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For Banks, Size Does Matter, Part 1


Bigger they come, harder they fall.

We're entering the next stage of the credit crisis, and one which is potentially more troubling than what we've already seen over the past year (absent some policy reactions by the central banks and governments worldwide).

The crisis was initiated by an intense run-up in leverage by financial institutions and investors worldwide, investing in increasingly risky assets such as subprime mortgages - and then came the realization that leverage could hurt. The deleveraging process started to intensify last year about this time. The easy part of that process is nearly complete. Now is the time for the really hard work. It won't be pretty.

In this week's letter, we look at the process and think about its implications for the markets and the economy, and we'll visit some data on the housing market and unemployment.

And just for the record: While the problems I'm describing in this letter are very real, this isn't the end of the world. We'll get through it, just as we've always done.

Thoughts on the Continuing Crisis

Let's start by explaining the process of de-leveraging in very simplistic terms. On average, FDIC-insured banks now have about 7.89% of capital for their outstanding assets (loans are generally about 60% of assets), so they're roughly levered up by about 12.5 times. Some investment banks are leveraged up to 30 times. Fannie (FNM) and Freddie (FRE) are leveraged 50 times. But to make matters simple, let's assume leverage of 10 times.

(For the record, to be considered "well-capitalized" you have to have at least 5% of capital in Tier One assets, and 10% in what are considered risk-based assets, with anecdotal evidence that regulators want to see 12%.)

That means for every $1 million in capital you have, you can lend out $10 million. The profit you make is the difference between the cost of your capital and money you borrow to lend, and the interest rate you charge. If you're paying 4% for your money and charging 8%, you would make 4% times $10 million, or gross profits of $400,000. That is a return of 40% on invested capital, which is why so many small banks are being started all over the country every year.

Nice business, if you can get it.
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