Anatomy of a Bank Run

One may be forgiven for asking what I can possibly hope to add to the voluminous commentary others have already put forth on the economic crisis. The answer, in short, is that our media – in particular the relatively few outlets whose reporters actually understand what is going on – has mostly proven inept at explaining the problem clearly to those of us who lack a background in corporate finance. Terms like “capital injection,” “credit derivatives,” “secured creditor,” and “repo market” are bandied about with little elaboration, as if the average person with a college degree has any clue of their meaning.

The sheer complexity of the problem is such that the vast majority of the educated public has an inadequate understanding of what is happening along with the costs and benefits of the alternative solutions. This, in turn, is allowing our financial and political elite to get away with highway robbery, all the while duping us into believing that the courses of action which happen to be most advantageous to themselves have no feasible alternatives.

What follows is a two-part series that gets to the heart of the matter – the paralysis of the global financial system. The first part examines in detail how a crisis of confidence around a particular financial institution can precipitate its rapid demise and take the rest of the financial system down with it. The next segment will address how we got to this point along with the possible remedies.

Other People’s Money
Let us begin with the crux of the problem: financial speculation using other people’s money. When one speculates with borrowed money, it does not necessarily have to create an existential threat to Western civilization – so long as the amounts borrowed are not excessive. Alas, our financial institutions – banks, brokerages, insurance companies, and hedge funds – have over the past twenty-odd years failed to heed this maxim.

Using borrowed money to supplement your own can be lucrative insofar as it can increase your profits over and above what they would be without the borrowed funds. Let’s say I have $500 and want to use this money to buy XYZ Corp’s stock. The stock is priced at $10 per share. Using my own money, I can buy $500 / $10 = 50 shares of XYZ stock. If the price subsequently increases by $2 per share, I stand to gain $2 * 50 shares, or $100 in profits. That’s a 20 percent return on my $500.

That may be fine for you, but I’ve got to keep my wife happy, and my son, for Christmas, is demanding the G.I. Joe with the kung-fu grip. Surely I can do better than 20 percent. Indeed, if I borrow another $500 and add that to my own funds, I now have $1000 to bet with. And I can buy twice the number of XYZ shares – that is, 100 shares instead of 50.

The portion of the $1000 that belongs to me is called my equity. The other, borrowed portion is called leverage. Using leverage, the same $2 rise in the stock’s price will give me double the profits than if I were only using my own $500; my profit now equals $2 * 100 shares, or $200. This represents a far more amenable 40 percent return on my $500, as compared to the meager 20 percent return I would obtain without any leverage. Sure, I still have to repay the $500 I borrowed. But I get to keep the extra profits for myself.

In this example, I am using 2 to 1 leverage; that is, the amount I borrow is twice that of my equity. The more I borrow in relation to my own personal funds, the bigger the potential return on my investment.

Like all good things, however, leverage has its downsides. If I’m using 2 to 1 leverage and the price falls, I lose twice the amount than if I were only using my own funds; a $2 fall in the stock price amounts to a 20 percent loss using no leverage and a 40 percent loss borrowing that extra $500. Using still more leverage can multiply my losses even further; not only can I lose everything I have, I can end up in the unfortunate position of owing money to my creditors.

Most traders and investors should never use more than 4 to 1 or 5 to 1 leverage. The Wall Street banks that have collapsed or been bailed out were frequently using leverage of 30 to 1 and, in some cases, 50 to 1. Employing leverage at such insane levels means the prices of the assets in which you are speculating have only to fall by a small amount before you are wiped out entirely.

One might reasonably believe that our financial institutions focus on their primary jobs and don’t get distracted by other ventures – insurance companies sell insurance, banks concentrate on lending to businesses, while investment banks stick to mergers, acquisitions, and underwriting. Yet this is not the case. Over the past several decades these financial institutions have come to believe that they can speculate as well.

The assets they speculate in are described in detail in my previous post, “Financial Market Chaos Explained.” In essence, the financial institutions make bets on various assets, such as mortgages. They don’t actually own your mortgage; they are just betting amongst themselves whether you will continue to make your mortgage payments. It is like you and I betting on the Giants vs. the Packers. Neither of us have any connection to the actual teams, but we can still place bets on the outcome of the game. The major financial institutions do the same thing with mortgages, corporate loans, credit card debts, auto-loans, and other assets.

When used prudently, these bets allow them to reduce their risk, which in turn enables them to lend more money to businesses and consumers and in doing so increase the amount of investment and jobs in the broader economy. When used excessively, however, they can be quite dangerous, as we will see.

