Real Estate Hedge Funds

Tesanista said …
“This is a great blog! Could you look into Real Estate Hedges? I saw an article on them on the housingbubble2 spot this evening. Do you know anything about them?
True.. I was specifically wondering if you had seen any data on the Real Estate Hedge Funds that are suposed to start trading in the spring of '06 (I think). I would like to find out their makeup and metrics.”

Tesanista,

I have not seen any such data yet. Hedge funds are known for their secrecy. The problem with Real Estate Hedge funds during a down fall is the risk of counter-party fault.

Even if the hedge fund has financial derivatives designed to take advantage of a declining market, the decline may bankrupt the counter-party so fast as to make it impossible to collect any such money.

For example say that I design a derivative which gives me the right to sell real estate for a price set today, but for one year in the future. The underlyer of the derivative is a specific unit of real estate like 1015 half street. The price of the option is 10% the price of the property.

The price of the property declines from say a starting value of $1,000,000 to $700,000. The derivative is 10% of the initial price of the property at a cost of $100,000. Therefore the derivative is worth $200,000 ($1,000,000-$700,000-$100,000).

The hedge fund demands this money from the counter-party, the financial entity on the other side of the derivative. If the counter-party has lost too much money it falls into chapter 11 bankruptcy (protection from creditors, or protection from having to pay the hedge fund).

Now the hedge fund cannot be paid and still looses. This can induce the hedge fund going into bankruptcy.

In reality the government has historically stepped in and assumes the debt from the defaulting financial institution in the name of systemic risk. The government then pays the hedge fund with US government debt or by just creating new money. Both methods of bailouts expand the broad based money supply.

Here is the real trick, when does this lead to broad based inflation?

It is when the money in circulation increases as opposed to the total money supply, then prices for general goods and services increase.

If the money is trapped in loans, loans which are used to purchase assets, they you get asset inflation.

Any money which is created and enters general circulation may also be taken out of circulation by a negative trade balance, investment, or foreign investment.

Therefore a currency may be hyperinflated, and broad based inflation is not felt in goods and services, however assets inflate at a rate much greater than the increase in the money supply.

Therefore as the financial system defaults, and money is created and the money supply is expanded, the ability to get money out of general circulation is diminished. This causes what most common people call inflation in goods and services.

Does this increase interest rates?

Interest rates are set by supply verses demand. So as long as the government can provide policies which induce the expansion of credit, then interest rates can remain low and actually be forced lower if the supply of credit increases and the demand for credit decreases.

How does this further affect hedge fund hedging strategies?

Hedge funds are part of the financial economy, therefore they are very vulnerable to low interest rates. Therefore the government may rig the system to always pay for the counter-party, but the buying power of that money may decrease, and decrease very quickly.

In the end if the government keeps with this policy then the all assets are then owned by the financial economy as the government transfers wealth to the financial economy at the expanse of the real economy via bailouts and increasing the money supply. Much like the system we have today whereas the real economy is now much smaller than the financial economy.

Therefore the strategy for any hedge fund or financial institution is to take as much risk as possible due to a lack of any real downside risk for major players. The only way this will end is if the other countries stop accepting our currency. Then the value of the real economy shall increase again.

The first sign of a currency rebellion will be when other countries refuse to pay the counter-party failures in their financial systems. Since all financial systems are closely connected, this will effect the US very quickly.

Chromatic Dispersion

The Federal Reserve is no longer tracking M3?

I liked this article from David Chapman

Chromatic Dispersion

Wednesday, November 23, 2005
Federal Reserve Statistical ReleaseNovember 10, 2005
Discontinuance of M3

On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars.

The Board will continue to publish institutional money market mutual funds as a memorandum item in this release.

Measures of large-denomination time deposits will continue to be published by the Board in the Flow of Funds Accounts (Z.1 release) on a quarterly basis and in the H.8 release on a weekly basis (for commercial banks).

As a former money market/foreign exchange dealer I grew up in the business on M3. I recall back in the late 1970's when we would sit around on Thursday's awaiting the Federal Reserve's weekly release of the Money Supply numbers. The market would centre on M3. The Bond market and the Eurodollar market would soar or plummet depending on how much M3 grew on the week. Volatility was the name of the game and one could make or lose thousands or more of dollars if you correctly (or incorrectly) surmised the weekly money numbers. As the years went by the weekly money numbers lost some of their aura as they began to target bands of growth or focused elsewhere rather than on the monetary numbers. Still it was never forgotten and dutifully I would go and check the weekly releases to find out how much money supply grew. Old habits die hard.

So what is M3? To understand what M3 is one needs to know what M1 and M2 are as well.

M1 - Money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, NOW accounts, automatic transfer service accounts, and balances in credit unions.

M2 - Money supply that includes M1, plus savings and small time deposits of depository institutions, overnight repos at commercial banks, and retail mutual fund money market accounts.

M3 - Money supply that includes M2, plus large time deposits, repos of maturity greater than one day at commercial banks, institutional money market accounts and Eurodollar deposits of US banks held at foreign branches and at all offices in the UK and Canada.

Note: These are the US definitions of M1, M2 and M3. The Bank of Canada's definitions of M1, M2, and M3 may vary.

While M1 and M2 are measurements of money that are held for the most part by the general public M3 adds the huge institutional funds to the equation. These funds are generally the most liquid funds. It does not capture all of the institutional funds but it does capture an important part of it sufficient enough to measure the growth of money in the financial system. It is M3 that has experienced the most explosive growth in the past decade. Since the end of 1995 M1 has increased a paltry 18.8% while M2 is up 89.5%. But M3 is up 130%. GDP by comparison is up roughly 67% in the same period so M3 growth is almost double GDP growth. Consumer debt has grown about 123% in the same period or about equivalent to M3 growth. Business debt is up 97%. It has taken an incredible amount of debt and money to obtain GDP growth over the past decade. This is monetary inflation at its best.

I have never paid a whole lot of attention to M2 and even less attention to M1.In the broader scheme of things they were just not as important as M3. Only M3 told us what was really going on with monetary growth and the big money is in the institutions. If the stock market started to jump sharply even though neither the economic situation nor the economic outlook shifted substantially one could look over at the monetary numbers and depending on how they grew get a good idea why the market was rising (or falling if M3 growth was exceptionally sluggish).

One certainly didn't rush to look at M1. Noting that M1 grew a paltry .7% in the latest 13 weeks was not significant. While M2 up 5.2% told us a bit more we had to go to M3 and find it up 10.1% in the latest 13 weeks. There is serious money and all that money goes somewhere. The stock market has soared recently. The last time M3 was actually negative was in the early 1990's and if one recalls it was the last time we had a serious recession. Since 1995 M3 growth has soared and this corresponds with the period when the Federal Reserve under Alan Greenspan decided to effectively print their way out of the recessionary early nineties.

M3 is very important. Indeed of the Fed's monetary numbers only M3 was of major importance and in other G7 countries we also focus on M3 including our own Bank of Canada. No word that they intend to follow. So why are they dropping M3? Well we have seen nothing to tell us why we only know they are doing it. Oh it's not that the numbers will completely disappear. For those that wish to take the time they can pore through the Flow of Funds accounts (released quarterly as Z.1 release and the H.8 bulletin released weekly for commercial banks) and piece together the former M3. Painstaking, but that is not the way it is supposed to be. European Central Bankers put great stead in M3 so why has the Fed after all these years decided to cease publication?

Some of the reasons we have seen floated around are as follows:

History has shown that only failing economies e.g. Soviet Union keep data secret (Financial Sense - Toni Straka - Unpleasant M3 Trend, November 12, 2005). An interesting premise and a theme we saw woven amongst a number of writers is that they have something to hide. The claim is that the Fed should be transparent and by not publishing the number the Fed now lacks transparency.

The end of publishing of M3 in March 2006 coincides with the start of the Iranian Oil Bourse. The premise here is that the with the oil bourse trading in Euros there will be a rush out of US$ into Euros and that M3 could drop sharply. A sharp drop in M3 would of course presage a recession as falling M3 is a characteristic of weak economic periods.

M3 is a measure of inflation in the economy. A somewhat unproven rule of thumb is GDP + inflation = M3. Will be able to properly measure inflation going forward if we don't know what M3 really is.

We are about to enter a period of hyperinflation and by eliminating M3 we will not know how much liquidity the Fed is pumping into the system. Remember the Fed doesn't really print money it is the banking system that expands money supply. But the Fed influences it through open market operations. We will have to watch daily Fed repo action very carefully irrespective of whether they are going to publish Repos (RPs) as noted in the bulletin above. The Fed doing repos puts money into the system and the Fed doing reverse repos takes money out of the system. Of course as well this is the exact opposite of the collapse in M3 premised with the oil bourse above.

Further on the theme above a period of hyperinflation would occur as the Fed tries to save us from a collapsing housing market and softer consumer demand. The Fed adds more and more liquidity to the system to stave off a sharp economic decline. By not publishing Repos (RPs) as noticed in their bulletin above the Fed again is hiding what they do on a day to day basis. This will make it difficult for both currency traders and equity traders to know what the Fed is up to.
The conclusion is that the Federal Reserve will be hiding a debasement of the US$.

One writer (Recently announced reporting changes at the Fed - Captain Hook, November 18, 2005 on SafeHaven) compared this move by the Fed to Nixon's closing of the "gold window" in August 1971. It might be although the ceasing of the publication of a widely watched monetary number does not quite compare to a default which is effectively what the US did when they closed the "gold window". But given the importance of M3 to market watchers we do have to wonder at what the Fed wants to hide. As Captain Hook notes "we just got another "big signal" from US monetary authorities that the rules of the game are about to be changed fundamentally, once again."

And the results might be the same. Indeed an examination of gold shows that that gold made a low November 4 near $456. By the time of this announcement Gold had climbed back to $470. Then 3 days later gold leaped and it has been on a tear ever since. This has come despite the recent rise in the US$. Indeed gold prices have been rising now for several weeks despite the strong performance of the US$. While it is possible that the US$ has a target zone of 95 based off what appears as a head and shoulders bottom it is not slowing down the recent jump in gold prices.

Putting aside demand/supply conditions that favour gold right now the recent sharp jump in gold prices can only be explained in light of a realization that a monetary disaster is in the making. Gold is or has been breaking out in a number of currencies recently as well. Gold is the ultimate currency and when it is going up against all currencies it is telling us that something big is going to happen.

































David Chapman Investment Advisor/Technical Strategist Union Securities Ltd. Director of Bullion Management Services Director of Hudson Read Asset Management

I'm Back

Sorry to have not posted in a few weeks. I get busy with work and family myself and I also need time to re-energize.

Chromatic Dispersion

Answer to Jay's Question

This is an answer to the previous post from Jay in the previous post.

Jay,

Interesting argument.

The question of Hyperinflation

Hyperinflation happens by circumstance, not by plan. It is a sign that the government has lost control of its financial resources. Also in a world economy no government can control their currency absolutely outside of their borders. Even the power of the US is dependent upon international consensus. Therefore to indicate in a major banking crisis that the US can control the value of the US dollar is not possible if enough countries decide to get rid of their US dollars.

Hyperinflation is not a political popular option; however inflation is a very popular political option. Why the difference?

Since politicians are in the job to get reelected, inflation is a good policy to follow because this provides additional money to the government in the form of printing money to gain price stability. Therefore in today’s situation whereas the US dollar is overvalued, the drop in prices by world wide deflation is countered by expanding the monetary base. This expansion of the monetary base is really a hidden tax on American’s.

Prices relative to incomes should be much cheaper; however this hidden tax gives the government a hidden revenue base.

Hyperinflation is avoided at all costs. This is because the amount of chaos it produces can easily destroy the political system of a country and destabilize the country. This would certainly not be the goal of any politician seeking reelection. The current political power structure would be in very serious jeopardy. Therefore when a country goes into hyperinflation it is definitely not by choice, but by circumstance.

I would also like to point out that even though hyperinflation is really bad, it is much better than having your banking system destroyed through massive defaults. I prefer to think of it as the lesser of two evils. Both totally screw up your country; hyperinflation screws it up slightly less.

I would hate to think what would happen to the US if we hyperinflated. Just think, in Germany they got a brand new political system complete with Adolf Hitler.

Democracy and Debt

Since we live in a Democracy in order to get and stay elected there is a huge pressure on politicians to overspend. This is due to the fact that the voting franchise is all encompassing and paying off groups of voters with through the accumulation of debt is a very popular tactic. This is true of both Republicans and Democrats.

The voting population does not want an increase in taxes, or to cut existing services and government goodies in which are given and not earned. Therefore all Democracies accumulate debt until the debt load becomes too unstable.

Too many financial promises are made, and when the country can no longer service its debts, the promises are still there. They just do not go away. The only option is a destruction of the countries currency as payments must be made on the government goodies promised, but which its society can no longer afford.

Therefore governments come up with all kinds of ways to pay for the promises and to keep their voters happy. One very popular way is to lower lending requirements on mortgages. This provides more tax money, increases GDP (through debt), and makes everyone feel rich. In these periods government increase spending.

The party only stops when the debt load can no longer be substance. However the country now goes into deficit spending to keep the people working and to stabilize the banking system. As a large unemployed population is a recipe for political unrest the government is very motivated to keep people employed in some way. Government spending goes on a binge, increasing when it should be decreasing.

This uncontrolled spending, the return of currency from foreign banks in the form of bonds and other securities denominated in sovereign currency leads to a sharp increase in the money supply in general circulation in the country.

Inflation is the plan, hyperinflation is what happens when government spending

Raising the Interest Rate as a fight Against Inflation

This technique does not work as well as it did 20 years ago due to derivatives and the securitization of debt into bonds. Now the banking system can get around almost all rules the government may implement just by selling the debt. (This is of course assuming there are buyers for the debt).

Therefore as long as foreign banks continue to want US debt, then the international interest rate set by the bond market bypasses the federal funds rate. The short term rate set by the Fed just is not considered as supply and demand is really at work here. This is why you can get an inverted yield curve.

Dr. Greenspan has spoken on this issue before and he has publicly exposed doubts about any real effects of adjusting the federal funds rate. In a time before derivatives this would have been more effective as debt holders would have been inside the country.

Repudiating the Debt

Do countries have a tough time getting loans after going through hyperinflation.

No, they do not, not at all in fact.

The world is full of countries which have repudiated, meaning that they tell the creditors that past debts shall never be repaid. This is a common occurrence. A typical strategy is that the country in question just invents a new currency, and just like new, all their old debts go away.

Does this hamper their ability to obtain new debt?

No, it may raise interest rates for a limited time, sometimes very limited. However a countries ability to borrow does seem to be endless. Just do a study of all the countries that have gone through hyperinflation, when the country stabilized, generally under another political system, borrowing at very reasonable interest rate occurs very quickly.

Argentina is a good example of this. This country suffered though chromic hyperinflation for years, and then very quickly interest rates on sovereign debt went down very quickly once the banking system stabilized in 1991. The country then went back into hyperinflation in 2001. Here is some historical data

Argentina’s Money Supply













Argentina’s Inflation Rate
1989 5,103%
1990 1,344%
1991 84%
1992 17.5%
1993 7.4%
1994 4.2%
1995 3.4%
1996 0.2%












Argentina’s Interest Rate














http://www.latin-focus.com/latinfocus/countries/argentina/arginter.htm

Argentina’s GDP
1991 10.5%
1992 10.3%
1993 6.3%
1994 5.8%
1995 -2.8%
1996 5.5%









http://www.blx.com/portal/inicio/paginasInfoLatam.aspx?PAG_ID=21&CAT_ID=5


The Question of Dr. Bernanke and Fed Policy

I do not think Dr. Bernanke is an idiot. He is very well studied on the mechanics of the Great Depression and his book can be found at Borders Books in Downtown Washington DC.

Dr. Bernanke thesis is that we did not inflate enough to prevent event the very few years of mild deflation we experienced during the 1930’s during the depression. He also believes that a country can grow their way out of a debt crisis. Given the right circumstances I do not disagree with him on this point if the growth is not dependent on the accumulation of debt and adds to the real economic base of the country.

I do no feel that this economic recovery fits that mold as just building houses with debt, and they increasing the value of the houses by flooding the market with debt doesn’t in any way really add to the economic base of the country.

If the country had increased the debt with jobs in manufacturing, engineering, and other real economy and wealth building functions that create an income stream I would expect the US to be in better shape than a society based on the expansion of credit. Of course if the money for manufacturing didn’t get allocated correctly, then massive oversupply would ensue.

