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This is a slight rewrite of the article I posted yesterday.
I originally posted this to TV Tropes to let people who aren't from America (and maybe a few people who are). understand American Finance It's rather long so I decided to include it here. I have also posted it a few other places and made corrections because some recent events required I clarify what I wrote (like Chrysler going back a second time for a federal loan guarantee; the one I refer to here was the one from Lee Iacocca), or because I forgot a detail (Rupert Murdock's company buying The Wall Street Journal. It's a bit long, but it should provide you with an understanding of what that money is going to be used for. (Or what it was intended when I wrote the article; they've completely changed what they are using it for since then.)
If you go far enough back (18th century) you find the U.S. looked very much like a small country, because it was one. There was no central bank, every bank issued its own bank notes, each state might issue its own currency, etc.
The U.S. Civil War was was a debate over states rights, in which the Federal Government forcibly informed them that it had the final say over certain matters. Among these are fiscal policy and money.
At one time or another, the state of Nevada has wanted to issue a commemorative silver coin, but it has been unable to do so, specifically because the U.S. Constitution specifically forbids the states from coining money. Also, since states can't run deficits forever - and can't print money - states have to balance their books. The federal government does not have these restrictions, which is why the U.S. government constantly runs a deficit and prints money (or sells debt in the form of treasury bills and treasury notes, which is almost the same thing).
Upton Sinclair's famous book The Jungle (1907) showed that there were major deficiencies in inspection of food products. The "Pure Food and Drug Act" and other laws changed this. The occurrence of severe local depressions caused the "Federal Reserve Act" (1913) to establish a national bank so that now, the Federal government had the power to change what would be local depressions into national ones. In fact, the term depression was developed because it didn't sound as bad as panic, the former term. Now, politicians say recession because depression is too scary.
The depression of (depending on whom you ask) 1929 or 1933 wasn't solved by President Franklin Delano Roosevelt's attempts to socialize the economy, it was solved when World War II reached America on December 8, 1941. (We declared war the day after Pearl Harbor.)
During the depression, a lot of people went to their bank to get their money out. Well, if you ever saw the bank run as shown in Its A Wonderful Life (which was actually a "Building and Loan" or what we would call a Savings and Loan or S&L today), a bank doesn't have the deposits in the vault, they've loaned out their depositors money. Before there was deposit insurance, if too many depositors show up, the bank closes its doors, and the banker tries to run out of town before the angry depositors lynch him. The bank is broke and the depositors who get there late probably won't get their money back.
Banks in the U.S. can be chartered either by a state government or by the Federal Government, this is indicated by the bank having the word "National" in its name or the abbreviation quot;N.A." for "National Association" (e.g. the full name of Bank of America is "Bank of America, National Trust and Savings Association" or "Bank of America, N.T.S.A."). Savings and Loans that are federally chartered have the word "Federal"; they do not have this word in their name if they are state chartered.) Banks that are state chartered do not have the word "National" in their name, e.g. the one-branch "Colfax National Bank" of Denver, Colorado, is chartered by a federal agency, while the twelve branch "Farmers and Merchants Bank of Long Beach, California," is a bank chartered by the Department of Banking and Finance of the State of California. Before the 1930s, outside of chartering banks at the Federal Level, the Federal government didn't really do much to protect depositors if their bank or S&L went broke.
One of the things that came out of the depression was the protection of depositors from losing their money if their bank lost all of its deposits due to bad investments. This is referred to as "Deposit Insurance." Each type of financial institution would have deposit insurance, from one of three agencies. Banks pay a fee to get it from the Federal Deposit Insurance Corporation (FDIC). Savings and loans would pay the Federal Savings and Loan Insurance Corporation (FSLIC). Credit Unions would pay their deposit insurance premiums to the National Credit Union Association (NCUA). Some states - Maryland and Rhode Island, for example - would have their own state-run insurance programs.
