More Banking Panics Are on the Way

After the creation of the FDIC in 1933, it became much more difficult to stir up a major banking crisis. The reason was simple: A key ingredient in the Great Depression and previous banking panics were bank runs by depositors, an issue that was effectively averted by government guarantees.

And yet here we stand today, in the wake of a major financial crisis that was significantly fueled by -- you guessed it -- runs on the banks.

Of course this time it wasn't the classic scene of Average Joe joining a long, jostling line in front of his local bank branch to try and pull out his money. This time around it was major financial institutions losing faith in their peers and yanking the short-term financing that was keeping many major financials afloat.

And if we want to have any hope of battening our system against future meltdowns, we absolutely need to address this issue.

A scary picture
Think those adjustable-rate mortgage loans with their resetting rates are unsettling? What if mortgage financing wasn't even that stable?

Imagine if the homebuying process involved negotiating multiple ultrashort-term lending agreements. Let's say, for example, that you're buying a $200,000 house and you end up borrowing $50,000 from four different lenders. Each is a daily maturing loan that automatically rolls over unless one of the parties decides otherwise.

While this financing might cause more sleepless nights, you might not notice the difference between it and long-term financing as long as you're employed, times are good, and the loans are continuously rolling over.

But what happens when the housing market starts to wobble and you're facing a 20% pay cut? Suddenly your lenders aren't quite as sanguine. Perhaps one decides to pull the lending agreement altogether, requiring you to cough up $50,000. Now.

Nothing new for bankers
Of course, using short-term financing to fund long-term assets is nothing new for traditional banks like BB&T (NYSE: BBT  ) and PNC Financial (NYSE: PNC  ) .

The most vanilla banks out there bring home the bacon by taking customer deposits and using them to make loans. For the most part, deposit customers are free to withdraw their money any time they want, while the bank's loans can range from a few years to multiple decades.

In other words, the banking system was built on mismatched funding.

This system became particularly dangerous when the economy hit the skids, fear got the best of depositors, and everyone came running to reclaim their money all at once. As noted above, though, the creation of the FDIC has made it unnecessary for most depositors to fret about their accounts. If the bank fails, Uncle Sam will be there to pick up the pieces.

No FDIC for the big boys
Since FDIC insurance only covers up to $250,000, what happens when you have, say, a few hundred million to deposit?

That's exactly the problem that many major money market funds, investment managers, and pension funds run into. When they have money that's uninvested, they'd like to put it somewhere that's safe and offers some sort of return.

Enter the repo market.

Repurchase agreements are typically very-short-term lending agreements (often just one day) between financial institutions. One party lends money to the other in exchange for some interest payment and a slug of assets to act as collateral. It is typically a safe way for lenders to earn interest on excess cash, while for borrowers it's a good way to finance activities with higher yields than what they're paying out in interest.

For many of the financial highfliers, these kinds of short-term agreements had become a primary source of financing in the precrisis days. Here's a comparative look at funding among more traditional banking institutions and folks like Goldman Sachs (NYSE: GS  ) back in '07.

Company

Total Assets
in 2007

Balance Sheet Funding
From Deposits and Long-Term Debt

Wells Fargo (NYSE: WFC  )

$575 billion

83.9%

US Bancorp (NYSE: USB  )

$238 billion

80.2%

Bank of America (NYSE: BAC  )

$1.7 trillion

63.9%

Citigroup (NYSE: C  )

$2.2 trillion

60.4%

Merrill Lynch

$1 trillion

36.9%

Lehman Brothers

$691 billion

22.7%

Bear Stearns

$395 billion

18.0%

Goldman Sachs

$1.1 trillion

16.6%

Source: Company filings and author's calculations.

Companies that rely heavily on funding sources other than deposits and long-term debt run an extremely high risk of having their liquidity lifelines cut. Couple that with high levels of financial leverage and you end up with a pile of tinder soaked in gasoline just waiting for a spark to ignite it.

In all the talk about financial reform and working to prevent future crises very little has been said about doing something about this very real challenge. The next wholesale banking run may not happen tomorrow or even five years from now, but unless it is dealt with, it's not a matter of if, but when it happens again.

