Crisis Coverage: Not All Banks Are Banks

It has been pointed out to me that nearly everyone discussing this crisis is referring to things like "banks need capital" or "the Fed increased liquidity available to banks" or "the financials are in trouble", yet no one has really explained why Bank of America and JP Morgan have been stable while Lehman and Bear were in trouble. Morgan Stanley is not in merger talks and even the great Goldman Sachs has rumors about it flying. Why are some stable and others disappear overnight?It turns out not all "banks" are banks in the sense you probably think of them. A little history helps. Way back before the Great Crash of '29, a bank was a financial institution that took deposits and made loans as you expect, but they could also be brokerages, extend margin credit to investors, and generally do Wall St. stuff too. When the crash came, banks were decimated overnight because so much of their assets were stock or credit to investors. Margin calls were impossible to meet and massive amounts of assets simply disappeared wiping out whatever capital they had. There was no deposit insurance, so as banks failed consumers lost their savings as well. The ripple effect was severe and swift. In other words, "banks" were investment businesses funded with deposits that had no real protection. Don't forget, smoking was considered "healthy" at the time too.

In the depths of the Depression, a bill called the Glass-Steagall Act of 1933 established the FDIC. As a condition of protecting depositors, banks could no longer be in the investment business, they could just be lending institutions- the plain old banks you know today. Out of this came "investment banks" such as Morgan Stanley, Lehman, Goldman, etc. In fact, Morgan Stanley was born in 1935 when two execs from JP Morgan, Morgan and Stanley, defected to start the investment bank while JP Morgan stuck with banking. (Morgan had no relation to JP Morgan himself, just a coincidental name share).

Investment banks are not deposit funded institutions. There is no drive-through window and free toaster for opening a CD. They are banks only in the sense that they borrow and lend. Instead of safe deposit boxes, they have armies of brokers, traders, and consultants who do mergers and acquisitions that are called "bankers" ("investment bankers" usually becomes just "bankers" as in "bankers are facilitiating News Corp's purchase of the Dow Jones").

Because traditional banks are FDIC insured, they must abide by strict regulation on how much leverage they hold and the quality of their reserves. In short, they must have high-quality, liquid capital and are limited to roughly 10:1 leverage. Investment banks have no such requirements, so in their lightly regulated world, they can assume 30 or 40:1 leverage, meaning just $2-$3 of capital for every $100 or so they borrow. What limits their leverage? Only the willingness of others to lend to them. Investment banks exist only by the grace and trust of other investors. When other Wall St firms and investors in general get worried about something at a firm like Bear or Lehman, short term funding (essentially loans) are not renewed forcing the equivalent of a giant margin call.

When an investment bank sells assets quickly to pay off debts, selling pushes prices down, steepening losses and making the situation worse. Often and investment banks investments are not liquid which causes its own problems. Remember, an investment bank exists to take calculated risks about returns, safety and liquidity. They do this by committing their capital (equity and borrowed) to opportunistic situations. While the purpose is to make money, their efforts help the economy by making transactions happen that otherwise might not. In effect, they lubricate capitalism and reduce the friction of modern business. But of course, things can go wrong as they have recently.

OK, so traditional banks like Wells Fargo, Bank of America and most small community banks are stable because they had plenty of capital to absorb the mortgage losses.  The leverage was not too much to bear and the quality of the loans on their books were not as bad as others.  This is exactly what you would expect from a well-run bank.   The fear investment banks won't meet their obligations because of leverage has caused investors to pull capital away, destabilizing the investment banks.  It is a run on the bank, folks- just investment banks instead of old fashioned banks- and the ripple effect is disasterous.

More later on the repeal of Glass-Steagall and how that allowed Citi to buy Smith Barney, Chase to buy JP Morgan and now BoA to buy Merrill; what this means and why it is happening.