Before the war, either most people had very little money or were afraid to buy anything. During the war, there either was severe rationing, things weren't being made because the plants that made them had been converted to producing war materiel, or you were encouraged not to buy them on certain days in order to conserve them for the war effort. Or you were out of the country in a foxhole in Europe or Asia fighting the war. So you couldn't buy much during the war either. Once World War II ended, the troops came home, and there was some 20 years of pent-up demand and people had money to spend. This tremendously increased the consumer demand and the interest in buying consumer goods. Easy credit made it possible for people to buy their own homes. In fact, that's worth a separate paragraph.
A lot of people suffered loss of their houses when they could not make payments during the depression. As I mentioned earlier, banks were hit by runs and had no choice but to liquidate the houses people had borrowed money against in order to pay back depositors who were screaming for their money. In fact, Upton Sinclair's 1907 book The Jungle tells of a scam that mortgage brokers used on unsuspecting immigrants. (That it doesn't look much different from the scams mortgage brokers use today shows how little imagination mortgage brokers have.) A person or family would buy their own homes by paying no down payment - or a very low down - and $7 a month (equivalent to a typical $700 monthly mortgage today), but the contract was a rent payment, unless you made all of the payments all the way to the end of the contract, they were effectively rent payments, which meant you had no equity at all. So if the house was priced at, say, $406 (equivalent to perhaps $40,600) and you've been paying $7 a month plus taxes and utilities (maybe another $50 a year), and even if you get to the point after 55 months - 6 1/2 years - that you owe two months payments, say $14, but you can't make your rent payment, you're in default and you lose everything. Since you didn't really own the place until after you made your last payment, you didn't even have the option of perhaps selling your house and maybe getting something back; it wasn't your house. They evict you, and put another
sucker family in who start the payment for the whole $406 all over again.
Prior to Federal programs of the late 1940s and 1950s, the only way someone could buy a house was to save 20 to 25% of the price, and if they were lucky, they could get a loan for five years.
After programs like federal loan guarantees for veterans, then Federal Home Administration (FHA) and federal mortgage buying organizations such as the Federal National Mortgage Association (FNMA) or ("Fanny Mae") and its sister, (or brother) the Federal Home Loan Mortgage Corporation ("Freddie Mac") it was possible for people to buy houses with only 5% down, and pay the rest over 30 years. A lot of ordinary people who couldn't afford to raise 20% of the purchase price were now able to buy their own homes instead of paying rent. In the days of 20% down and five year mortgages, second and third mortgages were extremely common. It was often the reason you had grandparents and parents living in the same house: it took that many people to afford to raise the money to purchase the house.
So, with the 1950s rolling around, and federal programs made it possible for a husband and wife to buy a house on their own, and people now having money they couldn't spend because of the depression and the war, a consumption boom exploded. Millions of people bought "the American Dream," a house in the suburbs, two cars in the garage and a stay-at-home wife who raised their 2.5 children.
Actually, it wasn't too bad. An example someone gave was that in the early 1950s, a man working in a steel mill made the equivalent, in purchasing power, of someone in 1980 making about $90,000 a year. So people did have significant income and prices weren't very expensive. On the TV show Dragnet, Detective Gannon admits to Detective Friday that he bought the house he owns, with a garage and a driveway, for (presumably a mortgage of) $8,000 in 1967. Flash forward 40 years later, and that same house in a good part of Los Angeles could probably sell for $400,000. Hell, in a bad part of L.A. it could probably sell for almost that much.
So houses were affordable back in the 1950s and 1960s and it was possible for ordinary people to buy them.
In 1969, Bank of America developed the BankAmericard in which you could purchase things and pay them off over time. United California Bank, Bank of America's biggest competitor at the time, decided to come out with a competing product which it licensed to other banks: Master Charge. (Over time these would become known as Visa and MasterCard.) Originally, you had to have a good job and good credit to get credit cards; if you didn't, your friendly neighborhood ghetto department store sold you junk and financed you at rates that, until now, were basically just south of usury. Today you can get over-the-phone loans from companies that advertise on TV at interest rates that would embarrass a loan shark.
