Tuesday, June 12, 2012

Why the Banks are Dead Long Term

For this explanation forget about banks that lent recklessly. Lets imagine you own a bank only lending at normal historical standards. And lets just talk about mortgages because it is the type of loan the average person is most familiar with.

At your bank you have 1,000 mortgages on the books. The downpayments are 20% of the home value. You are in a wealthier area so every borrower has a family income of £100,000 pounds a year, and all your mortgages begin as £300,000 on a £360,000 property. On the downside because you are so conservative with your loans, the spreads between what you get money at, and the rates you charge customers is small.

But change is afoot in the society. Robotics are taking jobs in factories, computers are replacing the mass cubicle workers, machinery is advancing and reducing man hours per job, foreign trade is causing factories to shut down, foreign workers are taking over jobs at home.

In Britain like clockwork the labour force is shrinking by 125,000 people a quarter. Half a million a year. Since the labour force is around 27.5 million, this 500,000 loss a year is 1.8% of the workforce disappearing a year.

So of your 1,000 mortgages, 18 a year are eventually defaulting. Now this is not a problem as long as you can seize the property and sell it for more than the 300k loan. (Hence the total focus of the UK government on keeping property price up).

There is another problem, since probably 80% of those mortgages are based on dual income, there is actually 1,800 incomes paying your 1,000 mortgages. Without both incomes they cannot maintain the loan. so 1,800*.018=32 a year who will eventually default.

There is an even bigger problem though. As a surplus of labour builds it eventually drives down the wages of those who do hold onto their jobs. So a great deal who are holding onto jobs will be facing loss of overtime, benefits cuts, even wage cuts. And if severe enough they will eventually fall into default.

Eventually with the labour force shrinking and wages falling, the prices on properties will come down. This is where you lose that cushion of the 20% down payment.

In the future if these trends continue banks will have to charge much higher rates on even safe loans. Like 8% would allow them to absorb the losses, run their organizations and still make a return on investment for their shareholders.

What screws them is they have millions and millions locked in on huge mortgages at exceptionally low rates. Going to 8% would crush the housing market, and cause mass defaults on their current mortgage pools.

I think the only option is continual bailouts and gradually rising rates the banks are charging until the business becomes viable again. Which is what we have been seeing.

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