Introducing P.J. Nagrom
Let us examine how the abuse of leverage can spark the unraveling of a fictitious bank. We will call it P.J. Nagrom. Similarly to the example of the leveraged speculator above, P.J. Nagrom obtains its operating funds through two sources. First, its owners put up their own money in the form of equity. The equity is divided into shares that represent the owners’ claim to any profits the bank makes. In the case of P.J. Nagrom, these shares are publicly traded on the stock exchange, where any owner can sell her shares at any time to a willing buyer. Secondly, the bank borrows money from others. The borrowed money represents leverage and, as in the above example, is designed to enhance the returns available to the bank’s owners, the shareholders.

Everyone – shareholders and creditors – knows at the outset that, if the bank fails, any money that is left over gets distributed among themselves. However, in the event that there does not remain enough money to satisfy everybody’s claims, the law gives some claimants priority over others.

At the top of this hierarchy are the senior bondholders; their claims are considered sacrosanct and must be made whole before those of anyone else. Below them sit the subordinated debt holders. The term “subordinated” denotes the fact that the debts the claimants are owed can be repaid only after the senior bondholders have received all of their money. The subordinated debt holders are in turn divided into senior and junior segments, with the former’s claims given priority over the latter’s.

Finally there are the shareholders. If the bank fails, the shareholders are the last to recover their money – if enough is even left over at all, which is rarely the case. But this is the price they pay in exchange for their right to the bank’s profits. The shareholders come in two forms – preferred and common. Preferred shareholders, as the name suggests, get priority over the common shareholders in the distribution of any funds that remain once the bank is wound up.

Like many other financial institutions, P.J. Nagrom made some bad bets on mortgages and now faces serious losses. It is the shareholders, who sit at the very bottom of the financing hierarchy, who are the first to take a hit whenever the bank loses money. After all, they are the last to receive any leftover funds if the bank goes belly up. Thus, by sheer logic, they are necessarily the first to absorb any losses the bank suffers. Accordingly, whenever P.J. Nagrom reports a loss for the quarter, it will announce a “writedown” in the value of the shareholders’ equity. As soon as the writedown is announced (and frequently beforehand), the stock price will drop to reflect the new, lower value of this equity.

Our bank, whose stock price reached an all-time high of $150 per share in July of 2007, suddenly reported its first ever quarterly loss from subprime mortgages in September of that year. This was followed by an unending string of further losses in every quarter since then, resulting in more writedowns and, consequently, a continuous decline in the price of the stock. In early September 2009, the stock plunged from $34 per share to $17 in the span of a week, as investors anticipated a major loss for the third quarter.

Until this one-week drop of 50 percent, debtholders had been rather complacent, assuming they would continue enjoying regular interest payments on their loans and get their money back in the end; the shareholders, after all, were there to soak up any losses the bank made. However, while the shareholders absorb the first losses, once the stock price falls to zero the debtholders begin to suffer. At that point, any further losses begain eating into the bank’s remaining assets, and there are no longer enough assets left over to satisfy all the debtholders’ claims.

Recall that the massive leverage P.J. Nagrom has taken on means that even a mild decline in the prices of the assets the bank owns takes a hefty chunk out of its equity. At these levels of leverage, the equity can disappear rather quickly, and it did, placing into jeopardy the claims of the debtholders.

P.J. Nagrom is sufficiently large that its debt is traded frequently among willing buyers and sellers, who daily agree to a price on the right to collect a given dollar of P.J. Nagrom debt. During the heady days of 2006, most market participants subscribed to the belief that P.J. Nagrom was immortal. As such the buyers were willing to pay $1.15 for the near certain prospect of collecting one dollar of P.J. Nagrom debt.

Now that the bank is looking rather like a mortal, and a frail, sickly one at that, the price of its debt has dropped to well below one dollar. The junior subordinated debt holders, who occupy the next lowest rung on the funding hierarchy after the shareholders, have taken the biggest loss; their debt is now trading at a mere 30 cents on the dollar. This reflects the market’s belief that they are not likely to receive much of the money they are due if P.J. Nagrom goes under.

The senior subordinated debt holders, who are next in line, have seen the value of their debt fall to 60 cents. Even the illustrious senior bondholders are aghast as they’ve watched the price of their bonds creep down to 95 cents on the dollar. Might the bank’s future losses be so severe as to extinguish the shareholders’ equity and burn through the debt of the subordinated holders to threaten the claims of the senior bondholders as well? Evidently, the markets believe they might.

