Why Banks Failed

I see pundits using lots of jargon, charts, and ratios trying to determine why banks failed. Some argue that leverage ratios of the investment banks are largely unchanged from those of the mid 1990s, and those of commercial banks actually declined, so are puzzled as to why we have the problem that we have now.

The bottom line is that banks (no distinction between commercial or investment) did not adhere to strict mortgage underwriting policies, largely because either a) they did not intend to hold the mortgages, or b) in the case of banks that held mortgages, they felt they had to in order to compete with the big conduit players.

Banks and investors relied on Loan To Value (asset value) as first way out - which as we know is always a mistake. Assets are only worth what someone will pay for them - unless they are cash flow generating, assets do not have inherent value.

The other issue, which often goes undiscussed because it is difficult to track statistically, is the impact of the CDS debacle. There are roughly $20 trillion in corporate and mortgage backed debt securities outstanding. Yet there are $56 trillion in Credit Default Swaps - or 2.8x the entire traded debt market. The counter party risk of such a pervasive, mispriced, and unregulated market is staggering, and we will feel its effects for years to come. Leverage ratios of banks and I-banks do not accurately reflect this risk - and therefore are grossly understated. This is a market that really only took off starting in 2002 - so comparing recent leverage levels to that of the 1990s is non-meaningful.

Our current market failure is also misunderstood - but is quite simple. Liquidity has been driven by both the issuance of $20 trillion in traded debt and $56 trillion in CDS, not to mention the untraded loan markets. There is zero net new issuance in any of these markets - in fact there is contraction. A contracting liquidity market means a contracting economy. Period.

As Bette Davis famously said in "All About Eve": "Fasten your seatbelt - its going to be a bumpy night."