Now it's your turn to weigh in. Scroll down to the comments section and share your thoughts on this financial system pressure point.

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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


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  • Report this Comment On March 31, 2010, at 2:55 PM, jrod87 wrote:

    I like that we say the chart on Balance Sheet Funding

    From Deposits and Long-Term Debt

    Main reason I joind Buffet and Picked WFC to win over the S&P and when the collapse happend in 08' I took my Millitary TSP Funds ( As I left Active Duty) An put it into my Roth, 60% went to WFC Simply base on those number. I felt theyed survive. and If they can make it thro this Decade when Its time for me to retire maby I can give them 250k to put in my Sav acct. ^^

  • Report this Comment On March 31, 2010, at 4:31 PM, Bot1 wrote:

    I wonder what the percentage was for WaMu before it was taken and sold to JP Morgan.

    If there is a disconnect in the premise, then I suspect that WaMu would show it.

  • Report this Comment On March 31, 2010, at 4:36 PM, holosys wrote:

    Surely you are not suggesting they do away with 30 year fixed mortgages? In the early 20th century, mortgages were short-term deals that required extreme financial stability on the part of the buyer. Now that may sound prudent, but considering hardly anyone would qualify, wouldn't the housing inventory just sit collecting dust (until it dropped so low that slum lords bought up entire neighborhoods and rented them dirt cheap)?

    I do wonder where a person who was visited by the Prize Patrol would sock those millions, considering the $250,000 FDIC insurance limit. A friend casually answered, "Why, they would open a bunch of bank accounts at $250,000 each, of course!" Now that's funny.

  • Report this Comment On March 31, 2010, at 5:17 PM, BMFPitt wrote:

    Solution: Make it a federal crime punishable by death to suggest bailing out any private company for any reason.

  • Report this Comment On March 31, 2010, at 5:27 PM, uncas10 wrote:

    hi , i think there will be many more bank closures this year and next . However, i believe the fed. and fdic will move us through these "crisises " successfully. Also, i think its time to take the stress off the government agencies and let them continue to do their job . I am more concrened with navigating through the next "bubble" than worrying about bank failures which the F D I C has moved through successfully to date . Thanks for reading . flawrence007@gmail.com

  • Report this Comment On March 31, 2010, at 5:37 PM, LessGovernment wrote:

    Thanks Morgan.

    Now I see why Paulsen and Geithner paid 100 cents on the dollar to AIG so AIG could give 100 cents on the dollar to Goldman Sucks. Goldman did not have any deposits to speak of. It all makes sense now. Thanks.

  • Report this Comment On March 31, 2010, at 6:24 PM, TMFKopp wrote:

    @Bot1

    "If there is a disconnect in the premise, then I suspect that WaMu would show it."

    Good question. WaMu had $328 billion in assets in 2007 and 72% of its liabilities were from deposits and longer term borrowings. So, yes, that bank ran into trouble despite the fact that it had a more stable financing base.

    However, the contention isn't that a stable deposit base makes an institution completely unassailable -- the hundreds of FDIC-insured banks that have gone under have proven that. But, what is clear is that most of the large, high-flying financial institutions financed themselves on unstable, short-term agreements that had a much higher likelihood of disappearing during a panic. Not only that, but the companies in question were much larger than even WaMu and posed a much larger threat to the system as a whole.

    The process of evaluating the safety of a bank would not go, "Step 1: check financing base. Safe? Ok, whew! Everything's alright!" Rather, making sure there's stable financing in place would only be an initial check. Past that, whether we're talking about regulators or investors, would be evaluating other important factors like loan quality.

    @holosys

    "Surely you are not suggesting they do away with 30 year fixed mortgages?"

    I'm not sure how that was your takeaway from this article, but, no, I'm certainly not suggesting that 30-year mortgages be eliminated.

    The point is that vanilla banks are able to finance longer term assets on shorter-term financing (deposits) because the deposits are federally backed. There is a similar maturity mismatch when it comes to assets and financing when the financing is repos and other short-term agreements. I don't think federally insuring repos and the like is the right idea, but instead I think we should be limiting the extent to which that dominates a financial institution's funding.

    @uncas10

    "Also, i think its time to take the stress off the government agencies and let them continue to do their job ."

