Charles Schwab, the founder and CEO of the Charles Schwab Corporation (NYSE: SCH), provided some simple yet insightful commentary on CNBC earlier this week.  When asked about what the financial services industry needs to do to restore trust among investors and depositors, Schwab put forward the simple yet obvious understanding about  what banking is ultimately all about.  Schwab noted that the money that banks play with is others people's money.  It's that simple.  Wall Street, with that understanding, took the low road of the options available.  Knowing that the money you are playing with is someone else's can either lead you to respect it and treat it better than your own OR abuse it and treat it as if it had little value because it wasn't your own.  

Incidentally, Schwab is one of the biggest individual contributors to the GOP. 

You can see this in the way Citibank's returns behaved relative to Wells Fargo (a more conservatively managed bank).  Citibank's net income shows up in blue and Wells' shows up in red.  With high risk (with other people's money at the craps table) comes high reward in the good years when you look like a genius relative to your competitors.  Conversely, that same high risk typically involves massive downside when things don't go so well.   

 It was this "approach to life" that led many banks into perilous waters.  But, unfortunately, the banks should not be perceived as some set of exogenous entities to be despised from afar.  Remember, the money they were playing with was ultimated OUR money (along with a lot of Chinese, Middle Eastern, and European money - and all of these folks are now pretty pissed off).  The old saying (with updated numbers) is that if you owe the bank $500,000, then you're in trouble.  If you owe the bank $500 billion, then the bank's in trouble.  Well, guess what, both situations exist in our current crisis.   

People often forget that banking is a fractional reserve system.  Folks put in deposits and earn an interest rate.  The bank lends that same money out at a higher rate and keeps the difference.  Your neighbors' cars, student loans, credit cards, and home are where your money is tied up.  That's right, it's ultimately YOUR money that went from your checking and savings account into all those credit lines and notes.  Some of those extensions of credit were smart but too many weren't.  The old saying of the bank only lends money to people who don't need it clearly broke down when your coworker started to finance a fancy lunch on his or her credit card.   Banking can be descibed as:

 Most people "know" this, but it's easy to forget.  Banks take on deposits, raise capital, etc. and loan that money out.  They keep a portion of that cash on hand for operating purposes.  Most commecial banks are required to keep a certain amount of cash on hand by virtue of regulatory requirements.  But, you can see how it might be tempting to loan that last bit of money out (under the safe) if you think you can make some more money off of it and juice up your profits (net income). The investment banks did just this given they were not regulated like the retail banks.  But, as a result of the repeal of the Glass-Steagal act in 1999 commecial/retail banks and investment banks became universal banks and bank holding companies.  In many cases, they became one and the same.  Therefore, a lot of the risk the investment banking side of the house started to take on was also being assumed by the consumer facing commercial/retail side of the operation of the combined entity.

Now, the banks balance sheet is just a function of the money it has on hand (under the safe again) and the value of the credit lines it has outstanding (in the form of credit card debt and shitty McMansions in Plano, TX).  The banks liabilities include obligations to bond holders and, of course, to depositors.  If what they (the banks) owe their debtors which include us depositors is greater than the value of the credit lines (homes and likelihood of payment of credit card debt) then the bank is screwed.  This concept sums up the mark-to-market debate.  In the wake of the Enron debacle, banks have to value these assets down to the value of the last sale price seen by a similar asset in the market.  In this market, all those prices are very depressed.  If these asset values fall below a certain level, the bank has to go out and raise money in a tough market to meet their reserve requirements (the cash on hand under the safe).  In this market, the cost of raising money  is pretty expensive with investors wanting interest rates in the 11% range...which is also why banks are putting the screws on credit card holders.  They are passing on the pain.  In the mark-to-market debate, banks simply argue that the prices of homes (more precisely, what other investors thing these bundle of loans is worth) does not reflect the true value of the mortgage.  Sure, home prices are depressed, but people are still by and large paying their mortages so the loan is still more valuable than the assessed value of the underlying home.  In other words, mortgage holders will likely pay off their loans even if their houses aren't worth what those loans originally bought.  This may nor may not be a fair assumption, but that's the debate.  

If the mortages turn out to be no good, then the banks are screwed.  But if the banks are screwed, to some extent so are we.  Yes, there is FDIC insurance; but the insurance company can go bust as well.  Only a few weeks back we heard that the FDIC was running extremely low on cash.  The FDIC is funded by charging member banks a fee for insurance.  The FDIC typically has about $50 Billion on hand in normal times.  With nearly 50 bank failures over the past several months, that fund has been depleted.  Now, the congress will likely recapitalize that; but in the end we're just printing money again to pay ourselves back to keep the average depositor (who has $3,000 in a savings account) whole.  If you look at the size of the banks involved, you'll see that if the big money-center banks go down the average depositor exposure to the government is nearly $2 trillion.

You can see this if you look at some of the largest banks and the size of their deposits:

It's a thorny problem.  Bailing out the banks to some extent involves bailing out the average depositor.  Banks are ultimately money middle men.  Their biggest asset is confidence in the institution.  They have been called Trusts in the past for a reason.  Runs on the bank happen when people don't think the "bank is good for it."  But, referring back to the reminder Charles Schwab gave us that we should take extreme care when dealing with other people's money; we should also take notice of the other side of the equation.  Our neighbor's may also not be good for it.  They, afterall, borrowed other people's money.  The cavalier nature with which people enter bankruptcy in this age is in stark contrast to stories of how people spent 14 years paying off old medical bills even though the doctor had forgiven it during the Great Depression  It was a matter of pride and an understanding that owing is not a good feeling and that you should treat other people's money more carefully than your own.  

Hank Paulson and now Tim Geithner have struggled between moral hazard and systemic risk.  Systemic is the operative word.  When we collectively are cavalier with other people's money, bad things happen to us all.