Deflation can't really happen unless money gets destroyed or the supply of goods increases faster than the supply of money. I think I've made the case that the supply of goods is probably going to go precipitously down. So how will the supply of money go down faster than that? How will my 150K get taken out of the economy?
I think you make a pretty good point perplexd. But let me give you one better. The Fed owes $8.8 trillion now. Let's make that easier to see
8 800 000 000 000 (yep, 12 zeros).
Everyone seems to think the Fed won't drop rates because they need to protect the value of a dollar. What incentive do they have to protect the value of a dollar? If our inflation adjusted GDP remains constant, but we had inflation of 300%, then the national debt quietly drops below 1990 levels.
Ultimately, we still need to buy oil, though, and people will stop selling it to us if our currency is obviously worthless. Chinese and Indian demand for energy is growing like 6% a year and they can actually pay for it with real goods and services.
So, keeping the confidence game (a.k.a. world reserve currency status) going is way more important than shrinking the debt. It is a rock-and-a-hard-place situation for the Fed where they can't afford to kill the economy, but making our customary imports of everything (but especially oil) impossibly expensive kills the economy anyway.
This is why they will avoid lowering or raising for as long as possible: they don't want to incite the avalanche on either side of the narrow valley they are walking through.
Regarding the inflation vs. deflation, here's something to chew on.
I used to argue the delfation case under a massive credit-loss scenario, but here's the counter argument that has me stumped and almost permanently in the hyperinflation camp...
So here's the counterargument: I still have the 150k and that money can't be destroyed. The bank can't come after me for the new buyer's loan. The money is here to stay, so if I don't put it into housing, then I'll just put it into something else.
Deflation can't really happen unless money gets destroyed or the supply of goods increases faster than the supply of money.
Seems like you're mistaking a Ponzi scheme for wealth creation.
Yes, $150K of real wealth was transfered to you, but you seem to be forgetting that someone else probably lost money, hence the net gain to the money supply may have been positive, negative or 0 depending on how much was lost.
To put it more generally, credit models are used to make predictions about how much people are going to be able to pay back in the future. Money has been lent based on these guestimates that are turning out to be wrong. As more of these future income streams turn out to be insufficient to support past consumption, the loans based on these incomes aren't going to get paid.
Clearly the mortgage lending industry got way ahead of itself in predicting what kind of spending peoples future income streams would support, and we're seeing a fairly sharp retreat in the other direction.
Say in February, you could go into Wells Fargo and qualify for a 125% home loan for $500K, on a $400K house and spend the other $100K on a new BMW M5. Today, Wells says "Nope, you're only good for $400K because we're unwilling to give you a $100K unsecured loan in addition to your home loan".
That money that you could have spend back in the first quarter no longer exists, and nobody got to put it in the bank.
I used to make a very similar argument, but the answer "somebody probably lost money" isn't really satisfactory. Who lost money and was the money just moved around or actually pulled out of the economy? If it wasn't removed from the economy, then I'd say this was a wholly inflationary episode.
Now, it seems to me that the only way it is removed from the economy is if it was somehow the BANK who lost the money [and the Fed doesn't bail them out]. Someone defaults and the money is just gone, period. Then the new money created for other new loans is countered by the money destroyed by the action of the bank just writing a $300,000 loan right off their books.
Is that what they do? I honestly don't know. Somehow I doubt this is that kind of a zero-sum game for the banking industry. It would be like having a casino shut down in vegas because people happened to start beating the odds for a couple weeks, and what's an honest casino operator to do against fate? Well, we know what the casino operator does, but somehow we don't like to think bankers do, effectively, the same things with their 'odds'.
Excellent point. I bet we'll all be learning exactly what the banks have been doing over the next two-three years. That's about how long it took for all the shenanigans in the dot-com fallout to surface.
I used to make a very similar argument, but the answer "somebody probably lost money" isn't really satisfactory.
If a borrower is foreclosed on and the home sold at auction, either the buyer lost the money (down payment) or the bank - depending on the LTV ratio and the sale price.
The meaning of 'lost money' is obscure to me with respect to whether 'lost' means it was destroyed or simply transferred to someone else.
