Zbigniew Piekarski How banks balance the books
"A man is judged not on how he begins, but how he finishes,"
- L. Miller, King of the Hobbits.
Phase I of the Bear Market - the retreat - was relatively orderly and calm. A little panic set in when the FT100 had a record losing streak of eleven days in a row (from January 13 to 27, 2003) but the bounce from March 13 of last year has raised the social mood to historic extremes of optimism. Rebounds after major market collapses are driven by 'linear thinking' and a 'conservatist bias' as investors are unwilling to give up their belief that markets and asset values always rise.
Unfortunately, two weeks ago saw this year's first weekly back-to-back declines in the S&P 500; the Dow Industrials ended lower in seven of the 13 weeks this year and the NASDAQ in nine of 13 weeks. Yet cash is flowing into U.S. stock mutual funds at the fastest rate since early 2000, and the total amount, if annualized, may even top the $309 billion (zł.1,198 billion) that American retail investors poured into stock market mutual funds just before the peak. The retail investor always piles in after the party has ended.
There may be a little more action on the upside, but uncertainties are clouding the horizon and Phase II of the Bear will be more disturbing as all asset classes start to decline.
The dollar is the reserve currency of the entire world and the Fed is the bubble-maker. Its rates, the lowest in over 45 years, have underwritten a huge boom in debt all over the globe. Assets backed by debt, especially property, have bubbled everywhere and prices as a percentage of personal incomes are at their highest levels ever in the USA, Australia, Ireland, the Netherlands, Spain and especially in the UK.
Property is a bigger business than stocks and shares. While there are about $30 trillion (zł.116 trillion) worth of stocks in the world, the property market is estimated at about $50 trillion (zł.194 trillion). Much of it is heavily mortgaged. In the expansion phase of the debt cycle, debt increases and everything you can buy with debt is bid upwards. In the contraction phase, which is just beginning, debt will be paid down, downgraded, discounted, renegotiated and written off. What it bought, notably property, will go down.
In the collapse of a property market there are no winners. Both the borrower and the lender lose. Jabberwockies comment that increases in interest rates may, eventually, curtail the property bubble and result in a 'correction.' But an increase in interest rates is not required to start the cycle of contraction, merely the inability to service interest payments or a contraction in demand.
Lenders are very conscious of the latter and continue to develop programs with ever easier terms, including low down-payment interest-only mortgages and 'self-certification,' in which you do not have to provide proof of your ability to service the debt. The last time such easy loans were prevalent was in the late 1920s, leading up to the Great Depression when, during the fourth year, 1933, roughly half of all mortgage debt was in default and house prices collapsed by roughly 80 percent. The seeds of disaster have already been sown and a slight upward bias in interest rates could do for the average house and the banking system what Al Qaeda does to hotels in Baghdad or Israel does to wheel-chair bound, half-blind and half-deaf militant preachers as they leave morning prayers.
Most people believe that banks re-circulate deposits, that they lend money that has been saved by others. Nothing could be further from the truth. Banks create money out of nothing and call it 'fractional reserve lending.'
When politicians decide that their country needs another $9 million (zł.35 million) they pass the relevant legislation enabling the Treasury to print an IOU for that amount. The Treasury agents then go to the banks and ask them to buy that IOU. The banks go to their computers and type in $9 million. It is as simple as that.
The books are always in balance as on the asset side is the $9 million in Government bonds and on the liabilities side is the $9 million that the banks have created. Money is never taken out of the banks. It never leaves the system.
This is a good deal for the politicians, as they have spent money without raising taxes, and a good deal for the banks, who get 'interest' on the government bonds that they 'bought.'
Not only do banks create money when they lend to the government, they create money when they lend to anyone. For example, if you get a $100,000 (zł.387,551) mortgage from Citibank, where do you suppose Citibank gets the $100,000 which they credit to your account? After they lend you the money is there a single depositor in the bank who has any less money in their account than before they lent you the money? As with the $9million, the bank creates the money with a simple bookkeeping entry.
Banks are motivated to create as much money as they can, as on each transaction they siphon off their share in terms of interest and fees. In fact, this simple process is so profitable that there has been an explosion in the number of parties entering this sector - take General Motors for example.
In order to continue to generate fees and interest payments, banks have had to lend to fewer credit-worthy borrowers and for more non-liqiud assets such as property. This is a very unstable situation and some in the banking industry know that.
Thus, they have encouraged the creation of sophisticated financial instruments (which they do not understand) that are designed to spread the burden of default within one localized area or sector onto each and every one of us. The butterfly is about to start flapping its wings.
Cycles repeat. On January 16, 1920, the importing, exporting, transporting, selling and manufacturing of intoxicating liquor was banned in the USA (instigators: expatriate Irish Women). March 29, 2004, smoking in all workplaces and public places was banned in the Republic of Ireland (instigators: local Irish Women). The only exceptions are prisons, psychiatric wards, nursing homes and hotel rooms. Penalty for smoking: 3,000 (zl.14,208).
