The Banking Crisis is Far From Over

There’s been much blame put squarely on lenders for this economic crisis.  While others like the Federal Reserve and Congress who approved spending bill after spending bill are to blame, the banks that approved less than credit worthy applications do deserve some of the blame. But have banks really learned from their mistakes or is the current banking system doomed to failure?

Banks Are Looking Closer at Your FICO Score

Banks loaned to many individuals because they lowered their standards and accepted people who had lower than average credit scores.  Because of this lack of good judgement, banks are now upping the FICO score needed in qualifying for loans to the 680 range with some banks requiring credit scores of over 700.  This is why many people are not qualifying for loans any longer.  In a future article I will write about why a good FICO score isn’t the problem with banks.

Banks Still Threatened By Bad Assets

At the same time that banks are scrutinizing loan applicants more, they are still threatened with their own bad assets. This means that many banks are still not going to loan people money because they don’t have liquid money to loan as it’s need to make their balance sheets look good to regulators.  Banks are worried about their own survival.  The culprit here however is the evil known as fractional reserve banking that allows banks to even create money (loans) out of thin air to begin with.

Fractional Reserve Banking Was Part of the Problem

Has anyone ever explained to you how the banking system works?  Do you recall every learning anything about it in school?  Probably not.

Understanding the process of Fractional Reserve Banking is essential to knowing why banks are still in trouble.  For the sake of limited space, please go here and read up on Fractional Reserve Banking.

For those that don’t want to get into the gory details, Investopedia’s simplistic definition of Fractional Reserve Banking is: “A banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties.”

It was the ability of banks to be able to loan out money based on the reserves that the bank held that helped cause the crisis.  If banks weren’t allowed to do this, or had stricter restrictions, the crisis may have been averted.

The problem also lies in the fact that banks lend at their own discretion.  This means they would look at one’s credit score, income or other criteria in seeing if they could pay back the loan to them over time.  In the past few years and leading up to the financial crisis, some banks even specialized in what were called sub-prime loans. If  someone could breath, they got a loan.  Who cares about credit scores when real estate will go up forever?  The problem came when the real estate market topped and the value of real estate plummeted.

When the banking crisis escalated, the first people to default were naturally the least credit worthy, those who took out sub-prime loans.  Right now, as real estate prices keep falling, foreclosures increasing and people are walking away from their homes, banks are trying to keep their balance sheets in line with regulatory standards.  The unemployment situation hasn’t helped.

FDIC to the Rescue

According to the FDIC, so far in 2009, seventy-seven have failed and been taken over with Columbia Bank, the last failure being the 6th largest in U.S. history and 100 times larger than any other failure this year.

How many of these depositor’s knew of their banks problems?  Does the Federal Reserve have any kind of warning system for the People in place? No.  They want depositors to just believe everything is ok till it’s too late.  That’s why the FDIC coverage has been increased from $100,000 to $250,000 on a temporary basis.

Why Are These Banks Still Failing?

In general, a bank is supposed to make money on the spread above what they pay you (as mentioned, 1.76% for the 50k CD) and what they can get someone to pay in loans (currently averaging 5.33% for a 30 year fixed) minus fees.

The nice part for the banks is by utilizing the fractional reserve process mentioned above, they get to keep lending and re-lending this newly created money via what is known as a multiplier effect that is based on a banks reserves.  The more a bank has in reserves, the more it can lend. But if a bank lends to entities or individuals that default, then the bank may be left with an asset that they can’t get rid of and take on the expense of maintaining, all the while hoping others don’t default on their loans.

Unfortunately for banks the only thing that is multiplying are the number of foreclosures they are experiencing.  This is occurring at the same time the FDIC is asking banks to pay higher FDIC premiums.

Now Is Not the Time to Take Out a Loan and Buy Real Estate

Mish Shedlock says the U.S. stock market has another 7 years down based on current trends in real estate in his “Collapse of the Ownership Society” article referenced below.

I say as long as we have a jobless recovery, it’s all fluff (by government spending intervention), and this spending will just making things worse in the long run, especially if Congress passes Obama’s Health Plan which I’ve been writing about a lot lately.

Take a look at Mish’s recent articles on Real Estate to get the big picture:

Too Early For Housing Price Stabilization

Collapse Of The “Ownership Society”

Brace for a Wave of Foreclosures, the Dam is About to Break

The astute buyer knows that if they receive a $8,000 tax break in buying a new home for $300,000 and the real estate market falls 10%, they’re down $22,000 on their investment.  The astute buyer knows it’s not time to buy and won’t be until the unemployment picture improves and the economy is growing again.

This won’t happen for a long time as the only thing stimulating the economy at present is government spending, the result of which is only a temporary improvement and eventually just an extension of the decline.

Banks Aren’t Lending to New Home Buyers or Most Anyone Else

While banks are busy trying to fix their balance sheets by restructuring loans and doing what they can to keep borrower’s from being foreclosed upon, the business of loaning to new buyers has dried up, despite government efforts to give the buyer tax incentives.

The Fed announced today; “Most of the banks polled expect their standards for all types of loans to remain tighter than average levels over the past decade through at least the second half of 2010.”

Is the Banking Crisis Far From Over?

“Failed banks are weighing on FDIC” is the headline in tomorrow’s Wall Street Journal.  Banks are being taken over at an alarming rate thus far in 2009.  Banks aren’t lending so it is difficult for them to make a profit while at the same time they are trying to resolve their past lending decisions.  Individuals are finding it difficult to secure loans with the more stringent FICO requirements.  Increasing unemployment is making it difficult for many more to maintain their home ownership.  As people who are now or soon to owe more than their house is worth decide to bail on home ownership, the bank will be left holding an unwanted, depreciating asset.  This is occurring all at a time when banks may be forced to mark to market their assets, showing their real estate holdings value based on today’s depressed prices thus revealing balance sheets that are becoming ever more weaker.

Yes, unfortunately, the banking crisis is far from over.