If we have new money created by new loans but never destroyed, then inflation can be our only ultimate destiny. In order to argue anything else, one has to show how the money gets destroyed or removed from the economy.
I can see how that happens if the bankers are required to sustain the losses every time the economy goes south, but the Fed doesn't seem to require them to do that, which is precisely why we see the banks behaving in an increasingly risky manner over the decades. The upshot is that it's a rigged game for them to some extent, and this hints to me that the money doesn't get destroyed by them taking the loss directly.
So, does the money get destroyed, and if so, how?
either the buyer lost the money (down payment) or the bank
If the bank really takes the loss, then the ditech-125 loans don't make any sense to me. If bankers really were fully exposed to anything & everything the buyer doesn't lose, why would they make such stupid loans? I mean, there is no down payment [skin in the game], and rates had to rise, so the ARMs sold at the 1% fed rate almost guaranteed failure. If we can figure this out I'm sure your average banker can too.
Ergo, either the bankers were exceedingly stupid, or they knew they could avoid exposure somehow (e.g. perhaps banking is a rigged game where the regulating agencies are captured just like most every other industry)
So, how do the banks avoid taking the loss then? and if they avoid it, doesn't that mean the money can't be destroyed because it is already out in the economy, just like my $150,000? If you or I take the loss that just means someone else has our money -- it's not destroyed.
Let me review the facts I'm looking at here. When I get a new loan, money is created by a bank right then and there. Even if I default, I already gave that money to someone else and it is out in the economy. My default doesn't make that money disappear. If something does do that, what is it? How does it work?
Let me review the facts I'm looking at here. When I get a new loan, money is created by a bank right then and there. Even if I default, I already gave that money to someone else and it is out in the economy. My default doesn't make that money disappear. If something does do that, what is it? How does it work?
Huh? Banks don't get to create money. Only the Fed does that. Banks can only loan money that they have. They get it either from deposits (think of the old Savings & Loan), loans from other banks or the Fed (that's what the Fed Funds rate is) or increasingly from securitizing the loans and selling them off to the market.
If they are securitizing, they work off a line of credit, say $500mm, that is provided by their underwriter (say, oh - Bear Stearns). When they have funded enough loans, their underwriter packages them up and resells them, then the bank/broker/dealer starts writing more loans for the next package.
That is how New Century and others went under - their underwriter pulled their line of credit, so they couldn't issue any new loans.
If the bank really takes the loss, then the ditech-125 loans don't make any sense to me. If bankers really were fully exposed to anything & everything the buyer doesn't lose, why would they make such stupid loans?
I was wondering about this a few yrs ago when the average home loan started to get exotic. The explanation seems to be that banks weren't concerned with whether people could afford to pay these loans back according to the original payment plans. It was assumed that the loan would either be refinanced or retired when the property was sold.
By and large, this is what happened. Most (probably 75%) of the riskiest loans issued prior to 2006 have already been refinanced or retired, and hence have no outstanding default risk. These lower initial payment loans were (and still are) a good way to "bait" people into taking out ARMS rather than locking in historically low rates. This planned turnover of the loans was where banks made most of their money, not collecting piddly little servicing fees on 30 yr fixed @5%.
The plan all along was to let these borrowers get into a loan they couldn't afford long term, so the bank could later sell them another loan and take a bit of the borrowers equity in the process. This we have seen plenty of.
The problem is that this strategy only works on the way up. The low default rates on this earlier generation of exotic loans were due to appreciation of the homes and increasingly loose lending standards. Now that appreciation is flat to down and lending standards have tightened some there is no 'easy out' for the borrowers and whomever is holding the loan probably isn't going to get full payment.
It seems pretty clear that banks participating in this knew it was game of musical chairs, but were convinced that when the music stopped they wouldn't be the one left holding the bag. Obviously, with 80 mortgage lenders out of business over the past 9 months several guessed wrong. Likewise, the Bear Stearns blowup has given some insight into who the other bag holders are this time around.
I'm sure most of these banks figured that as long as there was a worldwide liquidity glut that there would be no reason to tighten lending standards and no reason for the game to end. And because global liquidity isn't disappearing, there's a good chance that with some restructuring of the mortgage industry we may see housing bubble 2.0.
