The Coming Banking Crisis

Let me start off by saying that I do not normally preach doom and gloom. I understand the resiliency of our financial systems and understand that they have held up for the good part of 300 years.

The bankruptcy bill which will most certainly pass congress and be signed into law will wreak havoc on our financial systems. I am not a huge advocate of bankruptcy, however I believe that our banks have put themselves directly at risk to accumulate the mounting bankruptcies.

Here's the problem: Spurred by low interest rates, our credit systems are entirely too loose.

Cheaper money gives more purchasing power to home and car buyers. That $150,000 you could afford to spend on a home at 7% is now a $175,000 home at 5.5%, with the same payment. That $500 payment on your $25,000 car became a $400 payment with 0% interest.

The result has been skyrocketing home prices, what many call a bubble. And the bubble fever remains just as it did in the late 90’s with the stock market bubble. When the mindset is that something is guaranteed, and that the price will not fall, the investor will leverage their debt as much as possible. In the 90’s it was high-ratio margin accounts – allowing you to trade stocks with 2-5 times the amount of money you actually have. That works great with rising process, and not so great with falling prices. With banks, they are the introduction of interest-only loans and 100% financing. The same person above can now buy a $235,000, with the same payment.

Americans are sitting on unprecedented levels of debt. All of this is true -- no matter what bankruptcy bill will pass.

*Where does bankruptcy come in?*

Going to extremes rarely helps any situation. The best possible outcome for everyone will usually be a happy medium – which is what our bankruptcy laws are today. They let consumers get rid of much of their high-interest non-secured debt, while maintaining the lower-interest secured debt. By doing this, no assets need to be sold – and this is the key.

With unchecked power by the banks in controlling bankruptcy on the horizon, this is where the danger comes in. Banks are not interested in making sure every bank gets paid back as much as possible, they’re interested in making sure *Their* bank gets paid as much as possible. This is why I have 2-3 credit card offers in my mailbox every day. When it comes time to divvy up the assets for bankruptcies, those auto and home loans will be put in the mix.

*What happens then?*

Let’s look at the chain of events likely to happen:

1. Consumers begin losing their homes. Usually home loans are fairly secure investments for banks to make. In this environment that is not the case. Remember that 100% financed no interest home loan? That $235,000 home has not been paid down a dime. The bank needs to sell it for $249,000 just to cover their investment and pay the realtor! Obviously this won’t happen, as the banks are only interested in selling as quickly as possible. They’ll sell it for $200,000 if they can do it quickly.
2. This deflates home prices. Keynesian economics would call this “debt deflation”, which was the cause of the Great Depression. How do central banks usually control debt deflation? By lowering interest rates to make money cheaper! But how much further can we lower rates? Not much until we end up like Japan, in a rate trap, with no end in sight.
3. Now not only are the foreclosed homes selling cheaper, but so is yours! If I can buy that $235,000 house from the bank for $200,000, and you’re selling yours for $250,000, which will I buy?
4. If you owe more than $200,000 on your house, what do you do? If you can wait it out, you’ll probably be OK. If you need to move, you’ll have to come up with the cash.

Who’s getting nailed here? You are, and so are the banks. Who’s the government going to bail out? I think we already know that answer. The government (which is *we*, the taxpayers) will bail the banks out, and they’ll come out fine in the end.

You? You’ll be paying this off for the rest of your life, at 50% interest. Welcome to America.

(I left out the complications of Fannie-Mae and Freddie-Mac from this discussion, and just lumped them in as “the banks”)