As the losses mount, the prudent response for P.J. Nagrom’s managers would be to sell the bad assets and eliminate the problem once and for all. Alas, our esteemed chiefs, despite their Harvard degrees and untold fortunes, are human after all. And part of being human is to stick to one’s laurels when the going gets tough and hope luck intervenes in one’s favor. Did Joshua surrender to the enemy at the Battle of Jericho? Did Daniel cower before the ferocious beasts in the lions’ den? Did Gilligan ever give up hope of getting off that island?

Perhaps drawing inspiration from these heroic predecessors, the P.J. Nagrom executives resolved to hold onto the poisonous assets soon after their prices began dropping. Unfortunately, instead of giving way to a quick turnaround, the carnage only got worse; month after month, the prices kept falling.

Along with the mounting losses came the need for the bank’s leaders to justify their actions, or lack thereof. To do so they turned to the fallacious argument that the problem assets are “illiquid” – in other words, there are simply no buyers to be found. This, of course, was a myth. The truth is that there were plenty of willing buyers before, and there are plenty now. It is only that the prices the buyers are offering to pay are, in the opinion of management, unacceptably low.

At each step along the way the heads of P.J. Nagrom were holding out hope that the bloodletting's end was near. And so they chose not to recognize reality and sell the assets at their true prevailing prices. And now, it seems, the prices have sunk to such depths as to render our bank insolvent – that is, the value of P.J. Nagrom’s assets, at the new, low prices, would fall far short of the amount the bank owes to its creditors.

From Venerable to Vulnerable
If the sheer amount of leverage P.J. Nagrom employs has not endangered it enough, the structure of all this borrowed money leaves the bank even more exposed to jittery creditors. The problem is this: while the assets P.J. Nagrom owns are meant to be held over the long-term, the bank must repay its liabilities over much shorter time frames. Whenever this money comes due, the bank must renegotiate with creditors for new loans. If a creditor does not agree to roll over the old debt into a new loan, the bank must either find a new creditor to replace the old one or sell the assets the old loan had been financing.

The senior bondholders generally do not present a problem in this regard, as most of their bonds must be refinanced only every few years. But another big chunk of P.J. Nagrom’s debt consists of “commercial paper.” Purchased mostly by money market funds (which are similar to deposit-taking banks, only riskier), commercial paper is short-term debt that must be repaid in a matter of weeks, not years. As a result, every few weeks the bank must renegotiate with the commercial paper holders to roll over the old commercial paper into new paper. If this proves impossible, the bank must sell the assets the commercial paper was financing at whatever price the market can accept. As mentioned above, these prices would now be so low as to make the bank insolvent.

To make matters worse, another, very large portion of P.J. Nagrom’s assets are financed by “repo loans.” Whereas commercial paper must be repaid and renewed every few weeks, repo loans have to be renewed each day. Every morning P.J. Nagrom’s staff calls up the repo lenders and asks if they will agree to continue providing financing for one more day. Never has the answer to this question been anything but “yes.” But if the repo lenders ever responded in the negative, it would cut off the bank’s oxygen supply, and P.J. Nagrom would immediately be in danger of going under.

Another large segment of the funds P.J. Nagrom uses comes from other big financial institutions, like hedge funds, who rely on the bank as their “prime broker.” What this means is that these other institutions, speculators in their own right, use P.J. Nagrom to execute their trades for them. To do so they open accounts at the bank. Naturally, any hedge fund can close its P.J. Nagrom account at any time and demand its money back. Normally, however, new accounts are opened about as often as old accounts are closed. This leaves P.J. Nagrom sitting on a substantial, unused pool of cash. Like any bank, it puts this cash to use for profit. In P.J. Nagrom’s case, the money is used to fund the bank’s own speculative activities.

It is rather unlikely that many prime brokerage clients would demand their money back at the same time. Unlikely, but not impossible. If this ever did happen, P.J. Nagrom would have a problem; it would be forced to dump lots of assets on the market simultaneously, probably at very unfavorable prices, in order to raise enough cash to satisfy the demands of the fleeing prime brokerage customers. While this might have happened to failed rivals such as Bear Stearns and Lehman Brothers, P.J. Nagrom’s chiefs do not believe this to be a realistic possibility.

Endgame
Following its 50 percent plunge in a single week, P.J. Nagrom’s stock price appeared to be stabilizing. The respite proved short-lived. Several weeks later, it began falling again as fears about the bank’s solvency started to gain momentum. It was at this point that several large hedge funds, all prime brokerage customers, closed their accounts and withdrew their money.

