The Tao of Money and Banking

Banks and People (part 2 of 3)

“I’ve been here for three years and never once heard the word ‘people’.” [handwritten note posted on bulletin board in graduate department of Economics at University of Wisconsin-Madison]

Last time we looked at two key pairs of opposites that played a role in the financial crisis.

Liquidity vs Leverage (or “Illiquidity)
Solvency vs. Debt (or “insolvency” )

This time we’ll look at how these pairs of “variables” apply to people and to banks.

Let’s start with the first of two charts. This chart, the People Chart, is based on Robert Kiyosaki’s “Cashflow Quadrant” (in his Rich Dad, Poor Dad book series).

The Liquidity and Solvency of People

(A) Employees and self employed people
Have jobs (paychecks) or clients (payments) + usually are “cash poor” = liquidity + debt

(B) Homeowners
Own houses with mortgages (i.e., outgoes) + usually are “cash poor” = leverage +debt

[Note: “cash poor” usually means reliance on credit cards to stay solvent.]

(C)) Landlords and business owners
Own income-producing property and/or assets + usually are cash rich = leverage + solvency

(D) Wealthy investors and retirees
Own stocks, pensions, Social Security + usually are cash rich = liquidity +  solvency

We say that landlords, business owners (and homeowners) are “leveraged” because their income comes from assets which can take a long time to sell (months to years). Imagine that pile of money being “lever-aged” over your head. You can’t get your hands on it until it comes back down to earth. On the other hand, employees (who sell their own “labor”) and investors can get paid their money relatively quickly (days to weeks). So we call their income “liquid.”

It’s risky to be leveraged. Picture that heavy bundle of money over your head! What if you can’t get it back down? What if it falls? So leveraged assets usually pay higher returns on your investments in them.

Where “logic is deficient in the face of desire,” or more plainly, when the desire to “get ahead” and have some savings or “security” hits, people often leverage and take on more risk. And guess what? Banks do the same thing. Here’s the Banks Chart.

The Liquidity and Solvency of Banks

(A) Banks that sell stock in themselves or make short-term investments + take in deposits = liquidity + debt

(B) Banks that sell bonds in themselves or make long-term investments + take in deposits = leverage + debt

C) Banks that make long-term loans with higher interest rates + take in deposits = leverage + solvency

(D) Banks that make short-term loans with lower interest rates + take in deposits = liquidity + solvency

Deposits are the debt that banks owe to their customers. If a bank can pay back this debt quickly, it is liquid. The liquid assets of the banks bring in money more rapidly. The fastest way banks raise money, other than by encouraging deposits, is by selling stock in themselves.

But leveraged assets of banks are income the bank usually receives over a longer period of time. For example, bank bonds are usually long-term “loans” made by investors in banks. Likewise, long-term loans made by the banks are usually home loans.

Here, as in the People Chart, solvency refers to how able the bank is to pay out deposits at any given moment.

Some things to observe

(1) If you compare charts you’ll see that “cash” belonging to people in the People Chart shows up as “deposits” in the Banks Chart, and vice versa. People and banks are two sides of the same coin. In any “market transaction” between buyers and sellers we need to pay attention to both sides. Instead, the focus these days is on banks alone, and not people.

(2) Rather than blaming any particular parties, the financial crisis can be seen as a whole system where imbalances occurred among people and the banks. This brought about failures for both. In other words there’s no longer:

A bank for every person.
A person for every bank.

For example, let’s look at the banks’ option C, longer-term loans. When banks made long-term loans to landlords, both groups were leveraged, but solvent. Landlords who took out loans at the bank made rent off their property and paid the banks interest on their long-term loans. Both were better off from the deal. But when banks made long-term loans to homeowners or to landlords who were over-extended, the latter became leveraged and being “cash poor” were in danger of defaulting, i.e., becoming insolvent or bankrupt.

Likewise, looking at option B, when banks made long-term investments, particularly commercial loans in large building projects, or sold structured securities created from conglomerations of long-term personal loans sliced into pieces called “tranches,” banks put themselves in the same position as homeowners – they became highly leveraged and deeply in debt. They couldn’t get money easily, and they were obligated to pay their depositors (who have the right to demand money from them at any time).

Banks which went into debt and over-leveraged their investments to make profits during the bubble times are now failing daily. We’re up to 130 bank failures this year.

This “economic model” or “blueprint” with four paired variables (liquidity/leverage, and solvency/debt) has given us a very simple way to look at the problems of banks and people during the financial crisis. Now, in Part III, we can go ahead and use it to look at the “solutions” the government is using for banks and people.

Copyright © 2009 Nancy K. Humphreys