During the 1980s, a combination of what some consider blunders by Federal Reserve Chairman Paul Volker, plus actions which are agreed to be blunders by Presidents Gerald Ford and Jimmy Carter, inflation and interest rates went skyrocketing. In Ghost Busters one of the characters points out he had to refinance his house to raise the money to start their new business and the rate the bank demanded was 21%. But a number of banks or savings and loans weren't so lucky and had the amount they could charge restricted. In some cases, because of federal mandated interest caps, someone could borrow money from a bank, at say, 6% interest, and then purchase a Certificate of Deposit (CD) or other investment from the same bank that it had to pay them 12% interest.
One salvation for banks was those juicy checking accounts, which, because of federal law, they were specifically forbidden to pay interest on. At least, they were.
In the 1980s, some banks which were state chartered discovered that under their state's laws, they could, if they called them something else, offer checking accounts that paid interest. So they developed a type of account called a "Negotiable Order of Withdrawal," or N.O.W. account. Since they weren't federally chartered, they could now effectively pay interest on their
checking NOW accounts. And they could advertise for, and accept, depositors who wanted accounts and were outside of the state they were chartered in.
Federal banks screamed bloody murder; their deposits were flowing out to these state chartered banks. Then someone got the bright idea they could tie a savings account to a checking account in what was called a "sweep account." The bank would move all of your money out of your (non-interest bearing) checking account above $100 into your (interest bearing) savings account. As you wrote a check and it was received by the bank they would then transfer money back in blocks of $100 to cover the checks you wrote. Once you had more than $100, they'd sweep the money remaining above that back into your savings account. Eventually the rule forbidding banks from paying interest on checking accounts was scrapped, so sweep accounts were more-or-less eliminated. (Except for people who have them to cover overdrafts.)
So banks, wanting fees, and no longer having "free" money from non-interest bearing checking accounts, started offering credit cards to people who might not otherwise qualify, either because they already had several credit cards, or because their income levels were too low to justify having credit (in times when bankers had sanity). So now, virtually anyone who had a pulse could easily get themselves into crippling levels of debt, which they basically would be paying lots of profitable interest to banks.
Nowadays your average person has anywhere from six to ten credit cards, and some people have upwards of five figures of very expensive credit card debt.
Up until the 1980s, people who worked for very large companies had a pension plan. You contributed money to it and after a certain number of years you would be guaranteed a pension for the rest of your life, but only for your life; once you die, your pension ends unless it includes some provision for your widow/widower. This is called a "defined benefit" (DB) pension. It's how Social Security works; you get a benefit for life, you can never outlive your pension but you can't transfer it to your heirs when you die because it's not an asset you own. I will repeat that. You do not own the money in your DB pension.
In the 1970s, the Penn Central Railroad went bankrupt, and a lot of railroad employees had pensions that might not be paid, so Congress created the Pension Benefit Guarantee Corporation (PBGC), so that if a company offering a DB pension goes broke, the pensions will still be paid, the way the FDIC protect bank depositors, the FSLIC protects Savings and Loan depositors, and NCUA protects credit union depositors, PBGC protects pension holders. Chrysler almost went bankrupt and the prime reason that it got federal loan guarantees is because its pensions were insured by the Pension Benefit Guarantee Corporation; if Chrysler had gone under the underfunded pension liabilities it owed might actually have bankrupted PBGC.
When you hear about "underfunded pensions" they're referring to a company that has not made enough contributions to its (DB) pension plans to bring them up to the amount it's expected to pay out, based on actuarial tables that estimate how many of their pensioners will die and they stop paying them, e.g. if you're a man who is 60 years old and you retire, it's estimated that you will live to be 75, so whatever assets are in your pension plan have to be able to cover your pension payments for 15 years. If he's 78 years old and retires, the estimate might be he has two years to live, and so on. Average this out over everyone in the plan, and you have an idea of how much money you're going to have to pay out over the expected lifespan of the employees enrolled in the plan. From this, figure out how much interest you can earn from investing the money you have, plus liquidating the assets from time to time, and you know how much money has to be in the plan. If you can find ways to shorten people's expected lifespan, increase the amount you're going to earn in investments, or both, you can reduce the amount of money that the company has to contribute to keep its pension fully funded. That's why actuaries are one of the highest paid mathematical disciplines; a good one can make (or save) a pension plan or insurance company millions.