Huh? Banks don't get to create money. Only the Fed does that. Banks can only loan money that they have.
I think this is incorrect. Anyone who issues more credit than they have in reserves is "creating" money. In fact, central banks play a relatively minor role in money creation today, with most money being creating by a whole host of financial institutions. Banks routinely lend FAR more money than they actually have in deposits, and so do most other financial institutions.
This is what makes credit contractions so dangerous: there is not actually enough money to cover all the debts, causing deflation as everyone scrambles for cash.
Banks routinely lend FAR more money than they actually have in deposits, and so do most other financial institutions
I think you are confused. Banks have a reserve requirement, which says they can't even loan out 100% of what they take in deposits. There is a multiplier effect in terms of loaned money coming back as deposits, and then being loaned out again, which in essence "creates" money - but that is not the same as what you are saying. A bank doing what you suggest would be shut down immediately. and I am not sure what other type of financial institution you are talking about - but I don't know of any that can lend money they don't have.
Yes, the main way that banks issue more money in loans than they recieve in actual deposits is by accepting deposits of borrowed money as if it was real cash.
Don't non-bank entities (e.g. Freddie-Mac, Goldman Sachs, hedge funds) have the ability to create money even easier than regulated banks? My understanding is that a lot of the new money being created these days is from non-traditional sources creating all kinds of new securities (e.g. CDOs, etc) that can then be borrowed against.
Don't non-bank entities (e.g. Freddie-Mac, Goldman Sachs, hedge funds) have the ability to create money even easier than regulated banks? My understanding is that a lot of the new money being created these days is from non-traditional sources creating all kinds of new securities (e.g. CDOs, etc) that can then be borrowed against.
As long as the mortgage loans can be securitized and sold, the reserve requirements don't put much restriction on how many loans can be issued. The faster they can sell the securities the more new loans they can originate. There's another issue of how much the loan originators are required to hold in reserve to comply with contractual obligagions to the loan buyers. But as New Century demonstrated, nobody was keeping too close of tabs on those buyback reserves until they were depleted.
In retrospect, it looks like most of the bankrupt mortgage lenders spent 2006 shoveling crap into RMBS and getting it out the door before the buyers caught a wiff. Given that the whole concept of a "conforming loan" developed over decades to protect investors from this kind of repackaging of garbage it's amazing that there was such demand for this type of security at such high prices. But that's what a credit bubble will do.
From the looks of it, Alt-A is a real mixed bag. The lack of guidelines makes accurate analysis and rating of these securities close to impossible, especially as underwriting standards went down the tubes. I expect to see some big surprises both positive and negative with regard to these loan portfolios.
As long as the mortgage loans can be securitized and sold, the reserve requirements don't put much restriction on how many loans can be issued. The faster they can sell the securities the more new loans they can originate.
Stricly speaking, I am not sure that simply writing loans and selling them off to investors would "expand" the money supply in and of itself. However, if someone created a security (e.g. CDO) that was based off of a mortgage, and then borrowed money based on the supposed value of that security, then we might actually see an expansion of the money supply.
Stricly speaking, I am not sure that simply writing loans and selling them off to investors would "expand" the money supply in and of itself.
Yep, using the security as collateral for further borrowing/investing is the next step. (Bear Stearns FTW!)
Just the process of writing the loans only moves money from one place to another. Using worthless collateral for highly leveraged investments however...
What kills me is the underlying value of the subprime securities is tied up in future cash flows from known deadbeats. Seriously messed up.
Say I put $50k in the bank. The bank loans 80% of it out for someone to buy a house. Now I still have $50k in the bank and someone else has $50k for selling their house. The bank could run out of money if everyone tries to withdraw their savings at the same time or if too many of its loans go bad. What happens if the bank runs out of money and I want to withdraw my money? The government enacts its FDIC insurance and either prints more money or collects more taxes to make up the deficit. That either creates money which in turn devalues your money, or reduces the amount of money you have due to increased taxes.
Banks making long term loans has the effect of increasing the money supply. That supply may not dry up if the government is forced to match that increase if the whole thing unravels.
