Simple Analytics of the Financial Crisis

28 September 2008
by Cenen Herrera
Writing from Bracknell, Berkshire, United Kingdom

Understanding a bank’s operation starts with a simple balance sheet analysis. The typical balance sheet of a bank, i.e., large or small, would normally comprise of four main components:
Earning assets (loans and liquid) and non-earning assets (property, plant and equipment and others) on its left side, while liabilities and equity will be on its right side. Asset mix will be typically different when compared with its liability-equity mix. For example, a liability-equity mix of 80/20 would be compared to a 90/10 earning/non-earning asset mix. This means that the pre-shock financial scenario (before the sub-prime lending contagion) would typically have a large proportion of earning assets when compared to the total asset portfolio. An example is provided below.

Simplified Balance Sheet (pre-shock scenario)
[Rounded to the nearest billion of currency]

Earning Assets -------90-----Liabilities -------------------80
Non-Earning Assets --10-----Equity ----------------------20
Total Assets --------100-----Total Liabilities & Equity----100

The sub-prime lending financial shock gave rise to massive loan defaults arising mainly from the inability of bank clients to pay the debt service payments due on their housing loans. The corresponding market decline of housing prices led to borrowers defaulting on their loans instead of holding to their properties which were mortgaged to banks at much higher-than-market price. In the post-shock scenario, earning assets had been substantially reduced as a result of massive loan defaults giving rise to a “debt-overhang scenario” (where liabilities had no matching earning assets). Thus, bank failure was a result mainly of the inability of the institution to meet its maturing obligations, i.e., liability exceeding by large amounts the bank’s earning assets. Using the example presented earlier, a possible view of the balance sheet accounts after the post-shock scenario is provided below:

Simplified Balance Sheet (post-shock scenario)
[Rounded to the nearest billion of currency]

Earning Assets--------- 90--Liabilities----------------- -80
Loan Losses
from Sub-prime*------ (70)
Non-Earning Assets-- - 10 --Equity Beginning – Loan--- 20
----------------------------Losses from Sub-prime* --(70)

Total Assets----------- 30--Total Liabilities & Equity----30

*Note that earning assets were reduced by 70 as a result of loan losses, but liability remains at 80. Thus, negative equity stood at 50 [the amount of deficit that must be considered in business recovery].

In my view, it is expected that very few market participants would have avoided the current financial difficulties considering that such structured portfolio was a typical loan product of bank lending activities during the pre-shock scenario. Thus, market recovery appears to be dependent on a large-scale financial rescue program that may be considered as an inevitable exogenous variable in the post-shock scenario.