Why Your Bank Is Broke

Paul Havard talks on his cell phone inside a Citibank branch in New York on Jan. 16, 2009

JB Reed / Bloomberg News / Landov

Even without doing the math, you probably get that the government's financial-rescue effort is failing. The signs are hard to miss. Your friend in finance got pink-slipped. A house sale down the street fell through because the buyer couldn't get a mortgage. A local bank is closing a nearby branch or maybe shutting down altogether.
But do the math, and you can begin to understand how really botched this bailout has been. Since October, the government has deposited $165 billion into the accounts of the nation's eight largest banks. Yet those same financial firms are now worth $418 billion less than they were four months ago, and the Congressional Budget Office estimates that the government's preferred shares are worth at least $20 billion less. In Wall Street terms, that's throwing good money after bad. All told, the government's annualized rate of return on its investment in the nation's largest banks is -1,096%. That's well beyond Bernie Madoff territory; he topped out at a mere -100%. (See pictures of the demise of Bernie Madoff.)
So how could $438 billion — $418 billion of their money and $20 billion of ours — go poof, just like that? Here's the easiest explanation: our banking system has sprung a leak.
Financial firms are built on capital. They take in a dollar, borrow against it and then lend out $3, $4 or $9. Or $30. In the past few years, executives have been using thinner and thinner capital — acquisitions and questionable off-balance-sheet arrangements — to build their money pails. In good times, the more of those cheap sources of capital you use, the more profitable your bank will be.
For the past few decades, banks have been piling up risk, making more and more loans based on less and less capital. Years of economic growth, shallow recessions and record-low default rates lulled bankers into thinking that the future would resemble the immediate past, at least as far as risk went. Turns out it didn't. All it was going to take was a worse-than-average recession — and it looks as though we've got one — and many banks, including a number of the biggest ones, were bound to fail. The shockingly poor lending standards — housekeepers being approved for million-dollar mortgages — have only hastened their demise. "This crisis needs to be understood as something that has developed over the past decade," says Joseph Mason, a finance professor at Louisiana State University's E.J. Ourso College of Business. "This isn't just one black swan. It's a bunch of black swans that have hung out for a while and created a giant problem." (Read George W. Bush's top 10 economic mistakes.)
There's little hope that the type of shares the government is buying in banks as part of the Troubled Asset Relief Program (TARP) will plug the hole in the banking system's bucket. Paul Miller, an analyst at FBR Capital Markets who has written a number of reports on the capital issues of banks, says the only way to solve the problem is for the government to stop buying preferred shares and start taking direct ownership stakes. Of course, the issue with that approach is that the problem at the banks is so large, Uncle Sam may end up owning a good portion of the banking sector. Few seem to want nationalization. Unfortunately, that could be the only way out.