News of this event, combined with the plummeting stock price, prompted a number of commercial paper holders to decide it unwise to buy new P.J. Nagrom paper once the old paper was redeemed. Instead they took the prudent decision to hold onto their money until the market uncertainty abated.

With the stock price now at $5, and rumors circulating that the bank was running out of cash, the other debt holders and prime brokerage customers took fright. During a single week in December 2009, the stock plumbed new depths, closing the week at a mere $1.25 per share. Overnight repo lenders now feared that the evaporation of P.J. Nagrom’s equity and rapidly deteriorating cash reserves might threaten their ability to get their money back the next day. They too began stampeding for the exits.

The revolt of the repo lenders starved P.J. Nagrom of its very life source, leaving the bank with three options, all rather unpalatable. The first and least disagreeable option was to find a new investor who would purchase a substantial portion – if not a majority – of the bank’s stock at a price significantly above the market price of $1.25. Not only would this provide the bank with extra cash to satisfy the demands of the panicking debt holders and prime brokerage customers. It would also re-inflate the equity cushion that protects the debt holders from any losses (recall that the debt holders begin absorbing the losses once the value of the bank’s equity disappears). This might persuade the remaining debt holders to stay put and even convince those who had already fled to return. However, despite frantic negotiations over the weekend with a few potential suitors, none was willing to take on the risk.

This prompted the bank’s management to push for the second option – a government bailout. Under this plan, the government would guarantee most of the losses incurred by a private institution that acquired P.J Nagrom. That is to say, any institution that agreed to purchase the bank would have its potential losses capped at, say, $1 billion. The government would pick up the tab for any additional losses. At this late stage, though, the public and its elected representatives were suffering from a severe case of bailout fatigue. On the afternoon of Sunday, December 6, 2009, the president of the New York Fed notified P.J. Nagrom’s CEO that no government assistance would be forthcoming.

This left the bank with the much-loathed third option – bankruptcy receivership and liquidation. That Sunday night, P.J. Nagrom’s chiefs filed for bankruptcy. Tens of thousands of employees, having already witnessed the value of their stock options disintegrate, would be cast onto the street. Control of the bank was handed to a government-appointed bankruptcy receiver charged with overseeing the winding up of the hundred-year-old institution. The receiver would sell all of P.J. Nagrom’s assets and distribute to the debt holders any resulting cash that was raised.

Needless to say, the sudden appearance of such a vast supply of assets for sale on the market, umatched by any corresponding increase in demand from willing buyers, precipitated a severe drop in their prices. The prices of everything from mortgages to corporate loans, credit card debts, and auto-loans began tanking.

This development pushed a number of other large financial institutions into insolvency, as the prices of the assets they owned had now fallen to levels well below the amount they owed to their own creditors. The bank run, previously restricted to P.J. Nagrom, had now become systemic; fleeing creditors and frightened prime brokerage customers withdrew their money in hordes. The country was now on the brink of its first nationwide banking panic since the 1930s.

The placing of these institutions into bankruptcy receivership presented the horrific prospect of further asset firesales on an even larger scale; the new receivers, having taken control of the other bankrupt institutions, would now have to sell off the banks’ speculative assets in order to raise money to pay back the claims of creditors. This would further spur the downward spiral of asset prices and threaten still more banks, hedge funds, and other institutions.

To stem the panic, president Obama announced, for the first time since the Great Depression, the imposition of a national bank holiday. Nobody would be able to withdraw their funds from any bank for an indefinite period.

The bank holiday, however, was not sufficient to soothe the fears enveloping the remaining financial institutions. Amidst such unprecedented uncertainty, the country’s largest banks, money market funds, and other institutions had all but stopped lending to businesses and began calling in their loans. This offered up the possibility of a new wave of insolvencies throughout the broader economy, much bigger than any seen in decades; those businesses that did not have the cash to pay back their loans would be forced into bankruptcy and their assets sold to pay off their creditors. While the effect on unemployment would be difficult to estimate, it was clear that millions would lose their jobs.

The United States stood on the edge of the abyss.


Conclusion
While the above scenario may sound depressing, it is merely a possibility, not an inevitability. And, despite the short-term harm it could inflict, it will ultimately pave the way for a recovery. But it is a real danger.

The next and final part of the series will examine how we got to this point, what should be done, and what is likely be done (which is quite different from what should be done). I will also present a few simple steps you can take to protect yourself.

*For further reading, I recommend House of Cards by William D. Cohan, which provided the inspiration for this piece. It is the story of the rise and demise of Bear Stearns and includes a particularly gripping account of its final days.