    A large part of the reason that we're in the current situation is that government agencies weren't doing there job. That, and the fact that they simply weren't armed with rules and regulations that allowed them to keep the system safe.

    @LessGovernment

    "Now I see why Paulsen and Geithner paid 100 cents on the dollar to AIG so AIG could give 100 cents on the dollar to Goldman Sucks. Goldman did not have any deposits to speak of. It all makes sense now. Thanks."

    I think there was more to it than that, but the more we learn about that situation, the more it seems that Goldman really did need that implicit bailout.

    Matt

  • Report this Comment On March 31, 2010, at 6:56 PM, lucybelle77 wrote:

    The next big bubble is already being created by our government in Washington DC. Wonder who will bail us out?

  • Report this Comment On March 31, 2010, at 7:27 PM, kikico987 wrote:

    I have been looking for a stable bank not on the "fail when FDIC has money" list in my area. My whole county and one county to the west have all their banks on the severe watch list. Tell me it isn't spooky out there.

  • Report this Comment On March 31, 2010, at 8:14 PM, sonofdog wrote:

    You clearly have no idea how money is issued.

    "The most vanilla banks out there bring home the bacon by taking customer deposits and using them to make loans. For the most part, deposit customers are free to withdraw their money any time they want, while the bank's loans can range from a few years to multiple decades."

    Now that you've obscured the root cause of financial instability, instead focusing on a symptom of a much greater problem, how are you ever going to get back to explaining the root of the problem? The problem isn't so much with banks and bank runs, as fractional reserve banking and debasing currency.

    There will certainly be more banking panics on the way as long as the US monetary system is being run in this way by the Federal Reserve.

  • Report this Comment On March 31, 2010, at 10:27 PM, TMFKopp wrote:

    @sonofadog

    I was wondering whether we'd have someone regurgitating the Austrian talking points. However, the logic of "end the Fed" makes about as much sense as tearing down an entire apartment building because a pipe burst in 3A.

    I can understand why people look at financial system, cringe at the fact that it's wrought with complexity, and cry "off with its head!" But let's be serious, we live in a country with GDP of $14 trillion, there is little about our economy -- or financial system -- that's not going to be complex. And that's with or without the Fed.

    There are problems with the system, so we should address them. The idea of tearing the entire thing down is just silly.

    Matt

  • Report this Comment On March 31, 2010, at 10:43 PM, robertf36009 wrote:

    Let us not forget that the "Financial high fliers." were engaged in some very creative and risky instruments like CDS, CDO and my personal favorite MBS. Much of the bail out money paid to AIG left the country directly to pay their debt insurance obligations to foreign banks. Citti group (C), Fannie (FNM) and Freddie (FRE) became zombies because of the toxic MBS they had loaded up on. Then Uncle Sugar rode to the rescue with free money for the most egregious offenders from taxpayers which they in turn lent to those taxpayers at double digit interest rates. What a racket, and we arrested Madeoff.

  • Report this Comment On March 31, 2010, at 11:37 PM, Glycomix wrote:

    Greenspan recently revealed that between 2000 and 2005, Fannie and Freddie made 40% subprime loans in their "Mortgage Backed Securities." That number increased markedly in 2006-2008. In 2008, Fannie provided 76% of all loans, $5.3 trillion in loans, and HUD gave them the goal of giving 57% of the mortgages that they buy to the poor to ‘moderate’ income: If you multiply this out, then 43.33% of every loan made will probably go bad. Banks are only capitalized to 8% of loans. This percentage of bad loans could easily destroy the US banking system. If they fail, how much would the US taxpayer have to increase taxes to pay for this? 57% of 5.3 Trillion is 3.0 trillion.