Can Dr. Bernanke fight hyperinflation, I doubt it. Just like every other country that faces hyperinflation the government has too many promises to keep, and too much money abroad. In our case the shear amount of money abroad and the speed of transition for foreign banks to get rid of US currency is far faster than any government in the history of the human race could deal with effetely.

Dr. Bernanke does not make decisions on military, social security, or any of the other goodies that the government is giving to its people through the assumption of debt. He could not limit or get rid of these programs. I don’t think the President could either. So we are really stuck at our current spending level.

How would Dr. Bernanke even be able to deal with the collapse of the negative trade balance? It’s not like you can run a massive negative trade balance for ever. At some time your currency devalues due to it proliferation all over the world. A sharp decrease in the purchasing power of currency is hyperinflation.

If foreign banks stop buying our mortgages, then this US money coming into their countries through debt payments and a negative trade balance will no longer be trapped in a lending loop, it will now be free to devalue on the international currency market. There is no way out side of war that the US could stop this. This is precisely why we have this international lending loop whereas our money keeps coming back to the US in the form of credit.

In many ways I feel sorry for Dr. Bernanke. He will go down as the Chairman of the Federal Reserve when the world goes off the US dollar. I cannot imagine what history shall show him as, but it will certainly not be positive.

Paul Volker

I think the Fed chairman before Greenspan needs some attention.

In 1971 the US effetely went off the gold standard. Then the US dramatically increased the money supply through the 1970’s. This action reduced the purchasing power of the dollar.

US Money Supply M3 in billions
Year Supply (Billions) Percent Increase
1960 $303.4
1965 $450.5 48.5%
1970 $618.3 37.2%
1975 $1076.8 74.2%
1980 $1826.4 69.6%
1985 $3026.5 65.7%
1990 $4091.7 35.2%
http://www.federalreserve.gov/releases/H6/hist/h6hist1.txt

It is very easy to see that after the US went off the gold standard that the supply of money almost doubles in its creation from a high 30’s to high 40’s in before the US left the gold standard to high 60’s and mid 70’s after we left the gold standard. It is also very easy to see that in the 1980’s the money supply still gaining at an alarming rate.

From 1979 to 1987 Dr. Volker served as Chairman to the Federal Reserve and is credited with ending the 1980’s inflation crisis by raising the federal funds rate and therefore constricting the money supply. Dr. Volker increased the federal funds rate well over 17% in the 1980 and over 19% in 1981. The federal funds rate has over 10% in 1984 then declines between 6% and 7% by the end of his term.

The creation of M3 in the money supply starts out at about mid 70’s to mid 60’s when Dr. Volker increased the federal funds rate and then falls to mid 30% when the federal funds rate is relaxed.

The question you should really be asking is why did the money supply grow so fast after the US left the gold standard. Obviously Vietnam pumped money into the US economy, but without a huge negative trade balance, the money borrowed and created stayed in the country, causing inflation in everything.

During this time financial derivatives where not really in wide use, therefore international holding of US consumer debt was not nearly so widespread. I could be therefore argued that raising the federal funds rate was effective in the 1980’s as most of the holders of consumer debt (i.e. mortgages, car loans, credit cards) were inside the country.

At this period of time the securitization of debt into bonds easily defeats loan requirements and interest rates on credit are now far removed from the federal funds rate for the same reason. Once the debt left the country the Feds ability to manipulate it downward was dramatically decreased.

I could only see direct intervention by the government to limit the expansion of credit through the limits on selling debt. This would put the fed back in power.

CPI and PPI
I agree with your analysis of how CPI and PPI would and did work in the 1970 through the 1980’s under a high rate of money creation and a localized banking system with debt unable to be sold enmass.

Let’s expand the money supply to 2005 and we see this chart.

Us Money Supply M3 in billions
Year Supply (Billions) Percent Increase
1960 $303.4
1965 $450.5 48.5%
1970 $618.3 37.2%
1975 $1076.8 74.2%
1980 $1826.4 69.6%
1985 $3026.5 65.7%
1990 $4091.7 35.2%1995 $4397.4 7.5%
2000 $6630.5 50.8%
2005 $9480.6 43.0%

M1 is one measure of the money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, NOW accounts, automatic transfer service accounts, and balances in credit unions.

M2 is one measure of the money supply that includes all coins, currency held by the public, traveler's checks, checking account balances, NOW accounts, automatic transfer service accounts, and balances in credit unions.

M3 is one measure of the money supply that includes M2, plus large time deposits, repos of maturity greater than one day at commercial banks, and institutional money market accounts.

It looks like money creation is limited between 40 and 50 percent. However with the advance of derivatives money is now much harder to define. According to Aubie Baltin PhD. Writes “It appears that there is $1.971 trillion of money market mutual funds buried in M2 and these accounts have check writing privileges, so it is 'real' money. In other words M1 should actually be $3.3 trillion. It is being reported as $1.3 trillion (June 2004)."

So how does all of this debt in the form of bonds affect the money supply which is not classically defined under M1, M2, or M3?

Certainly when a person takes out a HELOC loans and purchases something this adds to the money supply. However this money is transported via a negative trade balance to another bank outside of the country.

When US bonds are sold by foreign banks, does this affect the purchasing power of money?

It certainly gives the buyer of the bond cash stream of US money. If the bond is bought at a discount then this effetely lowers the purchasing power of money. If the bond is bought at a premium this effetely raises the value of money. Therefore securities held internationally in terms of debt do in fact adjust the buying power of the US dollar in terms of those countries desire to hold onto that debt.

At this time the money paid on this debt is transported out of the US and to the foreign countries, where it is mostly sent back to the US in the form of mortgages. This held excess US currency out of our money supply by trapping it in MBS and ABS. HOLC money was sucked up by a comparable negative trade balance. This money also came back to the country in the form of MBS and ABS.

Therefore I would argue that the money supply is really much higher than the Federal Reserve is recording it to be since effective money substitutes are now everywhere thanks to new check writing rules and derivatives.

So how does this relate to CPI and PPI.

I would agree that as the purchasing power of the dollar falls then prices go up and people are layed off, reducing the base of people who can purchase goods. Therefore this creates oversupply and prices are forced down. As prices rise due to the money supply more and more jobs are lost. I do not disagree with this analysis.

What I expect to happen during the process is that the other countries with huge asset bubbles, I think this is a large percentage of all US trading partners, will experience the deflation of their asset bubbles at about the same time as the US for similar reasons. The bubbles are falling under their own excessive weight.

As these countries go into a banking crisis they shall start to bail out their banks by printing money. I would say borrow money, but who could you really borrow from. Even if you did borrow money, it is really just that country monetizing their debt in order to extend credit at this stage, and this would just add to the supply of money in their country.

This will effetely cut off effective borrowing. Not that countries won’t borrow from each other, just that the borrowing is really monetizing the debt instead using money from savings. This will cause a situation whereas money is created in both economies, the lender and the borrowing economy, increasing the money supply in both countries.

In this period I also expect democratic governments to increase spending on public works, military and social programs. In no way will the governments reign in current spending.

As the US dollar is the most widely used currency on the planet I would also expect to see foreign banks dumping US assets as they shift away from a US dollar standard to a basket of currencies. This will flood the international market with US securities, discounting them, and devaluing the purchasing power of the US dollar.

As the US dollar is highly overvalued in purchasing power I would expect to see the US dollar fall faster than other currencies. This will in effect make it cheaper to produce things in the US again and rebuild our manufacturing base.

The US negative trade balance with the world will also stop as countries start selling things to other countries. This will eliminate the negative trade balance and give the US a positive trade balance eventually.

The US government has expanded its spending with GDP growth induced through the assumption of debt. This spending will not be reduced, but increase during the crisis.

Government spending will now inject US currency into the US economy and into the US currency general circulation within the country. US dollars will be returning through the foreign banks divulging themselves of US securities.

Therefore even though I agree with your argument for CPI and PPI, I think that the international banking system and our own government spending will bring too many dollars into the country, bring with it hyperinflation.

Until the US gets a firm hold on its spending, gets rid of many social programs, public works and such, then the US is in serious danger of chronic hyperinflation for years to come.

Chromatic Dispersion

Jay Question to Chromatic Dispersion

Jay posted this question to me

Chromatic,I've heard ONLY Gold Bugs say, Fed will hyperinflate to reduce the burden of debt. But I've never heard an argument why.

Most of the dumb argument is that - well you pay the debt in depreciated money. This is not a very good argument - for the simple reason that - if everyone is defaulting and causing deflation - it is even a much better solution to the debt burden!!! Because, it is so painless!!! You owe nothing!!! Nada!!

As opposed to hyperinflation - where you owe something (whose value is less though)!!!Also, at the end of deflation, the currency value is preserved!!! There is no disadvantage in deflation at all!!!

It is just that Gold Bugs want their gold value to go up and hence they argue for hyperinflation!! If the government defaults on its loan - it is much easier!! The future generation dont have to pay this loan back!! But, by hyperinflating - they still have to pay some money. I'm not sure why people say govt will hyperinflate to reduce the debt burden.

Of course, whether the govt defaults OR hyperinflates - either case it is going to have tough time getting fresh loans in the future!! So why choose hyperinflation (as if hyperinflation is less painful than deflation)? If at all, deflation is better because government can print more money!!!

Do you see any reason why government should hyperinflate?One vague argument one might give is that - if government deliberately defaults it is like scar on the prestige - but if it hyperinflates, it can blame it on something like oil price instead of money printing. That is plain wrong.

For instance, government can allow GSEs to fail and say - oops it is the business that failed - but the US govt still pays the govt debt!!! How about that? Government will put the GSE executives in jail and tell the world - these greedy bastards...i.e instead of oil (as in the case of hyperinflation), they can blame the deflation on GSE/bank executives!!! Can you give me any reason why the Fed/Govt considers deflation as a bad problem as opposed to hyperinflation?

Also, people often say Bernanke said - helicopter money if there is deflation. The reason why Bernanke said this was that he was seeing deflation ahead. Guess what? if he sees hyperinflation ahead - he will convert to - money destructor - i.e burn as much money as possible instead of burning heating oil!!! I think Bernanke is only addressing the imminent threat - he will act either way depending on the situation.

I believe, the gold bugs are arguing that hyperinflation is easy to achieve. By now it is obvious to you deflation is also as easy to achieve!!!

Your argument is that - deflation is easy to fight - just print money is your argument!!! The argument you fail to see is that - Hyperinflation is also easy to fight!!! Just stop printing money and increase the interest rate!!! In Weinmar Republic, Hyperinflation STOPPED soon after Bundesbank stopped the printing press!!!

You are very well aware of that, arent you? So why do you think goverment wont stop hyperinflation by raising interest rates - like Paul Volcker did? If hyperinflation happens - you will see that Bernanke is better than Volcker!!! Are you telling me that is not the case?

I hope, you are not taking cheapshot argument like Bernanke is an idiot. Bernanke is only showing the colors that he wants you to see. Why should he show you the side that is not relevant i.e his capability to fight hyperinflation better than Volcker when hyperinflation arrives?

So, in short can you explain why hyperinflation is preferred in US than Deflation?

Ofcourse, when you say govt will go to any length to cure deflation - you have to assume they can also repeal the newly enacted bankruptcy law as well (so that it is easy on people to unload the debt burden!!!). It has the same weightage as - govt preferring to hyperinflate. Ofcourse, I agree that, Fed will fight deflation with a vengeance.

But they will only try to cause mild inflation - NOT hyperinflation as you envision. One another argument gold bugs put forward is: the money that is printed to fight deflation will turn into hyperinflation!! However, they are blind to the fact that - the money that has been printed so far will not cause deflation!!! So, deflation will happen first. If the country goes in the path of hyperinflation - the Fed will immediately stop it. Fed will distribute "Whip inflation now" badges etc!!

Tell me why Fed loves hyperinflation? They love mild inflation - that is all they want. Neither hyperinflation nor deflation. The moment they see higher inflation, they will rein in the money supply - the equivalent of helicopter money will be to increase the reserve ratio!! Can you tell me why the Fed wont do this to stop hyperinflation? If you are assuming deflation will be very brief, tell me why hyperinflation wont be. Are you telling me Fed is powerless to raise the reserve ratio, or raise interest rates like Volcker did?

Bottom line, my PPI vs CPI argument above is what is important, I believe. So, the deflation only goes deep as the Fed fights the deflation!! What people find hard to understand in the above statement is: As govt prints money in deflation, how can CPI directly go low? The mechanism is different in deflation. As Fed prints money PPI goes up - so more layoffs - so few people having money to buy - so products will be bought only if the prices are even lower!! i.e Jobless people can afford only if the prices are lower!! As more and more money is printed, more and more jobs are lost!!! Hence CPI falls!!!Do you still think, hyperinflation is going to happen?

Questions about Inflation/ Deflation Debate

This is a message that Jay sent me to answer. I have posted it as it may be interesting for some to read. This pertains to the Inflation/ Deflation debate.

Thanks for your interest Jay,

I need to answer this by item as you have asked a lot of question and made several arguments.

Issue #1
“Thanks a lot for your detailed explanation. One thing you did not explain is: What happens if people quit their job and take loans and default on it? Currently, people are taking loans AND also assuming the RISK associated with asset depreciation. The risk they are taking is that - they will have to pay later!!! And so far, Fed has not taken bad loans!!! So, if FED does it, ONLY THEN, we can see this problem happen. And I can bet you, lot of people today are not buying homes because they think it is risky, some think they can not afford etc. If FED is willing to take as much bad loans banks can create, What will stop banks from issuing tons of more loans? And what will stop people from taking these NO RISK loans (because fed is willing to take this back). If this happens, I am extremely convinced, even a 1 month old baby will apply for loans and pass the bad loan to FED. In such a NO RISK environment, you will not find any other job existing in the market/economy!!! You dont need interest or knowledge to do it!!! It is a guaranteed MILLION dollar winning lottery ticket!!! Dont you agree? Do you think, if people become aware of GUARANTEED million dollar lottery, dont you think everyone will play it whether they have interest or economic knowledge? I believe this is why BoJ did not take the bad loans!!!! It is not that BoJ is afraid of foreigners dumping yen - but it is the Japanese who will quit their jobs!!! Dont you agree?? “

Answer #1
What happens when people quit their job and take loans and default on it?

This has happened throughout US history. In the last 100 years the most famous time periods are the 1920’s with the resulting depression and the 1980’s with the S&L scandal. As many whom could understand, dream, followed the money, and willing to take risk move out of productive industry into the financial economy. As always a few lucky people get very rich and get out of the ascending market in time. The rest become bankrupt or wiped out and are worse off then when the asset bubble started.

Why do people become bankrupt, this is because even though the government creates some kind of corporation which assumes the loans, refinances them, and then liquidates them if necessary, like the RTC or HOLC, the borrower is still responsible for the balance of the loan, not the bank. So if the home goes underwater, the borrower is still on the hook to pay the difference. This leads to people losing all of their money.

This was the birth of Freddie Mac was through the programs generated in the Great Depression.

At this time some people have home owners insurance, protecting the borrower from owing on an underwater mortgage. Other borrowers have borrowed against the appreciation of the home and have nothing left to cushion the fall in value. Normally banks do not pursue the borrower for the underwater portion of the money due to past bankruptcy rules, however with the change in the bankruptcy laws they will. Banks always went after you if you could pay the underwater part of the mortgage, especially if you had money in the bank.

Therefore home loans are risky to the borrower, not the lender.

What prevents the banks from just giving out loans without abandon?

The government, as always, bails out the bad loans during a mass banking crisis. This does not bail out the borrowers, but in fact only bails out the lender. Creating a system which rewards banks for overextending credit. This is a very well documented phenomenon in US banking.

The BoJ did not assume the bad loans, they already had them, they just kept them on the books without getting rid of them, then borrowed heavily as many of these loans were not serviced (non-performing loans) to keep the banks from insolvency and bankruptcy.

The difference to which people compare the BoJ to US bailouts is that in America we buy the loans from the banks and either refinance them, upon further failure the US liquidates the loans. Japan kept the loans and kept the banks alive by providing them money to make up for the missed payments.

A country must be able to borrow effetely to accomplish this tactic that Japan used. It provided crushing debt to the Japanese and they still have never recovered from this cataclysm. As I stated before I am still open to further review of the Japanese banking crisis upon further information.

Therefore current US policy is to provide for expanding the money supply through lending for as long as can be accomplished.

Are governments worried about people not working in conventional jobs?

