How your cashing a check is related to the current credit catastrophe

HamdenRice

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Thu Sep-18-08 07:59 AM
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How your cashing a check is related to the current credit catastrophe

Edited on Thu Sep-18-08 08:11 AM by HamdenRice

It has been very depressing following the unfolding financial catastrophe. But almost as depressing has been the lack of basic economic and financial knowledge most of the media, and hence most of the public, seems to have about what's going on. That's because the entire industry is remarkably non-transparent.

But if we don't know what's happening to us, we can't become the informed public that helps shape how the next administration cleans up this mess and creates a new regulatory structure going forward.

So I've decided to do my little part in providing some background information about how the system works, and why this crisis is so much worse than the media is able to explain. Last year, as the sub-prime mortgage crisis began, I wrote the first of this series, here, explaining the crisis through the movie, "It's a Wonderful Life." The point was to relate the big picture to the way we, as mere consumers, interact with the banking system.

In this post, I'd like to explain just how serious a "freeze up" of credit between banks can be, by showing how it's directly related to everyday transactions you engage in like cashing a check or using an ATM machine.

Let's say that you have an account at Citibank and want to withdraw $20 to buy dinner. There's no Citibank ATM around, but there is a Chase ATM, so you use Chase's machine. While it is true on a superficial level that you got "your money" from "your account" and it was deducted from your account, but on another level, Citibank did not give you anything; Chase did.

The result: Citibank owes Chase $20.

Similarly suppose another person deposits a $300 paycheck from his employer. This employee has an account at Citibank and the employer's account is with Chase. On one level the employee's Citibank account goes up $500, and the employer's Chase goes down $500, but in fact, so far, Chase has not given any money to Citibank.

The result: Chase owes Citibank $300.

If these were the only two transactions in the world that day, then we could have Citibank give Chase $20 and then have Chase turn around and give Citibank $300.

Or, we could balance the two debts against each other. Why do two transactions when one will do the same thing?

The result: Chase owes Citibank only $280.

This process is called "settlement." That's why banks historically closed early in the day. Before there were computers, when checks had to be counted up by hand and totals against all the other banks figured out, it took them from 3:00 pm until late at night to tally up who in the banking system owed whom what.

But it gets a bit more complicated. In the old days, Chase could send $280 in cash by messenger over to Citibank at the end of settlement that night, but tomorrow, by settlement time, the situation might be the reverse, and Citibank might owe Chase $280 which would cancel out the loan. It seemed like a waste of time to have messenger boys running cash all across Wall Street at midnight (or more accurately, guards moving gold bars at JP Morgan's bank or the federal reserve, from the Chase pile to the Citibank pile) so it made much more sense for Chase to lend Citibank $280 overnight.

This system of "overnight" loans between banks is what gave rise to the interest rate index used in the U.K. called "LIBOR." That actually was originally an acronym, for "London Interbank Offered Rate" -- the rate offered between banks for overnight loans.

Now multiply this two-transaction world by the hundreds of millions of transactions and billions of dollars that flow through the system of thousands of banks and financial institutions each day these days. Oddly, the millions and millions of transactions cancel each other out, but at the end of settlement, some banks owe other banks money.

Because these loans are short term, they historically have been unsecured -- that is, the banks don't offer each other collateral. After all, the reasoning went, these are banks! (In the late 1800s and early 1900s, they might add, "and it's owned by solid gentleman of honor!") Of course they're not going to fail by tomorrow morning, and if they don't pay up, they won't be allowed to play in the settlement game. So these overnight loans were considered very safe -- the bread and butter stuff of everyday banking.

Now add the current financial and mortgage backed securities crisis. These securities are the basic building blocks of banking. That's where banks park their money. But right now no one knows whether they are performing and whic ones, how much they're worth, and which banks have how much good stuff and bad stuff. Moreover, with the sudden failure of gigantic financial institutions like Lehman and Bear Stearns, suddenly, it's possible that a bank really could disappear overnight.

So, one of the things that is happening in this crisis is that banks may not lend each other money to take care of these and other settlements. The result would be that all banks owe each other money every night without any bank being brave (or foolish) enough to take the other's word on payment in the morning or when debts cancel each other out. Even if one bank offers another collateral, that collateral is likely to be a mortgage backed security, which no one will accept right now.

To put it bluntly, a bank that can't meet its settlement obligations at the end of the day, even if it is because of a generalized credit freeze, is for all intents and purposes, "insolvent."

That is the picture of a generalized credit crisis. If banks can't trust each other on settlements, then they can't cash your checks or give you money from ATMs other than their own.

That's why this crisis is unprecedented. It's not even like 1929. This crisis actually looks much more like the financial panics of the late 1800s.

It's hard to even imagine the financial system way back then, but the crazy part of it was that most money was privately created by banks and wealthy individuals. Basically, personal and business checks and "notes" circulated like cash, which there wasn't enough of because of the gold standard. During a panic, however, these "checks" or "notes" became suspect. (Would the check writer eventually pay? Which checks are good? Who is holding good checks and who is holding bad checks? Sound familiar?) Hence, no one was willing to accept payment from any other person, leading to depressions that were much more severe than we can imagine. That's why the Federal Reserve was set up -- to create universally accepted money. (Take note goldbugs -- do you want to return to panics on the coat-tails of Ron Paul's lunacy?)

So the only short term solution is that the Fed and central banks have had to play a stronger role as the "bankers' banks" extending credit to banks for the most basic transactions like settlements.