Why The Banks Can't Be Allowed To Go Bust

[tomandlu]

I was reading the latest (?) blog post by Peston, and comment number 7 from MrTweedy seems to provide a pretty compelling explanation as to why the banks cannot be allowed to go bust.

Here's the gist:

Lehman Brothers was allowed to go bust in September last year, because its assets were worth less than its liabilities - it owed more money than it could repay.

When it did go bust, Lehman's creditors lost vast sums of money because there weren't enough good assets in Lehman Brothers to sell for cash to repay its creditors.

"So what" you say, "the creditors will have to lump it".

Trouble is, the creditors have money owed from Lehman sitting on their own balance sheets as assets. This means the creditors' balance sheets are weakened because their assets are now smaller than they thought, due to the bad debt from Lehman.

Who are these Lehman creditors?

The creditors are, you guessed it, other financial institutions.

So, now we have a situation where other important financial institutions have assets which have fallen in value, and find themselves in the situation where their assets are less than their liabilities.

If we let these financial institutions go bust, it will mean more assets have to be written off and more financial institutions will go bankrupt as a result.

The problems are so huge that letting one large financial institution go bust will, directly or indirectly, cause two more financial institutions to go bust, which then causes four more to go bust, and then eight, and so on and so on, until the vicious cycle eventually exhausts itself. Before you know it, the chain reaction has caused the whole financial system to go bust, and it would take the whole economy with it.

[tomandlu]

Bump (I really should get myself approved on this board - either that or the admins should set the timestamp of moderated posts to the time the get approved, not submitted).

[AteMoose]

Yes and Yes

[grumpy-old-man-returns]

ah, those multi-national multi-layered derivatives cakes with unknown unknowns & a nice bond topping.

we have had a couple of slices, but there are many more left.

Edited January 22, 2009 by grumpy-old-man-returns

[tiggerthetiger]

Known unknowns ? ooohh dear.What about the known knowns..no one really knows how far the melt down will go.So how can any bank draw a line under their balance sheet with confidence,now,next year or in five years time.

[uncle rogi]

seems to provide a pretty compelling explanation

yes it is called the domino effect for obvious reasons, not to be funny but this issue has been consistantly highlighted on these forums for years even before the actual risk of it happening "on the ground" for example the two bear sterns hedge funds that went pop in early 2006 first alerted a lot of people to the exact risk as and as the subprime contagion spread out whilst all the time the so called experts and people in charge said "its contained" people on here warned repeatedly about this risk and that it was to all intents and purposes inevitable once past a certain point.

the lastest desperate so called bailouts are merely the attempt to stall the monster all this will do in fact is to turn a deflationary death spiral into an inflationary one, the bust is coming ready or not.

[grumpy-old-man-returns]

Known unknowns ? ooohh dear.What about the known knowns..no one really knows how far the melt down will go.So how can any bank draw a line under their balance sheet with confidence,now,next year or in five years time.

well eveyone knows that the known knowns are already known, so therefore they are hardly a problem now, are they.

[grumpy-old-man-returns]

Known unknowns ? ooohh dear.What about the known knowns..no one really knows how far the melt down will go.So how can any bank draw a line under their balance sheet with confidence,now,next year or in five years time.

oh, but we do.

Edited January 22, 2009 by grumpy-old-man-returns

[A.steve]

The explanation is pretty reasonable, in my opinion.

The question that I think needs to be asked is this:

Even if a bankruptcy would set in motion a chain reaction of bankruptcies, why should this be prevented?

If banks did not anticipate this problem and plan around it, they should be allowed to be bankrupted - shareholders loose 100% of their investments and the assets are sold at auction to any other investors who believe they can run a more prudent bank. The BoE could even provide financing arrangements for new banks - assuming, of course, that the FSA were up to the task at regulation to ensure the taxpayer didn't take on unnecessary risk. This is the way to re-start lending... re-introduce competition.

[grumpy-old-man-returns]

The explanation is pretty reasonable, in my opinion.