    Table 1 from ‘HUD user’ website

    Fannie Mae/Freddie Mac HUD goals: > given% of 100% of loans must go to these

    Arena . 2000 2001-4 2005 2006 2007

    1 Poor-Moderate income 42% 50% 52% 53% 55%

    2. Underserved (minority) 24% 31% 37% 38% 38%

    3. S.Affordable(<60% avg area income) 14% 20% 22% 23% 25%

    If no overlap 80% 101% 111% 114% 118%

    http://www.huduser.org/portal/datasets/GSE/gse2007.pdf

    When divided by 142.3 million taxpayer the 57% that Fannie and Freddie provided in loans comes out to $20,829/taxpayer for 2008. The IRS reveals that they collected $1trillion from 142.3 million taxpayers. If one divides this out the following is seen; $1,000,000 million/142.3 million taxpayers = $7,027/taxpayer. If we divide $20,829/taxpayer by $7,027/taxpayer, we end up with the proportion 3.02. That means that the US taxpayer would have to add 302% to our 100% of our current taxation levels in one year to pay if all of Fannie and Freddie’s loans to the poor are defaulted on in 2008. That means that the new tax level for tax year 2010 or 2011 would be 402% of our current rate: If you paid $10,000 in taxes this year, you’d have to pay $40,400 in taxes in 2011. We’d have to pay the full amount in ONE YEAR because Fannie and Freddie must still give loans to people who can’t afford them in the Affordable Housing Act of 1990 and the Housing and Community Development Act of 1992, and the Affordable Housing Amendment of 1992.

    The words "Affordable Housing Goals" REALLY mean "Public Housing" and “Mortgages for those who can’t afford them” goals. Many banks are failing because of Fannie and Fredie’s subprime loans. Even more will fail in 2010 than in 2009 according to Geithner. Look at the Loan Goals that HUD required of Fannie and Freddie from 2000-2007. The stock market crash was caused by toxic subprime loans.

    Fannie and Freddie still have Affordable Housing Goals for 2010. By law their executives must meet these goals of buying loans to the poor or ultra poor or suffer dismissal. It’s difficult to know whether these stressors had a part in causing the recent suicide of Freddie Mac’s CEO? http://www.cnn.com/2009/US/04/22/kellermann.death.freddiemac...

    Fannie and Freddie executives must STILL give crazy loans to meet their “loans to the poor and minority” goals. Here is the exact language of the law:

    “(a) In general The Director shall, by regulation, establish annual goals for the purchase by each enterprise of the following types of mortgages for the following categories of families:

    (1) Purchase-money mortgages

    A goal for purchase of conventional, conforming, single-family, purchase money mortgages financing owner-occupied housing for each of the following categories of families:

    (A) Low-income families.

    (B) Families that reside in low-income areas.

    (C) Very low-income families.”

    http://www.law.cornell.edu/uscode/html/uscode12/usc_sec_12_0...

    Congress requires Fannie and Freddie executives to by loans made to those lacking rent? See § 4565 below. How could these meet the ability to repay? Maybe Fannie and Freddie buy loans that their executives pretend are good, made by payday loan companies who have no soundness requirements when making loans.

    § 4565. Duty to serve underserved markets and other requirements: Enterprise shall develop flexible underwriting guidelines to facilitate a secondary market to preserve housing affordable to very low-, low-, and moderate-income families, including housing projects

    (a) Moble Homes (b) rental assistance programs and (c) Homeless Assistance Act (42 U.S.C. 11361 et seq.).

    http://www.law.cornell.edu/uscode/html/uscode12/usc_sec_12_0...

    Banks can’t survive if their loans aren’t repaid. I doubt that money loaned to people for the purpose of “rental assistance” and for a house if you’re homeless will repay their loans.

    Please petition your Congressman and Senator to reapeal the Cranston-Gonzales Affordable Housing Act of 1990, and the Housing and Community Development Act of 1992 Public Law No: 102-550 to prohibit under threat of dismissal and prosecution setting goals obliging any of the GSE’s to provide welfare under the fantasy of banking:

    Avoid buying loans or giving loans to anyone who cannot pay:

    - loaning money to the homeless or to those needing rent.

    - the very poor who could never be expected to repay the loans.

    - minorities solely because they are a minority

    - any poor person who cannot be reasonably expected to repay their loan

    To avoid destruction of the remaining US banks, you might ask your congressman to consider repeal of the following areas of US code:

    US Code Title 12, Chapter 13;

    Section:

    1701s. Rent supplement payments for qualified lower income families.

    1701u. Economic opportunities for low- and very low-income persons.

    1701x. Assistance with respect to housing for low- and moderate-income families.