This sort of DB pension is expensive; in fact it's so expensive some large companies got in trouble over it (Requiesiat en pace Penn Central). With the competition from other countries where competitors to American companies don't have such generous pension plans, businesses had to find a cheaper way to do it.
So businesses were allowed to change over to a new type of pension. You as a potential pensioner would put money into it tax free, as payroll deductions, and could withdraw when you retired. It was named after the section of the tax code that created it: 401K. The company could also contribute to your pension if it wanted to, but it didn't have to. This type of pension is called a Defined Contribution or DC pension.
The difference is, you own the money in a DC pension. If you don't spend it all before you die, you can will whatever is left to your heirs. But unlike a DB pension, you can outlive it. You can use up all of your DC pension and not have enough money left to live on. But a DC pension is so much cheaper for an employer, that's basically the only pension plan available except for Social Security, which is a very expensive DB plan that is expected to go broke by 2025.
But let's go back to all those houses built in the 1950s and later. A lot of people lived in them for years, lived through the depression and didn't get into buying things, and had paid off their mortgage; this was a big thing, people would have a "burning the mortgage" party where, they took the mortgage document stamped "paid in full" and burned it in the fireplace; their home was theirs, all theirs. No more mortgage payments. But not everyone had this luxury.
For more than 100 years, in general, housing prices tended to go up over time, so thanks to mortgage brokers, people started to see their house as a form of "ATM machine," in which, as it became worth more, they could refinance and draw off some of the money that they had accumulated as equity (the difference between what the house could conceivably sell for if it was placed on the market, and the amount they owed on the mortgage (or mortgages)).
This works fine as long as the market continues to go up, or you can afford the new payments even if it doesn't. Well, with the purchase of a third car, a pickup truck, an RV, a boat and/or a Jetski, a vacation home, a pool in the back yard, taking vacations, plus credit card debt, most people tended to spend more money than they make and didn't save anything. They depended upon the estimate that their house would sell for in the market place to be able to borrow money to finance their lifestyle.
Beyond that, all of that interest you paid on everything was tax deductible. Then, President Reagan came along and changed things. The federal tax on incomes, at high levels, theoretically could be more than 80%. This encouraged rich people to hide income or get into "tax shelters" in order to reduce how much they pay. He decided to cut the actual maximum tax rate way down, to something like 30%, but a lot of exemptions were eliminated. While the tax deductibility of mortgage interest remained, almost all other interest payments stopped being deductible.
But that's okay, someone got the idea of creating the Home Equity Line of Credit (HELOC) in which you got a credit card or a checkbook and could use the equity in your house - again, "equity" means the amount you owe on it subtracted from the estimate of what your house would sell for on the open market - to pay off your credit cards, or spend it on big ticket items. So some people still kept balances on credit cards and used HELOCs for purchases. Interest paid on a HELOC is generally tax deductible.
Well, consider that a credit card is what is called unsecured debt, if you don't pay your credit card, they have to sue you if they want to collect. A HELOC is secured debt, if you don't pay it, they can foreclose on your house to collect. They do not have to sue you; they put your house up for auction on the courthouse steps, then proceed to evict you. The process can be very fast; a bank or mortgage company that follows the rules can have the property back and the former owner evicted as quick as 5 or 6 months from the first missed payment.
But again, it's not a problem as long as you can refinance. Real estate prices always go up, right? It's been that way for over a hundred years. Yes, over time real estate prices have gone up, but at times they do go down, and sometimes they stay down, sometimes for years.
In the 1980s, oil prices collapsed and real estate prices in Texas collapsed. Some say the collapse in prices was triggered by the S&L Crisis. And maybe I'd better explain that, too.
Some people got together and bought some small Savings and Loans, then had their friends buy properties, use other friends to give an inflated estimate as to the property value, and the Savings and Loan would make a loan based on the inflated value. The S&L either raised money by offering CDs with high interest rates, or borrowed from other banks and savings and loans. Then if the property was defaulted, if the S&L had too many bad loans, it went broke and the FSLIC (the federal government agency that insured deposits in S&Ls) would end up paying off the depositors. Most of the people involved got away with it too; the joke at that time was if you wanted to rob a bank, you were better off looting it, because armed robbery was a crime but using your friends to loot a bank was likely to not be prosecuted.
