Many people were complaining about how the central banks and Fed kept pumping in money. You know trying to keep things afloat. The reason has to do with confidence (which you already heard) and keeping credit moving (which you also already heard). Though when I hear these politicians sometimes I wonder. Let me explain the lending model a bit and you will understand why we have an increasing Libor rate
Imagine a bank gives out a loan, and for kicks let’s just say there are 5 people taking out loans at 6% for 100 USD. For simplicity let’s say that these were interest rate only loans. The income of the bank is:
| Loan | Interest | Cash inflow |
| 100 | 6% | 6 |
| 100 | 6% | 6 |
| 100 | 6% | 6 |
| 100 | 6% | 6 |
| 100 | 6% | 6 |
| 500 | 30 |
The bank earns 30 USD per year, but is owed 500 USD for the year. The monies owed sit on the books and it is expected that people will pay off these amounts during the length of their loan.
The counter party system kicks in because the bank needs the money to loan. The bank needs to get the money from somewhere. That somewhere might be other banks, savers, or what have you. The point is that the bank works on a spread. So let’s look at the cash flow of the bank if they could borrow at 2%.
| Loan | Interest | Cash outflow |
| 100 | 2% | 2 |
| 100 | 2% | 2 |
| 100 | 2% | 2 |
| 100 | 2% | 2 |
| 100 | 2% | 2 |
| 500 | 10 |
The bank owes 500 USD, but because the loan takers will pay the base of the loan it is a zero sum calculation. The true earnings of the bank of this interest owed minus the interest paid, which is 20 USD.
The problems begin when the bank has one of their loans default who takes a loan default on their books. When a loan defaults the bank is on the hook for the loan and the lost earnings. So imagine if one of the five loans defaults, then the cash flow is as follows:
| Consumer | Bank | Cash in | Cash Out |
| 100 | 100 | 6 | 2 |
| 0 | 100 | 2 | |
| 100 | 100 | 6 | 2 |
| 100 | 100 | 6 | 2 |
| 100 | 100 | 6 | 2 |
| 400 | 500 | 24 | 10 |
| -100 | 14 |
The balance book changes dramatically, because the bank has to pay the 100 USD and make up the lost interest payments. The bank ends up owing 86 USD, and that is where the problems begin. To make up the 86 USD they would have to make more loans, but that could result in more defaults and requiring more loans.
You start a death spiral where the bank goes bankrupt, even though it is still earning money. If a loan taker has really good credit it does not matter, because there is a probability that the loan could default. And that would mean having to take out more loans. Thus the bank hamster’s its money and does not make loans.
The current crisis is this death spiral. Even though people would like to say, "oh let the free market take care of this." My answer is that this free market is collapsing, and where it stops we don’t know. By having a bank or government pour in money you say to the market, "hey enough is enough."
It seems though many want the market to right itself. I suppose the House of Representatives vote was the pivot moment and the market watch article sort of says it all. In the article were comments like the following:
- Wall Street are a bunch of pigs
- Why are you asking if its justified. You should know better.
There is no logic to Wall Street. Just GREED. Screw somebody and see if you can get their money too (by the way the short stocks and give false BUY ratings and …..)
Yupe Wall Street is a bunch of pigs and all of this will get Wall Street were it hurts most. If it only were that easy. A good buddy of mine from America visited me over the weekend and he was of this opinion.
The credit crunch will continue, and continue, and continue. My models have broken down, and we are in rarely charted territory. That has me depressed and I have no idea where this will stop.
BTW if this continues any further what I can see happening is a forcible decoupling between the world and the American economy. That’s why I feel the House of Representative’s in their "stick it to the man" attitude actually buggered things up quite nicely. Evolution is Paulson, Bush, Bernanke and that can be controlled. Revolution is the House of Representatives and that cannot be controlled. Who knows where things will end up.