I’m no personal fan of bank bailouts, but I thought that I might try to explain why some banks are making the case that they are “too big to fail”.  There are a couple of things going on in the banking system today that we’ve seen in the past; why should bailouts be undertaken today?

First, the largest problem of all now is the danger of large banks failing.  Why is this a danger?  If we want the economy to keep moving, loans to small businesses and individuals must be available.  If banks won’t (or can’t) lend money, everything grinds to a halt.

Banks are required to keep reserves on hand to cover folks who want to come in and cash checks (demand deposits) or take money out of their savings accounts to buy Christmas gifts.  (How many of you even HAVE  a savings account?)  During good times, this means that a bank can loan more money than they have on hand – called creating money.  It works like this.  If the reserve ratio is 10%, it means that the bank must keep 10% of all capital, loans and deposits on hand in the bank (I’m oversimplifying, but for our discussion, it won’t matter).  If a bank has $1 million in capital, it means it can loan out $10 million.  With $10 million in loans, the 10% reserve ratio is satisfied if $1 million is “in the bank”.

Let’s assume that a bank has $1 million in capital, and it makes 10 loans, each for $1 million.  The chance of all of the loans going bad at once are usually pretty slim, unless the bank makes all of the loans in one industry and that industry goes bad (think of the real estate and oil business busts in Texas in the mid-80’s).

So what happens if one of those loans goes bad?  If the bank has to write-off one of those million-dollar loans, it can be in trouble.  Why?  Because the Feds (the Comptroller of the Currency, actually the national Bank Examiners) require banks to write off bad loans against capital.  It’s an accounting issue, but it sure as hell can sink a bank fast.  Why?  If that bad million-dollar loan is written off against capital, the bank would have none left.  See the problem?  If the bank only has $1 million in capital, and one loan goes bad, the loss is written off against the capital – and now we have no capital left in the bank.  And you wondered why banks give away toasters to get deposits?  HA!  They do it so that they have more reserves, so they can grow, but mostly to protect themselves against a capital shortage!

Bankers (good ones, anyway) watch capital levels like parents watch 2-years-olds in candy stores.  If loans start to go bad, you need to get deposits in fast (at least before the next bank exam or the next accounting reporting period).

How does this apply to the current crisis?  Exact same principle, simply more zeros in the capital needs than in the example above.  If Citibank has $5 billion in capital, and they have loaned out $50 billion, they are damned sure watching their loan portfolios.  As home loans start to go bad, Citi will have to start writing off some of those loans.  Pretty soon – technical insolvency.   The fly in the ointment today is that Citi doesn’t really know what its maximum exposure is.  We’ve all heard that banks can’t figure out how much some of their derivatives are worth.  Well, if they are on the books as worth $10 billion, and they’re written down by half, that’s $5 billion against your capital.  If that’s all the capital you have, you’re done (in the eyes of the Feds).

The bank won’t cease to function; you can still cash a check and use your credit card.  But the Feds will force you to either raise more capital or be acquired by another bank with more capital.  If the country is in a credit crunch, as it is today, who the heck is going to buy more Citibank stock (which is the quickest way to get more capital into the bank – sell stock)?  That’s what the banks are asking for – money from the government to apply to capital.  That’s why the government is getting stock as part of the transaction – it’s a clean accounting method to get more capital into the bank.

Well now – what happens if we give Citi (and others – I’m not picking on Citi, just using them as an example) $5 billion in capital?  Well, first off, we had better be damn sure they’ve written off all of their bad loans.  If we give them $5 billion, and they write off another $5 billion in loan losses in December, they’re just going to come back and ask for more (this is what happened at AIG).  So the Feds are trying to make sure all of the bad news is already known.  Trouble is – how can we know?

Your tax dollars are being used to prop up banks that the Feds consider to be “too big to fail”.  What’s the alternative?  Well, in the mid-1980’s we let a bunch of banks fail.  95% of them were so small that their customers went to other banks and got money.  There were a lot of large Texas banks that failed (RepublicBank, for instance), and it hurt the local economy, but there was no systemic threat to the overall banking system.

In some minds, Citi is too big to fail.  And so are many others.  It’s not that we couldn’t survive a Citi failure – we could – it’s that Citi’s failure could cause a domino effect to other large banks.

Right now, the banks are hunkering down, not loaning money to preserve capital.  This is precisely the wrong thing if we want the economy to grow.  So giving capital infusions to these large banks should allow them to start loaning money again – if all of the bad news is out there.  How do we know?  We don’t.  And that’s why the Feds had better be sure they’re propping up these tin-cup-holding banks and not just putting money in that will be lost in another 60 or 90 days.

Now you know why I’m not a great fan of bailouts – the bankers at Citi have an incentive to say “all is well –we’ve told you all of the bad news” in order to get the money.  And the money is needed so fast that the Feds can’t get in there and do a review of the books to see.  So it’s “trust me” from Citi (and the others).  When was the last time you felt comfortable when someone said “trust me”?  Especially with $25 billion of your tax dollars.