Why Real Estate Investors Should Know This

A super smart lady friend of mine sent me a real interesting article written by one of her friends. Its title is “Why Do Banks Keep Going Bankrupt? Moral Hazard, Regulation, and a Century of Systemic Bank Insolvency“. You can read it here. It’s a brief analysis on why banks keep going bankrupt. I thought it was well written describing the major banking crises in the last 100 years, their causes, and what should be done to prevent – or at least minimize – the risk of future banking failures.

In short, what I believe Mr. Cundiff is saying is that the banking industry has been (for the last 100 years) and it still is unstable. The three major events occurred during the Great Depression of the 1930’s, during the 1980’s and 1990’s Savings & Loans crises, and most recently during the 2007 Great Recession. One of the most important factor – if not the most important – is leverage. In comparison with the rest of the industries, where the debt to assets ratios are between 10-40%, the banking and financial industry ratios are in the 50-70%. Common sense dictates that a company with a high debt to asset (and equity) ratio is a high risk. Overall, if most depositors were aware of their bank’s degree of risk, they’d expect higher returns on their deposits (savings, money markets, CD’s, etc.) than the standard interest set by the bank.

But most depositors don’t take the time – nor do they care – to research their bank’s debt leverage because they perceive their deposits are safe due to FDIC insurance. Little, however is known that the FDIC fund does not have sufficient reserves to cover losses in a scenario where a large number of banks would fail. The government would have to resort to issuing more government debt (treasury bonds) to cover for losses, which implies the process of creating more (fiat) currency.

Moral Hazard

According to Wikipedia, “In economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could result will not be felt by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.”

The perceived consumer safety creates moral hazard. It allows banks to be high risk due to their high leverage ratios and less careful lending practices, without suffering the consequences of their actions. The consumers believe their deposits are safe due to FDIC insurance, thus they care little, if at all, how much risk is their bank taking when investing its depositors’ money. The bank will take high risk because it knows the government will step in and cover its losses up to $250,000 in the U.S. and up to 100,000 EUR in most European countries. In addition, most large banks are bailed out by governments. Bail-outs saves them from bankruptcy. From consumers to governments to banks, this is an example of moral hazard. (Bank bail-outs are more likely to occur when big banks are in trouble, while the small banks find themselves at an unfair disadvantage).

Even the well-off clients with deposits exceeding the FDIC insurance amount don’t seem to be too concerned. Most of them have not experienced the bank-runs throughout the Great Depression. Most of them have not experienced the more recent Cyprus bail-in, where depositors with amounts exceeding 100,000 EUR have lost significant amounts of their savings to save the Cypress banks from bankruptcy.

Finally, the free market solution to banks’ stability according to the article and to most Austrian Economists is to substantially increase the banks equity relative to the debt they carry. However, considering the powerful banking lobby in the U.S. and around the world it’s not realistic to believe the system will change anytime soon.

Finally, why do I think real estate investors should be among the first to know? First of all, I’d look at this as “food for thought” and just plain knowledge. Generally speaking, the real estate investor is likely to be more receptive to economic knowledge than the average person. Furthermore, I noticed many real estate investors have large liquid reserves. It would behoove them to check their bank’s level of risk. Bank Tracker provides a decent website where you can go in, click your state, your county, and then your bank. Click here to go to the website. Take the amount listed in the Loans column and divide it by the amount listed in the Assets column.  As Mr. Cundiff’s report describes, the leverage ratio is between 50 to 70%. The banks I checked in several parts of the country do have ratios between 50 to 70%. Of course, the closer to 70% that is, the higher the level of the bank’s risk.

Public awareness usually starts with individuals whose livelihoods are directly impacted by economic trends. Real estate investors are amongst those individuals. Past banking crises have been often the triggers for most economic sectors’ deflationary events. In 2008 Lehman Brothers’ collapse unleashed a chain of a dramatic banking crises. It contributed to the burst of the real estate bubble. Few real estate investors foresaw what was about to happen in 2007 and early 2008. Many weren’t aware of the current banking industry’s level of weakness (as a result of over-leverage), so they paid the price, they went from riches to rags. Because the boom-bust cycle of banking bubbles followed by banking crises is likely to continue, the real estate investor should prepare on how to position himself throughout various economic stages. But to develop a strategy one must first learn the circumstances. For me to act, I first must be aware.