The question that I think needs to be asked is this:

Even if a bankruptcy would set in motion a chain reaction of bankruptcies, why should this be prevented?

If banks did not anticipate this problem and plan around it, they should be allowed to be bankrupted - shareholders loose 100% of their investments and the assets are sold at auction to any other investors who believe they can run a more prudent bank. The BoE could even provide financing arrangements for new banks - assuming, of course, that the FSA were up to the task at regulation to ensure the taxpayer didn't take on unnecessary risk. This is the way to re-start lending... re-introduce competition.

very true A. Steve.

BUT this time it's far too big, we are talking about the UK being bankrupt, not just a few banks.

This is the BIG ONE my friend.

[interestrateripoff]

The banks have built one huge pyramid scheme and bought each others crap.

System failure more or less guaranteed with this genius idea.

[Bloo Loo]

A top video on systemic collapse.

very watchable, about 10 minutes.

[copydude]

MrTweedy seems to provide a pretty compelling explanation as to why the banks cannot be allowed to go bust.

Here's the gist:

It sounds wonderfully logical. Except that:

The bank(s) are bust. They are simply not being allowed to admit it.

The assets on other books are worthless anyway, but if the first bank doesn't own up to being bust, the second bank doesn't have to admit its assets are worthless. And so on.

The fact is, the banks have already failed at least once and the economy has already been brought down. Bail outs simply amount to nothing more than buying denial.

[Injin]

very true A. Steve.

BUT this time it's far too big, we are talking about the UK being bankrupt, not just a few banks.

This is the BIG ONE my friend.

Yep.

If they let it go we'd be back on our feet within 18 months and then would have a massive (and genuine) boom.

Instead we are going to get a re-run of all the shittiest bits of the last century.

****** you very much, statists.

[D.C.]

The explanation is pretty reasonable, in my opinion.

The question that I think needs to be asked is this:

Even if a bankruptcy would set in motion a chain reaction of bankruptcies, why should this be prevented?

If banks did not anticipate this problem and plan around it, they should be allowed to be bankrupted - shareholders loose 100% of their investments and the assets are sold at auction to any other investors who believe they can run a more prudent bank. The BoE could even provide financing arrangements for new banks - assuming, of course, that the FSA were up to the task at regulation to ensure the taxpayer didn't take on unnecessary risk. This is the way to re-start lending... re-introduce competition.

I agree. Even if it takes out 99% of the financials, there will be some left after holocaust. Money will flood into those few surviving banks who can buy up the rest of the good assets for peanuts, or new banks will rise from the ashes.

If the problem is systemic, the system needs to die. This free market stuff is neither here nor there in the boomtimes, it's the 'red in tooth and claw' bit that makes the system work, the markets need carnage in order to properly correct.

[DabHand]

Apart from owing eachother a load of pnzi'd bank credit IOU's do banks ever OWE money to the real economy. Generally this is a one way street.

Yes there may be some dodgy grey areas with pension admin, and holding shares in trusts...but l think one could allow them to go pop...yes it would bring down the whole lot. Refloat the banking function using taxpayer money in the form of bonds through the shells of the broken banks as the admin and implementation of the "bank de government".

Flog them back into private ownership when dust has settled.

Make pensions and savings whole along with any misc innocent losses caused. Sell debt on if and where possible. Has to be a cheaper and less destructive way than current no?

[Selling up]

I agree. Even if it takes out 99% of the financials, there will be some left after holocaust. Money will flood into those few surviving banks who can buy up the rest of the good assets for peanuts, or new banks will rise from the ashes.

Couldn't agree more. Why do we never hear the "experts" consider this option?

[grumpy-old-man-returns]

Couldn't agree more. Why do we never hear the "experts" consider this option?

because most of them are part of the problem. The ones that are not part of the system, are classed as conspiracy theorists or nutters.

Never ask a window cleaner if your windows need cleaning.