This was the "S&L Crisis," and it basically bankrupted the FSLIC. Congress had to step in with $500 billion and the FDIC ended up becoming the sole federal insurer for banks and savings and loans. Some states still operated their own insurance systems, however.
As far as the collapse of real estate prices in the 1980s in Texas is concerned, it took over ten years for prices to climb back to what they were. While it may have been the first place where prices collapsed, it wasn't the last. If you were in a mortgage that was more than your house was worth, and you were buried in debt and couldn't afford it and couldn't refinance, you were in trouble. Deep trouble.
Not all parts of the U.S. are the same. There might be huge demand for houses in Las Vegas while lack of demand caused prices to fall in Phoenix. Or people might be abandoning houses in Cincinnati in droves (driving down prices), while the demand for houses continued to skyrocket in San Francisco. One estimate is that the U.S. is not one single economy, it's an integrated market of about 30 different regional economies. I can testify to that; when a 2 bedroom home in the Washington, D.C. suburbs was routinely selling for upwards of $250,000, you could drive about 60 miles north to Baltimore, Maryland or 70 miles south to Fredericksburg, Virginia and find the same kind of house for less than $80,000.
But this wasn't the only issue. Banks (and mortgage companies) were still hungry for fees. Regular people who had houses already had their own problems with their mortgages and might not be interested in refinancing or might have kept their senses and didn't need to do so. But then there were people who had bad credit scores, either they'd not managed their credit cards properly, or had other problems, who couldn't afford a regular mortgage but could afford one if the interest rate was less.
I'll mention "credit score" here. Fair, Isaac and Company developed the "FICO" score; there are three national credit reporting companies in the United States, all of them use it, some give it different names. It's a secret mathematical formula in which how you pay your bills and how much you owe is compared to people who always pay their bills on time and other indications that you're a good borrower. Each credit reporting company runs it differently so you might have a perfect score at one reporting company and a lower score at another. It ranges from a horrible 500 to a really good perfect 850; the higher it is, the less you're going to pay in interest.
Oh, Interest. If you're in the United States, and you have a mortgage or a credit card where the interest rate can change, do you know who sets the interest rate? If it's a federally insured mortgage, it's based on what a government agency says it is. But if you have a non-federally insured mortgage or a credit card, your interest rate is what Dow Jones and Company says it is.
All debts where you owe money where the interest rate can change, the contract - whether it's a mortgage or the terms and conditions of your credit card - uses a third-party to determine what the rate of interest you are going to be charged is going to be. If your debt is federally insured like an FHA loan, it has to use the current fed funds rate which is what is being charged for loans. For everyone else, the interest rate is whatever Dow Jones and Company lists on the last day of the month of the Wall Street Journal. Remember that sometime; Dow Jones & Company has just as much affect on what people's interest rates will be as the Federal Reserve does when it raises or lowers the fed funds rate.
So people with bad (low) credit scores would be sold an adjustable rate mortgage, with a rate much lower than normal for their score, but it would "reset" after the second or third or fourth year, and could reset any time interest rates changed. But, if you keep paying your mortgage, what you owe goes down and as housing prices rise, what your house is worth is a lower percentage of what you owe. This, of course, ignores two things: your mortgage is 30 years long and it's paid for under the "rule of 78."
The rule of 78 works like this: let's say you loan someone money for one year with the right to pay the loan off early, but you want to make sure if they do pay you off early, most of their payments went toward interest. So, in a 12-month year, they pay 12/78 of the interest the first month of the loan, 11/78 of the interest the 2nd month, 10/78 of the loan the 3rd month, and so on until they pay 1/78 of the interest on the 12th month, in addition to 1/12 of the principal each month. Do this on a 360-month mortgage, and what happens is, for the first three or four years, maybe 99% of your payment is interest, and during the first 15 years, 90% or more of your mortgage payment is interest.
