Friday, January 16, 2009

47 to 1

About an hour after I posted my discussion yesterday regarding the possibility of Bank of America needing $100 billion in government support, I had a conversation with a customer of mine who works for the banking giant. I mentioned the number to him, and he laughed it off, saying the balance sheet was much stronger than most people think.

Less than an hour after speaking with him, I heard the press release on CNBC;

"Bank of America to receive $100 billion in government backing, with an immediate $20 billion cash injection."

This is now paired with the $300 billion backing Citigroup now has in place. As large as the $300 billion backing is, the major rumor yesterday was Citi's continued discussions on nationalization. This means the government just takes complete control over Citi, as they essentially have with Fannie Mae and Freddie Mac. This also means that the $300 billion is not nearly enough in many people's minds for them to stay solvent.

How is that possible?

It's possible through leverage. I was reading an article in the Wall Street Journal yesterday that was talking about our banking nightmare. The article mentioned that Citi was leveraged 47 to 1 on their tangible assets, and Bank of America was leveraged 30 to 1. What does that mean?

That means that between 2000 to 2007 they loaded their balance sheets with as many toxic mortgages as possible. They were bought in bundled packages called CDO's that were created to minimize risk.

So if Citi wanted to buy more, but they did not have enough capital, what could they do? They could leverage. Based on a 47 to 1 ratio, if they had $1,000,000, they could buy $47,000,000 worth of mortgages. The numbers obviously were much higher.

This works very well if the $47,000,000 increases in value, but as we've seen over the past 18 months the values have collapsed. If they're now worth only $20,000,000, that is a $27,000,000 loss that they have to write off. To cover that loss they have $1,000,000 in reserves.

The numbers are in the trillions, not the millions, which is the reason why $300 billion is questionable right now as enough to keep them solvent.

These numbers also do not factor in derivatives, which were instruments used "off balance sheet" allowing the leverage to go even higher in some cases. They were side bets made on how the assets would perform, which is why there is no limit to how large the derivatives market can grow. (It is estimated currently to be between $500 to $700 trillion in size)

The derivatives market is the reason that our policy makers feel that no large institution can fail. Allowing them to do so would pose "systemic risk," a term I'm sure you have recently heard. If a major institution could not cover their derivatives position, the entire $500 trillion market would collapse on itself sending every financial institution into bankruptcy. (The entire global economy is about $50 trillion in size to help you understand how large that number is)

So we've started on a path that we will not veer from. What will happen in the United States is pretty obvious at this point. Obama will run massive spending programs and the Federal Reserve will print trillions of dollars. The unknown comes from across the sea, as foreign countries watch the horror unfold and have to make financial decisions that will shape this world for many years to come.

How you think they will act in the next few years, and the subsequent outcome of that action in the markets, should be the most important determinant for where your money is now invested.

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