- L. Miller, King of the Hobbits.
Phase I of the Bear Market - the retreat - was relatively orderly and calm. A little panic set in when the FT100 had a record losing streak of eleven days in a row (from January 13 to 27, 2003) but the bounce from March 13 of last year has raised the social mood to historic extremes of optimism. Rebounds after major market collapses are driven by 'linear thinking' and a 'conservatist bias' as investors are unwilling to give up their belief that markets and asset values always rise.
Unfortunately, two weeks ago saw this year's first weekly back-to-back declines in the S&P 500; the Dow Industrials ended lower in seven of the 13 weeks this year and the NASDAQ in nine of 13 weeks. Yet cash is flowing into U.S. stock mutual funds at the fastest rate since early 2000, and the total amount, if annualized, may even top the $309 billion (zł.1,198 billion) that American retail investors poured into stock market mutual funds just before the peak. The retail investor always piles in after the party has ended.
There may be a little more action on the upside, but uncertainties are clouding the horizon and Phase II of the Bear will be more disturbing as all asset classes start to decline.
The dollar is the reserve currency of the entire world and the Fed is the bubble-maker. Its rates, the lowest in over 45 years, have underwritten a huge boom in debt all over the globe. Assets backed by debt, especially property, have bubbled everywhere and prices as a percentage of personal incomes are at their highest levels ever in the USA, Australia, Ireland, the Netherlands, Spain and especially in the UK.
Property is a bigger business than stocks and shares. While there are about $30 trillion (zł.116 trillion) worth of stocks in the world, the property market is estimated at about $50 trillion (zł.194 trillion). Much of it is heavily mortgaged. In the expansion phase of the debt cycle, debt increases and everything you can buy with debt is bid upwards. In the contraction phase, which is just beginning, debt will be paid down, downgraded, discounted, renegotiated and written off. What it bought, notably property, will go down.
In the collapse of a property market there are no winners. Both the borrower and the lender lose. Jabberwockies comment that increases in interest rates may, eventually, curtail the property bubble and result in a 'correction.' But an increase in interest rates is not required to start the cycle of contraction, merely the inability to service interest payments or a contraction in demand.
Lenders are very conscious of the latter and continue to develop programs with ever easier terms, including low down-payment interest-only mortgages and 'self-certification,' in which you do not have to provide proof of your ability to service the debt. The last time such easy loans were prevalent was in the late 1920s, leading up to the Great Depression when, during the fourth year, 1933, roughly half of all mortgage debt was in default and house prices collapsed by roughly 80 percent. The seeds of disaster have already been sown and a slight upward bias in interest rates could do for the average house and the banking system what Al Qaeda does to hotels in Baghdad or Israel does to wheel-chair bound, half-blind and half-deaf militant preachers as they leave morning prayers.
Most people believe that banks re-circulate deposits, that they lend money that has been saved by others. Nothing could be further from the truth. Banks create money out of nothing and call it 'fractional reserve lending.'
When politicians decide that their country needs another $9 million (zł.35 million) they pass the relevant legislation enabling the Treasury to print an IOU for that amount. The Treasury agents then go to the banks and ask them to buy that IOU. The banks go to their computers and type in $9 million. It is as simple as that.
The books are always in balance as on the asset side is the $9 million in Government bonds and on the liabilities side is the $9 million that the banks have created. Money is never taken out of the banks. It never leaves the system.
This is a good deal for the politicians, as they have spent money without raising taxes, and a good deal for the banks, who get 'interest' on the government bonds that they 'bought.'
Not only do banks create money when they lend to the government, they create money when they lend to anyone. For example, if you get a $100,000 (zł.387,551) mortgage from Citibank, where do you suppose Citibank gets the $100,000 which they credit to your account? After they lend you the money is there a single depositor in the bank who has any less money in their account than before they lent you the money? As with the $9million, the bank creates the money with a simple bookkeeping entry.
Banks are motivated to create as much money as they can, as on each transaction they siphon off their share in terms of interest and fees. In fact, this simple process is so profitable that there has been an explosion in the number of parties entering this sector - take General Motors for example.
In order to continue to generate fees and interest payments, banks have had to lend to fewer credit-worthy borrowers and for more non-liqiud assets such as property. This is a very unstable situation and some in the banking industry know that.
Thus, they have encouraged the creation of sophisticated financial instruments (which they do not understand) that are designed to spread the burden of default within one localized area or sector onto each and every one of us. The butterfly is about to start flapping its wings.
Cycles repeat. On January 16, 1920, the importing, exporting, transporting, selling and manufacturing of intoxicating liquor was banned in the USA (instigators: expatriate Irish Women). March 29, 2004, smoking in all workplaces and public places was banned in the Republic of Ireland (instigators: local Irish Women). The only exceptions are prisons, psychiatric wards, nursing homes and hotel rooms. Penalty for smoking: 3,000 (zl.14,208).
