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The mechanics of modern banking are opaque, misunderstood and arguably dishonest. Modern fiat money, the dollar, euro, yen etc are all based on debt. For every dollar in existence, there is somewhere an IOU for the same amount. This is best illustrated with an example of a typical mortgage.
Money Lenders, 1466
Imagine Jack wants to by Jill’s house for $100,000 and he has no money to buy it so he goes to his local bank and asks for a mortgage which is approved. The bank will ask Jack for a promissory note, an IOU, for the $100,000 and once he signs it, they open an account in which they create from nothing $100,000 for Jack in exchange for his IOU. That $100,000 is a liability for the bank, their asset is the IOU. The bank just ‘created’ $100,000 which is backed by the good faith of Jack to pay it back as well as the deed to the house he bought. Now the bank loans that money to Jack, with compound interest. The interest is the fee the bank charges for monetizing the debt. Jill would not have wanted an IOU from Jack for the 100K, so the bank did him the service of converting his IOU into dollars, and for this service they charge him interest. As Jack pays down his mortgage principal, the value of the IOU will be drawn down as well, until all the money ‘created’ is destroyed, and the IOU is worthless.
The money never existed before Jack signed his IOU. It was created entirely and only as an expression of his promissory note. All car loans, student loans and personal loans are created in this way, and it is the exclusive right of banks and the Fed to create money except for coinage which is handled by the Federal Government. Banks are restricted as to how much money they can create by the amount they have on reserve with the Fed. The formula is complex, but, for simplicities sake, it is around 10 times as much as they have on reserve, (actually more). If the bank has 1 million dollars on reserve with the Fed, for which they are now paid interest, they can create and loan out about 10 million dollars. Banks are paid for the privilege of creating and leasing money. This is our modern, fractional reserve banking system.
How does this differ from how other things that are borrowed or leased? When a house is leased, the owner must buy the house, then rent it, forfeiting his capital in exchange for an asset, the house. The typical return on residential real estate is about 5%, anything with a return of 10% would be snapped up in an instant. So how much do banks make when they loan their ‘created’ money out? Let’s assume Jack has been a good boy, and gets a fixed rate loan of 5% on his $100,000 mortgage for a period of 10 years. The bank is obligated to leave $10,000 in reserve, or 10% of the amount loaned out, but they do not give up the money, and they are now paid interest on it, so the bank now has no borrowing cost, only an opportunity cost. The return on the bank’s $10,000 is Jack’s compound interest payments of 5% on $100,000, or $5,000, a neat 50% return on their money. As he pays off the principal, the banks also frees up the corresponding amount in reserves, so the margin stays the same. On a 20% interest credit card with an outstanding balance of $10,000, the bank is holding $1,000 in reserve on which it is making 200% a year. Of course the bank has salaries to pay, rent, administration fees, marketing etc. but it is, nonetheless, a very lucrative business model.
What is special about banks that allows them such profitability? First, what is money? Money is two things: a store of wealth, and a means of exchange. Many would define money as human labor. Let’s say Jack is a truck driver and makes $50,000 a year, (very close to median US household income). Jack has recently married, bought a house and become a good boy and doesn’t pitter his money away anymore on wine and women, he now saves $1,000 every month, about one week's work for Jack and the average American family (before taxes). When he asks his bank how much they will pay him on his saving account, they say 1%. This seems legitimate to Jack, since they loaned him $100,000 at 5%. In fact, it seems like a very low margin to him as he assumes that the banks are loaning the money that other people like Jack have on deposit. Banks do not loan out deposits, deposits are used for reserves.
For Jack to earn $100,000 would take him two years of driving a truck, for which he would be paid by a bank a few thousand dollars in interest a year. For a bank, however, $100,000 is created digitally in miliseconds, and they are paid $5,000 a year in interest and if the borrower defaults, the bank will foreclose on the house with the full force of the law. Jack drove a truck for 2 years to make 100k, it is a store of value of his work, but what did the bank do in exchange for the interest on the 100k they loaned Jack?
