The Bookmaker of Business: A Financial Tale (4 page)

“When the speculator takes on more leverage, it requires him
to become even more accurate with his market timing, otherwise he’ll be wiped
out. The bottom line is, as the trader’s leverage increases his odds of success
decrease. It is my conviction that unless an investor can time the markets
accurately, he should not engage in leveraged trading. And it’s my experience
that such market timing ability does not exist. I believe this type of
speculation is gambling and not investing.”

“What’s the difference?”

“The difference between gambling and investing ultimately
comes down to the expectation. If the long-term payout of a game is positive
then it qualifies as investing. If the payout is negative then it must be
classified as gambling.”

David continued. “Colby tells me of a man who bets on the
ponies in an interesting way. When he wagers on a race he bets on every single
horse and sizes his bets based on information he gets from his contacts in the
industry. He enlisted the services of a mathematician to help perfect his
method, and after some testing, he applied it using actual money and found the
actual results mirrored his test results. He’s been making steady money ever
since. And since his long-term payout expectation is positive instead of
negative, you could say this man is investing and not gambling.

“In contrast, your typical leveraged trader has not tested
his strategy for long-term viability. Instead it is short-sighted. And when the
big loss occurs, which it always does, he scratches his head wondering what
happened. He didn’t realize he was actually gambling with his money. His
expectation was negative.”

David continued. “But here’s another interesting fact. Banks
are doing the same thing when they make loans. When they extend credit to
borrowers they are actually leveraging themselves similar to margin
speculators.”

5

“How do banks make loans?”

“I’ll get to that shortly. And I guarantee that if you can
grasp this concept, you will never be the victim of another bank failure.”

“Please go on.”

“Remember what I said earlier that a bank can still make
money even if they pay more on deposits than what they earn on loans?”

“I remember.”

“Well, this is because of
fractional reserve banking
.”

“What’s that?”

David reached into his pocket and pulled out his billfold.
He took out a crisp, new $100 bill and placed it on his desk. “Let’s say you’re
a depositor and you deposit this $100 into our bank.”

“OK,” Sean said as he stared at the money, wishing it were
his.

“Let’s say I paid you 3 percent interest on this deposit and
I loaned it to Colby at 6 percent,” he handed the bill to Colby. “Then I would
make 3 percent on the interest spread. Clear so far?”

“Yes.”

“And that is how most people perceive the banking system to
work. Unfortunately it’s wrong. The truth is that I can loan this $100 out a
further eight times.”

“What? How’s that possible?”

“Because like central banks, commercial banks also create
money out of thin air. Whereas central banks do it through bond purchases,
commercial banks create money by making loans. As long as we keep a fraction of
our demand deposits in cash we can leverage them 9 to 1 and earn interest on
those loans.”

“What does that mean?”

“Basically, when you deposit $100 into our bank, we can
leverage that money and make additional loans of $900 to the public. And it’s
perfectly legal.”

“I didn’t know that.”

“That’s OK. Most people don’t. But here’s the problem.”
David turned to another page in his binder with the following tables inscribed.

“Here’s your original deposit as it now appears on our
books. The bank has $100 cash in the asset column, but a liability of $100 to
Sean the depositor. But now we loan it to Colby.”

“After we loan the $100 to Colby the balance sheet looks
like this. The bank now has $100 in cash and $100 as a loan to Colby, for total
assets of $200. On the liability side, another demand deposit has been created:
$100 to Sean and $100 to Colby for a total of $200. You can see here how the
bank just magically increased its assets and created money out of thin air. Can
you see why real estate loans are so advantageous for banks? This newly created
money is now secured by real assets. This practice, called fractional reserve
banking, was invented by goldsmiths during the Middle Ages. Instead of using
gold for money the goldsmiths traded the promissory notes that were backed by
gold. And because they knew depositors would not ask for their gold all at
once, they issued additional promissory notes that paid them interest. This
spawned a new economic system whereby bank notes were used as money instead of
gold. In other words, debt became money. 

“But now, let’s say Colby decided to use the loan proceeds
and withdrew the cash that was loaned to him. The balance sheet would now look
like this:

“The bank now has zero cash, but is left with a $100 loan to
Colby. But it still has a $100 liability to Sean the depositor. But what if
Sean suddenly needed his money and went to the bank to withdraw it? The bank
could not meet the withdrawal request. It is now insolvent, or unable to pay
its debts.

