A Liability for Every Asset

One of my strengths (and weaknesses) is that I was trained as an accountant.  Double entry accounting follows specific rules.  The rules of accounting, like other endeavors, do ebb and flow over time but Assets are always the sum of Liabilities and Equity.

When banks fail, or nearly fail, as in the case recently in Cyprus, I unfortunately fall back on my accounting training.  Are the books of the Cyprus’ banks that much different in March than they were in February?  If we are to believe Cyprus was such a great tax haven, particularly for Russians, then where did all the money go?  Aren’t lots of deposits a good thing?

Obviously Cypriot banks are not in trouble because of their deposits; Cypriot banks are in trouble because their Assets are no longer good assets — they are chocked full of bad loans. So in the equation Assets (aka, Loans) = Liabilities (aka, Deposits) + Equity, there is obviously a problem when Assets (Loans) are not what they used to be.  Any losses would first be taken to reduce Equity.  But once Equity is assumed to be lacking (ie zero) then the equation is simply Assets (Loans) = Liabilities (Deposits).

The usual and reasonable assumption however is that deposits are there in the bank (any bank).  Though this certainly is not the case with Assets as they are not the bulk of what is locked in the safe.  Loans are the assets and once made, the money is spent and all the bank has is based on the strength of the collateral and/or the promise to pay.  New loans beget new deposits (which flow from the spent proceeds of loans) so banks usually are continuous growth machines.  Growth is good and continued growth is wonderful.

Problems arise at banks when depositors come to withdraw the deposits they assume are still there.  As we have seen, cash flow into banks are good for banks as new loans become new deposits (growth is good).  Cash flow out of banks is not so good, nor is it sometimes possible.

Cyprus bank customers did not just decide to go to their bank and withdraw their funds.  Remember, Cyprus was a tax haven.  Funds should only flow into Cyprus, for safekeeping.  That was the trend…and now the trend is over.

Safety is key in banking and the only reason to withdraw funds from the Cyprus banks would be if safety was somehow questioned.  This is where bad loans (less Assets) comes back to bite you.  Cyprus banks made loans, which turned out to be bad, many years ago.  The loans were made, money spent, that money redeposited (a banking wash, rinse, repeat as it were).  Bad loans?  No problem!  Then, sometime later, the bad loans are a problem.  Suddenly the banks in Cyprus are closed, for days on end, and it appears not all depositors will have their deposits honored.

Nor does the government play a role here.  The banks made the loans that turned out to be made…years ago.  No government decree can or will make them good unless the government is willing to pay it for the debtor.  Instead the government is interested in preventing a rush of withdrawals from banks because Cash In (Good); Cash Out (Bad).  To achieve this objective, governments instead use insurance  to allay fears and instill trust.  Cyprus banks are insured up to 100,000 euros; our banks have FDIC insurance up to $250,000, up from $100,000 from the previous crisis and $40,000 from the crisis previous which was up from $20,000 before that (well, you get the idea).

The difference between Cyprus banks in February and Cyprus banks in March was not the bad loans made years ago.  The difference was the amount of bank withdrawals that had already been made from Cyprus banks.

We will read and hear that Cyprus bank depositors lost confidence in Cyprus banks.  While lower confidence from February to March may help explain why depositors began withdrawing funds, one must also remember that no amount of confidence will make a bad loan good again.  Bad is bad, particularly when it happened years ago. 

The Cyprus stock market could and did rally tremendously as Cyprus banks made their bad loans (and their good loans).  Making loans is what drives stock prices higher, just like making loans creates money (inflation) that drives all prices higher.  It is the credit creation, creating money and deposits out of nothing, that drives the process.  Sound familiar?

The key is trends continue until they no longer do.  We were fortunate enough to live in a great bull market period, but we have also experienced times in which the music stopped (several times actually) and the response has always been the same: keep credit expansion going.  The reason is simple.  Credit expansion increases the cash flow into banks.  Credit Expansion Finished threatens to reverse the process meaning cash would flow out of banks.

We have already seen the devastating effects of Credit Expansion Finished on our economy.  Obviously a credit contraction must be the most feared event for the financial system of our world.  The Federal Reserve is (over)committed to making sure, at a trillion dollars a year, that this will not happen.  My point all along has been it will happen anyway.

Cyprus happened because bad loans happened and the big money is choosing a different venue.  Bad loans do matter.  But what we have learned these past several years is that they may not matter today.  Stock markets love credit expansion.  What Cyprus has hopefully taught us is that the gig can be up quickly and it can happen anywhere.  This is why Cash continues to be our asset of choice.

All of the Credit Expansion of the recent years cannot and will not turn all of the bad loans into good loans.  The world changes every day and mortgages that haven’t been paid for years will not become good again.  The sins of our past could be covered by a prosperous future but as the crises have added up, the credit expansion went exponential and our growth and prosperity has flat-lined, our sins are only greater now.  Prices will fall; remain nimble and own Cash.