Doug Casey: All Banks Are Bankrupt

The whole banking business is corrupt from top to bottom today. Part of the problem is that banks are no longer financed by the individuals who start them, putting their personal net worth on the line. Now, they are all publicly traded entities – just like all brokerages – playing with Other People's Money. Management has no incentive to do anything but pad their wallets, so they pay themselves gigantic salaries and bonuses, and give themselves options. These people aren't shepherding their money and that of clients they know personally. They've got zero skin in the game. This is true all over the world, not just in the US and Europe. All these banks are going to blow up, and not just in far-off, little countries.

(Interviewed by Louis James, Editor, International Speculator)

L: Doug, there is considerable disagreement over the significance of the Cyprus crisis. A lot of people are saying that it's just a flash in the pan; Cyprus is a small country, far off, and doesn't really matter. Other people are saying it's very significant. The European Central Bank took unprecedented steps. What do you think?

Doug: I think this could be the spark that ignites the keg of dynamite under the current financial system. All banks, all around the world, are bankrupt, and have been for years. That's because all the world's banks run on a fractional reserve basis.

L: I know what you mean, but we should spell that out: by law and backed with government guarantees, banks only have to keep a tiny fraction of the money people deposit on hand. They lend out the vast bulk of it, and in even in good times, they could not return all depositors' money at once, since loans cannot be called in instantaneously, and most would be defaulted on if they were. In bad times, the charade is even more hollow, since many loans that banks are currently owed will never ever get paid.

Doug: Yes, and they are all in that position. It was more serious in Cyprus because that economy is very leveraged to finance. In other words Cyprus was a banking epicenter for Europe. It was easier to make deposits – there were fewer questions asked – making banking the major business of the country. But I think the trouble will spread from there. It could spread to Luxembourg or Malta next; both are at least as leveraged to the financial sector as Cyprus. And from there... who knows?

Anyone with any sense should withdraw whatever cash they have in European banks, whether in euros or any other currency, immediately. Cyprus demonstrated that governments are quite willing and able to confiscate money sitting in a bank account in order to preserve the banking system. We live in Bizarro World.

L: Why would it spread? Cyprus was said to be particularly vulnerable because of its strong Greek connections; Cypriot banks had bought of lot Greek debt. Would people in Luxembourg be as exposed?

Doug: All banks are in effect creatures of the state at this point. They all own a lot of government bonds, which are considered the most secure form of capital. Of course, that's the opposite of the truth; all these governments are bankrupt as well. The Greek government is just more overtly bankrupt than most.

Actually, we should take a minute here to discuss what a properly run banking system looks like. Historically, banks offered two types of accounts: demand deposits and time deposits. Demand deposits are what we call checking accounts today, but the original idea was that you'd pay your bank to store your money securely, and you had the right to "demand" your deposit back immediately, and to transfer funds via check.

The idea of time deposits, which became savings accounts, was that the bank would pay you interest when you deposited your money with them for a specific period of time. That's why it's called a "time" deposit; you lent the bank your money for a given time, as did other depositors, and the banks would always know how much money they could lend out – at higher interest rates. Furthermore, loans made against time deposits were always short term, and also self-liquidating, against receivables, or excess inventory, for instance.

There were no government guarantees for deposits back then; bankers needed to capitalize their businesses with their own funds, and if they miscalculated, they were personally liable – and often did go bankrupt themselves if they made too many bad loans. Depositors naturally avoided banks known to make risky or illiquid loans. Banks competed to be known as the most prudent and solvent.

Both lenders and depositors were cautious. Before the early 20th century, people might well have laughed at today's depositors of Cypriot banks. If they were foolish enough to put their money in banks that made such stupid loans, they only get what they deserve.

L: Our friend Rick Rule likes to say that the idea that the state can guarantee everyone's deposits is just another unaffordable, unbacked social promise of the 20th century. Just another example of living beyond our means.

Doug: Yes. I don't think people understand this. People don't have a clue, do they? People read editorials by Paul Krugman and neither laugh nor roll their eyes. It's like they're all on Prozac.

L: The nature of real banking is not something they teach in school anymore, that's for sure.

Doug: Then it's worth repeating. The distinction between time and demand deposits is critical. They are completely different, actually unrelated businesses. Today the distinction has been totally lost. But it's much worse, since central banks have allowed the problem to compound to the nth degree.

Sound banks never made what we call consumer loans today, because there is no guarantee, no collateral. Banks in the past made only short-term commercial loans that were fully covered by the value of the assets being financed. You never had to rely on the good faith of the borrower. You simply facilitated short-term – short-term – liquidity. The idea of a 30-year, a 20-year, or even a 10- or 5-year mortgage was anathema to sound bankers. A building and loan society might grant a five-year mortgage to one of its members, with a very significant down payment; that's because even though it's an asset class with value, real estate is illiquid. Forget about credit cards. Forget about car loans; if you want a car, save up for one. It's funny, actually. Car loans started out with a one-year term and a big down stroke. Then they went to two years. Now they're five or more, when people don't just lease. So even the family car has gone from a minor asset to a long-term liability. Subprime loans would have been completely unthinkable in the past.