“Like the margin speculator, if a bank makes too many loans
it is over-leveraged and in danger of failing. The greater the leverage the
higher the probability of failure.”

“That’s very interesting. So how do we know if a bank is
over-leveraged?”

“That’s a good question.”

“A bank’s liquid assets, or its cash and government bonds,
must be greater than its demand deposits, otherwise it is over-leveraged and
potentially insolvent.”

“What are demand deposits?”

“Demand deposits are bank balances that are available on
demand. Examples are checking and savings accounts where depositors can
withdraw them any time they wish. Time deposits, on the other hand, are
available at a future date. These include certificates of deposit. They cannot
be redeemed until the maturity date.”

David continued. “Banks are usually fine so long as
depositors don’t ask for their money all at once. But banks should prepare for
this possibility as remote as it may seem at the time. Historically however,
bank runs are a common occurrence. Bank executives need to keep ample liquid
assets on hand to satisfy all depositor demands. This includes cash and government
bonds. Government bonds like United States treasuries are highly liquid and can
be easily converted into cash. Equities and corporate bonds have different
degrees of liquidity and must be judged according to their ability to raise
cash in a liquidity crisis.

“There are some naysayers out there who claim that the
entire banking sector is insolvent and just one big house of cards. This is
inaccurate although some individual banks may be. The banking sector is solid
for the most part, which is vital to a free market economy. Just check your
bank’s balance sheet to find out for sure.”

“Where do I find the balance sheet?”

“This information is available to the public in the bank’s
annual report.”

David turned to another page in his binder showing the
following figures.

“Here’s an example of a bank with a healthy balance sheet. A
depositor’s money would be safe from loss in this bank. This bank has $1
million in demand deposits. However, it only has $100,000 in cash. At first
glance it may seem shaky since there is not enough cash to meet depositor
demand should they all ask for their money at once. However, the bank does have
$1.2 million in government bonds. In the event of a liquidity crisis, or bank
run, the bank could sell its government bonds quickly and raise the cash it
needs for customer withdrawals. This bank would survive a liquidity crisis. You
can also see how this bank has $10 million in loans outstanding. I showed you
earlier how banks make loans. Although these loans may be generating income for
the bank, they are absolutely worthless during a liquidity crisis.”

“That actually makes sense.”

David turned to the next page in his binder.

“Here’s an example of a bank with an unhealthy balance
sheet. Even though it’s meeting the legal reserve requirement of 10 percent,
this bank is dangerously over-leveraged. Similar to the first bank, there are
also demand deposits of $1 million, versus $100,000 in cash. Unlike the first
bank, however, this bank has a loan portfolio of $20 million. At first glance
it may seem like this bank is stronger financially since it has greater assets
and shareholder equity than our earlier example, but let’s take a closer look.
Although its loan portfolio is larger and would generate more interest income
than the earlier example, this bank has zero government bonds. If depositors
asked for their money all at once, this bank would not be able to meet the
withdrawal demand. It would be insolvent.”

“How’s that?”

“Well, with demand deposits of $1 million versus only
$100,000 in cash available, you do the math.”

“I see your point.”

“Unfortunately, most depositors are unable or unwilling to
do a simple balance sheet examination before putting their money in a bank.
That is why they fall victim to bank failures.

“Honestly, I don’t understand why anyone would want to keep
most of their money in a bank when government bonds are freely available.
Considering how frequently banks fail, it just doesn’t make sense.”

“How can a government bond be safer than a bank?”

“When was the last time the United States government missed
an interest payment? And when was the last time a bank failed? The safest place
for your money is obvious.”

“Are you saying that no one should have money in a bank
account?”

“Of course not. Everyone needs a bank account. It makes it
easier to trade goods and services. All I’m saying is people shouldn’t keep the
majority of their assets in banks considering their failure rates historically.

“The problem is that many bank executives act like margin
speculators and don’t consider all the risks. They over-leverage their banks
out of vanity and greed and then scratch their heads when their banks fail. The
tragedy is that while margin speculators lose only their own money, bank
executives lose their depositors’ money too. And if bank failures are
widespread, it harms the economy since the banking sector is so vital to a
nation’s commerce.”

Colby stood. “Well fellas, I need to be getting back. I
gotta business to run, and it ain’t gonna run itself.”

“OK,” Sean said as he got up too.

“See ya around, kid.” Colby said as he shook hands with
Sean.

“Thank you.”

Colby and David nodded to one another once more before Colby
left the office. As he walked past the receptionist he winked at her. She
blushed.