Let's make it simple, if you have a 30-year loan on a house with a $200,000 mortgage, maybe your mortgage payments run $2000 a month, and in two years, you've paid the bank or mortgage company $48,000 and maybe $3000 of that is principal. You still owe $197,000. (Most people are shocked to learn that, after 30 years, they will have paid three times the amount they borrowed because 66% of what they paid went for interest.)
If your mortgage was 5%, and then resets because the rate has risen to 7.5%, your payment is going to rise from $2,000 a month to $3,000 a month. If you can afford the new payment, not a problem. If you can refinance and get a new loan at the previous rate, not a problem (which, if your credit score has improved, might be possible). If you can't get a lower rate, but you can refinance to cover the difference in cost, still not a problem. (Conceivably, in the future you'll have a better job, will make more money and can afford a higher mortgage.) If you can't refinance and can't afford the new rate, now you have a problem.
If your home is worth more than what you owe, it is possible you can sell your current house, and move into a smaller and less expensive house. But if you're in a down market, you might not be able to sell your house except at a loss (it's overpriced), and you may have a credit score that makes you ineligible to obtain financing for a new place. Now you're in trouble.
If you can't make your payments, you're in serious trouble. After 60 days of non-payments, you're in 'pre-foreclosure' and after 90, they start to foreclose, which is a fancy name for repossessing your house. Well, what you could do is, go bankrupt and go into court and the court can change the terms of your loan, perhaps reduce your principal.
Enough people started doing that that the banks got the bankruptcy laws changed so you can't do that for your first house. (Rich people who have multiple houses who might need to go bankrupt later on got the ability kept for the second and subsequent homes they owned.) Those with money had a field day
rewriting screwing around with the bankruptcy laws to make them less favorable to the debtor and more favorable to the guy who was owed money. Those of us who didn't have the money to pay lobbyists to protect us got screwed.
Well, anyway, since ordinary people weren't taking out mortgages, the bankers and mortgage brokers starve if they don't develop fees, which they make by closing loans. Ordinary people who had reasonable credit would go to a bank and apply normally. People who had credit problems might have trouble qualifying. So the finance people developed the "low doc" (minimal documentation) and "no doc" (no documentation) loans. "Documentation" means "proof of income." In short, if you had a
good credit rating pulse, they'd loan you the money to buy a house without you having proved you could afford the payments. Sometimes referred to as "liars loans."
Since there's more risk - these borrowers have lower credit scores - which means the interest rate charged is higher, and since these loans pay more interest, which means they're more profitable. So everybody wins. The borrower gets a house they couldn't otherwise obtain, the mortgage broker gets a fee for originating the mortgage, and the bank or mortgage company gets a high rate of interest on the money they loaned out.
But where did the banks and mortgage companies get the money for these new loans? They put bundles of loans into "packages", where, say, 500 loans which average $250,000 amounts to $125,000,000 would be sold to an investment broker, who might break the package up into 10,000 shares worth $12,500 and sell those. So everyone buys a piece of risk, and everyone wins.
As long as the majority of the borrowers can make their payments. Which they can do as long as housing prices keep going up so they can refinance, since when their loans reset, they probably can't afford the new rate. So if they can't afford the loan, and can't refinance, they're in trouble. Then their mortgage is foreclosed, and the bank finds that the housing market has collapsed, and the house that has a $200,000 mortgage might fetch $140,000. So now the bank who wrote up the mortgage is out $60,000. Oh no, they're not. The investors who bought the mortgage shares are out a piece of the $60,000. Which investor(s) depends on whether the shares were a piece of all the mortgages, or all and part of some of them. It might be that nobody knows for sure who eats the $60,000.
Some of those investors might be other American banks, and some might be people or banks in other countries. And some of those mortgages that have been defaulted on might not have been sold off.
Well, in the U.S., banks do not loan their own money. They either borrow it from other banks or they get it from depositors. But that's not all; banks are allowed to create money out of thin air by a practice called Fractional Reserve. It's like you put your furniture in storage, and the storage company rents it out to someone else, and while they're not using it, rents it to a third party. Not possible? Guess again.
