How to Avoid Paying for the Next Banking Crisis

How to Avoid Paying for the Next Banking Crisis

In a New York Times article, Ben Bernanke, Hank Paulson, and Tim Geithner explained how they saved the banking system. It has been 10 years since the financial crisis started.

The banking system has recovered. Wall Street has recovered. The government has been fully repaid. You know who hasn’t recovered? It’s those of us who collectively deposited $14 trillion in bank accounts that earned next to no interest for the last 10 years. No one ever talks about repaying these people. However, it is important to understand how this happened so you can protect yourself from having to pay for the next banking crisis.

How Bank Depositors Saved The Financial System

These numbers are not exact, but they are in the right ballpark.

Before the financial crisis, banks owned a portfolio of loans which paid them an average interest rate of 7%. The money to make those loans came from depositors who the banks paid on average about 5%. The 2% spread would be the bank’s gross profit if all the loans are good loans.

This means that If 2% of the bank’s loans go bad, the bank’s gross profit is reduced to zero. If 3% of the loans go bad, the bank’s shareholders have to make up the 1% difference. But bank shareholders’ capital accounts for about 5% of the banks liabilities. So, if 7% of the bank’s loans go bad, the bank’s shareholders are wiped out.

Treasury Secretaries Hank Paulson and his successor Tim Geithner ran the Troubled Asset Relief Program (TARP) which took $700 billion (about equal to 5% of bank deposits) of bad loans off the banking system’s books.

Federal Reserve Chairman Ben Bernanke’s zero interest rate policy reduced the interest rate banks paid to depositors to almost zero, thereby increasing the bank’s spread on their entire existing portfolio of loans from 2% to nearly 7%.

By sending the interest rates on $14 trillion of bank deposits to nearly zero, Bernanke saved the banks roughly $700 million per year for 10 years. This infusion of roughly $7 trillion is the lion’s share of what it took to save the banking system. This money otherwise would have been paid out as interest to bank depositors and which now has created a huge hole in many people’s financial plans.

Paulson and Geithner say the U.S. taxpayer has been made whole because the government made a profit on the TARP program.

But, the people who put up with zero interest rates on their bank deposits for 10 years are never going to be made whole. Maybe that’s why there are no ticker tape parades for Bernanke, Paulson, and Geithner.

Their plan only worked because the people who were least able to accept risk kept their money in bank deposits and other “safe” investments even though they received almost no interest. If the role these people played in saving the financial system was widely acknowledged you would think there would be some talk of making them whole.

Would You Do It Again?

The financial crisis reveals how the Federal Reserve can use interest rate policy to take money out of the pockets of those least able to accept risk and use it to recapitalize the banking system. The key to getting yourself off the list of people the Fed can tap to pay for the next crisis is to invest in stocks.

Bank deposits are considered riskless because you are guaranteed to get your money back. But that might be all you get after 10 years of zero interest rates. If the goal is to achieve your financial objectives, bank deposits are risky because their return can vary so much.

Stocks are considered risky because you can lose money on them. However, a stock’s return is largely determined by factors under the control of company management and the market. If you don’t like what management is doing to improve your returns, you can sell and reinvest the capital in another stock with a better risk/return profile.

In contrast, if you don’t like the interest rate your bank pays, you’re kind of stuck because all banks offer pretty much the same interest rates on similar kinds of deposits taking their cue from the Federal Reserve.

Investing some of your assets in stocks can improve the likelihood of achieving your financial objectives even though stocks are riskier than bank deposits.

My Take

If you kept significant money in bank deposits for the past 10 years, you’ve done more than your fair share to recapitalize the banking system and you are no closer to reaching your financial goals. It is time to make some changes to improve your chances of achieving your financial objectives and take yourself out of the group of people the Federal Reserve can tap to pay for the next banking crisis.

This article is part of a series I write for those who want to get their portfolios back on track. To be notified when the next installment is published, click here.

Author Bio

Ken Kam is the CEO and founder of Marketocracy, Inc., and portfolio manager at Marketocracy Capital Management, LLC, an innovative technology based firm that maintains a database of the world’s greatest “unknown” investors.

Source: Forbes
View Original Post

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.