How Zombie Banks are Ruining the Future
James Wesley, Rawles

The banks of the world are in a mess, but thankfully they are sorting out their problems.

Except that they're not

In the boom years, banks gave out more and more mortgages to riskier and riskier home owners, with the understanding that if things turned really bad, these mortgages would be terrible loans that would lose a fortune.

So when things did turn bad and the home owners could no longer pay for the mortgages, these mortgages bankrupted the banks that gave them out.

Except they didn't

The problem with mortgages for banks is that they don’t know how bad the situation is until they sell the underlying houses. If I buy a house for $300,000 with $50,000 of my own money and a mortgage for $250,000 from the bank, the worst that the bank is expecting is that if housing prices go down to $250,000, then the bank can foreclose on the mortgage (chuck me out) and sell the house to get back the amount of the mortgage. I'll lose my $50,000, but the bank will get back its $250,000 and come out even.

So what happens if the housing market goes so bad that the house is now only worth $200,000? In theory, the bank sells the house and loses $50,000 itself, and I lose my $50,000, and we both move on poorer but wiser. [JWR Adds: In actuality, if the foreclosure sale results an a $200,000 price, then, in theory, the homeowner loses $100,000 and is still obligated to repay the $50,000 shortfall to the bank. (One exception is in states with "non-recourse" loan laws.) But from a practical standpoint, this doesn't always happen, even where it is the law.]

Except that the bank doesn't sell

Understanding why is the most important lesson of the current financial crisis. The good news is that it's actually pretty simple.

Let's imagine a bank with a million loans just like mine. That means it has $250 billion dollars of debt across the million houses. In normal times this isn't a problem, because the bank will make back this amount of money plus interest over the next 20 years or so as everyone pays back their mortgages. The bank makes money, people get houses, and everyone is happy.

Now even in normal times, things can still go bad on some houses, and the bank might lose money on some loans. So the bank needs some reserve cash to act as a buffer against trouble. Let's say it's got a 10% buffer - that is, it has $25 billion dollars of cash lying around as a buffer against its $250 billion in mortgages.

So far so good, as long as things don't go really bad. Which they do

Let's say houses lose on average one third of their value - so my $300,000 house drops in value to $200,000.

And let's say the bank forecloses on all its loans and sells all the houses for their true current value of $200,000. The bank loses $50,000 on each sale, so for 1 million houses, that means the bank loses a total of $50 billion.

Now the bank had a cash buffer against bad times, so things should be okay, right? Well, the answer depends entirely on how much the housing prices drop and how big the buffer is. In this case, the bank had a buffer of 10% of the total loans ($25 billion), so if it loses $50 billion foreclosing all the loans and selling all the houses, then the bank has a problem. It has not only used up all of its buffer, but it still needs to find another $25 billion.

In other words, the bank is bankrupt, big time. No one wants a bank worth minus $25 billion

So what’s the bank to do? Well, if the whole situation is exactly as described above, then the bank is bankrupt and everyone at the bank is out of a job. But how can a bank with $25 billion in cash (the buffer) be bankrupt? I mean, the bank manager can walk down to the vault and feel all that money, and it's a lot of money!

The problem is that the bankruptcy is only theoretical until the bank actually forecloses on all of the houses and sells them at their true market price. So the bank avoids foreclosing, or if it is forced to foreclose, it avoids selling the houses - that way it can pretend that things are not as bad as they seem.

To do this, the bank has to engage in some creative accounting - in other words - lie. It needs to pretend that the housing crisis is not as bad as it seems and pretend that the true worth of the houses is not really $200,000, but maybe something closer to $250,000. But how?

Well, the bank deliberately sells only a few houses. And surprisingly, it sells the best houses on its books rather than the worst. This way, the bank sells a few houses for, say, $240,000, and claims that these are the worst houses, and that sure, it will lose some money along the way, but overall the buffer will be enough, and that things will get better in the future, and so the bank isn't bankrupt and everyone at the bank keeps their job (and bonuses).

So it is in the interests of the bank to avoid facing the true value of the houses, which means avoiding selling poor houses, and avoiding foreclosing where possible.

