For decades, American banks operated on a simple – and nicely profitable – business model: They took in deposits and lent out money.

In the simplest model, a bank might take in deposits of a million dollars and lend out a million dollars. In a perfect world, such a “matched book” is established if they know that the deposit will be left in the bank for a year and the loan they made has a maturity of one year. If the bank pays the depositor 3% and charges the loan borrower 5%, it can assume a profit for the year of 2% (the difference between the 5% loan rate and the 3% payout to depositors).

It Takes Money to Make Money – Disappear

In order to make more money, banks need more money to lend. In addition to taking in deposits, banks borrow money to make more loans, to buy assets to keep on their balance sheets, and to trade in the markets. They get this money by offering products such as certificates of deposits (CDs) to entice depositors to bank with them, they borrow overnight in the Feds Funds market (from other banks), they sell commercial paper backed by their balance sheets to investors, they get capital from profitable trades and investments, and they generate fees for their banking services.

The problem is that banks don’t just take in money in order to lend it out; they take in money to make more money with it by investing and, yes, speculating.

On the deposit-and-loan side of the equation, banks don’t even bother trying to run a matched book anymore. They borrow short and lend long. This works well if their short-term borrowing costs are substantially lower than their long-term lending rates. But if short-term rates start to rise, banking profits in the borrow-and-lend game start to get squeezed. And if short-term rates shift so much that they’re actually higher than the interest rates the banks are charging on their long-term loans, banks actually start to lose money.

Banking-system executives are fully aware of these interest-rate dynamics. Indeed, they knowingly speculate on interest-rate movements by not running matched books, and trying to increase their spread profits by borrowing as short as they can and lending for as long as they can. The bottom line: Banks actually are speculating on interest-rate movements.

Speculating on the Health of the U.S. Banking System

If you didn’t already know that banks speculate, you’re about to be really surprised. All the money that is not lent out to borrowers floats around in what’s known as the bank’s “treasury.” The job of the people who work in the treasury is to make money with the cash that’s sitting around. To a banker, idle cash is no better than idle hands – both are regarded as the devil’s playthings.

There’s some merit to that argument. After all, no one actually makes money with idle cash: It has to be put to work, lent out, used as investment capital or, of course, used as trading capital in speculative deals.

Banks lend treasury funds overnight – and for short periods – to other banks, and to such non-banking institutions as insurance companies, corporate clients, securities broker-dealers, and investment banks (investment banks do not take in deposits and are therefore not the same as commercial banks, nor are they regulated by the same supervisory bodies that oversee commercial banking operations).

For banks, the problem in making these loans is one of “counterparty risk” – will the borrower be able to pay the funds back? Banks have become very wary of counterparty risk and have drastically cut back their lending to many traditional types of borrowers.

Instead, banks invest in assets, including government bonds, corporate bonds, mortgage bonds, currencies and derivatives. Some investments actually end up on banks’ books because they have deals to hold assets they are not able to syndicate (sell pieces of to other bank partners). And sometimes banks hold assets so that they can profit as these holdings appreciate in value. (Of course, stating that a bank is “holding assets as investments” is actually just a polite way of saying that it is speculating).

The Bottom Isn’t Yet Within Sight

Lately, banks have been holding mortgage bonds and similar financial instruments in so-called “off-balance-sheet” entities. By doing this, the bank essentially takes assets off its books (which are visible to investors and regulators) and places them inside a special holding company, where they now will be out of sight.

Why would a bank do this? Simple. Banks are hiding risky assets so that their “books” and balance sheets look better. Truth be told, there’s no reason for off-balance-sheet entities. Period. They’re nothing more than a means for a fraudulent conveyance.

Banks trade – a lot. They buy and sell government bonds, currencies, derivatives and whatever else their charter allows them to trade. Banks trade billions and billions of dollars every day. They are speculating.

Particularly in the U.S. banking system, what has happened is that banks have over-speculated across the board. And the losses that have resulted have severely reduced their available capital. This means that they have less money to lend and will be much more strict with prospective borrowers, exacting tougher loan terms and demanding higher creditworthiness before agreeing to make any loans.

As banks lose money – something I expect will continue for perhaps the next several quarters – their stock prices will continue to fall, reducing their equity capital (which is what regulators look at to determine their stability).

Banks keep raising capital via investments from sovereign wealth funds and through preferred and common rights offerings. And still their losses continue. They have to keep going back to the well. Sooner or later, this capital-markets well will have to run dry. There are going to be bank failures and we will see the doctrine of “too big to fail” tested yet again, as a major bank sinks into the abyss (the failure of The Bear Stearns Cos. Inc. (BSC) was a test and the subsequent central-bank-led bailout seems to have proved that it was too big to fail).

Moody’s Investors Service, subsidiary of Moody’s Corp. (MCO), downgraded MBIA to A2 from Aaa, and Ambac from Aaa to Aa. The downgrade caused MBIA shares to shed more than 13% of their value, with an 86-cent decline to close at $5.59 on Friday. Ambac shares fared a bit better, gaining 2 cents to close at $2.05.

Moody’s downgrades follow similar reductions from Standard & Poor’s and Fitch Ratings Inc.