Edited January 22, 2009 by grumpy-old-man-returns

[VeryMeanReversion]

It sounds wonderfully logical. Except that:

The bank(s) are bust. They are simply not being allowed to admit it.

The assets on other books are worthless anyway, but if the first bank doesn't own up to being bust, the second bank doesn't have to admit its assets are worthless. And so on.

The fact is, the banks have already failed at least once and the economy has already been brought down. Bail outs simply amount to nothing more than buying denial.

Althought not worthless, that is pretty much true. The Japanese banks did that during their bust. Although their liabilities greatly exceeded their assets, this was pretty much reversed by 2006 according to the Chief Economist of Nomura (coming clean after the event).

UK banks can be profitable at the moment whilst milking the mortgagees and savers (thanks Gordon/Daring/King). They can eventually get back to 0 net worth as long as none of them fess up and/or go bankrupt in the meantime.

I still think they should be allowed to go bust (orderly administration), the good remaining ones will pick up the pieces and/or new banks should be encouraged to start up with fresh capital.

VMR.

[mightytharg]

I was reading the latest (?) blog post by Peston, and comment number 7 from MrTweedy seems to provide a pretty compelling explanation as to why the banks cannot be allowed to go bust.

All the banks have credit limits on each counterparty so that they will be fine if a few counterparties go bust. So this isn't the reason.

One suggested reason is that selling some of the illiquid securities in a failed bank would cause "price discovery". All other banks owning the same securities would have to stop lying about their values and use the real price - this could have a big effect on a lot of institutions and cause problems. Of course it isn't really causing the problems but bringing them out into the open - which could be a good thing.

IMHO the real reason for the bailouts is that the banks had the foresight to buy up plenty of politicians before they fell on hard times and are now demanding payback. Northern Rock paid out a lot to a Labour "think tank". AIG was bailed out to benefit Paulson's employer, Goldman Sachs etc. etc.

[Bloo Loo]

Althought not worthless, that is pretty much true. The Japanese banks did that during their bust. Although their liabilities greatly exceeded their assets, this was pretty much reversed by 2006 according to the Chief Economist of Nomura (coming clean after the event).

UK banks can be profitable at the moment whilst milking the mortgagees and savers (thanks Gordon/Daring/King). They can eventually get back to 0 net worth as long as none of them fess up and/or go bankrupt in the meantime.

Isnip

this is why there is a "shortage of money". Heard Mcfall saying it on Newsnight last night.

The cure to a shortage of money? print some more, Mein Heir.

watch as the calls for money increase.

Edited January 22, 2009 by Bloo Loo

[Injin]

Just two small reminders -

1) The banking system went insolvent in the 30's and it's still here.

2) The market value of the banking system has been zero since that time, because it's not a market at all - it's a series of forced associations with the taxpayer at the end of the rainbow.

One can measure tha anti market value of something by working how much the violence/coercion costs to maintain it.

Edited January 22, 2009 by Injin

[Converted Lurker]

it's also the wider issue of mass civil unrest unleashed throughout continents at the same time, should the system (which is all to do with banks) collapse then society (for what it's worth) goes too.

[sikejsudjek]

Depositors should be saved, banks should not. The attempt at bailing out everything is the worst long term option. It punishes savers, rewards the feckless, and prolongs the correction. Now instead of a bank or two going down, we are facing the real possibility of the entire state failing.

Unfortunately no politician wants to tell the baby boomers that their party is over, they are worth 1/10th of what they thought they were worth, and there won't be a recovery until they're 6ft under.

[Injin]

it's also the wider issue of mass civil unrest unleashed throughout continents at the same time, should the system (which is all to do with banks) collapse then society (for what it's worth) goes too.

Ah yes.

The 1-2% of people who benefit from the banking system will be just furious when the 97% who have to pay interest on everything up to the ability to fart are free of the debt burden.

I can see it now - "Lord Nathanburger Rockershild the 14th flattens downtown London seeking debtors, Japanese government asked for aid of godzilla."