Another week, another amazing This American Life episode. This week they tackle the economic crisis for a third time, and they explain things in plain English for everybody to understand in easy terms. They have a great explanation involving how exactly the banks got into trouble. You should listen, but here's a quick and dirty explanation.
Let's make up a bank. We call it "Bank A", and Bank A starts with $10 capital. That means that initially, the bank has ten dollars to loan out, to invest, to do what have you with. Of course, just sitting there, the bank makes no profit. Right now, their balance sheet looks like this:
Since the bank has $10 in capital, the bank is worth about $10 all in all on the market; the liabilities and assets minus the capital. Now, to make money, banks take deposits and make loans. Let's say that Andrew deposits $90 into the bank, and is promised a 3% interest rate. Now the balance sheet looks like this:
For now, we'll ignore that interest rate; let's say this all happens on the same day, as the interest rate is largely unimportant for the purpose of this explanation. Now, the bank has $100 total in its vault, but if it just sat there, the bank would of course lose money. In a year, the bank would owe back that $90 plus the 3% rate if Andrew returned to withdraw his money. But then, someone else comes along, Scott, who wants to purchase a house. He needs $100 in order to do this. Bank A gives him a loan with a 6% interest rate:
So now, in a year, Scott will owe $106, and the bank owes Andrew $92.70. They would make a profit of about $3.30 after this timespan. This is how banks make money - loan out money at a high interest rate, and take depositor money and give it a lower interest rate.
Anyway, the housing crisis comes along. Suddenly Scott's house's value plummets 25%, down to only $75. Scott, falling on hard times himself, loses his job because of layoffs. He defaults on his loan, and the bank must foreclose and take the asset for itself. This creates a significant problem. Here's the balance sheet:
Now the bank owns a house that is worth only $75. If Andrew came back and wanted his money back from the bank, the bank would be unable to pay it, even after selling Scott's old house. The bank could thus be said to be worth about $75 + $10 - $90, or -$5.
This is obviously a bad thing. The bank is no longer solvent. It no longer has enough capital and assets to pay back the people who put money into it. This is exactly the situation that the banks have been battling; struggling to keep their capital and assets combined above their liabilities.
Obviously, the problem arises when Andrew comes to withdraw his money. The money is not actually all there; if the bank went out of business (and the FDIC did not exist), then Andrew would only be returned $85 of that $90 he initially put in, and the bank is now worth nothing and goes into bankruptcy.
The solution so far has been to give money to those banks in order to ensure that they can pay off the people who want to withdraw their own money from the banks. What the banks have been advocating is that the government uses tax money in order to purchase those homes from the bank, essentially. The homes have a market price, but clearly even if the government paid $75 to Bank A, Bank A still would not have enough to repay Andrew. So the banks have wanted essentially the highest possible price the government could pay. The problem is, though, that banks wish to avoid nationalization at all costs; this essentially means that the bank's "life" as a corporate citizen comes to an end.
Herein lies the problem. If the government gobbles up the assets of the bank, and takes over 50%, it effectively has the majority say in the direction of the company. It can veto things the company tries to do or propose and hammer through its own opinions and methods. Of course, this would probably be temporary; the government would almost certainly sell the company back to private hands once the coast is clear, so to speak.
Anyway, listen to the podcast
here for plenty more great talk about what's actually going on.