Money is human labor transferred to a store of value, like dollars, euros, gold or silver. For example, when someone pays $30 for a kilo of fish, they are not paying for the fish in the ocean, they are paying for it on their plate. The difference between a happy fish swimming in the deep blue sea and a grilled halibut glistening before you is human effort. All other businesses that want to get a return on an asset must first buy the asset with money earned through work. This is not the case for banks. They earn interest on something they don't create.
In fact, a Minnesota Judge, Martin V. Mahoney, and a jury threw out a foreclosure on defendant Jerome Daly for just that reason. Daly argued that the there was no consideration in the contract between himself and the First National Bank of Montgomery. Consideration means both parties must give up something for there to be a contract. For example, if Jack offers to paint Jill’s apartment for free, there is no contract between them. If Jack bails on his offer to paint, Jill cannot sue him. Judge Mahoney ruled the bank gave up nothing in the contract. They created the money out of thin air hence they did not commit anything to the contract; there was no consideration and the bank could not foreclose.
For everyone except banks, money is an expression of human labor, creativitity, or even luck. But for banks, money is something they simply 'create' in exchange for IOU's. What Jack works ten years to pay back should not have the same value as what the bank created in the blink of an eye. They are two different things, yet they are treated as one.
How do Banks Lose Money?
It seems incredible with such a business model how banks could ever lose money, but they do. The problem for the banks is always the IOU’s. Fiat money is based entirely on outstanding debts. Modern money is based on debt and every dollar must be tied to outstanding IOU. But when the underlying IOU that backs up the debt becomes worthless, the bank must back up the ‘created’ money up with real money: deleveraging.
Let’s say Jack loses his job and stops paying his mortgage, and his $100,000 house is now worth $50,000 due to a crash in housing prices. Once Jack has been found to be certifiably broke, the bank must replace the IOU with reserves in the amount of the loan outstanding. Assuming Jack never made a payment, the bank must now add $90,000 to its reserves which, plus the original $10,000, will constitute the full amount of money they created. Once they foreclose on his house and get the $50,000 the bank is now in the whole for 50 grand. This is why banks traditionally only loaned 80% of the value of a home. The 20% was calculated to pay for expenses and fees, leaving them in a breakeven scenario in the case of an initial default.
But the bank's bag of tricks seems to have no end, according to Forbes:
"They (the commercial banks) are allowed to accrue interest on non-performing mortgages until the actual foreclosure takes place, which on average takes about 16 months. All the phantom interest that is not actually collected is booked as income until the actual act of foreclosure. As a resullt, many bank financial statements actually look much better than they actually are. At foreclosure all the phantom income comes off the books of the banks. This certainly explains some of the reluctance of banks to speed up the foreclosure process."
The same leverage that allows banks to make 50% returns on mortgages, and 200% returns on credit cards works in reverse when people default on loans, and it sucks up the bank’s liquidity like a thirsty sailor.
The liquidity problems of banks are directly tied to the very same leverage they use to make their immense margins. Banks are given a machine that makes money, for which they must leave deposoit of 10% of the money they want to ‘create’. When they give the machine back, they must show that all the money they created has been ‘destroyed’ (paid back) or they must make up the difference.
Banking is a fabulous busniness on the simple condition that risk is always controlled. When greed trumps risk, banks go south.
The Lure of Sub-prime
Banks will often package loans, securitize them into mortgage backed securities, and sell them off. The principal money is destroyed and the IOU is passed on to the buyer of the security. The banks keeps the margin they make on the deal, plus whatever interest had been paid before they sold the loan, along with fees etc. The problems began when greedy souls noted the difference between a 5% mortgage and 8% mortgage. For the Ivy league trained, this is no mere 3%, but a healthy 30% (10 leverage * 3%). Over a ten year period, the difference in the amount of interest paid on a 5% $100k mortgage ($27K) and an 8% $100k mortgage($45K) is a whopping 66% increase in ROI. Jack sees 3% and says big deal, Lloyd Blankfien sees 66% and gets himself into a frenzy doing God’s work...
Combine the greed with a rising prices that kept foreclosures to a minimum (who defaults on a house they can sell and make money on?) and it is clear how the leveraged orgy began and what kept it going. As Citibank's John Prince put it “you have to keep dancing while the music is playing”.