I don’t think the US or Japan has any policy about asset bubbles making jobs, in fact both the US and Japan had policies otherwise and encouraged it. “Ownership Society” is the common US mantra. Therefore governments see GDP growth through asset bubbles as providing jobs, they do not care if it is speculative in nature.

The US definitely does not have a policy about what type of jobs America’s have as we have lost most of our manufacturing base and real jobs to other countries. A disproportioned amount of US jobs are now either tied to the government or to the financial sector. Production of real goods has almost died in the US.

Will the government assume the distressed or non-performing loans?

The government has assumed distressed loans many times in our history. They have not recently, but with hyperinflation in housing, why would they need too. When housing really starts to decline you shall see massive government intervention in the form of a RTC or HOLC. Their have been many more of these corporations the US has set up to deal with distressed businesses and loans.

Since we are in a bubble not very many banks have gone bankrupt either for the same reason that massive appreciation protects banks from defaulting on their financial commitments.

Issue #2
“Also, in 1929, not just commodities, even food prices and essentials fell a lot ( greater than 50%) in price. I believe the reason is that: All though huge amount of reserves were maintained by the FED, the banks were not FULLY loaned. In murray rothbard's AGD, you will see that, the excessive reserves about 30Billion or some 30% (I dont know which one) was held as reserves!! In other words, all though reserves were high, money supply into the financial/real economy was curtailed by more than 30%!! That is why there was deflation in food and essential items!! This is exactly what Keynes called as "Liquidity trap". i.e there was tonnes of liquidity in reserve - but NO ONE borrowing!!!! This is what causes deflation!!!! “

Answer #2
I have always indicated that there might be some initial deflation in absolute monetary terms and I have stated this many times. It should be as no surprise that after a bubble prices fall in some areas, and some prices fall more than others. Even in our Depression we started inflating only after 3 years of mild deflation after many years of high inflation. Therefore the banks do in fact loan money out again.

The Story of Agricultural Goods, the WFC, and the RFC

Food prices in the Depression fell due to collecting a huge amount of agriculture goods through subsidizing farming not to deliver to market, then the enviable dumping of product. Murray Rothbard goes into this into great extend in his book called “America’s Great Depression” in his section of “The New Deal Farm Program”. Goods and services otherwise were really not effected much at all. Housing fell some, but never went down to its pre asset bubble values.

The story of food prices during the depression start with the War Finance Corporation (WFC) and a man by the name of Meyer who ran the WFC starting in 1918 at the end of the WW1. In the aftermath of the war WFC with capital of $500 million and the ability to borrow $3 billion was set on the task to subsidize and bail out companies in distress. WFC was used after the war to provide $1 billion in credit to finance American exports. WFC provided $150 million to finance the exports of various commodities and food goods including cotton and tobacco.

In 1919 Hoover’s European food relief program transported surplus US food to Europe and increased food prices

After the depression of 1921 Meyer who had left the WFC in 1920 started to lobby for the restoration of the WFC in order to subsidize agricultural exports. Meyer returned in 1921 with a directive to lend $1 billion to farmers’ cooperatives, exporters, and foreign importers. By 1923 WFC had loaned out $172 million to farm co-ops and $182 to rural banks. This money was used to increase food prices. In 1927 Meyer left the WFC and was now in charge of the Federal Farm Loan Board (FFLB), an institution he helped form.

In 1929 the Federal Farm Board (FFB) was given $500 million for the purpose of making loans and to establish stabilization corporations to control farm surpluses and increase farm prices. The first act was to increase wheat prices by giving loans to the coops to withhold wheat from the market, however prices continued to decline.

After the crash the FFB was able to hold wheat prices up for a time, but in response the farmer grew more wheat in order to get a bigger subsidy by growing wheat that would be held off the market. In the 1930’s saw the fall in wheat prices further as wheat in supply was increasing at a rapid rate. The surpluses continued to grow and prices continued to fall. Other countries began to increase production of wheat and this further drove prices down. Finally the FFB dumped its surplus wheat on the world and prices collapsed.

This story is basically the same for most of agricultural products in the Depression.

In 1931 Hoover tried to reform the old WFC in order to bail out distressed businesses, this became the Reconstruction Finance Corporation (RFC) and was formed in 1932 with Meyer as its head. RFC started with $500 million in capital and could issue $1.5 billion in securities.

So the farming and WFC philosophies were the basic financial structures used during the depression.

Back to the Answer

An interesting note is that if you were able to kept employed, due to Hoover’s directive to keep wages high, the working population actually gained in buying power as general goods and services only fell about 10%.

The banking system. I totally agree in a depression that banks tighten lending as banking defaults occurs, however, the game has changed since the 1930’s. The US, and the rest of the world for the most part has had a policy of bailing out troubles and distressed banks most of the time, and for the US this means every single time since the 1930’s.

The effect of the banks receiving this bail out money and not lending does in fact lead to an increase in the percentage of reserves. No question about this as this is well documented. The story does not end there however.

As I stated before in all countries that go through hyperinflation the banks die as the loans they made are either not paid, then bailed out, then the money coming in through existing good loans is so deflated in purchasing power that the bank cannot even pay the electric bill with the money and the banks go bankrupt again. So as inflation continues the banking reserves collected are depleted, lost to inflation.

This of course just one step on the road to hyperinflation. Banks must continue to lend or they will die through inflation. If they refuse, unlike the depression, the government can now dictate that they lend.

Now the next situation is borrowers. I would expect lending to fall initially, and then increase as home prices versus income become attractive. Businesses are really in a jam as they constantly need to borrow in order to survive. Not many large businesses can survive long without the ability to borrow. Not only that but many businesses will fail if they can not pay employees or buy materials with debt. This kind of debt is used to push money owed in the future to the present to accomplish goals. I do not mean debt used for sole purpose of expansion.

How about the US in the Depression?

Hoover did try and did hyperinflate the currency by having the Federal Reserve create $1.1 billion US dollars through monetizing the debt and borrowing, then pushed this money into the banks. Hoover, frustrated that banks were taking this money and using it to increase reserve instead of lending the money out stopped creating money in this way

I believe in 1934 the banks started creating money through lending in the US again at a great enough level in order to grow the money supply.

Here is the kicker, a government never has to use commercial banks to loan money or even loan money at all to expand the money supply. All they must do is create money. This certainly leads to hyperinflation. This money is then used on various social programs and such.

Why didn’t the US go into hyperinflation during and after the depression. The US government never embraced creating money to print its way out of the depression after Hoover gave it up. The banks started loans out money again and the money supply increased again through fractional reserve banking. The US was also in much better shape than the rest of the world as the US entered WW1 much later than Europe, this gave the US a stronger starting point than the European countries devastated by WW1. The European powers all went through massive inflation. The US at this time was still the biggest creditor nation at the start of the Depression.

Therefore an increase in bank reserves does not in any way prevent inflation. The US did certainly inflate the money supply after the 1934.

It would be more accurate to say that in the Depression that America experienced some mild deflation as the banking system started to disintegrate from lack of faith in it, then started to re-inflate as the banking system recovered.

Issue #3
“In other words, banks will not loan new money to any one (because people are defaulting). Why does this matter to banks? Today, banks are making huge profits in these loans. So they are reporting lot of earnings per share and hence the ceo and the top guys are getting lot of money. Once defaulting happens, the profits reported by banks will take a huge dive!! So will the CEO and the top guys bonus/salary!! Now, the CEO and others being selfish, they will start cleaning up their balancesheet - in other words "liquidity trap"!!! So what has happened now is that, banks have pulled their future profits into their current year - so they will show loss or no profit in the future!!! If FED is willing to take the bad loans from the banks - you are not understanding one important aspect: The bank ceo - just one guy - will take a TRILLION dollar loan to buy some hedge fund etc - and then declare that loan as bad loan and pass it to FED. Do you think, Congress will allow ONE guy to take a TRILLION dollar loan that easily just to protect the economy? How about other CEOs? Even if you assume the general populace is ignorant - do you think the CEOs will be content with JUST 1 TRILLION? Why wont they go all the way to 100 TRILLION?? Why are you saying this is exactly what is happening today? (when you say, today real estate agents are doing it currently!!). It is not happening today. It will happen ONLY if FED is willing to take the bad loans. This will not happen for the simple reason, CEOs of banks, the knowledgeable people will take 100 TRILLION dollars loan and pass it to fed as bad loan!!! Are you defending this is what FED will allow to happen? Ofcourse, you might argue, fed will put a cap for 300K per person - Then the CEO will create 0.25 TRILLION fake bad loans equivalent to 299K and then pass it to FED!!!! Are you defending that FED will still take the bad loan - and create ZERO RISK for taking loan?”

Answer #3
One of the most misunderstood parts about the Federal Reserve is that it was formed between the political alliance between two very power groups. One lead by J.P. Morgan and the other lead by J.D. Rockefeller. The Federal Reserve started out as a private bank with special ability to create a national currency. A banking cartel was formed in the form of a central bank. Regulation has brought it closer to Washington DC, but is still not a public agency. More like a GSE. Its private bank past is why the Federal Reserve used to be headquartered in New York City and this is why the New York Fed is still the most important of all the Fed branches.

Why is this fact so important to answering your question about loading the balance sheets, using derivatives to hide losses, and white collar crime in general?

The banks make the rules. The largest banks are here for one reason alone, to stay in business and power. If you make the currency, set the rules, then as a large bank you have no real need to steal the money outright because you can just adjust the rules in their own favor. This defeats the need to steal. You already have the buying power the dollar provides. At this point in the game you are trying to manage it.

The largest banks jealously guard their buying power. It is very hard to steal from these banks as they will go after you if you do. Most of the time they will never do business with you again and they can and will go after you. The largest banks either control the smaller banks or have a huge amount of influence in them so the system polices itself.

Why bother stealing when you can just adjust the rules. Selfish greed keeps the banks in line.

Thus when viewed under this light it is easy to see why Thomas Jefferson made his past comments that I posted earlier.

This is not to say that stealing doesn’t happen on a grand scale in the US. It does and is very well documented. During the S&L scandal for example the stealing was biblical, and then most of it was covered up by the bailout. William K. Black wrote a book called “The Best Way to Rob a Bank is to Own One”.

Does stealing happen in smaller banks, investment firms, and business?

Yes, Often.

Mr. Black was the Deputy Director of the Federal Savings and Loan Insurance Company among other jobs in the service of banking and banking crime and is a noted expert in the Saving and Loan Scandal which he was heavily involved in. His book goes into detail on how banks steal money, cook the books, and get away with it. The main focus of the book is the 1980’s S&L scandal. Very good book. I highly recommend reading it.

The Federal Reserve just doesn’t bail out any loan, only in a crisis or to hide the weaknesses from the public. They have silently forced many, and I mean many banks, investment funds, and hedge funds to merge with each other upon taking losses that jeopardize to bankrupt them. This is very well documented.

Many CEO’s steal and loot their companies. Many get away with it, but only in an emergency does the government start buying loans wholesale. You can steal a little money, but steal too much and the banks will want their money back.

So why does the government bail out banks, companies, and citizens?

Remember, almost the entire world is on fractional reserve banking. Therefore it doesn’t take that many losses to jeopardize the whole system and start cascading defaults. At this point the government has two choices, let the monetary system fail, or inflate. It is a shame they always choose to inflate, but is the politically easiest thing for them to do.

It is also interesting to note that the power of the largest banks, financially and politically has not suffered. They are very influential in American elections to this day.

Will the fed bail out these loans, remember, the Federal Reserve is the one who asked that these crazy loans be carried out to re-inflate the world banking system after the 1998 banking crisis.

Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”. “Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”“One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”

So my answer is yes, they will bail them out. They already have started as you can clearly see.

We are now living with aftermath of the last major crisis in 1998, which of course was the result of the crisis before that. Many view this as just a continuation of the Depression from the 1930’s. Remember, 1913 was the start of a national paper currency in the United States and of course this coincides with the birth of the Federal Reserve

Issue #4
“Finally, the only way the fed can help is reduce the interest rate (as opposed to taking bad loan) - Ofcourse, I can post the consequences in a separate section. So, in short deflation is in the cards - AS LONG AS FED CAN NOT CREATE ANOTHER ASSET BUBBLE!! I'm not sure if there are anymore assets going forward!!”

Answer #4
I personally think we are out of any more asset bubbles. Real estate is generally the last one you see because of its ubiquities nature and magnitude of money involved.

As a financial mechanic, the federal funds rate is just not that important. Think about it, they are just setting the interest rate for an overnight loan. If a business or bank needs a cheaper loan they can always get it on the international market. So if the federal funds rate is 3.75% and a thirty year bond is 4%, why not just buy the bond or borrow from a foreign bank. The federal funds rate is smoke and mirrors to distract the uninformed.

The Federal Reserve has many tools beyond adjusting the federal funds rate, which is not all that important beyond a political signal to the other countries. The Federal Reserve can and in the past has received all kinds of powers well beyond adjusting the short term rate. This is proven by Fed policy during the Depression and the S&L scandal. The power of the government over the banking system has really grown in the 70 years since the Depression.

Here is a list of just some of the powers of the government as it relates to our banking and currency many are not aware of.

The government can and has continued a policy of inflating the currency supply, a job for which the Federal Reserve was specifically invented to fulfill.

The government can and has forced banks to loan money. They do it all the time. This is a subject which is very, very well documented. Loans to minorities is a good example.

The government can and has taken the property rights away from the creditors of banks in order to keep insolvent banks from bankruptcy. This means a bank does not have to pay depositors or other creditors, but borrowers must still service their loans.

The government can and has changed the accounting rules of banks to hide massive insolvency. RAP is a perfect example.

The government can and has bailed out insolvent banks which are on the verge of bankruptcy, assuming the loans and obligations of the distressed bank, then liquidating or refinancing troubled loans.

The government can and has taken the property rights away from creditors from borrowers and allowed borrowers to hold loans without servicing the debt.

The government can and has made loans without any respect to the commercial interest rate in order to induce borrowing. This means that the government just arbitrarily chooses the interest rate of the loan. This happens every day.

The government can and has the right to confiscate your property and pay you at a value it feels is fair. This power was just radically expanded. This is a fairly common action. The most radical confiscation was during the depression with the confiscation of gold, and the immediate revaluation of gold verses the US dollar.

The government can and has the right to create any ability it seems necessary, limited only by sporadic voter uprisings.

By the trend in inflation and government intervention, inflation and hyperinflation are not only in the future, but the only outcome that can happen at this point.

Thanks for your responses

Chromatic Dispersion

World War 1 and the Gold Standard that Was Really a Tax Revenue Standard

Ben Green said...
"I think it would be extremely useful to analyze throughout history the transition period where an Empire (England in WWI, etc.) began to decline and the effects on its currency. It seems to be a game - of wanting everything at once instead of realizing that you can pursue at most one economic objective at any given time.Please elaborate more on England's transition during WWI and the actual mechanics of the decline. I find your posts very informative but have been unable to read much lately as very busy with work/school.

Regards,"

Anon said...

"Chromatic, while you make a compelling case above, I feel that due to the sheer magnitude of the credit and derivatives markets, large-scale defaults (which, IMHO, are highly likely when real estate collapses and our asset-based economy tanks along with it) will overwhelm the government's ability to print us out of a deflation. It's not like our government isn't in enough deficit trouble already. China and Japan, who have been dependent upon our spending binge over the past several years, will no longer have the continuing flood of dollars with which to help bail us out. Your thoughts? "

Thanks for your post,

Lets first take on you first statement about deflation and how it arises. This would indicate that the money supply is declining inducing reduction in asset prices (housing). The US dollar is overvalued is as a result jobs are shifting to cheaper, but not less incapable countries. So it looks like deflation is not only possible, but the pressures all look for a decline in labor costs and prices due to international economic pressure.

However, the US dollar is the world’s reserve currency. This means that all currencies are compared to the US dollar before any two currencies are exchanged with each other. Also foreign central banks, the countries banks have a majority of their assets in terms of the US dollar. This situation is similar to the post World War One when most of the world was on the British pound standard.

During WW1 England and all of the other European countries left their gold standards in order to fund the war. They therefore expanded their respective money supplies greatly. After the war England, whom was one of the financial leaders of the time, decided that they would restore England to economic leadership if they returned to the British pound sterling relationship to gold at the pre-WW1 level.

The banking system had already been moving away from gold as a world currency and replacing government debt (this is really the ability to obtain tax money) as the banks core reserve (the banks basis for lending out credit). Because government bonds, sovereign debt, is now used as a basis for a bank reserve, this linked money created through fractional reserve banking to a countries debt load.

This lead to a situation whereas countries now had a gold standard in writing, but in actuality there was no possibility of redemption in gold on a mass scale due to currency created through over lending. The ratio of gold as the core holding of banks was being diluted by the promise of future tax revenues (i.e. government debt). Currencies of the world were basically severely overleveraged in relationship to gold even before WW1.

Therefore a system of agreements was in place between trading countries so that promises were made for payment is gold, but gold didn’t actually leave their country en-mass before WW1. This is not to say that gold didn’t leave the countries, only that the rate at which it left was very negotiable.

Why a gold standard? Countries wanted to tie their currencies to gold because tying it to future tax revenue has always been unstable and lead to unlimited creation of money through printing, leading of course to the devaluation of buying power of the currency. With the illusion of gold backing the currency, the countries of the world could claim their currency was stable as long as they could redeem the paper currency for gold coins to the population. They then enacted policies to drive hard currency out of circulation until the final outcome was that gold was really only used for international settlements.

So in order to redeem their place as the center of the financial world, England came up with a plan that called for the British pound to return to its pre-WW1 value with gold. They then made payments to other European countries with British pound sterling. Foreign banks could then redeem their British pound sterling for gold inducing a control mechanism to slow gold from leaving England and making the British pound sterling the world’s reserve currency, much like the US dollar today.

As the value of the British pound sterling was still overvalued to the comparable money supply of other countries in its relationship to gold, this forced a negative trade balance with the other countries of the world. English currency entered the other countries like locus in a biblical curse.

During the 1920’s England refused to deal with their negative trade balance and provided money for their welfare state as unemployment skyrocketed. English sovereign debt and money supply went into to steep rise. Overextended as the English were, they continued to inflate their currency, but still kept their currency overvalued per agreements they had made with other central banks. This situation finally collapsed upon itself when England went off of the gold standard right before they had exhausted their supply of gold. This caused massive inflation in England.

So, as history dictates, countries will gladly sacrifice the value of their currencies buying power in order to pay for the social programs and government expenditures. Even though the banks are very very powerful, they cannot compete with the voting populist. This is because politicians are elected and not by banks, but by people. And politicians generally get elected by promising the what ever it takes to win an election.

As to our current situation with housing in the US, and the world for that matter you can expect some initial deflation in terms of the asset prices, but then the banking system will become unstable as banks become insolvent. If the banks cannot clear money transactions then the economic system get paralyzed as this induces first general insolvency and quickly, very quickly leads to bankruptcy.

With enough bankruptcies, which make it harder to people to earn an honest living, social breakdown always occurs. To combat this and keep in power the government must bail out the banking system. In bailing out the banking system will certainly deflate the buying power of the dollar. However the corollary to this is that prices rise very quickly.

Since the US dollar is the world’s reserve currency, exchange rates may not change that much between countries because this would induce similar situations all over the world.

Therefore Deflation, if you define it as the buying power of the dollar increasing can only happen as a lasting outcome with the total destruction of the banking system. The US would never allow this situation to happen, due to the fact that politicians are always trying to get re-elected and they need the political system in tact to do it, but the buying power of the dollar is an acceptable causality.

As for your comment

“I feel that due to the sheer magnitude of the credit and derivatives markets, large-scale defaults (which, IMHO, are highly likely when real estate collapses and our asset-based economy tanks along with it) will overwhelm the government's ability to print us out of a deflation”

There is no limit to how much the US can print. All that happens is that the world hyper-inflates with us, stealing the paper saving private citizens all over the world have accumulated. This would not be the first time a world currency has failed. The country in question just inflates in order to prevent social disintegration.

As I stated before the only way with paper money you can have deflation is if you can

A.) A mass exodus from the banking system, this is really not possible any more

B.) A competing currency is available, all other currencies are based upon the US dollar and gold is no longer a currency that can be used.

C.) Loss off Faith in the banking system, possible, but you have to at least have A or B in order to derail the amount of money created through fractional reserve banking and fend off inflation by removing money from the banking system.

D.) Hyperinflation can happen regardless of anything else. The government just prints its way out of debt. This happens every few years somewhere on the globe. There is NO DEBT LEVEL TOO HIGH THAT A COUNTRY WITH DEBT DEFINED IN TERMS OF ITS OWN CURRENCY CANNOT HYPER INFLATE OUT OF. Hyper inflation causes problems, but not nearly as many as the collapse of the banking system, at least from a political point of view.

China and Japan?

These countries economic systems are at risk just like any other country that holds large amounts of our debt compared to their economy. All countries will be affected, and their currencies shall fail, meaning their political system is destroyed as well, or they will hyper inflate, with almost as many political dire consequences.

Chromatic Dispersion

Clearing Up my last post

The point I was trying to make is first that the banking system, which started on gold as the basis for extending credit then transformed to a system which included gold and government debt as the basis for extending credit. This relationship change caused the value of the dollar to actual gold to diminish at a rapid rate. So as more dollars were introduced into the banking system the dollar was really held up by the promise of future taxes (government debt).

By the time World War 1 had ended the primary source of bank reserves was in fact government debt instead of gold. Gold could still be used for international settlements between countries, but these various countries were exerting economic, military, and financial pressure on each other to stop this. The US was still technically on gold, but all countries, including America were inducing the general public from using gold coins in everyday use. This is why central banks would only redeem their currency in gold bullion and no longer in gold coins.

The last point is the similarity between post-WW1 England trying to keep world financial dominance by putting the rest of the world on a British pound sterling standard and the US dollar standard. Both situations are similar in how the world monetary system was and is structured. In post-WW1 the British pound sterling was used as the basis for foreign banks to extend credit while today it is the US dollar.

I hope this makes things clearer. I also need criticism of my work. It helps me to improve and gives me clues on how to make my writing better.

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The Myth of a Gold Standard before The Great Depression

The Myth of a Gold Standard before The Great Depression

A popular myth is that America was on a gold standard through the 1920’s and through the Depression. This is not true an in this analysis I shall describe why America was not in fact on a true gold standard. I shall also provide a brief history of the development of the currency, the roll of the Federal Reserve.

The best place to start off is with the hard currency movement in the early 1800’s as a political movement tried to get rid of paper money in the United States. This is a very good place to start to learn about how the currency has developed over the centuries in America.

The desire for hard money as a common currency and the abolishment of fractional reserve banking started after the banking crisis of 1819. Andrew Jackson’s monetary policy resided in the belief that in a boom-bust cycle, the boom was driven by inflationary expansions of credit through fractional reserve banking. The bust was induced through the decline of lending standards during the boom and the inevitable bankruptcies which induce contraction of bank credit.

During 1833 Jackson attacked central banking in the US by removing public Treasury deposits from the Bank of the United States. He moved these deposits to a number of state banks around the country. This is not to say their were still not state banks did not offer bank notes used as currency, only the elimination of a central bank producing bank notes. Jackson also allowed foreign gold and silver coins to be used with the same privileges as US coins.

In 1857 all foreign currency was eliminated as legal tender within the US. “Free” banking laws were passed in 18 of 33 states. However, banking was not “free”. Free banking is neither subsidized nor regulated. When faith is lost in the bank and it is forced to redeem in hard currency, this forces the bank to declare insolvency.

Before the Civil War “free” banking really meant that they could suspend property rights of depositors when the bank became distressed. This is clearly shown in the banking crisis of 1857. Banks were also subject to various regulations at the State and Federal level. Under this regime banks used state bonds as the basis for expanding and extending credit. The bank notes were also used as the basis to pay taxes. Therefore fractional reserve banking existed and was based on the amount of state bonds obtained by the banks. This relationship linked government and bank inflation together very tightly.

The Civil War gave rise to the “greenback” currency and would be used as a basis for banking during the later parts of the Depression and after US went off Brenton-Woods in 1971. During the war the federal government outlawed state bank notes and a return to central banking.

In 1862 the government authorized the printing of $150 million in federal banking notes to pay for war debts, these notes were also legal tender for all debts. By 1863 there were approx $450 million “greenbacks” in circulation and the “greenbacks” depreciated quickly even after first issuance.

The banking system during the Civil War changed with the National Banking Acts of 1863 and 1864 replaced the state banking system with a centralized banking system under the federal government and Wall Street. This system was in place until the Federal Reserve replaced it in 1913.

This new banking system was set up in order to purchase the large amount of US sovereign debt needed during the Civil War. The National Banking system was set up upon three level pyramid. The levels were the Central Reserve City Bank which was New York, Reserve City Banks for other cities, and Country Banks for all other national banks.

The central reserve city banks were required to keep 25% of their notes and deposits in reserve of assets including gold, silver, and “greenbacks”. The reserve city banks were required to keep split their reserves between their vaults and as demand deposits in the central reserve bank. Country banks reserves were split 40% to their vault and 60% to either a reserve city or central city reserve bank. They also had a 15% minimum reserve ratio.

The net effect of this was a change from each bank having to keep its reserves in hard currency at each bank in favor of a system which provided a multi level reserve system enabling the same reserve to used several times. The basis for this new system was the pyramiding of the entire banking structure upon the top of a few large Wall Street banks. The definition of reserves was also changed to include not only metals, but also “greenbacks” and US sovereign debt.

This new structure added additional protection against individual bank failures, therefore allowing for a greater ability to inflate the money supply with paper currency. The individual banks were required to accept each others notes at par. This situation forced the free market out of banking as notes from shaky and distressed banks could no longer be discounted.

The Federal Reserve was born in 1913 and was instituted to solve the problem of coordinating the inflation of the currency and the need to bail out banks in trouble. The large banks charged that the current banking system did not let them properly expand the money supply, and a call to defeated “INELASTICITY” in favor of “ELASTICITY” or the ability to inflate the money supply in a highly coordinated way.

The world economy at this time was on a gold standard, not to say that each country was on a gold standard, only that how countries settles with each other was through the medium of gold. Every country’s currency was defined as its relationship to gold. The countries central banks could redeem this paper currency for its weight in gold coins. Gold bars were used to settle international payments.

During World War 1 the world went off of the gold standard, with only the US remaining on the standard (The US entered the war late). The value of these currencies with relationship to gold now floated, whereas in pre-WW1 these currencies were fixed to a specified weight of gold.

The world decided that it wanted to return to a gold standard, however, they had printed far more money than the gold in their banks would support. The easy and best solution would have been to just reduce the paper currencies relationship to the weight of gold. However, England, who wanted to remain the financial leader of the world tried to bring back their currency at pre-war levels. This action overvalued the pound sterling.

Not only did England want to have the pound’s relationship with the gold go back to pre-war levels, but it also wanted to institute a policy of inflating their currency. This set the stage for the destruction of the gold standard, America’s roaring twenties, and the Great Depression.

Therefore a plan was launched to have countries go back onto a gold standard, while outlawing the use of hard currencies in each participating country. The world was to go upon a gold bullion standard, whereas central banks would only redeem gold in 400 once bars. This was much too expansive for a person to buy, but ideal for international transactions. Gold coins were systematically taken out of circulation and replaced with paper notes and deposits.

European countries were therefore technically on a gold standard. However, they did not in fact receive the gold bullion in any great amounts. Therefore the countries were on a pound sterling standard. Therefore countries would not hold gold, but British pound sterling. If anyone in their country redeemed their currency for gold, they actually received British pounds rather than gold.

Murrey Rothbard writes in “A History of Money and Banking in the United States”

“For the other nations of Europe, it became an object of British pressure and maneuvering to induce these countries themselves to return to a gold standard, with several vital provisions: (a) that their currencies too be overvalued, so that British exports would not suffer, and British imports would not be overstimulated—in other words, so that they join Britain in overvaluing their currencies; (b) that each of these countries adopt their own central bank, with the help of Britain, which would inflate their currencies in collaboration with the Bank of England; and (c) that they return, not to a genuine gold standard, but to a gold-exchange standard, keeping their balances in London and refraining from exercising their legal right to redeem those sterling balances in gold.”

The United States was still on a true gold standard and this presented a real problem to England. England made agreements with the United States so that the US would inflate their currency, thereby deflating the buying power of the US dollar verses the British pound. The US agreed to do this in order to support to rebuilding of Europe.

England continued to inflate their currency without abandon in 1926, inducing gold to flow out of England into the United States and sterling to flow into other countries.

The first European chain began to break in 1929 as a large Austrian bank headed for liquidation. This was the beginning of the systemic banking failures which would start the largest international banking crisis ever experienced in civilization.


Source MaterialMilton Friedman and Anna Schwartz “A Monetary History of the United States”Murrey Rothbard “A History of Money and Banking in the United States”Murrey Rothbard “America’s Great Depression”

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Inflation/ Deflation

This is my response to question I posted on the Housing Bubble 2 Blog

Inflation/ Deflation

What do I mean when I say “if you cannot get your money out of the banking system en-mass hyper inflation is a very real risk.”

You are correct in assuming that when debt is defaulted upon, forgiven, or repudiated, then there is deflation. However, many countries go through asset bubbles and experience inflation, or hyper inflation when the debt stops expanding and implodes.

So then what is the difference?
Why deflation is for some and inflation for others?

The first mistake is thinking that prices in the Depression declines to their pre-asset bubble levels. They did not. Not even close. The economy in the depression experienced a very slight deflation.

The money supply only shrank from $68.25 billion to $64.72 billion for a decline of only $3.2 billion. The total money supply from the middle of 1929 at the height of the bubble started at $73.3 billion and only fell to $64.7 billion in 1932. This is a total compression of the money supply of only 11.6% or 3.3% per year. The inflation rate of the money supply was 7.7% per year during the boom in the 1920’s. Therefore we hardly deflated at all and prices never went down to their pre asset bubble prices.

So why didn’t we get a higher rate of deflation due to all of these bankruptcies, debt forgiveness, and repudiation of debt, because we were still inflating the currency. The inflation was just not enough to counter the downward forces of oversupply, increased efficiency, and destruction of money, and pulling money out of the banking system.

What does “removing money from the banking system en-mass” mean?

This means that the population and foreign countries as a whole can remove their money out of our banking system. American’s have the lowest rate of savings in the world, so what are you going to take out of the banking system, credit card debt? What currency would you then use to purchase things, you still must use the dollar, you cannot use gold or foreign currency inside of the country, it is against the law.

American’s are encased in a financial web of the banking system and don’t even truly understand it. Social Security, Medicare, Pensions, 401(k), 403(b), any retirement plan, and investment, and any purchase ends up in the bank. You can’t even operate a major corporation, or even a small corporation without being heavily tied to the banking system to pay bills with. Therefore American cannot get out of the banking system en-mass, and there is no other currency they can convert to, like gold. This blocks the deflationary aspect of the depression.

Common guys, its not like the Federal Reserve hasn’t thought think through isn’t it. You should just read some of their research papers on the subject. You would be shocked.

Foreign countries are so tied to us economically that they cannot get unwind their positions within our own financial systems without facing a banking crisis just based on that tactic. Less developed countries could very well become politically unstable. Therefore foreign governments cannot run to another currency at this time. Not that this may not change, just not right now.

Why does mass loan defaults tend to cause hyper inflation rather than deflation on an absolute monetary magnitude perspective. This means you are just looking at prices and ignoring buying power.

The defaults cause deflation, however, the act of the government buying up the defaulting mortgages leads to increasing the currency in order to pay for it, this then leads to increasing the base money in the banking system which can then be used to create additional credit. This leads to inflation or hyper inflation and not deflation. Defaults cause deflation, government policy causes inflation.

The next argument of protecting the dollar, the government will not bail out housing, leading to inflation or hyper inflation. This has never happened in the US since the Federal Reserve was formed in 1913. If people cannot service their mortgages, they the government must step in or the banks become insolvent, and without government intervention bankrupt. We are not talking about a few banks here, I am talking about the largest banks in the world, which by the way many of which are US banks will become insolvent. US will never give Economic Dominance without a war forcing it.

Japan had deflation when their asset bubble burst. Why?

Japan allowed their banks to hold onto their non-performing loans, loans which are not, and may never be serviced. Japan also borrowed heavily. It is more accurate to say Japan, even to this day has never recovered and they may very well face another major banking crisis again very soon.

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The Myth of The Federal Reserve Contracting the Money Supply during The Great Depression

The Myth of The Federal Reserve Contracting the Money Supply during The Great Depression

The last time broad based deflation was seen in America was during the depression. During this period President Hoover convinced US businesses to keep wage rates at pre-depression levels instead of reducing wages as had been done during other depressions. As a result of Presidents Hoovers action American companies tried very hard to keep wage rates from falling. As a result real earning power was increased for those who remained employed.