As long as the mortgage loans can be securitized and sold, the reserve requirements don't put much restriction on how many loans can be issued. The faster they can sell the securities the more new loans they can originate.
Stricly speaking, I am not sure that simply writing loans and selling them off to investors would "expand" the money supply in and of itself.
Simply writing new loans expands the money supply if you have less than 100% reserve against that loan, which nobody has 100% reserve, much less even 1% anymore.
Say I put $50k in the bank. The bank loans 80% of it out for someone to buy a house. Now I still have $50k in the bank and someone else has $50k for selling their house. The bank could run out of money if everyone tries to withdraw their savings at the same time or if too many of its loans go bad. What happens if the bank runs out of money and I want to withdraw my money?
First of all, if you put $50k in the bank, the bank probably loans out $500k to 2-3 million based on those reserves.
Second of all, the bank doesn't run out of money because they just borrow from other banks or the Fed. The "Fereal Funds Rate" that is announced at each Fed meeting is the overnight rate for banks to borrow from the Fed.
In the 30's people went to the bank to try to get cash and the banks had none. Now that we're all electronic, you'll never have that problem unless the Fed decides to let the bank fail.
First of all, if you put $50k in the bank, the bank probably loans out $500k to 2-3 million based on those reserves.
Second of all, the bank doesn't run out of money because they just borrow from other banks or the Fed. The "Fereal Funds Rate" that is announced at each Fed meeting is the overnight rate for banks to borrow from the Fed.
No, a bank can't loan $500k if they only have $50k. They can't even loan $50,001. The "reserve requirement" is one of the feds tools, along with the discount rate, and buying and selling of t-bills - that it uses control the money supply. If they set a lower reserve rate - they get a higher multiplier. If they set a higher reserve rate -a lower mulitplier. But there IS a reserve rate and banks DON'T lend more than they take in in deposits. If they loan out $500k - it is because they got more than $500k in deposits. True that it may be the same money cycled through the economy 10x, but that takes time. It is the rate of that cycling the Fed tries to control with the reserve requirment.
Fractional-reserve banking refers to the common banking practice of issuing more money than the bank holds as reserves.
Ultimately, the issue is that deposits double as a savings account and the bank's money. You wouldn't think the bank can loan out money that isn't theirs, but if you have a savings account, this is exactly what happens, the money is "yours", but it is also loaned out. Nice sleight of hand, eh?
Then on top of that double-counting, if the reserve requirement is 1%, then you have $100 in savings and the bank also created $99 of new money as loans. Then that $99 goes into someone else's bank account, and $98 of that subsequent deposit can be loaned out again, and so on.
So, because of the fact that a deposit acts as both savings and "the bank's money" at the same time, it is more than the reserve, and the fractional reserve multiplier means the money created is much, much more than simply this doppleganger-deposit amount.
No, if you put 50k in the bank, and the bank loans out 49,500, and the person they loan it to spends it, and deposits it in another bank (or maybe the same bank), and then 49,450 is loaned out from those reserves, and so on.
It could be different banks doing the loaning overall, but the money creation is the same, and far, far larger than the deposits which started the ball rolling.
No, if you put 50k in the bank, and the bank loans out 49,500, and the person they loan it to spends it, and deposits it in another bank (or maybe the same bank), and then 49,450 is loaned out from those reserves, and so on.
It could be different banks doing the loaning overall, but the money creation is the same, and far, far larger than the deposits which started the ball rolling.
What you've emphatically stated as possible, probably is possible. However, it is incredibly unlikely, and here's why.
I save $50k, which the bank pays me 4% to use (MMA). The bank loans that money out to someone else at a higher rate than they pay me, say 6.5%. So the entity borrowing it now has $48k. Why would they invest that back into the bank at 4%? In fact, if you know anyone who is willing to borrow $X from me at a high percent and then loan it back to me at a low percent, please introduce me! I'll play that game all day long.
Perplexd
yes, same thing I was saying with numbers X 10%. I understand the multiplier.
Rose -
The scenario you described there is how an S&L works. You might notice, S&Ls aren't as common as they used to be... but think about CDs, little old ladies, etc.
Perplexd
yes, same thing I was saying with numbers X 10%. I understand the multiplier.
