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peristaltorAbout a year ago I wrote here an open letter to NPR reporter Adam Davidson challenging him to delve into the subtleties of our nation's banking system that have, from the available evidence, thus eluded him. After reading several books by authors that otherwise appear quite competent discussing economics, I realize I may have been too harsh on Davidson, since even these authors miss a single subtlety that allows banks to run roughshod over our economic system and to this day party like it's 1928. I'm referring to a fact that I've mentioned here several times, but the stunning implications of which I only realized the day I typed my last entry.
From that last entry, I noted that banks are probably as flush with cash as they are relative to every other actor in today's troubled economy due to a quirk in de-regulation. I'm specifically referring to the Banking Act of 1933, aka the Glass-Steagall Act, which was repealed officially in late 1999 by the Gramm-Leach-Bliley Act. From the Wiki entry: "The repeal of provisions of the Glass-Steagall Act of 1933 by the Gramm-Leach-Bliley Act effectively removed the separation that previously existed between Wall Street investment banks and depository banks."
To understand why this separation is helpful to society — and a bane to bank profits — it's best to outline what those two different types of banks do. An depository (or commercial) bank is the one most familiar. Deposits (under $250,000) to these banks are insured by the Federal Deposit Insurance Corporation (FDIC). Loans from these banks finance most of the smaller investments in our economy (cars, houses, small businesses, etc.). Yves Smith gives a quick description of the common understanding of how commercial banks work:
I think Adam Davidson would agree with this quick description of commercial bank activity (though I don't have a citation handy to prove it). As the joke goes, bankers lead a 3-6-3 life: offer 3% interest on deposits, loan money at 6% interest, and be on the golf course by 3.
The problem is simple when you get right down to it. Where does the money offered by the bank actually come from? That 3% seems to appear out of thin air. If it did not, banks would be simply shuffling money from one place to another, making interest-bearing accounts an impossibility without someone else incurring losses somewhere else. Also, why does the media note that increasing the Federal Reserve Prime Rate "slow inflation" of the money supply? What does a bank's prime lending have to do with the money supply?
Several posts under my tag How to Make Money correct Smith and Davidson's mis-understanding. Essentially, commercial banks create the money they lend:
With this in mind, banks do not "lend out a portion of their deposits" as loans as Smith declares above. Instead, they loan out more money than they have. How much money they create through lending is determined by the "capital reserve" of the particular bank, which is (mostly) the sum of money deposited in the bank by customers. The bank owners or shareholders provide the initial start-up money, and the bank can borrow from the Federal Reserve to shore up it's reserves. The sum total of all this money creates the "fractional reserve," beyond which the bank cannot lend. As Smith noted, this reserve is about 10% of deposits and other assets. Actual reserve rates vary from country to country.
Therefore, assuming a 10% fractional reserve requirement, for every $100 a bank holds in its vaults, it can create up to $1,000 in loans. Those loans bear interest. The constant flow of regular loan payments (a monthly portion of the loaned principal plus 6% from the 3-6-3 joke) creates the 3% depositor interest rate.
What prevents the money supply from ballooning exponentially? Simply, most loans are secured with collateral. Let's take a personal example. The Wife and I secured our home loan with the home itself. The loan amount was based on our 20%+ downpayment, our remaining assets, our outstanding debts, our current income and employment history, and ultimately the value of the house we bought. The first factors insured that the bank had a reasonable expectation of repayment; the last factor gave the bank legal recourse in the event we defaulted. As long as our house maintained its value, the bank lost nothing.
And getting that house's value proves straightforward. After all, the family that inherited the house hired a realtor (our neighbor two houses away) who knew well how to estimate the house's value. She in turn hired an inspector to turn up anything that would affect the average value. We hired another realtor (a close friend) to search for houses in our price range. She had access to the same database of available properties as our neighbor. After our bid was accepted, we in turn hired another inspector for yet another inspection. That's six sets of eyes on the purchase price. That many eyes agreeing on the price makes for a pretty solid market estimate.
Therefore, the lending bank had both a revenue stream (our agreement to pay) and an asset (our house). As long as we do not default or, should we default, our house loses no market value which would cause its resale price to fall below the remaining principal of the loan, the bank could fairly certainly justify creating the money through the loan. The Market had spoken.
So what went wrong?
