Subprime Series 2 of 5 - Implications to a typical US bank

Hello! Hope I wont bore u guyz with my current post. Well, i received positive feedback(s) from people around regarding my series post.. So yeah, will try to share my insights with you all in a more jovial tone!

So its useful to add abit of accounting knowledge to make our subprime discussion useful. But i arent accountant trained. So yeah.. Correct me if necessary. The general equation of accounting is A = L + OE( or NW or BC )

Where A denotes assets -> generally things that can 钱生钱. So making loans is also considered an asset, because banks can earn the spread ( difference in high i/r loaned to business and low i/r given to depositors ). Equities, like 股票 also yield $$ ( dividends ). Lastly, banks also hold extra $$ just in case.

L denontes liabilites -> what the bank owes other people, which in this case consist of depositors like u and me. However, nowdays, banks also sell debts -> bonds to consumers. So in a way, the banks are borrowings $$ from people ( selling of bonds ). ( Bonds are IOU made by these big boys to you. If you lend them money, they promise to give you back your principal (orignal sum of $$) say after 5yrs, plus certain small amount of money every year->maybe 4-5% of money u lent them to compensate/reward you for lending them )

OE denotes owner equities, meaning what the owners of banks have. The owners are usually the Board of Directors, major shareholders like other big companies and small time retail investors like us. They hold shares of the bank, making them owning part of the bank. NW denotes networth of the bank, which is the other identity of OE. So when NW = 0, the bank is insolvent, meaning bankrupt. BC denotes bank capital, which is the amount of $ the bank have, also share the same identity as NW.

One usful example which i will be using is the Lehman brothers: its NW became -ve when A is smaller than L. So it effectively declared bankrupt few weeks back. So why did such a HUGE investment bank of near 200 yrs history failed in the 1st place? Btw, LM bros are the very tok kong class among the financial institutions lor. If u tell any1 u work in LM bros, they will really bai u.

So when the asset bubble broke as reported in the news, all the assets ( esp property )in US start to lose value. However, this is not enough to kill banks as banks have enough reserves and bank capital to withstand these shocks. ( BTW, reserves are required reserves that you are suppose to hold legally enforced by the government. There are quite complicated mechanisms in these which I will not be discussing )

However, US banks have this nasty habit of excessive lendings as discussed. Why? Because for every extra $$ you hold and not investing, you lose the opportunity of making extra $. Especially true for property market. Why? U earn 2-3% of US1million is alot. So most US retail banks are very active in the property loan markets by over leveraging => issuing more debts ( selling more bonds ) to borrow money and use them to earn more $$ via the property market.

Let us recall the eqn : A = L + OE

However, when property market in US turn sour, people default loans ( no $$ to pay ), your bank loans lose value. A falls as loans are part of A. Note: banks can also confiscate the houses back, but, what is the value left behind the house? Since the asset u confiscated plunge in value so much till no one is gona buy any houses anymore. So u confiscate, cant sell, also = lan lan suck thumb. Note: the longer you hold these troubled assets, the more worthless they become as prices of them drop almost everyday?

Ok, lets say u managed to sell a bargained A at a mark down price ( say 20% down ), this effectively brought down the entire property $$ by 20%. Why? Consumers will treat this as a market signal, so any $$ higher will not be sold. So effectively, this leads to spiral plunge of US banks' A, as all of them are required to mark down as well.

So assuming no changes in L and OE/NW/BC, an indefinite plunge in A will lead to similar results to BC, which lead US banks to either bankruptcy/ fall in share price/ earn alot less money.

So next week, we will scope into the fall of LM bros. Stay tuned.

P.S: Hope din bore u guyz. =X