The Credit Crunch – Why banks should be left to go down

Let’s call it the “credit crunch” – this will scare them. They won’t know that they are not impacted just that they have to trust us to fix it.

The root cause of the problem that we are in today is over lending to house buyers that fuelled an extraordinary rise in the value of property. Interest rates were low, no deposits were required, a borrower’s earnings were not even checked and mortgage loans being handed out to an ever more believing crowd so that…well, this is the question. Why were mortgage companies doing this?

A mortgage company has $1in capital provided by its shareholders and let’s assume no depositors. It then borrows $19 from the money markets. Money markets are where banks and such like are able to borrow short-term. The mortgage company lends $20 to borrowers to buy property. These loans are secured on the property. They are then packaged up into a $30 bond instrument by investment banks who take a fee for packaging them up and for then selling them. These packages may also come with insurance for the bond buyers provided by the likes of AIG. The packages are worth $30 because the interest rate paid by the borrowers is higher than the prevailing bond yield so bond holders, keen to place their money at higher interest rates pay more for the package than the original cost of $20. The mortgage company receives $25 and books a nice $5 profit. The other $5 has been paid in fees to investment banks, lawyers and other intermediaries.

Now, take this model and let’s look at the sums involved. The US mortgage market is around $12  trillion, just short of the US GDP at $13 trillion. Let’s assume that house prices fall 30%. The bondholders of the mortgage backed securities lose 30% on their bonds, at least! When your capital represents 5% to 10% of your liabilities then this means meltdown.

So, we know that everyone was making lots of money and times were good. We also know that the whole banking world is under threat. Has anyone clearly explained what will happen if mulitple banks fail?

Let’s assume that all banks fail immediately! In this instance the Government would need to create a nationalised banking sector that would focus on protecting deposits, ensuring cash is available and that credit and debit cards fucntion. It would also provide basic lending facilities. This is an extension of what happend with Northern Rock.

This situation is an easy one to deal with. How about if banks fail one by one over an extended period? Governments in my view should let these banks fail and certainly not help them into some merger like the Lloyds/HBOS merger. Private shareholders and banking executives MUST NOT be assisted and allowed to profit from Government support. The only reason they are is that the politicans and bankers have thrived in a mutually beneficial relationship since lending first became widespread.

Let the banks fail, state clearly that deposits will be protected up to the limit of £35,000, Speed up the time for such deposits to be repaid (currently 6 months) and put in place a plan to nationalis the banking sector if it can’t rescue itself.

Why should Warren Buffett be able to ride the US Government’s support for the markets and make a huge profit? He shouldn’t.

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