Excerpted from Gary North’s piece on LRC

When we think of bank runs, we have a mental image of a long line of people in front of a bank in the early 1930s. Or we have a mental image of the scene in "It’s a Wonderful Life," where depositors want their money, and Jimmy Stewart hands out – we never quite got this – $33,000 in honeymoon money to calm them. Yes, $33,000, which was what $2,000 was worth in 1932. Check the inflation calculator of the Bureau of Labor Statistics. (There was something endearing about Frank Capra’s movies, but it wasn’t his economics.)

In 1934, the government created the Federal Deposit Insurance Corporation (FDIC) and an equivalent agency for the savings & loan industry, which lent mortgage money. The depositors received government-subsidized insurance for their accounts, up to a limit that covered most depositors. After that, there were no further long lines of depositors trying to get their money out. So, we live in a mental world created by textbooks. The economic theme of the textbooks is universal: the New Deal saved American capitalism from itself. Most modern capitalists believe this.

In fact, the FDIC and FSLIC merely shifted bank runs from the front door to the back door. The large deposits are far above the insurance limit set by the U.S. government. The official limit was raised by the government from $100,000 to $250,000 during the crisis week of October 3, 2008. This temporary measure was made permanent in July 2010.

The big money for large banks is not gained from depositors who walk in the door. It is gained from pools of investment money that are not covered by any form of insurance. This is short-term money, usually tied up for no more than a few days. This is the heart of bank profits. The banks are borrowed short – days, not months – and lent long: years, not months. These are profitable arrangements because, except at the start of traditional recessions, long-term rates are above short-term rates: a positive yield curve. "Borrow low-lend high" is the law and the prophets for fractional reserve banking.

Investment banks – RIP – in August 2008 did not have to deal with the general public. They did not offer accounts to little people. They made lots of money in the far less regulated capital markets for very rich people.

But in March 2008, Bear Stearns tottered at the edge of bankruptcy. A rumor spread that it could not roll over its debts. The rumor became reality within three days. This was a self-fulfilling prophecy. Wikipedia summarizes:

In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved, however, and was sold to JP Morgan Chase for $10 per share, a price far below the 52-week high of $133.20 per share, traded before the crisis, although not as low as the two dollars per share originally agreed upon by Bear Stearns and JP Morgan Chase.
The bank had existed since 1923. It was highly respected, Wikipedia says:

In 2005-2007, Bear Stearns was recognized as the "Most Admired" securities firm in Fortune’s "America’s Most Admired Companies" survey, and second overall in the security firm section. The annual survey is a prestigious ranking of employee talent, quality of risk management and business innovation. This was the second time in three years that Bear Stearns had achieved this "top" distinction.
In other words, the financial community didn’t have a clue as to how vulnerable the company was. The experts were idiots. They were convinced that to be borrowed short and lent long is smart business. That is to say, they rejected Austrian School economics in general and Ludwig von Mises’ Theory of Money and Credit (1912) in particular.

"During the week of July 16, 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages." Lawsuits by investors began. Still, the financial world shrugged its shoulders. "No problem."

But what of the Securities and Exchange Commission, which regulated the investment banks. It was blind right to the end?

On March 20, Securities and Exchange Commission Chairman Christopher Cox said the collapse of Bear Stearns was due to a lack of confidence, not a lack of capital. Cox noted that Bear Stearns’s problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. "Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns," said Cox. Bear Stearns’ liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately market rumors about Bear Stearns’ difficulties became self-fulfilling, Cox said.
This was indeed the heart of the matter: a lack of confidence. When you are running a confidence game – which is what "borrowed short and lent long" is inherently – you always face the threat of a crisis of confidence by your lenders.

No lack of capital? Ha! The essence of capital for all fractional reserve banking is lenders’ confidence. Lose it, and the end is nigh.

Why? Because short-term debt matures in days and must be re-financed when it matures. If there is no one ready to buy the next round of debt, the bank is busted. This does not take weeks. It takes days.

The bank runs that we have in our mind rest on an image of depositors asking for currency. That image is wrong, and has been wrong since 1934. The correct image is that of a man in a suit looking at a computer screen. He sees that the deadline for repayment of a loan with many zeroes is due today. He contacts the bank to which his firm has made the loan. "Please transfer our money to our bank."

That’s it. Nothing else. No lining up. No presenting of a savings passbook. No exchange of pieces of paper. Just a notification by email that the loan will not be rolled over, so please send a bank wire of the funds. It’s all very clean. It’s all very fast. It takes one working day to complete the transaction. The words, "your check is in the mail," is not applicable.

In mid-September, Lehman Brothers, another investment banking firm, went through the same experience. In this case, however, the U.S. government and the New York Federal Reserve Bank refused to assist the firm. Henry "Goldman Sachs" Paulson, the Secretary of the Treasury, was seized by a fit of debt ceiling fever. He was the man who had unilaterally nationalized Fannie Mae and Freddie Mac on September 7. Over the weekend of September 13, no one came to the rescue of Lehman Brothers. On September 15, it filed for bankruptcy. It was the largest bankruptcy in U.S. history.

That sent a message to the other investment bankers. We read in the Wiki entry for Morgan Stanley,

Morgan Stanley and Goldman Sachs, the last two major investment banks in the US, both announced on September 22, 2008 that they would become traditional bank holding companies regulated by the Federal Reserve. The Federal Reserve’s approval of their bid to become banks ended the ascendancy of securities firms, 75 years after Congress separated them from deposit-taking lenders, and capped weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.
Can you imagine the lawyers? They had to complete the restructuring of these banks in one week. They did it. And then, lo and behold, the FED tossed the lifelines: $107 billion for Morgan Stanley, $69 billion for Goldman Sachs. All of this was done in complete secrecy. Nothing about it appeared on the FED’s balance sheets.

NOW IT’S GOVERNMENTS’ TURN

Greece is now paying 43% per annum on 2-year bonds. This is very close to the end of the road. This is a loan shark interest rate, but it is not the Mafia that is acting as the lender of last resort. It is Europe’s most sophisticated investors. It is also the European Central Bank. The London Telegraph reports:

The International Monetary Fund’s partner in the recent international bail-out missions is itself in danger of becoming a liability, Open Europe has argued.

In a report published on Monday entitled "A House Built on Sand?", Open Europe has calculated that the ECB has a total exposure of about €444bn (£397bn) to "struggling eurozone economies".
The bank is now "23 to 24 times levered" as a result of bailing out Greece, Ireland, Portugal and Spain.

The London-based think tank argued: "Should the ECB see its assets fall by just 4.23pc in value . . . its entire capital base would be wiped out."

The experts are desperately trying to conceal the thinness of the ice they are skating on. Legally, they are skating on behalf of the voters. Operationally, they are skating on behalf of the largest commercial banks. Their sovereign status makes them immune to lawsuits. But the market is imposing sanctions: 43% interest.

Bill Clinton avoided this, because he took Robert Rubin’s advice. The bond traders did not get him.

They are going to get Greece. They are going to get Portugal, Spain, and Italy.

Who will bail out the banks? How much money will it take?

CONCLUSION

You might imagine that very smart experts would have seen this coming. They did not, any more than they saw the Bear Stearns/Lehman Brothers crisis coming. The best and the brightest respect each other. They see their peers borrowing short and lending long, and they conclude that their peers are the smartest guys in the room.

These are people who thought Bernie Madoff was an investment genius. They thought the same of Bernie Cornfeld a generation earlier.

Avoid thin ice.