L: Many people might say that credit that tight would be impractical today.

Doug: Many people don't like the idea of having to live within their means. They feel they have a right to have whatever they want, now. That's why the average American has essentially zero net assets. If everyone had to pay cash for everything, our whole society – from individuals on the lower rungs to big corporations to the state itself – would be much, much wealthier. We would not be, individually and as a society, one paycheck from being forced to live in a cardboard box under an overpass.

L: Perhaps so, but again, many people think modern high finance is not just normal, but necessary for civilization today. Big Business requires Big Credit.

Doug: Nonsense. The way you become wealthy is by producing more than you consume, and saving the difference. We don't need a fractional reserve banking system, we don't need government guarantees, and we certainly don't need to use government IOUs backed by nothing masquerading as money.

I understand something like 20% of the US economy is financial in nature. It's ludicrous; millions of people spending billions of dollars bundling, swapping, and repackaging imaginary assets. I'd guess that in a free-market economy, banking and related industries would amount to about 2%, a tenth as much. Money is essentially just a medium of exchange and a store of value; it's problematic when it becomes a gigantic industry. All these people who spend their days gambling with ledger entries would have to go out and find something productive to do.

L: Get real jobs.

Doug: Exactly. The whole banking business is corrupt from top to bottom today. Part of the problem is that banks are no longer financed by the individuals who start them, putting their personal net worth on the line. Now, they are all publicly traded entities – just like all brokerages – playing with Other People's Money. Management has no incentive to do anything but pad their wallets, so they pay themselves gigantic salaries and bonuses, and give themselves options. These people aren't shepherding their money and that of clients they know personally. They've got zero skin in the game.

This is true all over the world, not just in the US and Europe. All these banks are going to blow up, and not just in far-off, little countries.

L: It's interesting that a part of the basis for your negative prognosis for the global financial network is rooted in human psychology – the perverse incentives of playing with Other People's Money, exacerbated by government guarantees and banks mistakenly viewing government bonds as safe investments.

Doug: Imagine you're a smart, young trader working for Goldman, Deutsche Bank, or one of these big financial institutions. It's actually in your interest to make incredibly crazy bets. You can win billions of dollars if red comes up on the financial roulette wheel. If that happens, you get a multimillion-dollar bonus. You win. But if your bet doesn't work out, what then? The bank loses a few billion dollars, and you just go work for another bank, with more experience on your résumé. And you do the same thing over again.

L: So what does one do with hundreds of trillions of dollars in derivatives?

Doug: I don't know, and neither does anyone else. Not even Warren Buffett. Nobody can possibly keep track of quadrillions of dollars of derivatives. It's a daisy chain in which nobody can really know who is creditworthy. It's impossible to assess the real counterparty risk. All these thousands of traders sitting at computer banks, second-guessing markets; it's actually quite insane. I can hear them on the phone: "Hello, New York? Buy! Hello, Tokyo? Buy! Hello, London? New York and Tokyo are buying. Sell." It's an immense waste of productive manpower, them and the divisions of highly paid lawyers, accountants, and administrators behind them. Little of this would exist in a free-market world without central banks spewing trillions of currency units out every year to support governments. Of course, a gigantic financial industry arose to deal with it.

In any event, the people who today imagine they run the show may have put a finger in a dike, but it's all going to come to very bad end.

One of the interesting things about this Cyprus thing is that, according to the numbers I hear bandied around, the Russians are supposed to have had somewhere in between $30 and $60 billion in Cyprus. Who knows what the real facts are, because you can't trust what's reported in the press… but I've been to Cyprus – both Northern Cyprus and the Republic of Cyprus. It's true that the place is overrun with Russians and Russian money.

Now, you've got to figure that if you're a Russian oligarch with a lot more than 100,000 euros in a bank and the bank tells you you're not getting it back – are you going to just sit on your hands and do nothing? I hate to say what I would do if I were a crony capitalist… but if I were, I might just send several very burly men with cold steel strapped under their arms to talk to the banker in question and make it very clear to him that I will get my money back.

READ ENTIRE ARTICLE HERE: http://www.proactiveinvestors.com/columns/casey-research/3555/doug-casey-all-banks-are-bankrupt-3555.html

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commented 2013-04-06 01:38:33 -0400 · Flag
A.A. writes:

It is difficult to disagree with anything Mr. Casey says. He is totally right about Europe. And the U.S. Anyone with the possibility has to get the hell out. As far as his prognosis for impending disaster…it is in the cards…merely a matter of time. The financial cataclysm — once it starts — will be Biblical in impact.
commented 2013-04-06 01:37:45 -0400 · Flag
Ben writes:

As with everything else the government gets its hands on, banking has been pretty well wrecked by governments. We’ve seen it in our k-12 educational system, our postal service, our mortgage industry, our railroads, etc, etc. When the US was becoming the world’s most prosperous nation with its free markets, banking was a very different industry than it is now. Then it was relatively respectable and a small but important part of our economy. Now it is huge and corrupted.