There's Stupid and Stupid - Oh and How Banks fail

There are two great ways to lose money when investing

1: You were wrong

or

2: You were stupid

Now there is nothing wrong with stupidity. I'm infamous for asking potentially stupid questions and I have no regrets about that at all. In fact, I consider it to be one of my greatest qualities.

However, there is a big difference between being stupid and being stupid. It's stupid to accidentally lock yourself out of the house, wearing your pajamas, without your phone and no one home (yes, I've done this before) but it is a different kind of stupid to invest millions of dollars without understanding the investment.

Here is the perfect example from the recent Credit Suisse "sale" and the headlines around the Credit Suisse AT1 bonds getting written down to zero while the equity still had value (admittedly sweet bugger all). Rather than the headlines and complaining about how this destroys the capital structure (heads up, it didn't), here is the truth in a very simple manner.

The owners of these bonds were stupid and didn't read the bloody paperwork. Now don't get me wrong, this paperwork is written in legalese, is convoluted and will not go down in history as one of the great reads of our generation but it is clearly written in there that these investments can go to zero while traditionally "riskier" levels of debt or equity may be fine.

See below from the documents from the AT1's:

"Furthermore, any Write-down will be irrevocable and, upon the occurrence of a Write-down, Holders will not (i) receive any shares or other participation rights in CSG or be entitled to any other participation in the upside potential of any equity or debt securities issued by CSG or any other member of the Group, or (ii) be entitled to any write-up or any other compensation in the event of a potential recovery of CSG or any other member of the Group or any subsequent change in the CET1 Ratio, Higher Trigger Capital Ratio or financial condition thereof. The Write-down may occur even if existing preference shares, participation certificates and ordinary shares of CSG remain outstanding."

I'll translate this from lawyer to everyday person "if Credit Suisse goes belly up, if you invested in this you don't get paid."

As anyone who has ever signed a contract would know, you need to read the paperwork. Those who chose to invest in the AT1 bonds with out reading the paperwork I have little sympathy for you (your clients on the other hand I do have sympathy for because it was your stupidity that cost them money).

Nutshell version these professional and sophisticated investors acted with immense stupidity and paid the price.

Fears around the banking system are understandably a big talking point, almost everyone still has memories of the GFC.

But how do banks fail?

Let's pretend I started a bank, Tyso Bank. With a name like that, Tyso Bank (TB) is obviously going to be incredibly popular and spread akin to wildfire.

You want money, we have money and we get paid to lend it out. In fact, unlike some other banks TB is kind and doesn't rip your eyeballs out with interest. We keep it inline with the average market rate.

But TB has a little secret behind the growth. We hate to deny loans, we are willing to lend money to anyone and during good times it looks like we are revolutionising finance. We even tell the market and our competitors that we use a "sophisticated, proprietary algorithm for credit assessment".

But TB doesn't have that at all. TB uses the mirror test (if we put a mirror under your nose if it fogs up when you breathe we will lend you the money).

Now when times are good, this model works great. Our loan book grows, missed payments/defaults are rare and we look like a great company.

But when times are rough, what happens is that all the borrowers who we never should have let borrow money fail, our losses consequently are huge and we fail.

This is basically what happened in the GFC, too much money was given to people that had no chance of paying it back.

Did I just over simplify that? Yes, but deal with it.

The other way is what is happening now. TB runs out of money.

What?? How can that happen?

Say TB has $1 Billion worth of deposits and we realise that we only need to keep $100m available at any point (because that's our maximum expected need and yes I am ignoring all the legal frameworks around banking here, again deal with it).

So what do we do with that extra $900m?

We invest it duh!!

But we are old school, conservative bankers that follow the 3-5-3 rule. We pay 3% on deposits, lend you money at 5% and are on the golf course by 3pm.

So we don't invest in junk bonds, equities or hedge funds. We buy simple government bonds and plan to hold them until they mature. Pretty safe (I mean they are the safest asset class).

Now we own $900m in bonds and life is rosy. Sure we are only getting 1% on those bonds but we are comfortable and feel with are being prudent.

But like a wolf in the night, here comes inflation and those nasty central bankers start hiking interest rates all the way up to 5%. Sure, we have some short term losses but unless the government will default we will get our money back with interest in the end.

Then disaster hits. Our customers want to transfer money out of our bank. Huge amounts of money, so we have to sell our bonds. But, we have to sell them at a loss, then as people see that we are taking losses they rush to pull their money out before we go under (which in turn becomes the very reason that we go under) as we are forced to sell more assets at a loss to fund redemptions.

That's basically how banks fail with the obvious exceptions like mass fraud etc.

Anyway, this article is already longer than I thought it would be so have a great day and as always don't invest based on this article, if I'm telling you to invest in something it will be in writing and you would have paid me for the advice.

Cheers,

Tyso