April 1, 2008 - The banking industry is in difficult times. After years of poor lending practices for mortgages by many banks and savings and loans, they're reaping the rewards for stupidity and greed. Those mortgages are now being abandoned by borrowers because they can't make the monthly payments. The houses behind the mortgages are being abandoned, reverting back to the lenders. As more and more houses are left empty, up for sale, they push prices lower and lower. The banks will lose money on the loans as they sell homes to recover as much as possible. Many sales won't pay off the loans. The difference will be a loss for the lender.

On the other side of the equation, where the funding comes from to make loans, are the deposits. In order for people to deposit money in any institution, they have to trust it. Banks have an added benefit of the FDIC (Federal Deposit Insurance Corp.) which insures an account up to $100,000, backed by the full faith and credit of the U.S. government. That gives consumers lots of confidence that their money is safe. In the Savings and Loan industry, there is the FSLIC (Federal Savings and Loan Insurance Corp.), another government backed guarantee.

There is definitely a feeling of comfort for depositors when they know insurance is covering their money. They also know that if an institution goes under, getting that money will take time and energy. In other words, there will be a hassle before they see a check. Still, they know insurance is in place.

But what would happen if several banks went out of business at once? Would people still feel comfortable about depositing money in their favorite local bank or S&L? Most likely not. Most people would cash their pay checks and put the money under the mattress and wait for better times, then reluctantly and cautiously go back to the bank.

That would mean banks and other financial institutions wouldn't have the money to lend. That would mean very little business. That would lead to more bankruptcies as both sides of the bank's books, loans and deposits, weren't happening. Shortly thereafter a banking collapse would happen.

That's a doomsday scenario, but one the Fed is constantly aware of. There was a run on the banks in the 1930's, and in the first 10 months of 1930, 744 banks closed. Within three years, 5000 banks closed. The day after Franklin Roosevelt took office, there was a 4 day "Bank Holiday" when all the banks closed. There was a panic, a well grounded one: banks were taking people's money and going out of business. The Fed can't and won't let that happen again.

We are a long way away from anything major happening. If there is even a hint of a problem, there will be mergers, blessed by the Fed. Look at the Bear, Stearns deal as one example. The firm was over leveraged and would have declared bankruptcy if JP Morgan hadn't stepped in, with the blessing of the Fed. There will be no major bankruptcy allowed.

The whole banking system runs on trust: trust that deposits are safe, insured by the FDIC or FSLIC. From those deposits, lenders can make the loans needed to keep the economy strong. If that first link is broken, if people don't trust the financial institutions, there are far reaching ramifications.

That trust can't be broken. The Fed knows it and will do everything and anything to keep it. That's why we're seeing new policies introduced, new changes in the banking world and in the stock market. The public trust is everything. It's been tested and will most likely be tested some more. But the very fabric of capitalism is at stake. Everyone in the federal government is aware of it. Every CEO is aware of it. Things will change, some for the better, some for the worse. Behind all of it is this: keep the public trust at all costs.

That's why you'll see many more mergers and acquisitions in the financial world. The large but weak sisters, ones that aren't as competitive, won't be allowed to get too close to bankruptcy before they're taken over. Smaller, less important entities can fail. That's also part of capitalism. Everyone understands that. But the biggest institutions can't. The waves from even one large failure would ripple for years. The Fed can't and won't let that happen.

- Ted Allrich