LRB on Banks

23:32 Mon 11 Feb 2008. Updated: 08:46 14 Feb 2008
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This John Lanchester article in the London Review of Books is an excellent overview of the current credit-related turmoil in the markets and includes a good summary on how banks work. Their manner of operation, in case you’re unfamiliar with it, looks remarkably like sleight-of-hand.

At their most basic level, they work by lending money at a higher rate than they borrow it. They borrow money, essentially, from depositors, and can then loan it (or most of it, the exact amount depending on regulations that vary by jurisdiction) to borrowers. They charge the borrowers more than they pay the depositors. Pretty simple. Lanchester has a more in-depth examination starting with “A well-run bank is a machine for making money” in his article—skip to that point if you’re more interested in the banking/financial side than the London/political side.

Much of the world’s market functions come down to methods for managing or passing on risk. One of the major problems with what’s going on right now is that nobody knows how to accurately measure the risks that major financial institutions are exposed to—partly because these institutions have set up the rules so that they don’t have to make public the derivative deals/trades they’re involved in. Since derivative deals can involve absolutely colossal risks, vast amounts of potential losses are simply hidden. What’s happening at the moment is that these losses are moving from potential to actual… but the ones that aren’t yet actual are still hidden. And still involve unbelievable amounts of money.

One thing I don’t get, however, is where the money is actually going. That the banks are losing money is pretty easy to get. But derivative deals are essentially bets with other entities, so some other entity must be on the good side of those bets, and must be making that money, unless I’m naively underestimating the weirdness occurring here. I do know that of the major investment banks, Goldman Sachs made a significant amount of money last year by betting on the other side of the subprime disaster. Presumably other people or institutions must have been doing the same thing, yet these losses are spoken of as if the money is simply disappearing into thin air.

One reason for that, I suppose, is that some of the value of these derivatives was based on the idea that the mortgage loans they’re ultimately based on would be repaid. If they’re not being repaid, then indeed that money does disappear, and perhaps a lot more of it, because someone is holding paper that was supposed to be worth the total payments on a lot of home loans but is now worth rather less, because those borrowers aren’t going to pay.

Transparency is obviously one problem, because allowing the players to hide the risks is asking for trouble. Another huge problem is that banks are supposed to be (and are in a bunch of ways) the linchpins of modern economies. Without them (without credit, really) the rest of the economy suffers hugely. Therefore they need to be safe, which is why they’re usually backed by government guarantees. But if they’re backed by guarantees, they’ll obviously have little incentive not to try rather risky things. At one time governments, in return for their guarantees, didn’t allow banks to engage in certain classes of dangerous or unpredictable behavior. But over the last forty years, the banks have managed to remove those constraints, and are free to risk huge amounts… normally of other people’s money. In fact, it’s really all other people’s money. This seems like a classic case of moral hazard… mixed in with some classic aspects of corruption, because these banks are also hugely influential in setting the rules of the marketplace, and in regulating large chunks of commerce. The fox isn’t just guarding the henhouse, but also charging the farmer rent per chicken, and in fact rent per projected chicken count over the next thirty years based on current trends of chicken reproduction, while also betting the farmer’s house that the fox’s profit per chicken will rise every day… forever.

One Response to “LRB on Banks”

  1. briang Says:

    Actually, quite a bit of the money is just disappearing into thin air and your supposition is correct. While buying options and futures is zero-sum, buying actual equity and debt is not. If there are a billion shares of Google outstanding, and the price of the stock drops 10 points, 10 billion dollars of equity evaporates.

    What is happening here is banks purchased debt obligations and expected repayment, and it is now clear they aren’t going to have the income stream they thought they purchased, so that value evaporates. The person selling the debt obligation got to unload it and make money on the transaction, but this revenue is already on the books and would have been booked regardless of how repayment went.

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