A popular myth of this time period is that The Federal Reserve allowed the money supply to contract after 1931, taking money out of circulation and producing broad based deflation whereas prices in almost all goods, services, and assets declined, increasing the buying power of money.

The key to understanding the Fed’s actions is in understanding the Glass-Steagall Act. This act changed the collateral requirements of the Federal Reserve to use US sovereign debt (US government securities) as well as gold (the historic bank collateral) to back Federal Reserve Notes (paper currency) in 1932.

Federal Reserve notes were redeemable in gold, thus pyramid was formed as US securities, backed by Federal Reserve Notes were used as collateral for Federal Reserve Notes, which in turn was redeemable in gold.

The Federal Reserve creates bank reserves by purchasing government securities, thereby linking public debt with the money supply. Bank reserves are then used as the basis for lending credit through fractional reserve banking whereas for every dollar in gold or US securities held by the bank as collateral can be used to create nine dollars of credit. Credit increased the total supply of money as money loaned out is actually currency which is created.

The Fed must purchase all US securities offered by the government. If the Fed sells US securities acquired, then national deficit increases, however, if the Fed just assumes the debt and does not sell it, this action increases the money supply without adding to the national deficit. This is equivalent to just “printing money” or creating new money, debasing the currency by expanding the money supply.

Therefore we must look at three important elements of the monetary system under Glass-Steagall, the national deficit, bank reserves, money supply, and the supply of gold held as collateral by US banks.

The National Deficit
As recorded by the Treasury the National Debt grew by $2.7 billion in 1932.

Bank Reserves
By February 1932 bank reserves had fallen to $1.85 billion, the Fed acted and purchased 660 million in government securities by the end of the year increasing their reserves by 35% in less than one year to a total of $2.51 billion at the end of the year. From February to July total reserves rose by $213 million. From July to December reserves increased by $457 million.

Securities holdings in the Fed increased from $740 million to $1.85 billion for a gain of $1.1 billion. After July President Hoover’s administration determined this was having no affect and stopped the securities buying program at the Fed.

Therefore in the first half of 1932 controlled reserves increased by $1.1 billion while uncontrolled reserves fell by $788 million due to $290 million reduction in bank indebtedness to the Fed, and loss of $380 million in the gold supply, and a rise of $122 million of money in circulation.

In the second half of 1932 controlled reserves rose by $165 million and uncontrolled reserves rose by 293 million due to the gold supply increasing by $539 million.

Bank deposits fell by $3.1 billion and remained constant until the end of the year.

Money Supply
The money supply changed in 1932 form $68.24 billion to $64.72 billion for a decrease of $3.52 billion for the year.

As the Fed purchased $1.1 billion dollars of US securities, and these securities could have been used as a base of creating money through lending of approximately $10 billion of additional money to the money supply in a very short amount of time. Due to positive feedback, the monetary mechanic of loaned money coming back into the banking system and being used again to create money through credit this number could have jumped much higher in a very short amount of time, but the money supply actually fell.

Gold Used As Bank Collateral
In the first half of 1932 the gold stock fell by $380 million while in the second half gold increased by $539 million for a positive increase of $159 million in gold stock.

Examining the data is very clearly shows an inflationary policy at The Federal Reserve embarked upon during the depths of the depression in 1932. The Fed tried in vain to hyper inflate the currency, however as faith was lost in the banking system as banks closed.

In the 1920’s approximately 700 banks closed each year losing $170 million in deposits. In 1930 1,350 banks failed with deposits of $837 million.
In 1931 2,293 banks failed with deposits of $1,690 million.
In 1932 1,453 banks failed with deposits of $706 million.

Therefore foreigners and US citizens observed an enormous increase in not only the exponential amount of banks failures, but the exponential magnitude of the failures. As a result US citizens withdrew their money from the banks in the first part of 1932 leading to a fall of bank deposits of $3.1 billion. Foreigners redeemed their US currency for gold leading to the fall of the gold stock in the first half of 1932 by $380 million.

The banks, afraid of taking on additional risk in a low interest rate environment build up excess reserves and did not increase the money supply through lending as they would have when they made loans to the maximum capacity in the 1920’s. Bank reserves were maxed out at 10% and then by the end of 1932 increased to 20%.

This activity driven by a loss of faith countered the normal positive feedback in the banking system as money fled out of the banking system leading to a $3.5 billion dollar reduction in the supply of money. When the Fed stopped its security buying program by the middle of 1932 gold came back into the country increasing the gold stock by $539 million.

Therefore the Federal Reserve did not in fact provide a policy of contraction of the money supply. The facts support that the Federal Reserve in fact tried to hyper inflate the currency by holding US sovereign debt and using this as the basis for creating money through lending. This tactic backfired when people and governments lost faith in the US banking system and pulled their money and gold out of the system.

Angered by the inability of the Federal Reserve to inflate the money supply and inflate prices back up to pre depression era prices President Hoover then began is war on Hording.


Appendix of Data

The national deficit as recorded by the Treasury department is the following
July 1st, 1920 is approximately $26 billion
July 1st, 1925 is approximately $21 billion
July 1st, 1928 is approximately $17.6 billion
July 1st, 1929 is approximately $16.9 billion

July 1st, 1930 is approximately $16.2 billion
July 1st, 1931 is approximately $16.8 billion
July 1st, 1932 is approximately $19.5 billion
July 1st, 1933 is approximately $23.5 billion
July 1st, 1934 is approximately $27.0 billion
July 1st, 1935 is approximately $28.7 billion

The US gold stock held as collateral by US banks is as follows
1920 is approximately $3.1 billion
1921 is approximately $3.7 billion
1922 is approximately $4.0 billion
1923 is approximately $4.2 billion
1924 is approximately $4.35 billion
1925 is approximately $4.3 billion
1926 is approximately $4.4 billion
1927 is approximately $4.35 billion
1928 is approximately $4.2 billion
1929 is approximately $4.3 billion

Source Material
Richard Duncan’s The Dollar Crisis
Milton Friedman and Anna Schwartz A Monetary History of the United States
Murrey Rothbard A History of Money and Banking in the United States
Murrey Rothbard America’s Great Depression

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Problems at Fanny Mae

Problems at Fanny MaeMy research into banking failures over the last 300 years in the United States has reviled to me some important facts about how our government handles bank failures. Fanny Mae may be a mortgage lending business, but it is really a bank by pseudo definition.

Most, if not all banking crisis since paper money was first used in the US starting in 1691 has resulted in one undeniable fact. Creditors lose property rights in favor of borrowers.

In terms of banking failures this means that the bank or banking system in distress is allowed to continue doing business while suspending payments to creditors. Contrary to popular belief banks tend to be the biggest debtors of all since they produce debt using a fractional reserve system of banking.

Therefore the government will in fact step in and inflate. If you study the origins of The Federal Reserve, you can clearly see the argument made by Jacob H. Schiff in his speech in January of 1906. In the book the A History of Money and Banking in the United States Murray Rothbard writes

“The campaign for a central bank was kicked off by a fateful speech in January 1906 by the powerful Jacob H. Schiff, head of the Wall Street investment bank of Kuhn, Loeb and Company, before the New York Chamber of Commerce. Schiff complained that in the autumn of 1905, when “the country needed money,” the Treasury, instead of working to expand the money supply, reduced government deposits in the national banks, thereby precipitating a financial crisis, a “disgrace” in which the New York clearinghouse banks had been forced to contract their loans drastically, sending interest rates sky-high.

An “elastic currency” for the nation was therefore imperative, and Schiff urged the New York chamber’s committee on finance to draw up a comprehensive plan for a modern banking system to provide for an elastic currency. A colleague who had already been agitating for a central bank behind the scenes was Schiff’s partner, Paul Moritz Warburg, who had suggested the plan to Schiff as early as 1903.

Warburg had emigrated from the German investment firm of M.M. Warburg and Company in 1897, and before long his major function at Kuhn, Loeb was to agitate to bring the blessings of European central banking to the United States”

In the case of mortgage lenders banks during the S&L Crisis of the 1980’s used several tactics in order to remain operational during a meltdown. The first attempt to save the S&L’s was in September of 1981 when the Federal Home Loan Bank Board permitted the Federal Savings and Loan Insurance Corporation (FSLIC) to buy Income Capital Certificates from insolvent S&L’s. This allows the S&L’s to appear solvent on their balance sheets when they are in fact insolvent.

GAAP requirement are dropped and replaced with Regulatory Accounting Principles (RAP) in January of 1982. This effetely avoids accounting which would indicate that the S&L’s are insolvent and liberalizes financial accounting.

So, during a crisis you could expect the US to keep on lending money for mortgages, it can do this because when all else fails, it can just print money. Not only can they keep on lending, but they can peg mortgage interest rates to be artificially low.

Remember, mortgage interest rates are normally set by interest rates of the MBS bonds, however, the government doesn’t have to sell the mortgages. Therefore they can technically set any level of interest they desire for mortgages or subsidize them. And don’t think they wouldn’t either. This is not an uncommon tactic for a country facing a contracting monetary system.

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The Blame Game

The blame game,

I find it very interesting that entities such as Fannie Mae and Freddie Mac were invented to uphold housing values. The Federal Home Loan Bank Act of 1932 during President Hoover term was his solution to falling housing values during The Great Depression.

During Presidents Roosevelt’s term in 1933 the Home Owners’ Loan Corporation (HOLC) was enacted and refinanced almost one million mortgages which were in default or distress for a cost of approx $3.1 billion. HOLC stopped refinancing mortgages in 1936. Per Fanny Mae a typical home in distress had lost at least 15% of its market value. HOLC secondary mission was to liquidate through foreclosure approx 198,000 mortgages it had refinanced. During the new deal mortgages extended their length from 5-7 years up to 30 years.

GSE’s are designed to be highly inflationary by broadening the base of people who can purchase housing, therefore increasing housing values. In the case of The Great Depression it was designed to prevent deflation.

Interestingly enough, this tactic only works if you can borrow money. If your country cannot effetely borrow money due to all of your partners also facing banking crises, then this tactic has no effect on housing values keeping pace with general hyperinflation.This is due to the fact that if the country that buys your countries debt just creates new money (prints money) to buy your debt, it is the same as if your country just creates new money.

Mr. Housing Bubble in the Washington Post

I found this post of Mr. Housing Bubble in the Washington Post Express when I was on the subway this afternoon.

http://www.washingtonpost.com/wp-srv/express/pdfs/EXPRESS_08172005.pdf
Page 31

You can purchase the I love the housing bubble T-Shirt at t-shirthumor.com

Response to GSE Risk A 'Revelation' For Fed Chief

I posted this response on the Housingbubble2 blog to GSE Risk A 'Revelation' For Fed Chief

Here it is

I have posted Treasury Secretary Snow’s and Dr. Greenspan’s comments before congress before.

I found it hard to believe that he didn’t understand how the exponential growth rates of the GSE’s were dangerous. Dr. Greenspan has always been a big proponent of derivatives and systemic risk has been brought up many times.

In fact one man Mr. Falcon was fired for bring up the problems with the GSE’s in 2003 called Systemic Risk: Fannie Mae, Freddie Mac and The Role of OFHEO.

Dr. Greenspan has a very clear understanding of what is going on. He “jump start” the economy by encouraging real estate to appreciate. That is why William J. McDonough, the President of the New York Federal Reserve, asked the lending standard to be lowered in the aftermath of the 1998 Russian/ US bond market crisis.

“On Feb. 5, a mere 24 hours after the report's issuance, the Bush Administration demanded that OFHEO Director Armando Falcon submit his resignation. Falcon, who been appointed to this post in 1999 by President Bill Clinton, had overseen the report's release. While the Bush Administration delivered the order for Falcon to resign, both the circumstances of the firing and subsequent events make it clear that the actual order for the firing originated from inside the boardroom of J.P. Morgan Chase—the world's largest derivatives bank with $29 trillion in derivatives outstanding—and the boardrooms of other major institutions that are heavily invested in derivatives and housing market paper.”

http://www.ofheo.gov/Media/Archive/docs/reports/sysrisk.pdf
http://www.larouchepub.com/other/2003/3010ofheo_rpt.html
http://www.snl.com/financial_svc/archive/20030210sl.asp

Dr. Greenspan is just trying to play ignorant. He cannot start a panic if he can help it.

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Letter from Clark Worswick

I have read your very informed and quite passionate posts on derivatives and I applaud you.

Sometime in 1998 I started a thread on Silicone Investor dealing with derivatives and my particular bent was a great worries about something called "the Herstat effect" ... that is, counterparty default.

For a history of these worries seee:
http://www.siliconinvestor.com/subject.aspx?subjectid=22689

My best to you

Clark

Dollar Standard in Jepordy

The Greater Fool Argument of finding someone who will purchase your property for a greater price in unstable conditions.

I think that it is irreverent at this point. How many people will get hurt in this exchange?

Answer, the whole world.

Real Estate is not our greatest asset in jeopardy. Personal bankruptcy and ruined lives aren’t either. The greatest threat is ubiquitous.

Right now the major threat to the US and its people is the ending of the US Dollar Standard. The US dollar is the world’s reserve currency. This means that all other currencies are measured to the US dollar.

Other countries keep assets and financial paper denominated in terms of the US dollar. They do this to hedge against fluxuations in their own currencies. This has given the US a dominant roll in world finance.

Since the US has a negative trade balance, foreign banks are collecting enormous amounts of US dollars and financial paper. Foreign banks have so many US dollars in their banks that if they were to trade them for assets denominated in another currency, the US dollar would decline.

Since the US financial paper is a huge amount of foreign banks assets, if the dollar would to decline substantially, it would lead to a foreign banking crisis.

This has shielded the US from a decline in the buying power of foreign goods. Foreign banks cannot do anything with their US dollars except to buy more US financial paper.

This is why our sovereign debt and mortgage backed securities (MBS) have such low interest rates. When MBS’s are low mortgage rates are low as MBS are mortgages that have been converted to bonds and sold on the international market.

If we go through a housing crash than the monthly payments to these bonds would be lessened to a great degree. This would cause untold banking crisis all over the world.

In order to save the international banking system the government would have to try to bail out the defaulting mortgages. The amount would be in the trillions of dollars.

I think the government would have to create “new money” because in the event of massive housing crash all of the lending sources oversees would be unavailable.

In times of crisis lending is very hard to come by. Superpowers have defaulted on debt in the past. US sovereign debt may not be viewed as a safe investment at that time and liquidity may dry up.

I also believe that the amount involved is just too large. Bailouts need to be done fast. Even if you could borrow trillions of dollars, could you do it fast enough?

We may very well find out.

If foreign lenders did in fact buy our sovereign debt, then what would they do with the money. They already have too much financial paper in terms of the US dollar.

This action would increase the amount to ludicist new heights. What would they do with the money, buy more US debt, assets, or securities?

The government would have to borrow money just to pay on the debt, not that we don’t already, but I think we couldn’t deny it any longer.

Countries would have to seriously look at their relationship with the US dollar standard. I am willing to bet that their analysis will not be favorable to us.

I would think that countries holding colossal amounts of US dollars would have to start to get rid of them or the investments would become sterile.This would still lead to a steep decline of the dollar and a new international banking crisis.

The dollar standard would be over forever. No longer could the US keep on piling up debt like it has for the last 80 years.

Our way of life would change forever.

Chromatic Dispersion

Inflation/ Deflation

The Narrator said in my comments section…
“Isn't a housing crash deflationary? A credit crunch, a lot of defaulted debtors and underwater debtors and out of work RE people certainly would reduce spending.”

This is a more complicated subject than it would first appear. Technically a lot of bankruptcies, if left to their own devices, reduce the money supply. Just as the fractional reserve system produces money exponentially, bankruptcies are the reverse affect of this.

However, our government deals with bankruptcies and every other crisis by providing liquidity. This means that the government offers an increased rate of sovereign debt in the form of treasury bonds, bills, and notes. This has an effect of increasing the amount of “leveraged” money in the money supply.

Let’s break the problem down into its component elements.

What is “leveraged” money?

“Leveraged” money is the money that is created through borrowing. This means that even though the money supply has gone up, there is an income stream that goes against this money in order to pay it back. Under normal conditions “leveraged” money is considered non-inflationary.

So then, what is “real money”, or money that is not “leveraged”?

“Real money”, is money that does not have an income stream against it to pay it off. This can take the form of savings, assets that are free and clear of debt obligations to name a few types. This money has a finite buying power and an increase in “real money” debases the currency.