The straightforward business of lending, however, carries unexpected surprises inherent in the system. Consider this: despite its reputation, banking is fairly unprofitable:
I can imagine that fact galls most bankers. After all, many of them like the idea of ever-increasing personal wealth and the prestige that accompanies it. The concept of poverty . . . ouch. And it's happened:
After this monumental collapse, I imagine bankers would be eager to find ways to avoid such losses in the future. Sadly, nagging restrictions set by Glass and Steagall prevented much in the way of banking innovation. This started to change after 1982, though, with the presidency of a man very publicly devoted to reducing regulation. The restrictions imposed on banks in 1933 were slowly eroded and often ignored, even by regulators. By 1999, repealing Glass-Steagall was simply a formality.
This long-term erosion and eventual repeal allowed banks to play fast and loose with what they are and what they should be. To understand what very well may have happened, remember that above I noted that "most loans are secured with collateral." Let's emphasize "most." In banking, unsecured lending is known as extending a "line of credit." Basically, a bank takes note of a lender's income and assets and guesses how much credit that lender can have without requiring collateral. This should be very, very familiar to people who hold credit cards. Yes, as I mentioned last October, "a credit card purchase also creates money."
Above I mentioned Yves Smith's misunderstanding regarding commercial banking. She spent over twenty years of her professional life in the other kind of banking, investment. An investment bank takes money from, well, investors, and invests it. Very importantly, no money is created through lending. The investments are stocks in existing companies and bonds of all sorts along with stuff I'll note later. Since the investments are not secured as a collateralized loan is, there is more risk buying stocks. Any given company could find and patent the cure for cancer or have its CEO abscond with the payroll for Brazil. Worse, even good companies get screwed in their stock price by market instability and shenanigans by corrupt short sellers. Still, our economy has been historically been growing, so a lot of the money that goes into stocks and bonds proves profitable.
In her book, Smith noted something called "derivatives," financial instruments that base their value on something else. Another investment banker and derivatives expert, Satyajit Das, confirmed in his book Traders, Guns & Money Smith's observations, often from personal experience, how many complex instruments were indeed fraud. Smith noted such an instrument that looked like a scam:
Like Das, Smith offered this example as a bank issuing a worthless instrument and therefore cheating the customer. Who issued this instrument? Undoubtedly an investment bank. Consider this investment bank example (called a "commodities trading unit"):
Do you see what happened there? Because Smith assumed that commercial banks lend depositor money, she is assuming that the Philbro investment bank used Citigroup deposits to fund speculative investments. Honestly, I don't know how Philbro is funded. Just for the sake of argument, though, let's get back to the role of a commercial bank and lending and ask a hypothetical question:
What if a bank extended itself a line of credit? In other words, what if a bank lent money to itself?
If true, this turns the whole Philbro example Smith provides completely on its head. Let's speculate that commercial banks fund their proprietary investment bank branches entirely through lines of credit. How much credit they extend depends entirely on how much of a fractional reserve the commercial bank has at the moment. This means the prop trading branch might be funded by the month, by the year, or even by the day. Essentially, the prop traders are given a dollar limit to their trading based on the reserve. Just like the limit on a credit card, they must not exceed this amount.
Ideally, the prop trader bankers would seek out profitable stocks to buy. As I said above, though, stocks and bonds do carry risk. Why not lower the risk to zero?
And here I'd like you, Dear Reader, to consider the "worthless" derivative Smith noted. "The client was paying $4 million a month for three years for the privilege of having an utterly worthless contract." What if that was the point?
Bear with me. Let's say not only the banker who created and sold this "worthless" contract knew it's true worth, but so did the buyer. What if the buyer had been another proprietary trading bank investor? Furthermore, what if there existed a very similar contract — worthless, but costing $4 million a month for three years — that was bought by the original seller?
Here's what would happen. The commercial bank lends that $4 million a month, creating the money through the prop trading subsidiary's line of credit. In another transaction, $4 million a month flows to the prop trading subsidiary as cold, hard cash. After the paying the banker who made these transactions, the bank pockets the difference, depositing this very real money in its vaults.
Two banks have just created money, in this case a cool $4 million a month, and given it to themselves. Yes, the instruments that backed that money creation were worth exactly zero, but they also carried exactly that much risk. Zero. It would be like money laundering, if washing machines could somehow be built to actually make clothes out of nothing.
I hope I just blew your mind. If I haven't, let me continue to try.
Most of us are familiar with lines of credit through personal experience. We must never borrow more than the limit, and we must always pay the monthly charges and the interest. What we never encounter in our personal experience is money that is lent without interest. There's no law governing how much interest banks must charge on their lines of credit. Since the prop trading desk is sitting in the bank itself, why would they charge any interest at all?
