Loans aren’t better than securities

By Felix Salmon
August 21, 2009
Floyd Norris in the NYT:

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A bad asset is a bad asset, whether it’s a loan or a security. And the distinction between the two isn’t particularly helpful, as is evidenced by equal-and-opposite newspaper stories today.

On the one hand, there’s Floyd Norris in the NYT:

Banks are now losing money and going broke the old-fashioned way: They made loans that will never be repaid.

As the number of banks closed by the Federal Deposit Insurance Corporation has grown rapidly this year, it has become clear that most of them had nothing to do with the strange financial products that seemed to dominate the news when the big banks were nearing collapse and being bailed out by the government.

There were no C.D.O’s, or S.I.V.’s or AAA-rated “supersenior tranches” that turned out to have little value. Certainly there were no “C.D.O.-squareds.”

Staying away from strange securities has not made things better.

On the other hand, there’s Robin Sidel in the WSJ:

U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made. Now the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other banks.

Federal officials on Thursday were poised to seize Guaranty Financial Group Inc., in what would be the 10th-largest bank failure in U.S. history, and broker a sale of the Texas bank to Banco Bilbao Vizcaya Argentaria SA of Spain. Guaranty’s woes were caused by its investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation’s worst lenders.

Guaranty owns roughly $3.5 billion of securities backed by adjustable-rate mortgages, with two-thirds of the loans in foreclosure-wracked California, Florida and Arizona, according to the company’s latest report. Delinquency rates on the holdings have soared as high as 40%, forcing write-downs last month that consumed all of the bank’s capital.

Guaranty is one of thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry and financial institutions.

So, which is it? Was Phase 1 of the crisis based on securities while Phase 2 is based on loans, or was Phase 1 the souring loans and now Phase 2 is the securities? Frankly, it’s neither. Banks’ assets soured, and they failed. Some of those assets were loans, and others were securities. Some banks trusted the structured-finance wizards more than they trusted their own underwriters, and loaded up on highly-rated CDOs. Others trusted their own underwriting more than the structured-finance wizards, and lent out billions of dollars in housing loans which will never be repaid. Both were doomed: the only way to win was not to play.


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Well, OK, but– here’s a question… What’s your ‘model’ for how a bank makes a profit? Is there something distinctive about a ‘bank’, or is it just a collocation of dollars and people? Does a bank make money principally by charging fees for services? Or by holding assets whose value increases? Or by lending capital at some rate of interest? Or… what?

Posted by MattF | Report as abusive

MattF, I believe the classical definition is that a bank makes money by borrowing short and lending long, and setting the interest rates accordingly. It’s surprising how many different ways have been invented to mess that up, especially since (with prudence and moderate backing by the FDIC) it’s relatively easy money.

But I also wanted to hit the real meat of the story. Is Gov. Perry of Texas aware that furriners are taking over one of his state’s banks?

Posted by Ken | Report as abusive

Felix, of course, bad assets are bad assets, regardless of whether they’re loans or securities. So in principle, losing money on loans or securities will lead to the same outcome. Yet in reality, there’s the issue of accounting – which is crucial as accounting dictates when you have to swallow losses. And critically, securities tend to be marked to market, while loans booked to maturity (of course, if the loan default you have to recognise it). If you go back and look at the S&L crisis of the 80′s, the “bad” loans where those made before the Fed hiked up rates – in effect the S&L where lending at 5-7% while paying out 10+% on deposits – not a recipe for staying in business for long. Their way out was to keep lending like crazy to inflate the asset side of their BS so that overall they would look profitable. Then of course, as in any lending bubble, underwriting standards slipped and loans soured. But the point is that it took almost 10yrs from the initial “bad” loans to actually bankrupt the S&Ls.

Posted by fxtrader | Report as abusive

I’m looking forward to the day when you call for the “disaggregation” of The Economist.

Posted by GaryD | Report as abusive