Now despite the enormity of the situation, most bankers are not bad people through and through. Most would find it hard to sleep at night if the situation described above was crystal clear to them. So the banker needs to engage in some psychological gymnastics to avoid facing grim reality.

The bankers persuade themselves that while things might be fairly bad at the moment (of course, not as bad as reality, but still, pretty bad), if things get better in the near future, then the problem evaporates and the bank is ok.

In our example, the bankers might persuade themselves that the houses are now worth $226,000 each, which if all foreclosed and sold would use up $24 billion of the $25 billion buffer (so, happily, the bank isn't bankrupt, just in difficult times). But if everyone just holds on and waits a few years, the houses will go back up to, say, $270,000, and so everything will eventually be alright (even if the home owner has still taken a bit of a dive).

And here's the crucial psychological trick - the banker might be right. Who knows what the future will bring? Maybe things will get better, and all the worry was for nothing. So the banker engages in some fudging around home sales, throws in a dash of good old optimism, and presto, no crisis.

And you know what? This strategy has been a pretty good strategy in the past. Things have gotten better more often than not, and banks and home owners avoided a whole lot of trouble by skipping over temporary bank insolvency until times were better again.

But sometimes things don't get better. Or more exactly, they don't get better soon enough

So what happens then? What happens when things don't get better, and banks are stuck in a situation where they really are insolvent, but they are fudging the books and engaging in optimistic self-deception to avoid facing this reality? You get a "Zombie" bank. A bank that is actually dead, but still walking around acting as if it is alive.

And worst of all, we all know what Zombies do. They eat the living

So Zombie banks try to solve their problems by draining money from the parts of society that are doing well - other successful businesses, home owners with good mortgages, and so on. They do this by charging more than they should for loans using unfairly high interest rates.

Now in a normal free market with lots of competing banks, this strategy wouldn't work, because the banks who are free of bad mortgages would charge businesses and people a fair interest rate, and because this rate would be lower than the Zombie bank rate (because the Zombies need to charge higher rates to make up for their bad past loans), no one would go to a Zombie bank for a high interest rate loan.

So the free market works - good banks make fair loans to healthy businesses and people, bad banks fail to get new business because their rates are too high, and eventually the bad banks go bust.

Except this isn't what is happening today

In today's world, almost every bank is full of bad mortgages. So every bank is now a Zombie bank - and there is nowhere else to go for a loan with a fair interest rate.

In other words, the successful businesses and people of today are paying extra above the fair rate they would otherwise pay in order to help the banks recover from their bad loans of the past. It’s like a tax on successful businesses and people today to make up for the mistakes of bankers from yesterday.

Now even this lousy approach has sometimes worked in the past. When it works, you get slower growth, because the successful businesses and people are paying more than they should for loans (so the businesses have less money to employ staff, the people have less money to buy goods and services), but so long as the total Zombie bank "tax" is less than the pace of new growth, things work out eventually.

But what happens when grow is poor? When businesses can barely employ the staff they have even at a fair interest rate?

Well, that is where we are now. A society full of Zombie banks charging too much for loans to make up for past mistakes just at a time where society is barely keeping its head above water as it is.

Now this story simplifies many complicated dimensions of the banking and mortgage market, such as how housing prices drop with increased supply (selling a million houses at once would force the prices down even more, because there wouldn’t be enough buyers) and how banks avoid foreclosure by dropping monthly repayments to levels that will never pay off the mortgage, but which are enough for the bank to pretend it doesn’t need to foreclose. There are hundreds of other factors, such as how some banks sold the mortgages to other banks or government, how government keeps interest rates low to avoid even more foreclosures, and so on.

But none of these factors change the fundamental problem - the banks are broke due to bad loans, and they’re hiding it in the hope that things will get better

And here's the dilemma that may cost us our comfortable life as we know it - we can't get out of this trap. We either face the fact that our whole banking system is bankrupt with all the chaos that this would entail, or we stumble on with the undead ruling the finances of our society, trying to regain life by sucking it out of the living, but in the end only destroying the living without regaining new life.

And all for three bad decisions: first, too many bad loans to start with, then second, dodgy home sales to hide true losses, and finally, believing the world will get better soon when it won't.

Sometimes optimism is the worst approach to life.


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