Thought of in this way, any purchase made by a commercial bank's prop trading unit becomes profitable even if the purchase loses money. Why? As long as the prop trader sells the asset before it loses 100% of its value, the difference becomes equity that can be applied to the commercial bank's reserves. Wouldn't this explain the quirky computer-generated high-frequency trading where assets are sometimes held only for a split second?
Furthermore, consider the now-infamous credit default swap. The wiki article points out that a "credit default swap is a bilateral contract between the buyer and seller of protection," meaning that two parties agree to "insure" each others' assets for an agreed price. (I put "insure" in scare quotes because banks never held the kind of reserves actual insurance companies are required to maintain; if they had to pay out on a contract, the bank would be unlikely able to pay.) If one party had stock in GM and another in AIG, for example, they would swap protection money, agreeing by contract that if either company folded (or the stock price plummeted) the value of the failed stock would be compensated by the issuer to the holder.
What very few reporting on this practice bothered to consider is that most of the CDSs issued were protection for companies that just about everybody considered too big to fail. Here's a question: If you thought General Motors would always be a dominant car company or American Insurance Group would always be an enormously profitable insurance leader, why would you bother paying millions each quarter for insurance against its demise? Wouldn't it be a better practice to buy protection for assets everyone considered likely to fail?
The CDS makes sense, though, if the money paying for this protection came from a line of credit, and if matching amounts returned to the issuing bank from the selling bank . . . exactly like the "worthless" contract noted by Smith. Sadly, though, as everyone now knows, some companies were not invulnerable.
Unlike fancy derivatives with dizzying complexity and zero worth, CDSs proved too volatile in the end. They actually had risk of payout. It took only one or two firms to default, and the entire interlinked edifice threatened to collapse.
If this theory I've outlined it true, wouldn't there be evidence to support it? A good question. It turns out there is evidence. After noting that "Wall Street money flow is 58 times the size of Main Street," Steve Roth explains:
This self-created financial wealth leaves its mark. Just about every asset bubble since the 1980s has been explained in every detail save one: Where did the initial money that inflated the tech bubble and the housing bubble come from? If I am correct, it came self-created from banks to banks. The only limit was the difference between the bank's required reserve amounts and what was left over for the prop traders after regular lending. Yes, the created wealth can leach into the Main Street portion of the economy. After all, inflating the money supply causes, well, inflation. Roth elaborates here:
Roth provides a graphic example of how enormous this disparity between things of value and the financial instruments supposedly represented by things of value has gotten:
It boggles the imagination.
Now that you have witnessed here what could bring down the economy again, what conclusions should one draw?
I have to say that I'm ambivalent. No, I don't think that banks should be able to create money just for the sake of creating money. Banks perform a service for the societies in which they operate — they assess the value of assets and through lending create money reflecting that valuation. They really shouldn't put their own profits above the value this service provides society.
On the other hand, the disparity between asset value and the money reflecting that value has gotten so large that an adjustment will undoubtedly prove catastrophic. Let's face it, in this case "adjustment" means removing incestuously created dollars from the economy — deflation. If this removal happens slowly, the value of everything we own will only fall over time. If it happens quickly, the value of everything we own will plummet. Either way, life as we know it will suck as a result.
Furthermore, the banks have the ultimate defense for what they are doing: It's perfectly legal. Please, leveling the accusation that some actions are legal but still should be condemned as abhorrent or indefensible or immoral (take your pick) is only so much childish stamping of feet and holding of breath. If a society cares enough to recognize the harm caused by an action, it has the option of making it illegal. Let's face it, folks: If you want something to happen, make sure it's legal. If you want it to happen slightly less often, make it illegal.
Senators Glass and Steagall sifted through Ferdinand Pecora's hearings and crafted the Banking Act of 1933, complete with its famed (but poorly understood) firewall separating different types of banks. We find ourselves today with the firewall gone and as a result smack in the middle of the next (and even larger) Great Depression even before we have recovered from the deflation caused by the last asset bubble pop, and quite un-ironically the only thing preventing a slide into a catastrophic meltdown is incestuous money creation propping up the commodities markets and the banks that buy the commodities offered thereon. Maybe we should take aim at preventing the more egregious abuses of money creation, or simply looking at the bright side of legal but unproductive action, perhaps finding a way to use them to benefit more than just an issuing bank. Society at large could easily benefit and profit from this method of reproduction through masturbation.
But I'll speculate on that future later.
From that last entry, I noted that banks are probably as flush with cash as they are relative to every other actor in today's troubled economy due to a quirk in de-regulation. I'm specifically referring to the Banking Act of 1933, aka the Glass-Steagall Act, which was repealed officially in late 1999 by the Gramm-Leach-Bliley Act. From the Wiki entry: "The repeal of provisions of the Glass-Steagall Act of 1933 by the Gramm-Leach-Bliley Act effectively removed the separation that previously existed between Wall Street investment banks and depository banks."