Rose -
The scenario you described there is how an S&L works. You might notice, S&Ls aren't as common as they used to be... but think about CDs, little old ladies, etc.
Well, I think my point was that regardless of the banking model you use, it is really predicated on interest rates dampening the loans entities are willing to take out. This dampening effect should help prevent "Free Cash Forever"
Well, I think my point was that regardless of the banking model you use, it is really predicated on interest rates dampening the loans entities are willing to take out.
Actually, I am not so sure that interest rates have all that much of an impact on the number of loans made. People were much more eager to borrow money in Japan during the 1980s when interest rates were much higher than they are today.
I think that the desire to borrow (and lend) is more a function of the optimism people have for future economic prospects rather than the interest rate levels themselves. I am sure that low interest rates are somewhat stimulative, but in and of themselves low interest rates won't spur borrowing/lending.
perplexd is correct on this issue about Banking, as I used to work for a bank and was amazed at how the ponzi scheme worked!
Banks only have to keep ~5% of deposits in reserves (mandated by the FED). However most keep an additional 1%-2% for liquidity issues so they dont have bank runs or have to deal with credibility issues.
This allows banks to lend out ~93% of your money you deposit. So of the $50K in your bank account the bank gives you 1% in your checking account and lends it out for mortgages at 6.5% (damn cheap money for them, which is why banks fight for deposits...cheapest money known to bank kind). Which means they only have to keep $3.5K "in the bank", allowing them to lend the rest. This is why banking is so profitable!!!
The kicker is that with the mulitpication factor this essentially creates a 14.3 (1/7%) times the money supply in the market, or $714K in additonal money in the economy to be loaned out...which is a main source of how banks "find" money to lend. [My math is approximated, yet the concept is 100% correct.]
This is why when the FED increases the Money Supply by a small percentage it causes such large waves throughout the financial market. Thus the reason a 0.01% (1 basis point) change in the market has a large impact (epecially with hedge funds that operate like a bank, double the 14.3 times leverage with LBO's).
Which is when the credit markets fall it wont be pretty...which is why I locked my refi rate in today (got a killer deal due to my 40% raise at work that reduced my DTI ratio, even though rates have recently gone up).
Comments
I think you make a pretty good point perplexd. But let me give you one better. The Fed owes $8.8 trillion now. Let's make that easier to see
8 800 000 000 000 (yep, 12 zeros).
Everyone seems to think the Fed won't drop rates because they need to protect the value of a dollar. What incentive do they have to protect the value of a dollar? If our inflation adjusted GDP remains constant, but we had inflation of 300%, then the national debt quietly drops below 1990 levels.
For more fun, check out these debt clocks.
So, keeping the confidence game (a.k.a. world reserve currency status) going is way more important than shrinking the debt. It is a rock-and-a-hard-place situation for the Fed where they can't afford to kill the economy, but making our customary imports of everything (but especially oil) impossibly expensive kills the economy anyway.
This is why they will avoid lowering or raising for as long as possible: they don't want to incite the avalanche on either side of the narrow valley they are walking through.
Seems like you're mistaking a Ponzi scheme for wealth creation.
Yes, $150K of real wealth was transfered to you, but you seem to be forgetting that someone else probably lost money, hence the net gain to the money supply may have been positive, negative or 0 depending on how much was lost.
To put it more generally, credit models are used to make predictions about how much people are going to be able to pay back in the future. Money has been lent based on these guestimates that are turning out to be wrong. As more of these future income streams turn out to be insufficient to support past consumption, the loans based on these incomes aren't going to get paid.
Clearly the mortgage lending industry got way ahead of itself in predicting what kind of spending peoples future income streams would support, and we're seeing a fairly sharp retreat in the other direction.
Say in February, you could go into Wells Fargo and qualify for a 125% home loan for $500K, on a $400K house and spend the other $100K on a new BMW M5. Today, Wells says "Nope, you're only good for $400K because we're unwilling to give you a $100K unsecured loan in addition to your home loan".
That money that you could have spend back in the first quarter no longer exists, and nobody got to put it in the bank.
It's gone.
