Donald Mackenzie’s latest in the LRB

May 3, 2013

The London Review of Books is running an informative essay by Donald Mackenzie that discusses why banks prefer debt over equity.

The piece is written to explain what banks do to raise funds. To make this accessible to a broader audience Donald draws an analogy to personal housing finance. He explains that when a financial institution takes on debt instead of issuing equity, this is tantamount to a homeowner putting down a smaller down payment in favor of a bigger loan.  The consequence is that when the asset price falls, people with a lower down payment will find themselves in negative equity –  the popular term is ‘underwater’ – much sooner.

I would challenge the line, “Negative equity is nasty for a homeowner, but for a bank it is potentially fatal.” After all, the banks are alive and kicking for precisely the reasons Donald lays out: in the UK, when the credit system crashed they were given a £107 bn subsidy!  While countless people continue to struggle with their personal finances, RBS for example, “is expected to report one of its strongest quarterly profits when it discloses results for the first three months of 2013”. According to today’s FT, the bank’s chairman announced it will soon be ready for reprivitization.

Households are not distributed shareholder companies. They do not start suffering financially when they go into negative equity. Down payments are an essential form of personal savings, so when this value get gobbled by market fluctuation the consumer is threatened… immediately. The political result of the £107 bn subsidy is that disappearing equity has been very nasty for consumers in reality, but fatal to banks only in theory.

Despite this tiny burr, an artifact of his tight focus on the internal workings of financial institutions, Donald’s overall presentation in this piece does an excellent job of illustrating how financial theories such as the Modigliani-Miller theorem have influenced banking practice.

…No spoilers! The last two paragraphs – but you’ll have to work to get to them – are priceless.

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