Tuesday, October 4, 2011

Lesson 11: Why I am staying away from banks

So, here's how the accounting for banks work. People like us deposit money into checking and savings accounts. This shows up as a cash asset and a liability on the balance sheet. Then, the bank uses their cash to lend out. In return, they receive a securitized mortgage. Their cash balance decreases and the appropriate asset account would be incremented. Hold to maturity, available for sale, whatever the securitized mortgage falls into. At other times, banks can buy mortgage backed securities as these are supposedly the same as lending out money.

It's easy to evaluate the balance sheet if a company is holding something simple like cash or liquid marketable securities. When the balance sheet is full of mortgage backed securities, I have no idea if the bank has properly written down any securities that are in default or at risk of default. As result, it is very difficult to estimate what the shareholder equity should be.

The point is to stay out of what you don't understand, or stay away until you learn it.

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