Welcome to Part 4 of the Recession Series. While not exactly essential, I strongly suggest that you peruse Part 1, Part 2 and Part 3 before you read any further into this article.

I wanted to title this post “How the hell can a bank go Bust – when it was  worth billions such a short time ago?“, but that title sounded far too long, so I shortened it a bit. As you’ve guessed, in this post, we are going to try and understand how a large bank (such as WaMu, Bank of America or Lehman) can go bankrupt. We will start by understanding how a Bank works in it’s simplest form and then move into the complex scenarios, again in simplified form.

The business of Banking, in essence, is straightforward. Let’s assume for the sake of example that you are the CEO of GU Bank (which proudly stands for Growing Up Bank). GU Bank takes money from people as Deposits, on which it pays them a low interest rate, say 3%. Then, GU Bank finds someone who needs money and lends the depositors’ money to them at a sufficiently higher interest rate, say 7%. The Bank earns for itself the 4% difference generated between these two transaction percentages as profit. Once this is complete, the Bank repeat this process over and over – that’s it. Simple, isn’t it?

There are some limitations to the above Banking methodology. We’ll talk a bit about them below:

1. You cannot lend what you don’t have – In other words, if the total deposits in your vaults is 1 million – that the maximum amount that you can lend out (minus government restrictions, CRR etc etc).
2. Your Bank and you are competing against the other Banks out there - some of who have more deposits than you and can outpace you easily. In other words, you need much more than what you have, if you want to grow against the tough competition.

So, from the 70’s, Banks that wanted to grow came up with two innovative ideas to generate money: Dipping into their own money chests and, Getting investor money – both of which we discuss below.

1. Over time, Banks had saved off a part of their profits for rainy days. With the competition in the market becoming more and more intense, Banks began to dip into this rainy-day fund to start getting money to increase their lending power.
2. Banks moved into Wall Street as institutions and started selling pieces of themselves as shares. Based on their reputation and marked standing, they were able to garner investor money by selling part of their ownership through Stocks. This provided even more money for lending.

Soon, things at GU Bank reached a point where the deposits in your vaults totaled 2 million. However, by dipping into your emergency funds and selling pieces of yourself in the Stock Market, you are able to raise capital that equals another 40 million. Hence, GU Bank now has 42 million available to lend. Compare this to your competitors who are still lending only what they have in Deposits – you soon realize that GU Bank is now firmly in the Big League.

The only thing that stops you is this (silly) Government law which stipulates that that maximum amount you can lend is 15 times the cash you have. Since you have 2 million in the vault, you can lend up to 30 million only. And you wonder – How old-fashioned – whoever heard of  loans being backed by deposits in this age?

However, what you have NOT realized (or blinded yourself to – same thing) is that a lot of the money you are lending out as Loans is now YOUR OWN and if the Lender fails to pay back the loan – YOU will be directly hit. Compare this with the traditional Banking business where you are lending out Depositor’s money, not your own.

But hold on a second – while you’ve grown your Lending Funds out of nowhere, your competitors have realized your trick and they’ve done it too. In other words, the entire Banking industry out there has now realized how to blur the line of distinction between a Bank and an Investment House,  everyone is dipping into their savings and selling pieces of themselves in the Stock Market and pretty much everyone out there has tons of moolah to lend and is looking for Borrowers. There’s a craze in the market to lend and every Bank out there is trying to get you to borrow more and more money from them.

Here are some samples of what Banks did with all this crazy money in the 00’s:

1. Industry leading salaries and record benefits to employees
2. Multi-million dollar bonuses to executives
3. Stock Buybacks – Buying back company stock from the open market
4. Sports Sponsorships
5. Private Jets for company executives

The list is long and crazy…

But even this was not enough, In 2007, Henry Paulson, the US Treasury Secretary and former CEO of Goldman Sachs pushed the US Lawmakers to lift the 1 deposit = 15X loans restriction as well. In other words, you were now free to lend everything you had.

Based on our example, Growing Up Bank has deposits of only 2 Million. It raised another 40 million but was able to lend out only 30 Million. Thanks to this new amendment, the Bank is now able to lend out the entire 42 Million.

Wow – you and Growing Up Bank are now at the top of the Big League. You’re having parties on your private yatch for your private guests, your wife is busy with buying those crocodile-skin designer bags, your Kids go to a private top-of-the-line school with their Nanny – in other words, you’ve got it all.

So what’s next? Next comes the Big Downturn, which we will talk about in the next post.