Now, it seems to me that the only way it is removed from the economy is if it was somehow the BANK who lost the money [and the Fed doesn't bail them out]. Someone defaults and the money is just gone, period. Then the new money created for other new loans is countered by the money destroyed by the action of the bank just writing a $300,000 loan right off their books.
Is that what they do? I honestly don't know. Somehow I doubt this is that kind of a zero-sum game for the banking industry. It would be like having a casino shut down in vegas because people happened to start beating the odds for a couple weeks, and what's an honest casino operator to do against fate? Well, we know what the casino operator does, but somehow we don't like to think bankers do, effectively, the same things with their 'odds'.
Excellent point. I bet we'll all be learning exactly what the banks have been doing over the next two-three years. That's about how long it took for all the shenanigans in the dot-com fallout to surface.
If a borrower is foreclosed on and the home sold at auction, either the buyer lost the money (down payment) or the bank - depending on the LTV ratio and the sale price.
Is this obscure?
If we have new money created by new loans but never destroyed, then inflation can be our only ultimate destiny. In order to argue anything else, one has to show how the money gets destroyed or removed from the economy.
I can see how that happens if the bankers are required to sustain the losses every time the economy goes south, but the Fed doesn't seem to require them to do that, which is precisely why we see the banks behaving in an increasingly risky manner over the decades. The upshot is that it's a rigged game for them to some extent, and this hints to me that the money doesn't get destroyed by them taking the loss directly.
So, does the money get destroyed, and if so, how?
If the bank really takes the loss, then the ditech-125 loans don't make any sense to me. If bankers really were fully exposed to anything & everything the buyer doesn't lose, why would they make such stupid loans? I mean, there is no down payment [skin in the game], and rates had to rise, so the ARMs sold at the 1% fed rate almost guaranteed failure. If we can figure this out I'm sure your average banker can too.
Ergo, either the bankers were exceedingly stupid, or they knew they could avoid exposure somehow (e.g. perhaps banking is a rigged game where the regulating agencies are captured just like most every other industry)
So, how do the banks avoid taking the loss then? and if they avoid it, doesn't that mean the money can't be destroyed because it is already out in the economy, just like my $150,000? If you or I take the loss that just means someone else has our money -- it's not destroyed.
Let me review the facts I'm looking at here. When I get a new loan, money is created by a bank right then and there. Even if I default, I already gave that money to someone else and it is out in the economy. My default doesn't make that money disappear. If something does do that, what is it? How does it work?
Huh? Banks don't get to create money. Only the Fed does that. Banks can only loan money that they have. They get it either from deposits (think of the old Savings & Loan), loans from other banks or the Fed (that's what the Fed Funds rate is) or increasingly from securitizing the loans and selling them off to the market.
If they are securitizing, they work off a line of credit, say $500mm, that is provided by their underwriter (say, oh - Bear Stearns). When they have funded enough loans, their underwriter packages them up and resells them, then the bank/broker/dealer starts writing more loans for the next package.
That is how New Century and others went under - their underwriter pulled their line of credit, so they couldn't issue any new loans.
I was wondering about this a few yrs ago when the average home loan started to get exotic. The explanation seems to be that banks weren't concerned with whether people could afford to pay these loans back according to the original payment plans. It was assumed that the loan would either be refinanced or retired when the property was sold.
By and large, this is what happened. Most (probably 75%) of the riskiest loans issued prior to 2006 have already been refinanced or retired, and hence have no outstanding default risk. These lower initial payment loans were (and still are) a good way to "bait" people into taking out ARMS rather than locking in historically low rates. This planned turnover of the loans was where banks made most of their money, not collecting piddly little servicing fees on 30 yr fixed @5%.
The plan all along was to let these borrowers get into a loan they couldn't afford long term, so the bank could later sell them another loan and take a bit of the borrowers equity in the process. This we have seen plenty of.
The problem is that this strategy only works on the way up. The low default rates on this earlier generation of exotic loans were due to appreciation of the homes and increasingly loose lending standards. Now that appreciation is flat to down and lending standards have tightened some there is no 'easy out' for the borrowers and whomever is holding the loan probably isn't going to get full payment.