Many even question MBIA’s very survival, as it lacks the $2.6 billion in capital needed to regain its Aaa rating, according to Moody’s.

MBIA Chairman and Chief Executive Jay Brown fought off critics, saying that “despite the change in our ratings from Moody’s, our financial condition is very strong.”

“We remain committed to maintaining capital strength for our policyholders and financial flexibility consistent with our goals of increasing shareholder value,” Brown added in a company statement.

The downgraded ratings may have had an immediate affect on the insurers’ share prices, but also raised more questions about the more than $1 trillion in securities the firms guarantee. Those securities become riskier with the downgrade of the guaranteeing firms, making it more likely that defaults will escalate.

“The trouble for the banks is that the protection provided by the monolines becomes ‘less effective’ as the credit ratings of the monolines are downgraded,” said Simon Adamson, an analyst at CreditSights, MarketWatch reported.

“In other words, the probability that the monolines will pay out on the contracts decreases,” he wrote in a note to clients last week.

Some see the decline in ratings as an open door to new competitors.

“The issue really is, would they ever be able to get back to a triple A rating and I would think that would be a very heavy lift for them,” billionaire investor Wilbur Ross said in an interview on Bloomberg Television on Friday. “On the other side of this credit crunch, people will be even more sensitive about ratings and the quality of the paper they’re buying.”

And it’s likely that the “other side” of the credit crunch is still far off, according to analysts at the Royal Bank of Scotland Group PLC (ADR: RBS).

RBS analysts have warned clients to brace for a full-blown crash in the global stock-and-bond markets in the next three months, as the conflicting realities of slowing growth and rising inflation paralyze the world’s major central banks – causing “all the chickens [to] come home to roost,” Great Britain’s Daily Telegraph newspaper reported.

The predicted swoon would cause the U.S. Standard & Poor’s 500 Index – already down 16% from its trading high of 1,576.09 reached Oct. 11 – to nosedive all the way down to 1,050 by September. For the closely watched, broad-based U.S. stock index, that would represent an additional decline of 20% from Friday’s close of 1,317.93- and a total decline of 33% from its Oct. 11 apex.

Source: Moody’s Joins Other Rating Agencies in Downgrade of Ambac, MBIA 

It has also warned that there will be no real growth in activity in the US until well into next year.

US stocks are hurting, too, particularly those in the financial sector. Shares in banking giants Citigroup and Merrill Lynch both dropped about 6% at the end of last week — and there are rumors that bellwether Merrill is on the verge of issuing a profits warning.

No wonder. The Daily Telegraph has it that the sector faces up to $10 billion in further banking writedowns on the back of serious downgrades to the world’s two largest bond insurers, Ambac (NYSE:ABK) and MBIA (NYSE:MBI).

“The rest of the week could be a potential landmine for the markets,” says Christian Hill in Investor’s Daily Edge.

The first of many important reports this week is Consumer Confidence for June, which comes out at 10:00 am tomorrow morning. Last months reading was 57.2, and this month expectations are for a slight decline, down to 57.

While the decline is mostly expected, I feel the amount of the decline is excessively optimistic. Gas prices keep rising, and May’s unemployment figures showed the highest monthly jump in more than two decades. This leads me to believe there is a very good chance the figure comes in closer to 56, well below expectations.

Wednesday gets going quickly with the Durable Orders report at 8:30 am. The report is expected to show zero growth, which would still be an improvement over last month’s contraction.

This report is tough to call. Since the Economic Stimulus checks started hitting mailboxes last month, retail sales have improved. But is this increase in spending the reason for the expected improvement from last month’s 0.50 percent drop to this month’s 0 percent growth?

Hard to say, but I wouldn’t be surprised to see this report eek out a small gain of a few tenth’s of a percent.

On Wednesday, the New Home Sales report for May is expected to show a decline in sales of approximately 16,000 units. Later in the day, the Existing Home Sales report for May is expected to show an increase.

I think both will beat estimates, and here is why: last months’ New Home Sales report beat expectations, and the most recent Construction Spending, Pending Home Sales, and Building Permit reports all beat expectations.

I think the surprise could come from the fact that the home-buying season is just starting in northern states, which typically grinds to a halt during winter months.

Wednesday also has the FOMC Policy Statement, when the Fed will announce if interest rates are changing. Investors are expecting rates to remain the same, but their statement afterwards will be closely monitored. The explanation of their actions or inaction will cause the market to react.

The week ends with Personal Income and Personal Spending reports on Friday. As expected, the Personal Spending report will likely show a hefty jump from last month. Personal Income is also expected to increase, and I can only think this is due to economic stimulus checks, not from any real, long-term increase in personal income.

Source: A Very Important Week for the Market

Buffett’s comment is in step with a large number of economists and commentators. The US economy has yet to see two straight quarters of declining gross domestic product, the traditional measure of recession.

The legendary investor and chairman of Berkshire Hathaway also said he is no longer offering to guarantee $800 billion of municipal bonds backed by bond insurers MBIA, Ambac, FGIC.

Buffett’s own insurance and investment company, Berkshire Hathaway, meanwhile, has reported an 18% decline in Q4 profit.