    1701z–3. Experimental housing allowance payment program.

    1715z. Homeownership or membership in cooperative association for lower income families.

    1715z–1. Rental and cooperative housing for lower income families.

    1715z–1a. Assistance for troubled multifamily housing projects.

    1715z–1b HOPE for Homeowners Program.

    1701z–3. Experimental housing allowance payment program.

    1715z–9. Co-insurance of eligible mortgage, advance, or loan

    1715z–24. Pilot program for automated process for borrowers without sufficient credit history.

    If you do not wish to add the same amount to your taxes next year, you may ask your Representative and Senator to IMMEDIATELY REPEAL the following sections:

    TITLE 12 > CHAPTER 46 > SUBCHAPTER I > Part B > subpart 2

    subpart 2—housing goals

    • § 4561. Establishment of housing goals

    • § 4562. Single-family housing goals

    • § 4563. Multifamily special affordable housing goal

    • § 4564. Discretionary adjustment of housing goals

    • § 4565. Duty to serve underserved markets and other requirements

    • § 4566. Monitoring and enforcing compliance with housing goals

    • § 4567. Affordable housing allocations

    • § 4568. Housing Trust Fund

    • § 4569. Capital Magnet Fund

  • Report this Comment On March 31, 2010, at 11:56 PM, avoter wrote:

    Gee, wouldn't it be a real shame if people actually had to qualify for their mortgages like we did 30 years ago when we bought our first house. It was a VA mortgage, was appraised for less than the selling price, so we had to show that we could repay the 30-year 11.5% mortgage. We also had to prove that we were not borrowing money for the down payment & closing costs.

    Do you know what that did? It kept us from buying a house we could not afford & going into debt with credit cards for daily expenses.

    The result of this was that we bought a starter house, not a McMansion & upgraded it as we could afford it. 5 years later we sold it for twice what we paid for it, and could afford a large down payment on our next house, which we paid off in 15 years.

    Then we were able to retire early, sell our second house & buy our retirement house for cash.

    All because we were fiscally responsible.

  • Report this Comment On April 01, 2010, at 12:17 AM, domambaman wrote:

    Good point, but his article is addressing a future problem. Yours is in the past, currently being dealt with by Congress. And the best minds agree that the Federal Reserve had to help out--or else. Matt raises a valid point, and should acknowledge his own point: the banking system is too complex to single out one aspect of it. Remember, it wasn't just ACORN or Greenspan or dishonest mortgage brokers or big institutional firms or the Feds allowing Bear Stearns to go under or CDOS, etc--you get the idea--that almost brought our system down.

    I agree with sonofadog. His points are more likely to cause a problem than Matt's, If banks keep their capital reserve ratios at appropriate levels, which they now will, I don't see Matt's problem playing out.

  • Report this Comment On April 01, 2010, at 7:53 AM, YouHeardItFirst wrote:

    Maybe I'm not seeing the forest through the trees here, but I have a concern for the smaller banks that are going under.

    What are smaller banks responsible for? Well, for starters, they are usually making a lot of their money by lending to small and medium sized businesses. In many cases, these businesses may not fall under the typical 'equations' that bigger banks use to define how much money to lend, even if they are capable of paying off the loan.

    What happens when these banks fold up and businesses can't get the funding they need? I think we'll see a lot of those businesses silently go under as well. Keep in mind, somewhere around 50% of employment in the US is small business. Big banks may need to get heavily scrutinized, but the closing of these smaller banks could have a surprising effect on the employment numbers and our economy as a whole.

    Everyone seems genuinely (and understandably) concerned about the big banks and how money is being mismanaged on that end of the spectrum. However, I feel the amount of attention they're currently getting has a good chance of resolving at least some of these problems, even if not perfectly. The effects of these smaller banks going under may be very important to our long term health as a economy as well. I think it's a concern that shouldn't be overlooked.