It seems pretty clear that banks participating in this knew it was game of musical chairs, but were convinced that when the music stopped they wouldn't be the one left holding the bag. Obviously, with 80 mortgage lenders out of business over the past 9 months several guessed wrong. Likewise, the Bear Stearns blowup has given some insight into who the other bag holders are this time around.
I'm sure most of these banks figured that as long as there was a worldwide liquidity glut that there would be no reason to tighten lending standards and no reason for the game to end. And because global liquidity isn't disappearing, there's a good chance that with some restructuring of the mortgage industry we may see housing bubble 2.0.
I think this is incorrect. Anyone who issues more credit than they have in reserves is "creating" money. In fact, central banks play a relatively minor role in money creation today, with most money being creating by a whole host of financial institutions. Banks routinely lend FAR more money than they actually have in deposits, and so do most other financial institutions.
This is what makes credit contractions so dangerous: there is not actually enough money to cover all the debts, causing deflation as everyone scrambles for cash.
I think you are confused. Banks have a reserve requirement, which says they can't even loan out 100% of what they take in deposits. There is a multiplier effect in terms of loaned money coming back as deposits, and then being loaned out again, which in essence "creates" money - but that is not the same as what you are saying. A bank doing what you suggest would be shut down immediately. and I am not sure what other type of financial institution you are talking about - but I don't know of any that can lend money they don't have.
Perhaps this will help
http://money.howstuffworks.com/bank1.htm
Yes, the main way that banks issue more money in loans than they recieve in actual deposits is by accepting deposits of borrowed money as if it was real cash.
http://en.wikipedia.org/wiki/Fractional-reserve_banking
Don't non-bank entities (e.g. Freddie-Mac, Goldman Sachs, hedge funds) have the ability to create money even easier than regulated banks? My understanding is that a lot of the new money being created these days is from non-traditional sources creating all kinds of new securities (e.g. CDOs, etc) that can then be borrowed against.
As long as the mortgage loans can be securitized and sold, the reserve requirements don't put much restriction on how many loans can be issued. The faster they can sell the securities the more new loans they can originate. There's another issue of how much the loan originators are required to hold in reserve to comply with contractual obligagions to the loan buyers. But as New Century demonstrated, nobody was keeping too close of tabs on those buyback reserves until they were depleted.
In retrospect, it looks like most of the bankrupt mortgage lenders spent 2006 shoveling crap into RMBS and getting it out the door before the buyers caught a wiff. Given that the whole concept of a "conforming loan" developed over decades to protect investors from this kind of repackaging of garbage it's amazing that there was such demand for this type of security at such high prices. But that's what a credit bubble will do.
From the looks of it, Alt-A is a real mixed bag. The lack of guidelines makes accurate analysis and rating of these securities close to impossible, especially as underwriting standards went down the tubes. I expect to see some big surprises both positive and negative with regard to these loan portfolios.
Stricly speaking, I am not sure that simply writing loans and selling them off to investors would "expand" the money supply in and of itself. However, if someone created a security (e.g. CDO) that was based off of a mortgage, and then borrowed money based on the supposed value of that security, then we might actually see an expansion of the money supply.
Yep, using the security as collateral for further borrowing/investing is the next step. (Bear Stearns FTW!)
Just the process of writing the loans only moves money from one place to another. Using worthless collateral for highly leveraged investments however...
What kills me is the underlying value of the subprime securities is tied up in future cash flows from known deadbeats. Seriously messed up.
Banks making long term loans has the effect of increasing the money supply. That supply may not dry up if the government is forced to match that increase if the whole thing unravels.
Simply writing new loans expands the money supply if you have less than 100% reserve against that loan, which nobody has 100% reserve, much less even 1% anymore.
First of all, if you put $50k in the bank, the bank probably loans out $500k to 2-3 million based on those reserves.
Second of all, the bank doesn't run out of money because they just borrow from other banks or the Fed. The "Fereal Funds Rate" that is announced at each Fed meeting is the overnight rate for banks to borrow from the Fed.
In the 30's people went to the bank to try to get cash and the banks had none. Now that we're all electronic, you'll never have that problem unless the Fed decides to let the bank fail.
