Professor Elam

So spake Poor Richard in his almanac over two hundred years ago.  Well, that advice is coming home to big banks that have lent to sub prime mortgage companies.  In intermediate I we study how companies allow for potential losses. We later study how companies allow for additional potential losses with reserves and notes to statements.  When banks think they have goofed, the text books in accounting refer to their handing off these dud loans as ‘securitazation or privatizing the loans, IE, the greater fool theory.  That being ‘these loan stink let’s hand them off to the customers. ‘  Okay I exaggerate, a bit.

Specifically, when banks hold these loans, if the loans really go bad before they can be re packaged and handed off to someone else, the banks will suffer for some losses. Now analysts are saying that is about to happen to everyone, both investment bankers and commercial bankers that stayed too long at the sub prime mortgage lending party.  Check out the list, how could all these smart companies loaded with MBAs be so foolish-Bear Stearns, Lehman, Bank of America!  Answer, the business cycle has not been repealed….the thing that make the next great crash is the absence of participants in the last one who have no memory of it happening.   

To see just how fast things can go wrong in the sub prime business, click on the chart of NEW Century Mortgage Lenders at left.  As you can see the stock has completely collapsed the last two weeks.  This is what a capital market meltdown looks like.  This is what 1929 looked like especially from the standpoint of the lenders. Back then the sub prime loans were broker call loans, one could buy stocks on 10% margin. You put up 10 cents, the bank loans you 90 cents. Obviously if the value of the stock falls more than 10% you have no equity. Recall back then that there was no FDIC bank insurance.  By March of 1930 it was obvious that many banks were underwater due to loans on securities that now had negative equity.  Within two years one third of all the banks in the US closed taking investor savings with them.  This collapse in the money supply is what really kicked off the  Great Depression, there was then no way to replace all that money that was sucked out of the economy. 

Now consider what has happened.  Banks have not just been making 10% margin loans, they have been making 0% margin loans. Little or nothing down, or worse, don’t bother to make principal payments, just pay the interest, the real estate will be sure to go up in value anyway.  This is why one of the bedrock principles of accounting is conservatism, not being optimistic in expressing value.  As you can see in the graph of NEW, investors are finally getting very conservative in their valuation of NEW. Please read the article and let’s discuss this in our classes as it combines accounting finance and economics.