Last week, we explored in some detail how the small time US Banks of the 1950s slowly grew into global International players. We saw how the small banks of yesteryear began to dip into their war-chests and started to use that money as well as floated shares on the exchanges to get the common man to invest money into themselves. Additionally, we realized the importance of the lifting of the Government 15:1 restriction which forced the banks’ Investment arms to stop lending at 15 times what they really had in their vaults.

Now let’s fast-forward into the year 2002 and beyond and look at our very own Growing Up Bank (aka GU Bank) to see what’s happening.  As we discussed earlier, the Bank has taken complete advantage of the easing of the 15:1 restriction and we’re in the stage where the Bank has 50 million in the vaults, but by wiping out our “rainy-day funds chest” and selling a large amount of stock, the Bank has successfully loaned out about 5 billion. In other words, GU Bank’s loan to deposit ratio is a cool 100:1 (compared to 15:1) as the Bank has managed to leverage it’s deposits to loan out 100 times that amount. You, the Chairman and CEO are at the zenith of glory and you spend a lot of time jet-setting around the globe as you strive to control and grow the Bank’s business. Everything’s going great.

There’s one small problem. It’s called the law of “Supply and Demand”. No matter how high your connections, no matter how much money you have, this simple principle is something that’s out of your control. Here’s the problem: When money was tight, your Bank always ensured that before you granted loans, you looked at the credit-worthiness of the borrower. Which is why borrowers hardly ever defaulted. However with all of this excess cash available, the law of Supply and Demand has kicked in. The amount of cash in supply in the market has zoomed while the demand for it has not. Our Bank’s Executives have hence come up with two simple solutions:

1. GU Bank decides to lower the strict standards of evaluation to determine which borrowers are eligible to get loans from the Bank – in other words, GU Bank is about to increase it’s lending activity to subprime borrowers. In other words, the new mantra for GU Bank is: Need a Loan? No Problem
2. GU Bank’s Investment Management unit will use surplus cash to purchase mortgage-backed securities – in other words – the Bank will buy housing loans made by other banks as well. After all, the markets are going wild, GU Bank is just joining the flock.

Let’s now fast forward a little more to year 2008.

You’ve received an urgent call about a slight problem. You check your emails and the news on TV to hear a catastrophe – there’s a big subprime crisis going on. What’s worse – your bank is right in the middle of it. What the hell happened – you ask at the crisis meeting in the office? How did Growing Up Bank suddenly turn into Going Under Bank? Here are the answers you get:

1. Of the large number of subprime borrowers that GU Bank had provided loans to, a substantial number are defaulting on their loans. Worse, the effect of this has pushed a large number of others on the brink too, so they may be defaulting soon as well.
2. Of the large number of mortgage-backed securities that GU Bank had invested in, a substantial portion were related to subprime borrowers, so they are taking a toll as well.

As the crisis goes on outside, the Crisis Management Committee in the Bank is brainstorming for solutions. This is what’s on the table:

1. You authorize Bank officials to look at the “Rainy Day” accounts of GU Bank to provide some relief from this sudden lack of cash that has arisen. As expected, the officials come back to you with the bad news that while these “Rainy Day” accounts do exist, the contents are woefully inadequate since everything was raided long ago (at your own orders, they add).
2. The Bank tries to use stakeholders money, but there’s none left because the Bank loaned it out long ago. Worse, the shareholders are in a tight spot because all of their investments are in trouble (not just GU Bank – obviously, you were not their sole banking investment).
3. Officials look at the vault to see what’s available there, but there’ s not much left. Remember for every unit in the vault, the Bank made loans of 100 units to borrowers. The market is tight and new depositors are hard to find. Even worse, thanks to #2 above, depositors know GU Bank is in trouble and are not eager to invest more money.
4. Trying to get credit from the market is extremely difficult because every other financial institution out there is in the same fix and is struggling to find a means to stay afloat.

After all options have run out, the Crisis Committee decides to go to the Government for help. At this point, the crisis is so acute that if the Government backs out, the Bank will collapse and hundreds of employees jobs will be lost (not to mention the thousands of people who life savings will be wiped out too). From this point on, any financial news channel or news website will tell you what came next: The near collapse of several major banks and the subsequent bailout by the Government.

With the background in this (and the previous post), you should be well on your way to understanding how the subprime mortgage crisis affected today’s financial institutions. Feel free to look up references on the Internet – they exist in plenty. Below are some resources I found interesting that you might want to look up as well:

1. Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud and Ignorance – Richard Bitner (Amazon)
2. Subprime Lenders Gone Too Far – A Time Bomb Waiting to Explode – Article by Michael Dawson @ EZine Articles
3. How to stop the Banks’ Bleeding – No easy choices – Article in Time Magazine
4. Leverage by the numbers – Article @ Option Armageddon
5. Bank of America tops Leveraged-Loan Business – Article in CFO Magazine