Perfect Games and Rigged Games
From The New York Times :
"Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball. On Sunday, Dallas Braden of the Oakland Athletics pitched what was only the 19th perfect game in baseball history. But Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase Company produced the equivalent of four perfect games during the first quarter(2010). Each one finished the period without losing money (trading) for even one day."
Did the same "beautiful minds" doing "God’s work" that blew up the world financial system suddenly find their fast ball? More like Vaseline and a razor blade, or in banking lingo, the carry trade.
The Fed Discount Window was a mechanism used by the Fed to make very short term loans to member banks facing liquidity problems, the loans where generally paid back within hours and the rate was 100 basis points (1%) above the Fed funds rate. During the credit crunch in 2008 the Fed loosened the terms on the Discount Window, extending the terms up to 90 days (one quarter) and reducing the rate to 25 basis points (.25%).
So how did the banks turn this into a money machine? They borrowed from the Fed using around 30 times leverage at .25% and immediately bought US Treasury 10 Year Notes at 3.5%. Doesn’t seem like a big spread? Imagine that you start with $10 million in assets. You borrow $300 million, you make 3.25% (3.5% - lending cost .25%) on 300 million dollars. The banks interest earnings are $9.75 million a year, or about $800K a month on an initial outlay of $10 million, 8% return a month or 97% a year. One hell of a big strike zone.
This begs the question of how interested are the banks in stopping wars and reigning in the federal budget deficit. The moral hazard here is twofold as the banks reap risk free, incredibly high returns from budget deficits and all the destruction they entail and the taxpayer ends up paying the spread. The Fed charges banks .25% and the Treasury pays the banks 3.5% and the difference is paid by Jack and Jill.
In the current PIGS crisis, Portugal, Ireland and Greece are being 'bailed out' to insure that the banks recieve full payment on the bonds they hold. At least one generation will live and work in austerity in order to pay back banks with 'real' money raised with hard earned taxes to pay for that which was created without a drop of sweat and with a few clicks of a mouse.
The New York Times
In May of 2010, two months after the banks ‘perfect’ quarter, The New York Times ran a front page piece about a middle class family in Florida that had opted without qualms for strategic default on their home .
“Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino.”
The article had over 800 comments, a lot even for The New York Times. The blogoshpere lit up with outrage over these ‘deadbeats’. But how many people understand how banks actually work? Would there be the same outrage if people understood that the money they were given was made with a few clicks of a mouse? You don’t see cover stories in The New York Times on the mechanics of banking. It just doesn’t happen.
Everywhere banks are foreclosing on homes and even forcing austerity on entire nations as payment for the money they loaned, and the risks they assumed. But did they actually lend real money? Was the money they lent created through work or was it simply a slight of hand for which they now demand their pound of flesh? As the entire world financial system becomes undone people will begin to understand that money as a store of value and work and the money banks lend are two very different things for which the banks want you to think they are one and the same.
The financial crisis was actually a run on the banking system. Only it wasn't a run in the usual sense of the word where jittery depositors line up on the street waiting to withdraw their savings, but a run on the shadow banking system where traditional banks get their funding via short-term loans in what's called the "repo market". (short for "repurchase agreement") The shadow banking system has become a critical part of the infrastructure of the modern financial system. It provides a way for banks to move credit risk off their balance sheets, thus reducing the amount of capital they need to support their operations. The banks argue that this new system has made credit cheaper for borrowers which, in turn, generates more activity and growth in the economy. But, of course, the risks are much greater too, as we can see from trillions of dollars that were lost following the meltdown of 2008. These risks cannot be contained as long as shadow banks remain unregulated.
So, when did the crisis actually begin?
Well, most people would point to September 15, 2008, the day that Lehman Brothers defaulted and markets went into freefall. But that's not when the trouble actually started. The trouble began a full year earlier on August 9, 2007, as Pimco's Paul McCulley recalls in his comments at the 19th Annual Hyman Minsky Conference. Here's an excerpt from the speech:
"On August 9, 2007, game over. If you have to pick a day for the Minsky Moment, it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System” at the Fed’s annual symposium in Jackson Hole.
