Why US banks are failing

The reason why the banks are going bust in simple terms is:

The banks traded in complex derivatives products between themselves, in what is termed as the over the counter market. The exposure to the Securitized debt packages was further exaggerated by the use of leverage of in many cases more than 30X the banks assets against valuations based on complex models that inflated the packages values during the boom times which allowed huge profits and bonuses to be banked (Fraud?). However the critical point is in the final link in a long chain of sliced and diced debt packages was the US housing market.

As US house prices fell, the gap between the real value and the banks inflated model values to boost profits grew, until the crunch point of August 2007, when it dawned upon market participants that in actual fact they did not have a clue as to the real value of these mortgage backed securities and hence the credit markets froze as no one wanted to buy something they could not value and nor lend to financial institutions that may default on their obligations. The impact hit all banks, whether or not they had exposure to the US housing market, as those banks whose business model relied heavily on the short-term money markets to finance long-term mortgages were in deep trouble, i.e. Northern Rock and to a lesser extent ALL of the other UK mortgage banks.

Now many banks are left with assets that are worth LESS than 50% of their "mark to market" booked value. Now that does not mean a 50% loss for the banks on investments, remember the greedy banks deployed LEVERAGE of as much as 30 times of assets, so capital of say £100 million is controlling risk of as much as £3,000 million. Therefore a 50% loss results in a loss of value of £1,500 million, that's 15 TIMES the capital. Hence the banks have been reluctant to price their debt packages at the real market price as that would mean that the bank is effectively bankrupt with losses far greater than the banks capital base. So the market remains frozen until all of the illiquid mortgage backed debt has been transferred over to the tax payers in exchange for liquid cash, hence prompting the US Mother of All bailouts plan.

So Basically there are TWO related problems at work driving the Banks Bust:

1. One of collatorised debt that is not being valued at market prices, hence frozen money markets with banks sitting on over leveraged time bombs that have started to explode in recent weeks, as the credit markets tighten further.

2. Mortgage banks reliant on short-term money markets to finance long-term mortgages that threw caution to the wind and loaned far too much money to people who could not afford to repay the mortgages are now being hit by increasing defaults as the western housing markets crash from over inflated 'bubble' levels, as their losses mushroom but now find that they are unable to borrow money to cover day to day operations due to the increased risk of default and thus hoarding of cash (if they have any left) amongst investment banks in advance of further asset price mark downs. Therefore the only avenue available for short-term cash is from either the Bank of England or individual savers, hence high savings interest rates relative to the base interest rate of 5%.

And there's more .... mortgage backed securities are the tip of the credit crunch iceberg, the next inline are credit default swaps which are basically investor insurance to protect themselves against losses on the debt packages. However as we saw with collapse of and nationalisation of the worlds biggest insurer AIG, this is another huge part of the derivatives market that is imploding, perhaps in the region of $60 trillion. Its the reason why ordinary people are going to find problems with the credit card freeze next as defaults rise and retailers start to charge a premium on card transaction due to risk of default on the transactions, or even refuse to accept credit cards, but that has yet to happen..

United States Answer To Collapsing Banks is a $700 Billion Bailout Plan

Despite all of the noise of Congress's qualms that we will witness played out during the next 24 hours or so, the bailout plan will more or less pass . Despite the fact that it represents madness, an ultimate manifestation of the subprime contaigent spreading and infecting the US Treasury with all of the consequences of loss of confidence in ALL US paper as the value of US debt devalues in the eyes of all investors.

The US Treasury and Central Bank are eager to get the US Congress to pass a blank check bill so as much of the toxic mortgage backed bonds can be bought up to prevent a further collapse of the financial system. $700 billion is not enough, not in the face of the huge deleveraging of the $500 trillion dollar market, as I warned of 6 months ago. The $700 bailout plans two un-said objectives are -

a. To delay the potential of financial collapse until AFTER the November election.

b. That the real bailout cost will run to several trillion dollars as the US government seeks to prevent a chain reaction of collapsing banks in the wake of counter party failures amongst the huge $500 trillion global derivatives market.

