It appears that the $150 billion “rebate” plan is, essentially, a loan on your regular 2008 (paid in 2009) tax refund. Most people’s withholding is a little excessive, so they get a refund. Basically, the government is paying your 2008 refund in advance! CNN reported this on their website as follows:

The package, which passed the Senate 81-16, will send rebate checks to 130 million Americans in amounts of $300 to $600 for people who have an income between $3,000 and $75,000, plus $300 per child. Couples earning up to $150,000 would get $1,200.

The checks are an advance on next year’s refunds, and most, if not all of the money, will be deducted from taxpayers’ refunds in 12 months’ time.

This was later modified to read:

Do I have to pay the rebate back?

No. And here’s why.

Your rebate is a one-time tax cut – an advance on a credit you’ll receive on your 2008 return.

It’s based on your 2007 income initially. If it turns out that your 2008 income and number of children would have qualified you for a larger rebate than the one you received, you’ll be sent the difference. If it turns out your 2008 income was lower than in 2007 and you should have gotten a lower rebate, you get to keep the difference.

“If you were supposed to receive a larger payment than you did, you will get the extra money,” said Treasury spokesman Andrew DeSouza. “If you received more than what you should have gotten, you will not be penalized.”

This is more confusing, but it basically says the same thing. More commentary on the “phony rebate” is here.

MSN Money reports that: “It’s Not Really Free Money

Remember, this is your money you’re getting back, and the rebate checks are basically an advance on your 2009 refund. When similar rebates were sent out in 2001, said tax expert Mark Luscombe, “a lot of people were upset to see their (next) refund reduced.”

Well, that’s pretty funny! Usually the government is a litte less sloppy than that. They should have just recapitalized the banks. That might have accomplished something. Now, nothing has changed except that even Subaverage Joe is aware that he is being governed by criminal knuckleheads.

The Web Bot project (see for more details) indicates a “tax revolt” coming in the spring. Indeed, when a government loses all legitimacy it sometimes finds that tax payments plummet. It happened in Argentina, for example, just before the economic collapse in 2001. Americans, who like to think they’re “independent-minded” but actually act like medieval serfs, would not normally be ones to simply not pay taxes. However, this display of government arrogance, combined with the “just walk away” boom for all kinds of financial obligations, might prove the Web Bot right in the end.

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There has been a lot of hoopla in recent days about “borrowed reserves.” We haven’t talked about this too much, but you should nevertheless be able to figure out the difference between a bank’s “reserves” (a somewhat archaic item that doesn’t really exist anymore in a functional sense) and its capital base. Carolyn Baum of Bloomberg gives a decent tutorial here.