No, a bank can't loan $500k if they only have $50k. They can't even loan $50,001. The "reserve requirement" is one of the feds tools, along with the discount rate, and buying and selling of t-bills - that it uses control the money supply. If they set a lower reserve rate - they get a higher multiplier. If they set a higher reserve rate -a lower mulitplier. But there IS a reserve rate and banks DON'T lend more than they take in in deposits. If they loan out $500k - it is because they got more than $500k in deposits. True that it may be the same money cycled through the economy 10x, but that takes time. It is the rate of that cycling the Fed tries to control with the reserve requirment.
http://money.howstuffworks.com/fed8.htm
The link you provided says
Seems like exactly what I've been saying...
Look at the article sniglet posted again:
http://en.wikipedia.org/wiki/Fractional-reserve_banking
Ultimately, the issue is that deposits double as a savings account and the bank's money. You wouldn't think the bank can loan out money that isn't theirs, but if you have a savings account, this is exactly what happens, the money is "yours", but it is also loaned out. Nice sleight of hand, eh?
Then on top of that double-counting, if the reserve requirement is 1%, then you have $100 in savings and the bank also created $99 of new money as loans. Then that $99 goes into someone else's bank account, and $98 of that subsequent deposit can be loaned out again, and so on.
So, because of the fact that a deposit acts as both savings and "the bank's money" at the same time, it is more than the reserve, and the fractional reserve multiplier means the money created is much, much more than simply this doppleganger-deposit amount.
This was not
So in your example, I think it would be:
if you put $500k in the bank, the bank probably loans out $450-485k and keeps only $15-50k in reserves
not
if you put $50k in the bank, the bank probably loans out $500k to 2-3 million based on those reserves.
It could be different banks doing the loaning overall, but the money creation is the same, and far, far larger than the deposits which started the ball rolling.
What you've emphatically stated as possible, probably is possible. However, it is incredibly unlikely, and here's why.
I save $50k, which the bank pays me 4% to use (MMA). The bank loans that money out to someone else at a higher rate than they pay me, say 6.5%. So the entity borrowing it now has $48k. Why would they invest that back into the bank at 4%? In fact, if you know anyone who is willing to borrow $X from me at a high percent and then loan it back to me at a low percent, please introduce me! I'll play that game all day long.
yes, same thing I was saying with numbers X 10%. I understand the multiplier.
Rose -
The scenario you described there is how an S&L works. You might notice, S&Ls aren't as common as they used to be... but think about CDs, little old ladies, etc.
Well, I think my point was that regardless of the banking model you use, it is really predicated on interest rates dampening the loans entities are willing to take out. This dampening effect should help prevent "Free Cash Forever"
Actually, I am not so sure that interest rates have all that much of an impact on the number of loans made. People were much more eager to borrow money in Japan during the 1980s when interest rates were much higher than they are today.
I think that the desire to borrow (and lend) is more a function of the optimism people have for future economic prospects rather than the interest rate levels themselves. I am sure that low interest rates are somewhat stimulative, but in and of themselves low interest rates won't spur borrowing/lending.
Banks only have to keep ~5% of deposits in reserves (mandated by the FED). However most keep an additional 1%-2% for liquidity issues so they dont have bank runs or have to deal with credibility issues.
This allows banks to lend out ~93% of your money you deposit. So of the $50K in your bank account the bank gives you 1% in your checking account and lends it out for mortgages at 6.5% (damn cheap money for them, which is why banks fight for deposits...cheapest money known to bank kind). Which means they only have to keep $3.5K "in the bank", allowing them to lend the rest. This is why banking is so profitable!!!
The kicker is that with the mulitpication factor this essentially creates a 14.3 (1/7%) times the money supply in the market, or $714K in additonal money in the economy to be loaned out...which is a main source of how banks "find" money to lend. [My math is approximated, yet the concept is 100% correct.]
This is why when the FED increases the Money Supply by a small percentage it causes such large waves throughout the financial market. Thus the reason a 0.01% (1 basis point) change in the market has a large impact (epecially with hedge funds that operate like a bank, double the 14.3 times leverage with LBO's).
Which is when the credit markets fall it wont be pretty...which is why I locked my refi rate in today (got a killer deal due to my 40% raise at work that reduced my DTI ratio, even though rates have recently gone up).
congratulations
:twisted: