Will it ever end? For more than a year, the financial system has struggled to function, stricken as it is with economic Ebola. Cash is the only cure, and banks have raised almost $400 billion. That's not nearly enough, however, so the federal government has committed to various bailouts that will cost hundreds of billions over time. The most expensive yet - a new super-agency to buy bad debt - may eventually cost north of $1 trillion.
As bad as the situation is, we're in deeper trouble than most realize. The virus infecting banks - too much debt - is spreading to the federal government. If Washington falls victim, we could be headed for another Great Depression.
Trillions of dollars in bad loans infected bank balance sheets during the housing bubble. As house prices started to decline nationwide, those loans turned virulent, dropping in value and robbing banks of the capital they need to stay in business. The disease spread so quickly because banks have little uncommitted capital to defend against losses.
During the housing bubble days, bankers lent as much as possible, confident that housing prices would never go down. Consequently, they were left vulnerable to even a small decline.
Understanding why too much "leverage" can kill a bank is crucial to understanding why the credit crisis is dropping major financials like flies, and why the federal government is vulnerable.
Like all businesses, banking involves risk. If, for instance, borrowers default on their mortgages, the bank may struggle to pay back its lenders. So it keeps cash in reserve. But reserves earn no profits for the bank, so it minimizes them.
Assets make money, and reserves provide protection. Putting the first in the numerator and the second in the denominator, a bank's "leverage ratio" measures how much risk a bank is taking to make money. A higher ratio means more potential for profit but also less protection against loss. A sound bank should have a leverage ratio around 10-1. The major Wall Street banks operated with leverage ratios north of 30-1.
If leverage gets high enough, even small losses will cause a bank's creditors to panic. Worried that cash in reserve won't be sufficient to pay them back, they cancel credit. When a bank loses access to credit, it is put out of business.
Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Bear Stearns and even Baltimore's Constellation Energy Group all relied on credit in order to do business. When their credit disappeared, they ceased to function independently.