The latest tactics is to suggest that the US Tax payer may even make a profit on these toxic securities. The fact of the matter is that the US will probably be looking at a loss of over 50% on maturity of the anticipated price paid as there is no way that market prices will be paid, as primary reason for the freeze of the interbank money markets is that the securities are NOT being priced by the market for if they were then the market valuations would imply that the financial institutions are bankrupt, hence the free market has been suspended. Taking an estimated eventual exposure of some $2 trillions, therefore implies an eventual US tax payer loss of at least $1 trillion. Which is more than enough to send the US bond market toppling as the US is heading for a budget deficit of more than $1 trillion.

The real question that the peoples representatives should be focusing themselves on is how do we bring those who benefited from the greatest fraud in history to account for their actions and the possible repatriation of wealth stolen in recent years to the tune of more than $1 trillion due to huge bonuses paid on the back of boosted fake asset valuations. That would probably increase confidence in US paper more than signing a blank check for $700 billion .

Is your Bank Safe ?
The US Fed's and other central back actions do not mean that banks will now be saved, as last weeks example of WaMu going bust, America's biggest bank failure illustrates that literally many hundreds if not a thousand plus banks will go bust during the course of the worsening credit crisis, with all of the consequences for depositors. The following report by EWI presents a list of the 100 safest US banks.

UK Toxic State Mortgage Bank

The ground work for the bank bailouts was laid earlier in March and April 08 on the announcements that the UK Government would loan £50 billion to the Banks in exchange for toxic illiquid mortgage backed securities in an attempt to unfreeze the interbank market , at the time I warned that this is just the first step and that eventual liability would extend to several hundred billions if pounds which would still be a drop in the ocean compared to the ongoing deleveraging of a 500 trillion derivatives market which has highly deflationary implications for the credit and asset markets as we have been observing in recent weeks.

First Northern Rock and now Bradford and Bingley mark Britain's own emergency government intervention of the bailout of toxic mortgage backed securities. The estimated UK tax payer exposure in terms of anticipated losses to date is about £40 billion, £20 billion for Northern Rock and £20 billion for B&B. This is in addition to the money loaned to the UK banks as a consequence of the freeze of the interbank money markets and represents a total tax payer exposure to of at least £150 billion, or some $280 billion which compares against the US tax payer exposure of approximately $1.2 trillion that takes into account the proposed $700 billion weekend bailout.

What can Savers do ?

The only thing that savers can do is to attempt to limit real terms losses as much as possible, this implies locking in fixed savings rates ahead of now increasingly anticipated interest rate cuts. The first port of call should be fixed rate cash ISA's which currently range between 6% and 7.3%. The next port of call should be Fixed rate bonds for at least 1year and preferably 2 years, in this case savers have a window of opportunity with rates ranging from between 6.3% to as high as 7.2%. The current market leader is ICICI Bank which pays 7.2% for terms of between 1 and 3 years. Remember to adhere to the limits mentioned above of £35k per banking group.

UK Housing Market

The implications for the UK housing market both as a consequence of the HBOS takeover and Bradford and Bingley bust are going to hit the mortgage market hard with both a reduction in supply of mortgages and an eagerness of the two banks to seek to reduce their mortgage books by trying to induce their customers to remortgage to other banks via higher mortgage interest rates and therefore reduce their risks of default in the wake of the ongoing housing bear market.

The Labour government has attempted to support the housing market by suspending the 1% stamp duty taxed on house purchases on properties up to a value of £175,000 for a period of 1 year and to support new house prices through Homebuy Direct Interest Free loans.

The Halifax's latest house price data shows that the housing market crash continued to accelerate into August, plunging by 1.7% that saw another £3000 wiped off house prices following the £3,300 write off for July to stand at down 12.8% on the year to August (on a non seasonally adjusted basis). UK house prices have now fallen by more than 8% since April. If a fall of 8% in 4 months cannot be considered a crash in UK house prices than I do not know what can. No wonder Chancellor Darling virtually threw in the towel recently in his famous "I give up, please let me spend more time with my family" speech.