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Financial Crisis 101

Everybody knows about recessions, as we normally have one every 4-8 years and are due for another.  The conventional definition is that GDP must drop two consecutive quarters, usually at an annualized rate of about 3%.  Despite the fact that investors invariably over-react to the first hint of a recession, the really scary thing out there is not a recession . . . but a financial crisis.

Because the financial system is the cardio system for the economy, a financial crisis is a heart attack for the economy.  They happen relatively suddenly and do far greater damage than recessions.

Normally, it happens because banks have made too many loans that go bad.  Bank accounting rules require that loans be written off to their market value.  The amount of that write-off is subtracted from earnings.  If earnings have already been wiped out, that amount must be subtracted from net worth or stockholders equity.  If that is decreased, banking regulations reduce the amount of loans that the bank may make or hold.  (This restricts lending when the economy needs it the most!)

A clear example in the recent past was the Savings & Loan debacle in Texas in the late 1980’s.  The savings institutions made too many bad real estate loans and were subsequently forced to carry the loans on their books at market value, necessitating huge write-offs.  Fortunately, while it was certainly a financial crisis in Texas and Oklahoma, it was localized enough not to threaten a national problem.

But, banks and savings institutions were no longer the sole avenue of a financial crisis after the capital markets were developed, because that allowed development of what Warren Buffet described as “financial weapons of mass destruction,” i.e., derivatives in general and credit default swaps in particular.  It was a mere thirteen years ago that he made that statement.

To explain a credit default swap, let’s assume I loan you one million dollars.  Later, I don’t feel comfortable with that much exposure to your credit or your ability to repay me.  So, I pay somebody else to guarantee your debt, called the guarantor A.  Let’s say I pay them $50 thousand.  I paid that amount to have the certainty that I will receive a net of $950 thousand back.  But, the creditworthiness of guarantor A has then declined, because he has a liability to repay me, if you don’t.  Guarantor A has a huge exposure to you, and he doesn’t want that much exposure either.  So, he might pay $25 thousand to guarantor B to guarantee $500 thousand of your debt and so on . . .

In 2008, nobody knew who was holding whose swaps nor how much.  In other words, I’m sleeping well at night, knowing that guarantor A will repay me if you don’t.  Suddenly, I find out you may not be able to repay me after all.  Even worse, I don’t know anything at all about the current financial condition of guarantor A.  Am I going to get repaid or not?  (This was a major concern during the Greek bailout in 2011.)

In a financial crisis, everything freezes.  Stores won’t accept personal checks.  Banks won’t make loans.  Indeed, in 2008, Bank of America wouldn’t accept deposits by personal checks totaling more $3,000 each day.  Many customers had to make daily deposits, because they could not deposit more than $3,000 each time.  The financial system was frozen.

I don’t advocate increasing cash in the face of recessions, only in the face of a financial crisis.