Summary of banking meltdown

Excellent summary of the bank meltdown, in three grafs:

Over the past 25 years, the cost of finance has been low and asset prices have generally been rising. That has encouraged banks to use more leverage in order to earn high returns on equity. The process of lending money against the security of assets, or trading assets with the banks' capital, helped to push asset prices even higher. A sizeable proportion of the profits that resulted from all this activity was then handed out to employees in the form of wages and bonuses.

But when asset prices started to fall, the whole system unravelled. Banks were forced to cut the amounts that they had borrowed, putting further downward pressure on prices. The "shadow banking system", which relied on bank finance, started to default. The result was losses that outweighed the profits built up in the good years; Merrill Lynch lost $15.3 billion in the fourth quarter of 2008 alone, compared with the $12.6 billion of post-tax profits it earned in 2005 and 2006 combined.

In effect, executives and employees were given a call option on the markets by the banking system. They took most of the profits when the market was booming and shareholders bore the bulk of the losses during the bust.

Pay special attention to that last sentence. This is what it means to "privatize gains, socialize losses." In other words - heads I win, tails you lose. Or to summarize the whole thing in just one word: fraud.

See also: Notes on the financial crisis

• Feb 10, 2009
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