...while the run commenced on August 9th of 2007, it was pretty much an orderly run up until September 15, 2008. And it was orderly primarily because the Fed.... evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility....
The Fed created a whole host of facilities to stop the run. In fact, they expanded the Primary Dealer Credit Facility to what are known as Schedule 2 assets, which meant that dealers could rediscount anything at the Fed that they could borrow against in the tri-party repo market.
Concurrently, the FDIC stepped up to the plate, doing two incredibly important things. Number one, they totally uncapped deposit insurance on transaction accounts, which meant that the notion of uninsured depositors in transaction accounts became an oxymoron. If you were in a transaction account, there was no reason to run. And then the FDIC effectively became a monoline insurer to nonbank financials with its Temporary Liquidity Guarantee Program (TGLP) allowing both banks and shadow banks to issue unsecured debt with the full faith and credit of Uncle Sam for a 75 basis points fee. No surprise some $300 billion was issued.
So, bottom line, you had the Fed step up and provide its public good to the Shadow Banking System. You had the FDIC step up and do the same thing with its public good. And as Paul Volcker was noting this afternoon, you had the Treasury step up and provide a similar public good for the money market mutual funds, using the Foreign Exchange Stabilization Fund." ( After the Crisis: Planning a New Financial Structure, Paul McCulley, 19th Annual Hyman Minsky Conference, Zero Hedge)
This is a great description of what happened, but McCulley is a Managing Director at the country's biggest bond fund, so naturally his perspective is different than yours or mine. From a working man's point of view, this is what happened: The banks had been creating dodgy loans that they knew would never be repaid because the mortgage applicants weren't truly qualified to borrow as much money as they did. (Many of the applicants were called Ninjas...aka--"No income, no job, no assets") But the regulators and ratings agencies looked the other way because there was a lot of money involved and everyone was getting very rich. The dodgy loans were chopped up into securitized bonds (mainly Mortgage-Backed Securities) and sold to insurance companies, retirement funds and foreign investors. Then, on August 9, 2007, the Merry-go-round ground to a halt when Paribas Bank (BNP) stopped redemptions on assets that no one really knew how to value. (So, the crisis wasn't really a "panic" as much as it was a repricing event. The market had not yet repriced these toxic assets which were plunging in value on the ABX index.)
The problem was that the banks had been using these toxic assets to secure funding in the repo market. Now that their value was plunging, the banks were becoming increasingly less liquid and less inclined to deal with other banks that they knew were also in trouble. Keep in mind, that "according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created," through this process which put the entire global financial system at risk. So, it wasn't just subprime mortgages (which only amounted to $1.5 trillion) that caused the meltdown, but the trillions of dollars in complex securitized bonds that had been traded through shadow intermediaries. As Anat R. Admati, Professor of Finance and Economics, Graduate School of Business at Stanford University said, "Housing policies alone, however, would not have led to the near insolvency of many banks and to the credit-market freeze. The key to these effects was the excessive leverage that pervaded, and continues to pervade, the financial industry." ("Fed scholars: A run on the repurchase market caused the financial crisis and will probably happen again", Repowatch)
Understanding how the repo market works is crucial, but it's also hard to grasp. So, let's use an analogy.
Let's say I need some cash to finance some other business operations I have going. So, I go down to the local pawn shop with my custom-built Maserati, my original Chagall oil painting, and my collection of Renaissance gold coins. The pawnbroker takes one look at my trove and says he can lend me $25,000 for a week, but I'll have to pay him $26,000 to get my stuff back. I say, "Okay", and borrow the money. This allows me to keep my other business operations running. Then, a week later, I return to the pawn shop and repay the money I borrowed.
Okay, so far?
So, next week I go back to the pawn shop and try to get the same deal. Only this time, the dealer has done a little research and discovered that my custom Maserati is actually a late-model Yugo with a flashy paint job; my original Chagall is actually a paint-by-numbers fake I picked up at a flea market, and my collection of Renaissance gold coins, is actually a scattering of slot-machine slugs with a pyrite finish. So the dealer gets all huffy and says he'll only lend me half of what he had before, ($12,500) But that's a big problem for me, because now I don't have the money to fund my other operations or pay my employees. So I have to dig into savings (bank capital), which makes it harder for me to lend money to anyone else. As time goes on, I am forced to sell more of my personal belongings (assets) just to stay afloat.