  • Report this Comment On April 01, 2010, at 8:47 AM, facts101 wrote:

    Glycomix, the problem is not with the Fair Housing Act, it's intent was to cut down on banks red-lining whole neighborhoods and demographic groups making it impossible for low income families to ever realize the American Dream of owning a home. Now, what's been done to Fannie and Freddie since then is the problem. As you noted it's HUD that sets the 'quotas' for loans...I hope you noted your own facts enummerating the years when HUD jacked up those quotas...during the last administration, the same time banking regulations were loosened or left unenforced...'banks' (financial institutions) were freewheeling mortgage machines slicing and dicing the 'risk' to themselves and passing that on to the taxpayers through Fannie and Freddie quotas.

  • Report this Comment On April 01, 2010, at 9:25 AM, LessGovernment wrote:

    When one reviews the litany of Legislation changes that deregulated banking controls, and the numerous financial products that were created, and the huge risk associated with making what amounted to bad loans just to earn a loan generation fee, and then you throw in the GSE's buying the bad loans from the originators so the originators could do what they wanted without any real risk, and then consider the Clinton administration and their pressure on Fannie and Freddie to lower the credit standards so the GSE's could buy even lower grade crap, is it any wonder we had a melt down?

    All of the so called cures will be worthless unless the "cure" requires the originator of the loan to hold risk. Risk is the only oversight that will keep the originators from being stupid again.

    Currently, the GSE's under Obama mandate, are still loaning 125% loan to value on mortgages they are buying, thus insuring an ongoing supply of bad mortgages and foreclosures well into the future. We are allowing banks to re-issue non-performing loans and sell them to the GSE's thus getting them off the banks books and onto the books of the taxpayer. None of this to me appears to be serious resolution, but instead, just more of the plutocracy stealing from the future.

    When I heard today that the 25 top fund managers received a total of over 25 $Billion in bonuses last year, I am more convinced than ever that the entire system is broken and nothing we are doing is getting at the root problem.

    The root problem is the off loading of risk to the taxpayer. We should never have bailed out the first bank. They should all have been allowed to fail and the pain would have been terrible, but the pain would have been contained in the generation that caused the problem. What we have done with our arrogance and greed, and in our search for a "painless" resolution, is to encumber the future with horrible debt, higher taxes, lower standard of living, and much reduced job opportunities going forward.

    We will still pay for our shenanigans when we try to sell our homes as we get older and find that the younger generation is making less money, paying higher taxes, has been forced to pay for health care they might not have wanted, all of which has reduced their discretionary incomes. Add to this the higher interest rates we will then be paying for the higher national debt, and higher mortgage rates, and your house just became a lot more difficult to sell unless you drastically cut your selling price so some poor next generation type can afford to buy it given the reduced discretionary income we have bequeathed to them.

    The greatest generation has fathered the most selfish generation and that generation is simply becoming more so. I laugh at the ignorance of government in what they are trying to do, which is simply give everyone what they want and send the bill to the future as though that will not harm the future. Fools. All of them. Just plain old fools.

  • Report this Comment On April 03, 2010, at 1:10 PM, burrowsx wrote:

    I was delighted to see your skepticism of recent legislative attempts at serious bank regulation. Clearly, the government needs establish a level of control which comports with its level of investment. Larger fees to the FDIC are clearly required.

    The Volcker Rule is only the tip of the iceberg on investment banking. There must be ratings applied to individual mortgages which are securitized, and changes in the ratings due to personal circumstances of the mortgagee must result in re-rating. Such ratings could be automated, to rely on credit ratings of individual mortgagees, but privacy would have to be relaxed. If individual mortgagees would not relinquish financial privacy for purposes of mortgage securitization, they would have to be rated in a separate category, where investors would know they were dealing with the unknown.

  • Report this Comment On April 03, 2010, at 4:32 PM, Gorm wrote:

    1) Banks make their money by taking advantage of the spread plus margin in the yield curve, ie borrow short and lend long.

    2) Banks rarely book mortgages. Virtually all residential are sold off in the secondary market. Banks are in market for origination fees, perhaps a small spread, and servicing rights. Banks book non-conforming loans they can't sell and ONLY then to good customers or good spread. Banks DO book commercial RE, often for 5 year terms, so they can reprice and re-evaluate the relationship.

  • Report this Comment On April 03, 2010, at 5:48 PM, anthony1775 wrote:

    Where does Western Union (WU), an SA active pick, fall in all of this?

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