As the world progresses the population increases, factories are made, goods are produced, and services are needed. This is what we call an expanding economy. The more productive, the amount assets are worth in “real money” terms goes up.

This would mean that if you had a finite amount of “real money” the value of each dollar bill would increase with time as the world became more productive. However, since these factories and other improvement are paid for through debt, and this debt is eventually paid for, the “leveraged money” becomes “real money”.

So this has the effect, since by using a fractional reserve system that money is created exponentially, of diluting the value of “real money”. Therefore as the economy expands exponentially, the money supply expands exponentially.

If the economy expands faster than the supply of “real money”, then the value of money increases. If the supply of “real money” expands faster than the economy, then money devalues. If these two forces are unitized, then the value of money keeps the same buying power.

Why “leveraged money” is not considered inflationary?

Well, in moderation it is not. The new money created goes against a new factory or something that increases the economy. If the asset that the “leveraged” money goes against hasn’t appreciated overly due to uncontrolled speculation the amount of the loan is fair. The money is then trapped in the deal. Hopefully, the bank has made a good investment risk and will be paid back.

Here is the problem, if speculators have increased the price of the asset, then the loan amount is incorrect, this leads to asset inflation. Speculators overly increase the price of an asset by lending too much money into an industry or asset class. This causes an exponentially larger amount of money to chase a limited amount of assets.

That is just the first problem. Since speculators paid too much for the asset, the borrower may not make enough money to pay back the loan. If the borrower cannot service their debt they become insolvent, which can lead to bankruptcy. Bankruptcy has the opposite effect and contracts the supply of “real money” at an exponential rate. If too much money is lost the lender themselves may default on their payments and go into bankruptcy.

Uncontrolled lending increases inflation in the assets that the loans are targeted against. However, due to the “velocity of money” this can increase the prices of goods and services as well. As asset prices go up, so do workers incomes in that industry or asset class. The people spend more money on goods and services. Since goods and services are priced according to the willingness to pay for them, their prices also go up accordingly. It just takes time for the money to float down to that level of the economy.

So how wouldn’t a housing crash, a crash in the price of an asset, be deflationary, and increase the value of the money.

Due to bankruptcy and foreclosure, a decline in the value of housing would reduce the amount of “leveraged money” and the same amount of “real money”. Therefore if a home cost $500,000 with 10% down or $50,000 of equity for a loan amount of $450,000. Then lost 20% of its value during a foreclosure sale, the value of the property would be $400,000. This would mean that there is $100,000 lost in the deal. The owner loses $50,000 of equity and may still owe $50,000 of unsecured debt. If the owner cannot pay this debt then the lender loses $50,000. This money goes against the lenders core assets.

So if a bank has $1,000,000 in core assets, the bank can lend up to $10,000,000. Now the bank has $950,000 and can lend up to $9,500,000. If the bank has $9,550,000 in outstanding loans, the bank must now find a way to repair its core assets. The bank must be very careful in making additional loans or face insolvency. If the bank experiences too many bankruptcies and the bank cannot service their debts or payments, the bank may go into bankruptcy itself.

Now, how does the Federal Reserve handle this situation with mass insolvency of banks. If too many banks become bankrupt the financial system is destroyed. This is due to the exponential nature of money creation using a fraction reserve system. The Federal Reserve would have to try to take over the underwater mortgages. It would do this by purchasing these mortgages from the banks. This would have the impact of monetizing the bad debt.

What is monetizing the debt?

Monetizing the debt is the act of creating new “real money” to purchase debt. This debt is then diluted into the “real money” supply. The government would then sell these properties for what ever it could get for them. The government would most likely sell the loans as well.

This would have the effect of first increasing the amount of “real money” into the system by making the original “leveraged money” into “real money”. Then through borrowing, this real money is used to further increase the amount of “leveraged money” into the system at an exponential rate.

Therefore the value of the money would go down exotically as the amount of “real money” increased exponentially. This will cause inflation of the dollar or a decrease in spending power of the dollar.

The final answer is, even though a housing crash may be initially deflationary, it will lead to massive inflation of the dollar as the government tries to save the banking system.

Will this work, can this save the housing crash, and more importantly, the banking system?

In short, No.

Why the hell not.

Banking has changed in the last 20 years. Our banking system no longer is the only major entity that is creating “leveraged money”. With advent of modern derivatives, lenders have been able to take mortgages and turn them into bonds called mortgage backed securities (MBS). These MBS’s are sold on the international market. Many countries use these MBS’s as core assets for their banks.

American also has a negative trade balance. This means that when we buy goods from other countries, we receive these goods and they receive dollars. They have so many dollars that if they were to trade these away to other countries the value of these dollars would devalue.

This is not that bad, however, the US dollar is also the world’s reserve currency. This means that many countries use this currency as a hedge against fluxuations in their own currencies. If the dollar devalues, than their core assets devalue, this can lead to a banking crisis in their own countries.

In order to prevent this situation from happening, these countries buy US debt in the form of our sovereign debt, corporate bonds, and MBS’s. This causes these countries to obtain even more assets that are terms of the US dollar.

If the US monetizes this much debt as to save the banking system from the housing debt, then the US dollar shall devalue. This will cause all financial instruments based on the US dollar to devalue. Therefore other countries banks to go into crisis as their core assets devalue.

Why the hell should we care anyway? Screw those losers.

When lending institution goes into crisis they must get rid of assets in order to maintain their fractional reserve. This means that they must shed corporate bonds, stocks, and other assets. They are also likely to not honor their debt with other banks throwing these banks into crisis.

Hedge funds, which borrow billions from banks, leverage their investments 20 to 30 to one. Even small changes can destroy these investment institutions. This will cause the hedge funds to become insolvent and bankrupt.

Now, since the US has saved the housing crash by monetizing the debt, it has now gone back into crisis as other outstanding debt is not honored due to global insolvency.

Remember, the US is not the only country with a housing bubble, most of the G-8 countries also have housing bubbles. All of these bad debts just boomerang back at you through the equities and derivatives markets. There is just no way to avoid it.

There comes a point where too much money is at risk. At that point, due to the mechanics of the fractional reserve system, there is no way to save the banking system. If the banking system goes the currency goes.

Chromatic Dispersion

Mr. Kudlow's Article

I was asked to read the following article by Larry Kudlow called “The economy in the Fed’s hands?”

http://www.nationalreview.com/kudlow/kudlow200505110857.asp

What is my take on it the article. Well let’s break it apart one section at a time.

“Take, for example, the latest monetary data from the Federal Reserve Bank of St. Louis. The data show a marked slowdown in key money-supply measures. The adjusted monetary base, over the past six months, is growing at a meager 2.6 percent annually. A broader money measure known as M2 has slipped to a below-normal 3.5 percent
There may be two key reasons for this money slump. First, the Fed is injecting less and less new cash into the economy as it raises its short-term target rate. Second, the increase in short-term rates to 3 percent from 1 percent may be reducing future economic demand.”

When Kudlow talks about new cash he means monetizing the debt. This is when the Federal Reserve credits the US government with money, but doesn’t sell any debt. This action causes inflation. This is also called debasing currency.

Normally the US government needs money and wants to borrow to obtain it. The Federal Reserve then offers Treasury bills, bonds, and notes (The distinction is on the amount of time the debt is good for). This is called sovereign paper and the Federal Reserve is our Central Bank.

The Fed then sells the paper on the international market. The interest rate it receives, the yield, is determined by the marketplace. If the market is lax the interest rate goes up to attract buyers. If the market is tight and many institutions want to own US sovereign debt, then the interest rate goes down.

The short term rate Kudlow is talking about is the rate the Fed charges for very short time periods, like overnight. The fed has not set a bottom for the long term rate. The long term demand is the devil setting bond prices all over the board.

Why the slow down of the rate of increase in the money supply? It is hard to tell from Kudlow’s writing, but I will assume that the US government didn’t offer as much additional debt on a logarithmic scale. What does that mean?

Lets say you have a total money supply of 1,000,000 (I am using small numbers) and you increase it 10% per year. After 8 years the supply of money would be over 2,000,000. This is an exponential jump in the amount of money in your economy. So in each year how much money did you create?

Year 0 = 100,000
Year 1 = 110,000
Year 2 = 121,00
Year 3 = 133,100
Year 4 = 146,410
Year 5 = 161,051
Year 6 = 177,156
Year 7 = 194,871.

In each period, the amount of money supply increases exponentially. So to say that the money supply grew only 2.6% over 6 months just means the money supply didn’t grow as fast. It certainly didn’t decelerate. So if you on creating the same amount of money let say 146,000 per year after year 5, than it looks like in year 8 that the money supply is slowing. It is really just not going up at an exponential rate any longer.

Consider this, as per my last argument that mortgage rates are low due to foreign banks not finding enough debt to invest their US dollars. When these countries run out of US sovereign debt they just buy mortgage backed securities (MBS) and other US bonds. This would make the MBS very attractive and competition for them would be very high. This would explain the low mortgage rates you see.

By lowering the amount of government debt on the market, you make obtaining bonds, MBS, and other forms of US debt the only way of maintaining the value of the US dollar. Remember, if the US dollar falls, then these countries, which have a lot of US paper as their core asset go into a banking crisis if the paper devalues.

Kudlow writes “Every one of the monetary readings is now way below the 6 percent growth of current dollar GDP. While the fit between money and national income is a loose one, it is not irrelevant. It could be predicting a sub-par economy next year.”

He indicated that if the money supply does not expand than the economy shall slump. With a negative trade balance you have to create more money through borrowing or you go bankrupt. The real problem he is alluding to is the ability to obtain loans from other countries. If the US cannot borrow any more money, we have to pay our debts through monetizing the debt, and then the currency will inflate (hyper inflate).

“It seems apparent that Greenspan is not targeting market-price indicators. So what is he targeting? Maybe he has the so-called housing bubble in his sights, or the mortgage credit-expansion behind it. If he is watching housing, he’s looking the wrong way. The key reason behind the surge in housing investment is the shower of tax advantages that have fallen on this sector since the 1997 tax bill. On a tax basis, it’s much better to invest in homes than in stocks as home-sale profits are tax-free up to $500,000.”

Mr. Kudlow has omitted many historical facts and is ignoring the impact of lower lending standards in his argument about housing appreciation. How very political of him to blame a “shower of tax advantages”. He knows, from his former job at the Federal Reserve that the United States and the other G-8 countries suffered an enormous banking crisis in 1998 due to Russia defaulting on its loans.

During the 1998 Russian banking crisis, the US bond market crashed. This was due to the fact that all of the banks in the world went under their fractional reserve limit and could not lend any more money. Here are some quotes from the history books about this time.

Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”. “Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”“

One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”

Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”

“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”

The Federal Reserve lowered the lending standard in order to inject currency back into the economic system. This action is what really lead to the housing bubble in the G-8 countries. In my opinion the tax advantage meant very little. The psychology of greed is what made people flip houses just like day traders bought and sold stock. Stocks had no such tax break, but that didn’t stop people from day trading did it.

“In the last economic cycle the Fed ignored falling inflation and instead aimed its guns at the Internet bubble. We soon were reminded that any time you deflate the money supply, the overall economy slumps badly. Stocks delivered their worst performance in over 40 years. As for signs of inflation today, the price of metals and overall spot commodities are dropping, gold is going nowhere, and long-term bond yields are at 45-year lows. These tried-and-true inflation indicators are saying: “No inflation.””

Kudlow is right on target here, any time your country depends upon debt to keep going, any small bump in the road will send your economy into a slump. However, we are still in the same economic cycle. How can that be, we never really recovered from the damage done to the banking system during the Russian banking crisis or the speculation of the dot.com crash. Instead of repairing the damage, we have “leveraged” our currency even more. This is not a recovery, this is a recipe for disaster when the lending stops.

Signs of inflation? The inflation numbers from the Federal Government have been manipulated for years. See Jim Puplava thesis called “The Core Rate” about how the government does this.

Stocks performed badly, of course, when massive speculation and bad investments hit bankruptcy, lending and investing institutions must liquidate in order to keep solvent and above their fractional reserve limit. This leads to the dumping of good stocks onto a market with few buyers, causing the stock prices to go lower.

Commodities prices are dropping, what planet is Kudlow on. I guess he never heard of rising food or energy prices. The two biggest expanses for people and let’s just ignore them. I guess that’s why the federal government took food and energy out of the inflation index.

Long term bond yields are at a 45 year low. Of course they are, when your currency is in every else’s banks, they have to buy your bonds or go into a banking crisis. This makes your bonds very important to them. The problem is when they decide that this has gone on for too long.

Under these conditions, if the US doesn’t offer as much as an increase in debt as expected, then the other countries will have to buy bonds with the money they would have used to buy US Treasuries. If they don’t buy US securities or assets, they dollar will devalue even faster and that could send them into a banking crisis.

“Milton Friedman taught us that inflation is a monetary problem caused by too much money chasing too few goods. However, as supply-side tax cuts expand the workforce, production, and investment, the increase in goods absorbs the existing money supply. Instead of prices rising, prices fall”

Friedman’s thesis is correct. The problem with our economy is that we have gutted our manufacturing base, so we don’t build that much stuff here anymore. “It's a deeply embedded structural problem," Warren Buffett said. "We're going down a path that's long being described as dangerous by some of the most intelligent people in this country."

“Former Federal Reserve governors Manley Johnson and Wayne Angell argue that financial and commodity-market indicators can inform the Fed whether money is too loose or too tight. Free-market prices, they’re saying, are smarter than central planners. Right now these market indicators, like the money-supply figures, are telling the Fed to stop tightening.”

I don’t agree tat the markets are good indicators here. If borrowed money dries up, than these businesses are in trouble. They need uncontrolled money expansion through borrowing or their companies will collapse. They think that the Fed has an impact on this. The lynchpin is really the health of the foreign banks.

“There’s a tug of war going on in the stock market today as the bulls and bears try to figure out which direction the future economy will go.”

The tug of war is really keeping this debt party going. The bears see it ending and the bulls are trying everything to keep it going. Tug of war, not really. It’s really a fight with our country forcing other countries lend us more money. Thank god we have a large military.

Mr. Kudlow has intentionally tried to steer focus away from the actual problems into a bunch of meaningless economic clichés. But what can you expect, he is a politician. Just check his resume.

Inverted Yield on Long and Short Term Debt

Nathan-Kaufman said in my comments section
“What do you think of the inverted yield curve in the U.S.?
11:26 PM, July 06, 2005”

I have the same opinion as Jim Puplava from Financial Sense Online. In his broadcast show this week he goes into this phenomenon. First we need to answer a few questions.

Why are mortgage rates so low anyway?

Who wants to buy United States Treasuries and Mortgage Backed Securities?

What is the current driver that makes foreign banks want to buy US securities?

What does it mean to be the world’s reserve currency?

What does “Inverting the Yield Curve” accomplish?

The US dollar is the world’s reserve currency. That means that the US dollar and US paper is held in foreign banks as part of their core assets. Core assets are the base to which banks are allowed to lend against (reference the fractional reserve system). The US dollar is used as a hedge against fluxuations in their own currencies.

The US has a negative trade balance, and the US dollar is the world’s reserve currency. These two facts make foreign banks to want to obtain US paper. As countries sell goods to the US they end up collecting the US dollar. Even without a negative trade balance other countries wanted to collect the US dollar as a hedge.

As countries increased the size of their debts, they decided to finance this through borrowing. In order to expand the money supply countries securitized debt. This makes it possible to sell mortgages and other hard handle financial arrangements as bonds to an international market. Using this method, other countries are essentially expanding your “leveraged” money supply for you.

With a negative US trade balance, countries start to collect far more dollars than they can use. You see, most of these dollars are “leveraged”. This means that this is money in a quickly expanding money supply. Countries on the other side of our trade balance cannot get rid of the dollars they are collecting.

Why, how can that be?

They have collected so many dollars that if they were to trade them for, let’s say other currencies; the value of the dollar would drop. So the countries make money when they sell the US goods. These countries receive “leveraged” US dollars in payment. So at this moment these countries are making money by selling, and losing some of that profit on the decline of the value of the US dollar.

Now the situation gets interesting. The only thing these countries can buy with these US dollars is US debt, because to do anything else would devalue the dollar. If the dollar were to devalue they would be sacrificing value of the past gains they made through selling the US goods.

So, now these countries must buy US assets in order to maintain the value of the dollar. In fact so many dollars have been sent oversees that the US doesn’t produce enough debt (even though our debt is rising to biblical proportions).to offset this arrangements. So these countries are forced to buy mortgages or anything else they can get their hands on.