U.S. Banks are required to deposit a portion of their assets with the Federal Reserve and can loan out the difference. The portion they have to deposit is called a reserve, it's used in case there's a run on the bank, and also to cover checks their depositors write that get deposited in other banks; I'll explain that part later. Well, let's you and I open a bank with $1,000 between us. If there's a 5% reserve, we have to deposit $50 with the Federal Reserve and can loan out $950. That's how you might do it, but I'm smarter than that; I figured out a way to legally loan out money we don't have, a practice that in other industries would get you 3-5 in Baltimore's Supermax prison for fraud, but perfectly legal as long as you're a bank.
The Federal Reserve says that we (as a bank) have to put 5% of what we are going to loan out in reserves. So, instead of putting in $50, and loaning $950, I'll put in $500, which means I can now loan out twenty times that much, or $10,000. So I loan that out by letting people open checking accounts. If one depositor of mine gets a loan for $3,000 and writes a check on his account for $2,000, and another depositor of mine deposits that check for $2,000, I collect interest on the $2,000 that the first depositor has "borrowed" from me. Then I pay some of that interest to the depositor who put the money in his account.
My books (as a bank) still balance. I have assets consisting of the $500 in cash, the $3,000 that the first depositor has has borrowed (of which he has spent $2,000). On the other side of the ledger I have liabilities of the $2000 that the second depositor has left in the bank and the $1,000 the first depositor has left in the bank. And if you wonder how I can call money someone has borrowed and spent an asset, and money that someone that has placed on deposit with me a liability, you might start to understand why banks get into trouble.
Just realize, this works all over town, if people write checks on my bank, and then other people deposit those checks back into my bank, I haven't had to pay any money. As long as I don't have to actually convert the loans into real money, I can keep doing this all day long, and collect interest on money that doesn't really exist. (Sweet deal, isn't it?)
Now let's say that one of my borrowers writes a check to a depositor at another bank. What happens is, that bank goes to the Federal Reserve and presents it to them; the Fed gives them part of the reserve I have on deposit to match the amount of the check, and reduces my reserve. They give the check to me and I reduce the depositor's account, and I give them the cancelled check back. (Or I used to before Check 2000; now I just send you a picture of the check). If I take checks deposited from that bank, the reverse happens and if everything clears, it may end up a wash, neither bank has to pay the other. In any case, as long as my reserve is at least 5% of the amount I have outstanding as loans I've issued, I'm okay. Otherwise I have to bring my reserve back up to that 5%.
It can get weirder, in which, in some cases, I can actually put some of those fictional deposits up as reserve and increase the amount I can loan still further; even I don't understand all of it. Basically through what are called "multipliers" the amount loaned out can be more than twenty times the amount of reserves.
It's only when I have problems getting my loans paid or have to foreclose. Because, remember, I only really have 5% of the money I actually loaned out; the rest was created out of thin air, and that money has actually been spent on houses. (Or on factories, construction of office buildings, cars, boats and fur coats, or all the other things people borrow money for, but remember, I want to keep it simple so it's easy to understand.)
This is the classic fatal scheme of "borrowing short and lending long." The money which has been loaned out is on 30-year mortgages but the deposits are due either immediately (for checking accounts) or short term (90 days to five years). If too many people want "real" money or I have too many defaults so that my reserve drops below 5%, then I (as the bank) am in trouble.
So take the one foreclosure where the bank has taken a $60,000 haircut (loss) and multiply it by 1000, and even a large bank might not be able to bring their reserves up to cover that $60,000,000. So this bank is now "bankrupt." If the public discovers this, they start going to the bank en masse to withdraw their deposits before there is no money left. That's where a "run on the bank" occurs. If the bank decides to close before a run happens, there's a notice on the door, then the next morning there's an announcement that the bank has been placed in receivership. Which means the FDIC has to cover the bank for the amount of deposits which are insured. In some cases, instead of paying off all of the losses, the bank which has gone broke is taken over by another bank that hasn't gone broke. Usually done over the weekend because typically the bank is closed.