This is precisely what happened to the banks during the financial crisis. Financial firms that had been providing full-value for securitized bonds (my Maserati) got worried that those bonds might contain toxic subprime loans (my Yugo). So they reduced the amount of money they would lend on the bonds. These so-called "haircuts" set-off a slow-motion panic that lasted for over a year, draining nearly $4 trillion from the shadow banking system. The problem was compounded by the fact that no one knew which bundles held the worst mortgages or which banks had the biggest pile of bonds. So, interbank lending slowed to a crawl, LIBOR skyrocketed, and the credit markets went into a deep-freeze. When Lehman Brothers defaulted on September 15, 2008, the downward spiral accelerated and the entire financial system crashed. That's why Fed chairman Ben Bernanke stepped in and provided blanket guarantees on the financial assets of banks and shadow banks alike.
The essential problem with shadow banking is that it allows private industry (financial institutions) to generate as much credit as they want, thus, adding to the money supply, increasing economic activity, inflating gigantic asset-price bubbles, and setting the stage for a catastrophic meltdown. Economist James Hamilton explains how this works in a recent post titled "Follow The Money". Here's an excerpt:
"If you buy a mortgage-backed security (or collateralized debt obligation constructed from assorted MBS), you could then issue commercial paper against it to get most of your money back, essentially making the purchase self-financing. This was the idea behind the notorious off-balance sheet structured investment vehicles or conduits, which basically used money borrowed on the commercial paper market to buy various pieces of the mortgage securities created by the loan aggregators. The dollar value of outstanding asset-backed commercial paper nearly doubled between 2004 and 2007.
“Yale Professor Gary Gorton has also emphasized the importance of repo operations involving mortgage-related securities. If I buy a security, I can then pledge it as collateral to obtain a repo loan, again getting most of my money back and allowing the purchase to be mostly self-financing as long as I keep rolling over repos. Although I have not been able to find numbers on the volume of such transactions, it appears to have been quite substantial.
“The question of how the house price run-up was funded thus has a pretty clear answer: Other People's Money. Because of so much money pouring into house purchases, the price was driven up." ("Follow The Money", James Hamilton, Econbrowser)
This is how Wall Street pumped up leverage to ungodly levels and steered the financial system off the cliff. The debt-instruments and repo market were used to create a humongous debt pyramid balanced precariously atop a few crumbs of capital.
Consider this, from an article titled “Liquidity Crises – Understanding sources and limiting consequences: A theoretical framework,” by Robert E. Lucas, Jr. and Nancy L. Stokey:
"In August of 2008, the entire banking system held about $50 billion in actual cash reserves while clearing trades of $2,996 trillion per day. Yet every one of these trades involved an uncontingent promise to pay someone hard cash whenever he asked for it. If ever a system was “runnable,” this was it." (RepoWatch)
Are you kidding me? "$2,996 trillion" in daily trading was propped up an a paltry $50 billion in cash reserves!?! No wonder the system crashed. Even the slightest trace of doubt in the quality of the collateral being exchanged in the repo market, would automatically set off alarms and trigger a panic. And it did!
So, what is the likelihood of that happening again? Are we still in danger?
Yes, we are. In fact, another crisis is probably unavoidable since congress has done nothing to address the repo problem or to make the necessary changes in regulation.
Policymakers need to raise capital requirements, toughen lending standards, and ensure that trading takes place on public platforms that can be monitored by government regulators. Also, financial institutions that function like banks must be regulated like banks. Otherwise, the banks will create more structured instruments that will (eventually) spark another bank run forcing the public to bail out the system once more.
As economics professors T. Sabri Öncü and Viral V. Acharya say, "Leaving the repo market as it currently functions is not an alternative; if this market is not reformed and their participants not made to internalize the liquidity risk, runs on the repo will occur in the future, potentially leading to systemic crises." (RepoWatch)
The only way to prevent another financial crisis is to fix repo, but Dodd-Frank doesn't do that.