Even if Greenspan were to “invert the yield” on short and long term treasury debt, this may not change anything. These countries have nothing else to do with our currency. They have already run out of options for our dollar, which is why mortgages rates are so low. Counties keep on buying our mortgage debt because they are running out of things to do with our dollar.

Here is the sticky point. If the dollar devalues than these countries banks core assets devalue at the same time. This shall send them into a banking crisis. It is coming to the point were these countries will not be able to make “real” money from selling to the US. At this point they won’t care if the dollar devalues because they cannot do anything with it anyway.

Just like in the 17th century with John Law, the first to cash in will do the best. When foreign banks stop buying US debt we shall enter a housing crash that will destroy the US dollar. If the housing market gets too high, and it really already is, than no one can afford a loan, the housing market will crash under its own weight.

If any member of the G-8 has a housing crash, and they are all in trouble like we are, than through the derivatives market, we shall also be put into a banking crisis which will lead to a housing crash.

If we get into a trade war with China, they can devalue the dollar, sending us into a housing crash.

These other countries see the writing on the wall, they are just doing what they can. After almost all banking crisis there is a “revolution”. They are just trying to stay in power.

This situation has a time limit, and that time limit is quickly coming to pass.

Bankruptcy, The Real Threat Part V Sins

Bankruptcy, The Real Threat Part V Sins 1 & 2

The Sins of the Banks are born upon the Populous.

The First Sin, Unknown Loans
Banks very rarely know the how the loan shall be used. Hedge funds intentionally keep the lending banks in the dark as to how the money shall be used. Therefore the banks don’t really understand the risks they are exposed too.

The hedge fund then goes to another bank and makes derivative contracts on the assets they wish to arbitrage. Since derivatives contracts cost only a fraction of the actual value of the stock or bond, the hedge fund gets a greater gain or loss depending on the price difference.

The affect is that banks do not really have any idea of how stable the loans they give out are. When times are going well banking has never policed itself very well. The flaw of the human condition, it’s hard to argue with success.

The owners of the banks see other banks making money in hedge funds, and not wanting to be left behind, they follow like lemmings. This causes a situation in which many more banks are trying to invest in a limited amount of hedge funds. Hedge funds are in a position to pick and choose which loans it takes from banks and can play banks against each other. Therefore banks are willing to give loans to hedge funds without actually understanding the risks of the loans.

Not only are the loans unknown, but the size of the loans have increased. Therefore the failure of just one hedge fund can bankrupt several banks. When the hedge fund called “Long Term Capital Management” became insolvent during the Russian banking crisis, almost sent some of the biggest banks in the world into bankruptcy at the same time.

The Second Sin, Using Derivatives to Leverage Investments
Hedge funds like to use derivatives because they do not actually own the asset (stock, bond …) they are arbitrating. In essence, they only own the right to bet on the direction the value of the asset. The option is worth only a fraction of what the asset is worth if they were to own it outright.

The major difference between owning stock outright and owning derivatives, is that stocks is actual property. A derivative is more like insurance. So a derivative is only good for up to a certain time in the future. When the time runs out, the value of the derivative is zero. So stocks that losses value still have value. A derivative that losses value against the stock it is tracking has no value. It only has value if it increases in value over time, but no value if it does not.

Let’s look at a simple example.

If a hedge fund had $1,000,000 and wanted to buy a stock worth $100 they could buy 10,000 shares of stock. The same option for a stock would be worth $10. If the hedge fund bought options they could own 100,000 options of the stock. The options have a limited life span. We shall assume six months in this example.

The difference between owning options and the stock itself is that an option is set at a price and has a limited time. So 10,000 shares were obtained they would own these shares like property. If the value of the stock fell, the owner would still retain the value of the stock, just at a loss. If the value of the stock increases they also realize the increased value.

For example if the value of the stock became $120 a share for 10,000 shares owned. The value of the investment would have grown to $1,200,000 from an initial purchase of $1,000,000 for an increased value of $200,000

Now using options, if the value of the stock became $120 per share, the hedge fund owns 100,000 options. The value of the investment would be $2,000,000. Remember, options only track change in value of the stock, no the stock itself. So the gain is determined by taking 100,000 options multiplied by the change in price between $120 and $100.In this case the change is price is $20.

$20 is now multiplied by the number of options owned which is 100,000 which gives a total gain of $2,000,000. The cost of the option is subtracted from the price so you spent $1,000,000 on the option. $2,000,000 minus $1,000,000 equals a net gain of $1,000,000. This is five times more than the $200,000 made by owning the stock outright.

Now let’s take a gloomier picture. Let’s say the stock lost value instead of gained value. So unlike stock, options have a limited life span. In this example we shall assume that the option has a life span of six months.

The stock price starts at $100 per share and as before and the hedge fund buys 10,000 shares of stock. This gives a total investment of $1,000,000. The stock looses value and the value of the stock is now valued at $95 per share. Now the total investment is valued at $950,000 so the investment is down $50,000. The hedge fund can hang onto the shares or sell the shares for a loss.

Using derivatives in the form of options, the hedge fund spends $1,000,000 to buy options priced at $10 per option for the stock priced at $100 per share for six months in the future.

Since the stock has lost value from $100 down to $95 per share. Since the stock has lost value and the option in this example only has value if the stock appreciates, then the value of the investment is $0. Since options have a limited time span the hedge fund cannot hold options and wait for the underlying stock price to increase..

In this example the straight stock investment losses $50,000 while the derivative investment losses $1,000,000. Therefore using derivatives has lost twenty times more money than just owning the stock outright. If the hedge fund just held onto the stock, the stock may increase and no loss may be required.

This situation begs the question, so how do hedge funds “Hedge”?

In the case of stocks and other assets hedge funds make bets using derivatives regardless if the asset goes up or down in value. So a hedge fund will deal in two different types of options on stock. One option called a call makes money if the stock appreciates and losses money if the stock depreciates. The other option called a put makes money if the stock depreciates and losses money if the stock appreciates.

For example, a hedge fund wants to make a hedge against a stock in the form of an arbitrage. The stock is currently worth $100 per share. The hedge fund sells call options (the right to buy a stock for a specified price over a specified amount of time) if the stock price goes above $100 per share then the derivative makes money. The price of the option is $10 per option and is good for six months.

The hedge fund also sells put options (the right to sell a stock for a specified price over a specified amount of time) that make money if the price falls below $100 per share. The price of the option is $9 per option and is good for six months. They sell 50,000 call options for $500,000 and sell 50,000 put options for $450,000.

If the price of the stock goes to $110 per share
(50,000 call options) *($10 price rise) = $500,000
(50,000 put options)*($0 price decline) = $0
Price of the sale ($500,000 call options sale)+($450,000 put option sale)=$950,000
The hedge fund has made $950,000 - $500,000 = $450,000 in the deal

If the value of the stock goes to $120 per share using the same math the hedge fund would lose $50,000

If the stock price goes to $90 per share
(50,000 call options) *($0 price rise) = $0
(50,000 put options)*($10 price decline) = $500,000
Price of the sale ($500,000 call options sale)+($450,000 put option sale)=$950,000
The hedge fund has made $950,000 - $500,000 = $450,000 in the deal

If the value of the stock goes to $80 per share using the same math the hedge fund would lose $50,000

Hedge funds can use very exotic techniques in order to make money. In this case as long as the stock doesn’t move up or down too much the hedge fund makes money. If the stock moves outside of the range, the result can be disastrous.

A hedge fund can also lose money if the stock rises and falls dramatically during the course of the time period. This is referred to as volatility. When this happens then when the buyer is in a position to make money and they do so immediately, without waiting for the option to come close to expiration.

Under this condition, the hedge fund can lose money in both directions during the six months the options are good for.

The Sins to be continued.

Banking, The Real Threat Part IV

Banking, The Real Threat Part IV

The unseen provides the worst horror

Banks thrive and decline based on the value of their risks. Money kept at banks earns interest. This interest is generated from banks making loans and investments. These actions take the form of mortgages, credit cards, loans, bonds, and other services. Banks have an intimate relationship with the financial engineers.

Financial engineers, the mystical artisans of mathematical science whom reside in the lofty citadel of hedge funds. They develop contracts that track the value of assets, like stocks or interest rates, without actually owning the underlying asset itself. These contracts provide the means of transforming assets. Using this technique, two parties can exchange cash flows. Known as derivatives, this technique has been around since the beginning of recorded time.

For example an American has loans which are denominated in the French franks while a French man has loans denominated in the US dollar. Each would like their loans to be in their own currency. Upon examination of exchange rates, interest on the loans, and matching up the life of the loans they decide that they can each make a bundle of loans that shall be equal to each other.

Instead of liquidating or renegotiating the terms of their loans, they decide to write a contract to swap loans with each other. So each man takes the monthly payments from each bundle of loans and transports it to the other mans account. Now the American receives dollars and the French receives franks.

Another form of derivative contracts is stock options. These contracts provide the ability to bet on the price of the stock either appreciating or declining without actually owning the stock. These contracts give the investor the right to buy or sell the stock the option is based upon at a certain price for a finite period of time.

The value of the stock must move above the price of the option for the holder of the option to gain money. If the value of the stock does not exceed the option price the issuer of the option makes money. Options only cost a fraction of what the stock is worth. However, like Cinderella’s pumpkin carriage, when an option time is exceeded, the option expires and is worthless. Investors exponentially increase there leverage of a stock as it moves up or down for the same amount of money as it would have taken to own the stock.

These are two very simple examples of how derivatives work. There are many more complex uses of derivatives. However, these examples give enough definition in order to understand how derivatives and banking is liked together.

Seems innocent, doesn’t it. So did Smurfs and Care Bears. Looks can be deceiving. These helpful little contracts can morph into giants, titans that can unleash unholy retribution upon an unsuspecting country. For no mathematics spell is circumspect enough to encompass human experience.

But how?

Examine the beast; its number is not “666”. The true monster is zombie lending by banks providing for excessive leverage using derivatives. Cloaked in darkness provided by private contracts, the beast has found a way around the fifty percent margin requirement, regulation T. The black death of bankruptcy has unlocked the shackles holding the beast back.

Arbitrage, is the magical ability for financial engineers to find “risk free” investments. Like the Miners 49er, they search for the real gold in the minor price differences in stocks and bonds. The bet they make is that the price shall converge, or the price between the two similar bonds shall contract.

The price differences are very small. Long Term Capital Management called this process “vacuuming up nickels, dimes, and quarters”. Since such a small amount of money is being made in each transaction, the amount of money used in the transaction becomes very important.

In order to increase the money made in arbitrage, hedge funds use borrow money from banks. The banks in return require collateral for the loan called a “haircut”. Since hedge funds are supposed to hedge their assets, the loan is considered safe. Therefore the amount of collateral required by the banks is low.

The horror materializes in the banks lack of prudence. Sins of the banks shall be born upon the populous.

To be continued.

History of Derivatives by Don Chance

A Brief History of Derivatives
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. A few years ago I compiled a list of the events that I thought shaped the history of derivatives. That list is published in its entirety in the Winter1995 is sue of Derivatives Quarterly. What follows here is a snapshot of the major events that I think form the evolution of derivatives.

I would like to first note that some of these stories are controversial. Do they really involve derivatives? Or do the minds of people like myself and others see derivatives everywhere?

To start we need to go back to the Bible. In Genesis Chapter 29, believed to be about the year 1700 B.C., Jacob purchased an option costing him seven years of labor that granted him the right to marry Laban's daughter Rachel. His prospective father-in-law, however, reneged, perhaps making this not only the first derivative but the first default on a derivative. Laban required Jacob to marry his older daughter Leah. Jacob married Leah, but because he preferred Rachel, he purchased another option, requiring seven more years of labor, and finally married Rachel, bigamy being allowed in those days. Jacob ended up with two wives, twelve sons, who became the patriarchs of the twelve tribes of Israel, and a lot of domestic friction, which is not surprising. Some argue that Jacob really had forward contracts, which obligated him to the marriages but that does not matter. Jacob did derivatives, one way or the other. Around 580 B.C., Thales the Milesian purchased options on olive presses and made a fortune off of a bumper crop in olives. So derivatives were around before the time of Christ.

The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting. The celebrated Dutch Tulip bulb mania, which you can read about in Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, published 1841 but still in print, was characterized by forward contracting on tulip bulbs around 1637. The first "futures" contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees.

Probably the next major event, and the most significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of Trade in 1848. Due to its prime location on Lake Michigan, Chicago was developing as a major center for the storage, sale, and distribution of Midwestern grain. Due to the seasonality of grain, however, Chicago's storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. Similarly, its facilities were underutilized in the spring. Chicago spot prices rose and fell drastically. A group of grain traders created the "to-arrive" contract, which permitted farmers to lock in the price and deliver the grain later. This allowed the farmer to store the grain either on the farm or at a storage facility nearby and deliver it to Chicago months later. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. Farmers and traders soon realized that the sale and delivery of the grain itself was not nearly as important as the ability to transfer the price risk associated with the grain. The grain could always be sold and delivered anywhere else at any time. These contracts were eventually standardized around 1865, and in 1925 the first futures clearinghouse was formed. From that point on, futures contracts were pretty much of the form we know them today.

In the mid 1800s, famed New York financier Russell Sage began creating synthetic loans using the principle of put-call parity. Sage would buy the stock and a put from his customer and sell the customer a call. By fixing the put, call, and strike prices, Sage was creating a synthetic loan with an interest rate significantly higher than usury laws allowed.

One of the first examples of financial engineering was by none other than the beleaguered government of the Confederate States of America, which is sued a dual currency optionable bond. This permitted the Confederate States to borrow money in sterling with an option to pay back in French francs. The holder of the bond had the option to convert the claim into cotton, the south's primary cash crop.

Interestingly, futures/options/derivatives trading was banned numerous times in Europe and Japan and even in the United States in the state of Illinois in 1867 though the law was quickly repealed. In 1874 the Chicago Mercantile Exchange's predecessor, the Chicago Produce Exchange, was formed. It became the modern day Merc in 1919. Other exchanges had been popping up around the country and continued to do so.

The early twentieth century was a dark period for derivatives trading as bucket shops were rampant. Bucket shops are small operators in options and securities that typically lure customers into transactions and then flee with the money, setting up shop elsewhere.

In 1922 the federal government made its first effort to regulate the futures market with the Grain Futures Act. In 1936 options on futures were banned in the United States. All the while options, futures and various derivatives continued to be banned from time to time in other countries.

The 1950s marked the era of two significant events in the futures markets. In 1955 the Supreme Court ruled in the case of Corn Products Refining Company that profits from hedging are treated as ordinary income. This ruling stood until it was challenged by the 1988 ruling in the Arkansas Best case. The Best decision denied the deductibility of capital losses against ordinary income and effectively gave hedging a tax disadvantage. Fortunately, this interpretation was overturned in 1993.

Another significant event of the 1950s was the ban on onion futures. Onion futures do not seem particularly important, though that is probably because they were banned, and we do not hear much about them. But the significance is that a group of Michigan onion farmers, reportedly enlisting the aid of their congressman, a young Gerald Ford, succeeded in banning a specific commodity from futures trading. To this day, the law in effect says, "you can create futures contracts on anything but onions.”

In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgages. While the contract met with initial success, it eventually died. The CBOT resuscitated it several times, changing its structure, but it never became viable. In 1975 the Merc responded with the Treasury bill futures contract. This contract was the first successful pure interest rate futures. It was held up as an example, either good or bad depending on your perspective, of the enormous leverage in futures. For only about $1,000, and now less than that, you controlled $1 million of T -bills. In 1977, the CBOT created the T -bond futures contract, which went on to be the highest volume contract. In 1982 the CME created the Eurodollar contract, which has now surpassed the T -bond contract to become the most actively traded of all futures contracts. In 1982, the Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line Index. The Chicago Mercantile Exchange quickly followed with their highly successful contract on the S&P 500 index.

1973 marked the creation of both the Chicago Board Options Exchange and the publication of perhaps the most famous formula in finance, the option pricing model of Fischer Black and Myron Scholes. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of derivatives. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor's and became known as the S&P 100, which remains the most actively traded exchange-listed option.