This is why you'll often notice that a bank closes on Friday, there's an announcement that the bank was taken over, and Monday morning your friendly neighborhood "Bank of Your Town" changes its name and has a sign over the door saying "Yourtown Branch, Eighth National Bank." Bank Of Your Town went broke, the FDIC has sold the assets to the other bank and now it's just another one of thousands of branches of Eighth National Bank. What will then happen is that the new bank (Eighth National) will negotiate with the FDIC over what loans it will accept and which the FDIC will have to buy back from the (dead) Bank of Your Town.
If the bank that went broke is really bad, then the FDIC has no choice, it liquidates the bankrupt bank, pays off the depositors, sells the loans that haven't been foreclosed on to other banks, and forecloses on the loans that have gone bad. That's when you get a new set of coupons for your car loan because your loan held by Bank of Your Town has been sold to Bank of Some Other Town. You make your payments on time so your loan is one of those that has been sold.
But if too many banks have loans that have to be foreclosed upon ("bad paper") then even the FDIC is going to be in trouble. Remember, the FSLIC went belly up when the S&L crisis happened. But there were forewarnings. A small savings and loan in Maryland named Old Home Savings went broke. It wasn't insured by the FSLIC, it was insured by a Maryland state agency. It basically bankrupted the state-operated insurer and the State of Maryland - in other words, the taxpayers of Maryland - had to pick up the tab. After a similar incident broke Rhode Island's bank insurance agency, the states got out of that business, and now all banks and savings and loans are federally insured.
So now there are a lot of banks who are in trouble because of bad loans that they may have to foreclose on, which could reduce their reserves and leave them with insufficient assets. With a fall in housing prices, those assets are now worth less. Plus, the banks need to liquidate them fast (remember, they have to restore their reserves to the 5% level, they need the money as soon as possible), so they may have to take even further losses. (When you have to sell something in a hurry, you don't have the luxury of time and it costs you money.)
Well, thanks to Congress, when those loans go bad, banks can sell them to the government. That's what the money is for. So now, if you can't make your payment, a federal agency now owns your mortgage. And a number of things can happen. First, they can foreclose, (or if it's already foreclosed) and sell your property, same as the bank did, and if, as in the example I cited above, the federal government takes the $60,000 loss instead of the bank.
Or, if the loan isn't foreclosed, they might change the terms of your loan so now you can afford it. They may allow you to refinance it. This is the only scenario where the government doesn't lose any money or might conceivably make money off the deal.
Or they might conceivably ''forgive'' your mortgage, and ''give'' you your house. They may put some kind of name on this where very low income people get foregiveness on their debt. Habitat for Humanity does something this, but people have to work for it by providing free labor on the house built for them and others, and they still have a mortgage they have to make payments on.
Don't be surprised of the idea of the government simply "giving" people loans they end up not having to pay them back, there are some programs where people were given huge loans to go to school, and in exchange for being a doctor in some poorly served area in the U.S., like Alaska or other rural areas for a few years and setting up a practice, (and charging people for medical services), the government cancelled their loan without their having to pay it. Their debt was forgiven in exchange for taking a slot in a rural area for a while. And sometimes home loans are used as
bribes incentives to get people to work as teachers or other low-pay jobs in some locations.
And now you know why Congress had to create that huge bailout, so that the banks which have spent all that money don't drop below their reserve requirements (and can continue to make new loans). (A cynic might add, "and continue to pay huge CEO salaries"). And maybe you understand why this happened, and can understand why it will probably happen again.
Not to mention, we (as individuals) in the United States now have lots more credit card debt, very little savings, a DC pension plan that can go broke before we die (if you've chosen to contribute to a 401K, a lot of people don't), and a Social Security DB pension plan that probably will go bankrupt before we die, means that we can expect to see more troubles like this in the future.
There's one small point of hope in this mess. Credit unions are not insured by the FDIC, they are still insured by the NCUA. We've never had the kind of messes at credit unions that banks and savings and loans got into. Maybe it's because credit unions tend to be small, they're non profit (all profits have to go back to the members), and they tend to be involved in local issues. So they know their customers, don't really have an incentive to take on a lot of risk, and are more familiar with whom they deal with, and as a result, credit unions have never had this kind of scandal that required bail outs.
Or, if you're a pessimist, you could say they've never had one yet.