Brace Yourself: Why a Crisis on Wall Street Is Coming to a Bank Near You

By Robert Ironside, Ph.D.

Within every crisis lies opportunity and that is a subject I will address later. First, we need to understand why a problem on Wall Street is going to infect every Canadian bank and thus indirectly, every Canadian, whether they be an investor, a small business owner, employee or retiree. To understand the problem, we first need to look at a very simplified Balance Sheet of a typical bank.

Balance Sheet
As of October 31, 2008

Assets

Liabilities
Securities Retail Deposits
Loans & Mortgages Money Market Borrowing
Owner's Equity

As you know, a Balance Sheet lists assets on the left hand side and liabilities on the right hand side. The major asset of a bank is the loans that it has made. For every dollar of loans that have been made, the bank has to obtain funding on the right hand side of the balance sheet. For large Canadian banks, the major source of funding is retail deposits. But if the bank makes more loans than it has retail deposits, it has to fund the difference from some other source. That other source is primarily money market borrowings.

The money market is the market for high quality, short term debt instruments. Banks issue a variety of instruments into the money market, including negotiable certificates of deposit. These are purchased primarily by large institutional investors seeking a safe haven for short term cash surpluses.

Banks participate in the money market as both borrowers and lenders. When a bank has excess funds at the end of the day, it will typically lend these out on an overnight basis through the interbank market. A bank that is short of funds overnight will borrow the money. In the US, the rate for this overnight borrowing and lending of surplus funds is referred to as the fed funds rate. On Tuesday, September 30, the posted fed funds rate was 2%, as set by the US Federal Reserve. However the actual market rate was 7%.

Because the money market is an institutional market rather than a retail market and because the dollar amounts are large, money market borrowings are not covered under any form of deposit insurance. This leads to a high degree of risk aversion among money market participants. At the slightest hint of risk, money market participants quickly move their cash surpluses to a more secure investment.

We now have the background to understand the current situation. Fear and uncertainty is everywhere. Banks are not comfortable lending to other banks, because they have no certainty they will be repaid. Institutional investors are scared to lend to banks because they too fear that they will not be repaid when the instruments mature, similar to the problem faced by thousands of ABCP (asset backed commercial paper) holders in Canada, who collectively hold over 30 Billion of former money market securities.

Now we have to look at some data, specifically the loans to deposit ratio for the large Canadian banks. The loans to deposit ratio has been rising over the last several years. A rising ratio indicates that more of the loans made by the banks are funded in the money market, rather than from retail deposits, which tend to be "stickyî. But given the current climate of fear, banks are finding it increasingly difficult to access funds in the money market.

So what does this all mean to me, the average Canadian? There are several probable outcomes. These include:

1. Funding costs are rising quickly for the Canadian banks. This will most definitely be passed along to those wanting to borrow money. Watch for interest rates to rise quickly on bank loans, especially for longer term, fixed rate money.

2. Loans will become harder to obtain. When money is cheap and easily obtained, banks will lend. When money is tight and hard to obtain, banks do not want to lend. Those with weaker credit will find it increasingly difficult to obtain credit and the cost of credit, if it can be obtained, will rise sharply.

3. The interest rate on credit cards will likely rise. For many years, banks have aggressively pushed a wide array of credit cards to an increasingly diverse group of consumers, many of whom have used the credit thus obtained to fund a lifestyle which they really can't afford. As the economy slows, credit card defaults will rise. The response from the banks will be to monitor card holders more closely and reduce available credit to those most at risk.

4. Yields on deposits will rise. If you are an investor with large cash balances, you have just become your bank's new best friend. Now is the time to aggressively negotiate better terms on your deposit funds, as the bank badly wants your money, as they know very well that retain deposits are much more "stickyî than money obtained through the money market.

5. Volatility in equity markets will remain. This problem is not going away any time soon, irrespective of the $700 Billion bailout package passed by the US Senate and Congress last week. The primary underlying cause of the problem in the US banking sector is falling US residential real estate prices. The banking sector will not really stabilize until residential real estate prices stop falling. This will likely not happen any time soon, as the real estate market is caught in a vicious downward spiral. As market prices fall, more homes become worth less than the debt against them, leading more borrowers to default, which in turn leads to more foreclosures and forced sales, pushing prices yet lower.

6. Real estate prices will fall.

In the end there is something else to consider: called "Reversion to the meanî óall markets go back to their long run averages. Our P/E (price/earnings) ratios have been ranging in average of 28, and now coming down, likely to around 10. The long term average p/e ratio is about 16. If P/E ratios are falling, stock prices will not do well. We have this issue now.

Historically, however, over longer holding periods, markets have provided investors with a 6.8% real rate of return (Jeremy Seagull 1802). We know that markets will always give us this real return even though we can have extended periods of much lower rates.

So, if you are 20 or so, hold on and wait. If you are in debt, try to reduce discretionary spending and pay off your credit cards. Cash is king. Get safe and be prepared to weather a storm of 6 to 8 months in case you need to.

There is danger is for those who are 45 plus. We don't know when things will recover. It's difficult to predict retirement income. Returns may not be good over the next few years. So the bottom line is this:

Brace yourself: for tighter lending and the inevitable fallout for business, which will affect profits and returns on investment.

Robert Ironside, ABD, PH. D is the author of several Knowledge Bureau certificate courses, including Financial Literacy: The Relationship Between Risk and Return