The 1980s marked the beginning of the era of swaps and other over-the-counter derivatives. Although over-the-counter options and forwards had previously existed, the generation of corporate financial managers of that decade was the first to come out of business schools with exposure to derivatives. Soon virtually every large corporation, and even some that were not so large, were using derivatives to hedge, and in some cases, speculate on interest rate, exchange rate and commodity risk. New products were rapidly created to hedge the now-recognized wide varieties of risks. As the problems became more complex, Wall Street turned increasingly to the talents of mathematicians and physicists, offering them new and quite different career paths and unheard-of money. The instruments became more complex and were sometimes even referred to as "exotic."

In 1994 the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known and highly experienced firms, such as Procter and Gamble and Metallgesellschaft. One of America's wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England's venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office. These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. While some minor changes occurred in the way in which derivatives were sold, most firms simply instituted tighter controls and continued to use derivatives.

These stories hit the high points in the history of derivatives. Even my aforementioned "Chronology" cannot do full justice to its long and colorful history. The future promises to bring new and exciting developments.

Don Chance is a professor of finance at Louisiana State University He can be reached at dchance@fenews.com

For More Reading

Black, Fischer and Myron Scholes. "The Pricing of Options and Corporate Liabilities." The Journal of Political Economy 81,637-654.

Chance, Don M. "A Chronology of Derivatives." Derivatives Quarterly 2 (Winter, 1995), 53-60.

Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. New York; Harmony Books (1841, current version 1980).


This column is excerpted from “Essays in Derivatives” by Don Chance (John Wiley & Sons, 1998)

Mortgage Backed Securities

I got this off of the Housing Bubble 2 posted Yeasterday

I thought this was a great post

zed said... "
I thought I'd comment on some of the posts I'm seeing here. There are some good comments, some bad/misinformed ones, and some in between. Let me try and shed some light on some issues here, to the best of my ability.

First, a bit about me: I work for a Wall Street firm. We securitize mortgages of all sorts, Option ARMs included. As an example, we will buy the loans from the bank, package them into bonds whose payments are backed by the loans, and sell those bonds to investors (hedge funds, mutual funds, pension funds, etc.).The typical structure of a deal might be as follows:

Class A Bond: 700 million
Class B Bond: 200 million
Class C Bond: 50 Million
Class D Bond: 50 Million

I am simplifying, but bear with me. The way these bonds get paid is sequentially. Every month when borrowers make their mortgage payments, the A bonds get interest first. When they are paid, then the B bonds get interest, and so on. After the interest then the principal gets paid, once again in order.

What this does is effectively shield the higher class bonds from suffering losses. They are safer, and the lower classes are riskier. As a result when these deals are done, the lower classes will pay higher interest rates (to compensate investors for additional risk), and these classes will be rated lower by the rating agencies (S&P, Moody's, Fitch).

The job of the agencies is to rate the security of each bond so that investor can roughly gauge what they are in for. The deals are stressed enough in terms of prepayments/defaults/losses than the Class A Bonds are extremely well covered from losses. The lower classes suffer most should things go wrong. So a statement such as:"My alarm was that these mortagages were now being used to back securities up by 40%! They're not secure for a mortgage in my opinion...along the same track...Do some reading on pension funds etc..They are all invested. You may not even have near what you think you had coming when this unravels..

Heck you don't need your pension or SS you have your home equity right? By this fiasco being encouraged all will be affected...Maybe their point? Blow it all up so noones' liable..."

is incorrect. Pension funds will typically invest in these higher classes, and even if the shit hits the fan they will be relatively well off. I am not a pension fund manager but I believe they are usually restricted in the types of rated bonds they can purchase (read: only the highest rated types).Moving on to another comment:

"My ex-friend is using Option ARMs to flip. Even more crazy."

Well...it depends. This product is certainly unique, and certainly carries risks. But it was designed for borrowers with a certain risk tolerance. You pay more up front (in interest) for a 30 year fixed rate loan because you are paying for that extra security (your rate never changes). Hybrid ARM loans (fixed for a certain period, then floating) carry additional risk (floating rate later on). As a result, you will pay less in fixed rate costs initially. Mom and Dad buying a house they will live in for years and years and years to come would go with the 30 year fixed, or maybe a 10/1 hybrid arm to save a little interest initially. But let's say I'm someone who knows he'll be moving in 2-3 years (planning on graduate school) and am buying a place. The 30 year fixed is a bad idea. Why pay more in interest for those 2-3 years when I could maybe do a 3/1 hybrid arm instead. Before the loan converts to a floating rate I will already have sold my place and paid off the loan.

The Option ARM is good for a borrower who 1) is willing to take on risk, and 2) is looking to manage cash flow. #2 does *not* mean "I can't afford the loan any other way, so I will make this minimum payment and stay current." Anyone who takes out this loan with that line of thought is going to get raped when their payment adjusts after a year. #2 *does* mean someone who has income that is relatively discrete over the course of the year. Maybe you own your own business. Or (in my case), the majority of your income shows up once a year in your bonus. In that situation the Option ARM could make sense...if you are willing to accept the risk involved.

I should also note that just because you have the OPTION to make a minimum payment does not mean you HAVE TO. If I were to take out this loan (which I haven't), I'd probably use the minimum payment feature for a few months until my bonus arrived. At that point I'd pay down a chunk of principal at once. And if I felt like paying my loan normally and amortizing on a normal schedule, I could do that as well.If you are flipping in a 3-4 month time frame, and KNOW you will sell at that point, then this loan is perfect for your needs. A 1.5% teaser rate for 3 months is impossible to find anywhere else...in that case the only risk you run is having housing prices collapse in that timeframe (which is a valid concern, but a separate one from the mortgage risk being discussed here)

If this product blows up (and I suspect that some originators will and others won't, depending on the types of guidelines they are using to make these loans), the only people to blame will be the originators for offering loans to borrowers they shouldn't have, and the borrowers for taking on a mountain of debt they couldn't have afforded. Just because someone offers you something doesn't mean it a good idea. The blame down the line, if there is any, should be shared by both sides.

Who will lose money? The owners of the riskier bond classes backed by these loans, the borrowers when they go delinquent and potentially default. "
7:56 PM

Bankruptcies, The Real Threat Part III

Bankruptcies, The Real Threat
Part III

Fantasy has many elements, but non so damaging as imaginary wealth.

Bankruptcy, the creeping death, fallen angle, the bane of a leveraged monetary system. The wizards of the Central Bank live with the demon every day. A secretive sect, they are the monks of the banking.

The Eccles Building looks pristine, strong, and fortified. A worthy temple to apply their trade. A shrine to the monetary system, the worlds currency. Deceiving in its strength, it is actually very fragile.

The United States uses a monetary system called a Fractional Reserve System. The magical process of creating money is guided by this philosophy. The rules are known by many, but few understand the impact this system has on the world. The Black Death of Bankruptcy understands all too well.

First of all a bank must have assets, whether it be currency, treasury bills, bonds, or whatever holds value. The banks can then lend (this is simplified) up to ten times their assets. So if a bank has one thousand dollars in currency, it can lend up to ten thousand dollars. Basically, a small amount of real money is supporting an exponentially higher level of leveraged (borrowed) money.

It is a truly mystical process, for the question must be asked, how did this new ten thousand dollars come into being. Did the government print more money and this loan represents that? Where did this money come from? It is as if a stork brought in the money like a baby to a young mother.

The answer is actually very magical. The bank created new money by giving the loan out. This means that the amount of money in the world has increased. But you ask, How Can That Be. Isn't there a finite amount, an absolute limit to the amount of money in circulation.

Mere Mortal, how dare you challenge the clerics of the banking system with such pathetic questions that your primitive intellect cannot possible understand.

The answer is magical. New currency is created in this way. The only limit to the amount of money in circulation is controlled by the amount of money a bank must have in assets verses the amount it gives out in loans. The Central Bank determines that ratio of assets to loans. The Central Bank also polices the system to make sure all of the banks comply.

Money creation is also thought to be controlled by short and long term interest rates. As the amount of interest the Central Bank charges on short term loans, (few days) this should make interest on longer term loans (few years) go up as well. As interest rates rise, fewer and fewer can obtain loans. In this way money creation is limited.

Or is it?

The Black Death of Bankruptcy smiles for it knows a secret.

Once upon a time in a land not so far away, banks made loans to people, governments, and people. The banks would hold onto these loans until they were paid off. Banks would scrutinize its borrowers very carefully. This was necessary to try to pick loans that the borrower would pay the bank back. If the borrower didn't pay the bank back the bank would lose all of the loaned out money.

Now money lost in this way is special. Like a child dying, the parents are distraught and the damage to a life is forever destroyed. In this way the loaned out money not recovered by the bank is taken out against its asset reserve. So let lay out how this disease spreads through the child's body.

The bank needs ten thousand in assets to give out a hundred thousand loan. Lets say the bank has one million in assets total. This amount shall let the bank make teen million dollars worth of loans.

If bank lends out a hundred thousand and the borrower defaults, takes the money and runs. Then the bank sustains a loss. The loss is against the banks reserve assets. So the bank goes from having one million in assets to nine hundred thousand in assets. Now the bank can only lend nine million. If the bank has nine million five hundred thousand dollars worth of loans outstanding, then the bank can not make any more loans until the difference is made up for.

If the bank makes too many bad loans it kills the bank, the bank becomes insolvent. Banks can borrow from other banks to prevent from going into bankruptcy. Once the bank does not have the cash flow to service existing debt and expenses, then the bank goes into bankruptcy.

If it was only so simple, the horror is in the complexity.

To be continued.

Questions about the Fractional Reserve System

I have been asked about the franctional reserve system. I shall be writing about this in the third part of my story of the dangers of bankruptcy. This is a good site to give you an overview of how it works until then.
http://en.wikipedia.org/wiki/Fractional-reserve_banking
http://www.lewrockwell.com/rothbard/frb.html


I should have part III done this weekend. I have been very busy at work.

Bankruptcies, The Real Threat Part II

Bankruptcies, The Real Threat
Part II

Society determines the enveloping structure, people chose the cognitive path.

Much like the gods of antiquity a new religion of banking has its clerics casting spells from their sanctuaries. Omnipotently large structures, expansive and reaching, powerful and petty, their temples shrines to society. People fear, distrust, and depend upon their unearthly advice and guidance.

Businesses, Banks, and Governments share the risk of loans and other investments using a whimsical creature called a Derivative. These tiny goblins are the servants of the financial wizards. Created using the components of Differential Equations and Probability to cast spells of warding against demons of default and monetary loss.

However, the Black Death of Bankruptcy is not deterred. There is a weakness in the structure of the spider web spell of financial protection. His creeping death is held at bay, shunned out of the light and into the dark reaches of misunderstanding. His power grows, his minions integrate, and his clerics of greed spread forth of the gospel of easy loans with no down payment.

The exact incantations of the derivatives spell is structured using advanced mathematics, the language of describing two structures as they move in relation to each other. Clever are the wizards casting these incantations. Clever enough to forget, and in many cases, never to have known the weakness of the spell, as many of these new financial wizards are not the true master of the art.

The magic is structured along one massive linchpin, a fulcrum of financial instability. The eight largest banks in the world have ninety percent of all of the derivatives of the world homed in upon them. Twenty five of the largest banks have ninety nine percent of all of the world derivatives homed in upon them.

The businesses, banks , and governments of the world make agreements with each other. In order to protect these agreements from the ethereal floating of interest rates, currently values, and commodity prices (there are more elements), an insurance is needed to protect against radical changes in the financial system in the future. A premium is paid to lock down price or the element is question or to pay off a failure, like in life insurance.

Creatures of risk, the sorcery of derivatives is invoked when a business, bank, or government needs to limit how much a financial element can change that would induce their contract lose money. They determine that they would rather pay an additional cost in the present and have another group assume the risk of things changing that would hurt them.

If things change in a more favorable way, then they make additional money minus of course what they lost paying for the derivative. If darkness comes and things change in a negative way, then they have only lost the premium and have saved themselves from additional losses.

Within the hallowed halls of the twenty five largest banks are the facilitators of the risk market. These priests of odds take on the risk. They gaze into their mathematical crystal balls, scrying for hints of a future, sacrificing their time and effort to the gods of premiums. They make money when the premiums they charge are higher than the change in the future market shifts.

The ward of protection looks to be impervious, like the Walls of Constantinople. Using derivatives like insurance. The risk of loss is managed onto these huge international temples. Enormous size and diversity is the steel platemail that protects these knights.

The Black Death of Bankruptcy is not deterred. It knows the truth, the weakness, knowledge ordinary man was not meant to know. It knows the banks in the world have committed an error. Its priest hid it, none dare speak of it. The same error has occurred time and time against in the history of mankind.

To be continued

Bankruptcies, The Real Threat

Bankruptcies, The Real Threat

Bankruptcies, the bane of the monetary system, destroyer of money creation through lending. Probably the biggest determining factor in the value of real estate. Analysts look for clues of the beast, tracking it like a ranger in ancient times. Following the broken twigs of rising mortgage rates, the torn cloth of currency valuations, and the blood late payments.

The Federal Reserve and the Central Banks of the world live in fear of the pestilence caused by this creature. They tried to avoid a recession by injecting the world with money through borrowing. Never before has the value of housing risen so fast around the world at the same time.

The Central Banks have called for a crusade of liquidity with the mantra "give loans to anyone who asks for it". Flood the cities of world with newly created money and the populous shall compete with each other over property. Using leveraged money to bid up the property, the seller walks away and buys another home which he then bids up. So the circle of abundant cash following limited assets begins.

The circle injects money into the building industry, new homes are built, fortunes are created. People become employed in the mortgage, construction, and other related fields. The people rejoice at the miracle of their new found prosperity. Housing valuations go up and increased taxes are collected.

But something is amiss. Rents remain the same or lower as housing prices ascend into the realm of the heavens. It becomes much cheaper to rent than to buy. Some of the foolish mortals not in hallowed halls of the Central Banks begin to wonder "Where is all this demand for housing coming from?"

The black death of bankruptcy hangs over the central banks. The Allen Greenspan's of the world know what is up. They sit in their offices in fear of the black death. They understand that if the population stops borrowing and creating new money, than the black death shall creep in, fester, and take back what was stolen, take back the leveraged money created through deceptive demand.

The derivates market has made it possible to transfer mortgages from the originating bank to investors in the form of an asset backed security called a mortgage backed security (MBS). These securities take the form of bonds sold onto the international market, where pension funds and banks all over the world use them as assets and reserves.

These securities in America track the 10 year Treasury bond very closely. This is due to the fact that they are seen as just as safe, as the investor still has the property to fall back upon in case of default by a delinquent borrower. Like unthinking troglodytes, investors buy them up, never questioning the actual value of the property supporting the MBS.

The sickness of greed hits the population. Bankers and buyers pressure the appraisers to artificially raise the price of there property. Bankers lower their lending standards to the lowest possible point, even lending to a dead man (True story). The population thinks it has found a way to get rich without working or knowledge. It must be gods grace. God must really love America, or the United Kingdom, or Australia, or Spain. So much love, they all must be hippies. The feeling of wealth and success is better than drugs.

Housing continues to rise in all of the countries. Leveraged money inflating the housing values to the heavenly clouds. The black death of bankruptcy is still waiting, waiting for the people to come to the edge of affordability, waiting for the panic, waiting for some minor event to change the hearts and minds of gods chosen people from a feeling of success, to one of panic, fear, and doubt.

To be continued

The Great Banking Lynchpin

The Great Banking Lynchpin

This blog is to explore the relationship of the derivatives market on the banking system.

This topic needs to be addressed as a huge asset appreciation in the world wide housing market caused by a lowering of the lending standard. This has raised the amount of questionable loans to frightening heights all over the world.

The Big Question

How many bankruptcies and foreclosures on a world wide scale will it take to endanger the derivatives market, causing an international banking crisis of historic magnitude.

With 90% of all derivatives exposure located in the eight largest banks and 99% of all exposure through the 25 biggest banks on the planet, the question becomes, did we really move the risk onto the counter party, or just fool ourselves into thinking we did.

At this time there is 45 trillion to 55 trillion dollars worth of derivatives exposure. With a major banking crisis forming due to bankruptcies and foreclosures, is their really any way to escape the damage in a heavily leveraged monetary system?

The genesis of today's lending standard

Why can anyone get a loan, a recent history.

In 1998 at the annual meeting of the International Monetary Fund and World Bank was the turning point for bank lending standards as systemic risk nearly destroyed the banking system.

Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”.
“Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”

“One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”

Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”

“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”

This set off the trend in lending in which we have today. The Central Banks of the free world started a policy of giving loans to anyone in order to inject the economy with cash.

Now that banks sell their loans to the international market in the form of bonds, they have diminished their risk from loan process. Banks have responded by reducing their lending standards.