Inside Wall Street: The Real Reasons the U.S. Banking System Lost its Way

By Shah Gilani
Contributing Editor

Unlike Dorothy in "The Wizard of Oz," the brutalized U.S. banking system will never again return to that comfortable, cozy, and cushy capital place it once happily referred to as "home." But its "Wicked Witch" was its own greed. The curtain has finally been pulled back on the machinery, and the hot air used to pump up the U.S. banking system’s version of the Emerald City in the Land of Oz.

For decades, American banks operated on a simple - and nicely profitable - business model: They took in deposits and lent out money.

In the simplest model, a bank might take in deposits of a million dollars and lend out a million dollars. In a perfect world, such a "matched book" is established if they know that the deposit will be left in the bank for a year and the loan they made has a maturity of one year. If the bank pays the depositor 3% and charges the loan borrower 5%, it can assume a profit for the year of 2% (the difference between the 5% loan rate and the 3% payout to depositors).

It Takes Money to Make Money - Disappear

In order to make more money, banks need more money to lend. In addition to taking in deposits, banks borrow money to make more loans, to buy assets to keep on their balance sheets, and to trade in the markets. They get this money by offering products such as certificates of deposits (CDs) to entice depositors to bank with them, they borrow overnight in the Feds Funds market (from other banks), they sell commercial paper backed by their balance sheets to investors, they get capital from profitable trades and investments, and they generate fees for their banking services.

The problem is that banks don't just take in money in order to lend it out; they take in money to make more money with it by investing and, yes, speculating.

On the deposit-and-loan side of the equation, banks don't even bother trying to run a matched book anymore. They borrow short and lend long. This works well if their short-term borrowing costs are substantially lower than their long-term lending rates.  But if short-term rates start to rise, banking profits in the borrow-and-lend game start to get squeezed. And if short-term rates shift so much that they’re actually higher than the interest rates the banks are charging on their long-term loans, banks actually start to lose money.

Banking-system executives are fully aware of these interest-rate dynamics. Indeed, they knowingly speculate on interest-rate movements by not running matched books, and trying to increase their spread profits by borrowing as short as they can and lending for as long as they can. The bottom line: Banks actually are speculating on interest-rate movements.

Speculating on the Health of the U.S. Banking System

If you didn't already know that banks speculate, you're about to be really surprised. All the money that is not lent out to borrowers floats around in what's known as the bank's "treasury." The job of the people who work in the treasury is to make money with the cash that's sitting around. To a banker, idle cash is no better than idle hands - both are regarded as the devil’s playthings.

There’s some merit to that argument. After all, no one actually makes money with idle cash: It has to be put to work, lent out, used as investment capital or, of course, used as trading capital in speculative deals.

Banks lend treasury funds overnight - and for short periods - to other banks, and to such non-banking institutions as insurance companies, corporate clients, securities broker-dealers, and investment banks (investment banks do not take in deposits and are therefore not the same as commercial banks, nor are they regulated by the same supervisory bodies that oversee commercial banking operations).

For banks, the problem in making these loans is one of "counterparty risk" - will the borrower be able to pay the funds back? Banks have become very wary of counterparty risk and have drastically cut back their lending to many traditional types of borrowers.

Instead, banks invest in assets, including government bonds, corporate bonds, mortgage bonds, currencies and derivatives. Some investments actually end up on banks’ books because they have deals to hold assets they are not able to syndicate (sell pieces of to other bank partners). And sometimes banks hold assets so that they can profit as these holdings appreciate in value. (Of course, stating that a bank is "holding assets as investments" is actually just a polite way of saying that it is speculating).

The Bottom Isn’t Yet Within Sight

Lately, banks have been holding mortgage bonds and similar financial instruments in so-called "off-balance-sheet" entities. By doing this, the bank essentially takes assets off its books (which are visible to investors and regulators) and places them inside a special holding company, where they now will be out of sight.

Why would a bank do this? Simple. Banks are hiding risky assets so that their "books" and balance sheets look better. Truth be told, there’s no reason for off-balance-sheet entities. Period. They’re nothing more than a means for a fraudulent conveyance.

Banks trade - a lot. They buy and sell government bonds, currencies, derivatives and whatever else their charter allows them to trade. Banks trade billions and billions of dollars every day. They are speculating.

Particularly in the U.S. banking system, what has happened is that banks have over-speculated across the board. And the losses that have resulted have severely reduced their available capital. This means that they have less money to lend and will be much more strict with prospective borrowers, exacting tougher loan terms and demanding higher creditworthiness before agreeing to make any loans.

As banks lose money - something I expect will continue for perhaps the next several quarters - their stock prices will continue to fall, reducing their equity capital (which is what regulators look at to determine their stability).

Banks keep raising capital via investments from sovereign wealth funds and through preferred and common rights offerings. And still their losses continue. They have to keep going back to the well. Sooner or later, this capital-markets well will have to run dry. There are going to be bank failures and we will see the doctrine of "too big to fail" tested yet again, as a major bank sinks into the abyss (the failure of The Bear Stearns Cos. Inc. (BSC) was a test and the subsequent central-bank-led bailout seems to have proved that it was too big to fail).

To understand this crisis is to first understand what's wrong with banks. We cannot come out of this credit crisis if we do not repair the damage to the commercial lenders in the U.S. banking system. And by "repair," I’m talking about fixing their credibility and integrity just as much as I am referring to the need to restore their capital base.

This country is the capitalist behemoth that it is because of our banking system. Where are the regulators? Where is Congress? Where are the outraged stockholders and borrowers? Will it take a banking-system collapse and a run by depositors to get these problems addressed and fixed?

Until the banks are fixed, avoid all financials - especially commercial banks and investment banks. Stay short on the dollar. Short the major stock indexes. If you have to remain long in equities, sell calls on a rolling basis.

The next stop on the Dow Jones Industrial Average is likely a test of 10,000.

[Editor’s Note: Contributing Editor R. Shah Gilani - and his column, "Inside Wall Street" - are brand-new additions to the Money Morning lineup. Gilani brings readers the ultimate insider’s view: He’s toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. His self-professed goal is to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and past the "velvet rope" that typically keeps the average investor from learning the secrets that sit beyond, just out of reach.]

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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