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Understand the Banking Crisis in 59 Minutes

Posted By Jim On 03/12/2009 @ 2:21 pm In Banking | 7 Comments

Are you confused about what the deal is with all this bad bank stuff? Not really understanding why exactly our financial system is in shambles? Do you have 59 minutes? Invest an hour listening to This American Life from Chicago Public Radio’s episode #375 Bad Bank [3] (or read the transcript [4], but the show is more entertaining) and I guarantee you’ll come away with a better understanding of a large portion of the current banking crisis.

As Alex Blumberg [5], contributing editor to NRP’s Planet Money, and Adam Davidson [6] explain their bank example, you may get a little confused with all the numbers. Alex and Adam do a great job going back and helping the listener but if it’s too much for you to follow, here’s a little cheat sheet:

  • Bank investors, which is Adam, invest $10 in the bank; Bank customers, which is Alex, depost $90. The bank has $100 to lend out.
  • A borrower, Caitlin Kenney, a Planet Money producer; borrows the $100 for a dollhouse.
  • The bank’s balance sheet looks like this:
    Assets Liabilities
    $100 dollhouse $10 capital
    $90 deposits
    Total: $100 Total: $100
  • Caitlin defaults, the bank forecloses and takes ownership of the dollhouse now worth only $95.
  • The bank’s balance sheet now looks like this:
    Assets Liabilities
    $95 dollhouse (-$5) $5 capital (-$5)
    $90 deposits
    Total: $95 (-$5) Total: $95 (-$5)
  • If the bank is forced to “mark to market,” or show the current market value of the dollhouse on its books, it would be unable to balance its balance sheet because it can’t reduce the value of customer deposits. If the house were worth only $50, then the bank would have to show a loss of $50 (from the original $100) on the other side of the balance sheet. Since the only value it can lower is capital and that’s only $10, the $40 can’t be balanced. The bank has to raise capital or face bankruptcy.

The show is more than just this one example but I think seeing the balance sheets written out, rather than spoken aloud, is a lot easier to understand. If you’re still in the mood for some more crisis fun, the latest Wired magazine has a story about the math function that killed Wall Street [7]. It covers something that lots of mainstream media often glosses over but is a little tougher to digest. If you’ve heard people say “people on Wall Street never anticipated housing prices would fall” or how their “risk equations assumed housing prices would always go up,” then reading this article will give you an understanding of that.

Have you listened to the show? What did you think of it? I thought it was a great plain English explanation of the crisis and well worth the time.

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[1] Tweet: http://twitter.com/share

[2] Email: mailto:?subject=http://www.bargaineering.com/articles/understand-the-banking-crisis-in-59-minutes.html

[3] #375 Bad Bank: http://www.thisamericanlife.org/Radio_Episode.aspx?episode=375

[4] transcript: http://www.thisamericanlife.org/extras/radio/375_transcript.pdf

[5] Alex Blumberg: http://www.npr.org/templates/story/story.php?storyId=94077777

[6] Adam Davidson: http://www.npr.org/templates/story/story.php?storyId=4646803

[7] math function that killed Wall Street: http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

Thank you for reading!