To understand why this separation is helpful to society — and a bane to bank profits — it's best to outline what those two different types of banks do. An depository (or commercial) bank is the one most familiar. Deposits (under $250,000) to these banks are insured by the Federal Deposit Insurance Corporation (FDIC). Loans from these banks finance most of the smaller investments in our economy (cars, houses, small businesses, etc.). Yves Smith gives a quick description of the common understanding of how commercial banks work:
Banks hold deposits and pay interest on them. Depositors have the right to demand their funds at any time, but through experience, banks know that only a small percent of the funds they hold in trust will be withdrawn on any given day, and even that might be matched or exceeded by a new inflows. Thus banks, to earn additional profit, lend out a portion of their deposits, typically $9 for every $10, at a higher interest rate than they pay to their depositors.
(Yves Smith, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Captialism, St. Martin's Press, 2010, p. 204.)
I think Adam Davidson would agree with this quick description of commercial bank activity (though I don't have a citation handy to prove it). As the joke goes, bankers lead a 3-6-3 life: offer 3% interest on deposits, loan money at 6% interest, and be on the golf course by 3.
The problem is simple when you get right down to it. Where does the money offered by the bank actually come from? That 3% seems to appear out of thin air. If it did not, banks would be simply shuffling money from one place to another, making interest-bearing accounts an impossibility without someone else incurring losses somewhere else. Also, why does the media note that increasing the Federal Reserve Prime Rate "slow inflation" of the money supply? What does a bank's prime lending have to do with the money supply?
Several posts under my tag How to Make Money correct Smith and Davidson's mis-understanding. Essentially, commercial banks create the money they lend:
Most of the "new" money in national economies is now created by commercial banks in the form of loans to customers. Governments through their central banks attempt to control how much money is created in the form of debt through two related instruments. One is the base rate — the rate at which the central bank loans money to commercial banks. The other is the reserve requirement — the percentage of deposits that banks are required to hold in reserve and which cannot therefore be used to make loans. The lower the base rate, the more likely commercial banks are to make loans.
(Tim Jackson, Prosperity Without Growth, Earthscan, 2009, pp. 25-26.)
With this in mind, banks do not "lend out a portion of their deposits" as loans as Smith declares above. Instead, they loan out more money than they have. How much money they create through lending is determined by the "capital reserve" of the particular bank, which is (mostly) the sum of money deposited in the bank by customers. The bank owners or shareholders provide the initial start-up money, and the bank can borrow from the Federal Reserve to shore up it's reserves. The sum total of all this money creates the "fractional reserve," beyond which the bank cannot lend. As Smith noted, this reserve is about 10% of deposits and other assets. Actual reserve rates vary from country to country.
Therefore, assuming a 10% fractional reserve requirement, for every $100 a bank holds in its vaults, it can create up to $1,000 in loans. Those loans bear interest. The constant flow of regular loan payments (a monthly portion of the loaned principal plus 6% from the 3-6-3 joke) creates the 3% depositor interest rate.
What prevents the money supply from ballooning exponentially? Simply, most loans are secured with collateral. Let's take a personal example. The Wife and I secured our home loan with the home itself. The loan amount was based on our 20%+ downpayment, our remaining assets, our outstanding debts, our current income and employment history, and ultimately the value of the house we bought. The first factors insured that the bank had a reasonable expectation of repayment; the last factor gave the bank legal recourse in the event we defaulted. As long as our house maintained its value, the bank lost nothing.
And getting that house's value proves straightforward. After all, the family that inherited the house hired a realtor (our neighbor two houses away) who knew well how to estimate the house's value. She in turn hired an inspector to turn up anything that would affect the average value. We hired another realtor (a close friend) to search for houses in our price range. She had access to the same database of available properties as our neighbor. After our bid was accepted, we in turn hired another inspector for yet another inspection. That's six sets of eyes on the purchase price. That many eyes agreeing on the price makes for a pretty solid market estimate.
Therefore, the lending bank had both a revenue stream (our agreement to pay) and an asset (our house). As long as we do not default or, should we default, our house loses no market value which would cause its resale price to fall below the remaining principal of the loan, the bank could fairly certainly justify creating the money through the loan. The Market had spoken.
So what went wrong?
The straightforward business of lending, however, carries unexpected surprises inherent in the system. Consider this: despite its reputation, banking is fairly unprofitable:
(If) you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back — but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.
(Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, 2007, pp. 206-207.)
I can imagine that fact galls most bankers. After all, many of them like the idea of ever-increasing personal wealth and the prestige that accompanies it. The concept of poverty . . . ouch. And it's happened:
In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking — everything. They had been lending to South and Central American countries that all defaulted at the same time — "an event of an exceptional nature." So it took just one summer to figure out that this was a sucker's business and that all their earnings came from a very risky game.
(Taleb, ibid, p. 43.)
After this monumental collapse, I imagine bankers would be eager to find ways to avoid such losses in the future. Sadly, nagging restrictions set by Glass and Steagall prevented much in the way of banking innovation. This started to change after 1982, though, with the presidency of a man very publicly devoted to reducing regulation. The restrictions imposed on banks in 1933 were slowly eroded and often ignored, even by regulators. By 1999, repealing Glass-Steagall was simply a formality.
This long-term erosion and eventual repeal allowed banks to play fast and loose with what they are and what they should be. To understand what very well may have happened, remember that above I noted that "most loans are secured with collateral." Let's emphasize "most." In banking, unsecured lending is known as extending a "line of credit." Basically, a bank takes note of a lender's income and assets and guesses how much credit that lender can have without requiring collateral. This should be very, very familiar to people who hold credit cards. Yes, as I mentioned last October, "a credit card purchase also creates money."
Above I mentioned Yves Smith's misunderstanding regarding commercial banking. She spent over twenty years of her professional life in the other kind of banking, investment. An investment bank takes money from, well, investors, and invests it. Very importantly, no money is created through lending. The investments are stocks in existing companies and bonds of all sorts along with stuff I'll note later. Since the investments are not secured as a collateralized loan is, there is more risk buying stocks. Any given company could find and patent the cure for cancer or have its CEO abscond with the payroll for Brazil. Worse, even good companies get screwed in their stock price by market instability and shenanigans by corrupt short sellers. Still, our economy has been historically been growing, so a lot of the money that goes into stocks and bonds proves profitable.
In her book, Smith noted something called "derivatives," financial instruments that base their value on something else. Another investment banker and derivatives expert, Satyajit Das, confirmed in his book Traders, Guns & Money Smith's observations, often from personal experience, how many complex instruments were indeed fraud. Smith noted such an instrument that looked like a scam:
For instance, consider this piece of artwork:
Maximum of [0:NP x [7 x [(LIBOR2 x 1/LIBOR) - (LIBOR4 x LIBOR-3)]] x days in the month/360
Where
NP = $600
LIBOR =6 month dollar LIBOR rates
The beauty of this formula is that no matter what values were plugged in the value was always zero. The client was paying $4 million a month for three years for the privilege of having an utterly worthless contract.
(Smith, ibid, pp. 149-150. I emboldened.)
Like Das, Smith offered this example as a bank issuing a worthless instrument and therefore cheating the customer. Who issued this instrument? Undoubtedly an investment bank. Consider this investment bank example (called a "commodities trading unit"):
An extreme example of banks carrying on recklessly is Citigroup and its Philbro commodities trading unit. Let's start with the obvious: commodities trading is not a financial activity that the government should be backstopping. There are already active commodities exchanges that serve the useful social function of helping producers and manufacturers hedge against price changes. The Philbro unit is not an important or even an ancillary part of the crucial credit infrastructure that the authorities rushed to save. And Citigroup is already heavily dependent on government support, with the Treasury soon to be a 34% owner.
But it gets even better. The Philbro operation . . . is a proprietary trading business, which means it was gambling with your and my money.
(Smith, ibid, p. 279, boldly going mine.)
Do you see what happened there? Because Smith assumed that commercial banks lend depositor money, she is assuming that the Philbro investment bank used Citigroup deposits to fund speculative investments. Honestly, I don't know how Philbro is funded. Just for the sake of argument, though, let's get back to the role of a commercial bank and lending and ask a hypothetical question:
What if a bank extended itself a line of credit? In other words, what if a bank lent money to itself?
If true, this turns the whole Philbro example Smith provides completely on its head. Let's speculate that commercial banks fund their proprietary investment bank branches entirely through lines of credit. How much credit they extend depends entirely on how much of a fractional reserve the commercial bank has at the moment. This means the prop trading branch might be funded by the month, by the year, or even by the day. Essentially, the prop traders are given a dollar limit to their trading based on the reserve. Just like the limit on a credit card, they must not exceed this amount.
Ideally, the prop trader bankers would seek out profitable stocks to buy. As I said above, though, stocks and bonds do carry risk. Why not lower the risk to zero?
And here I'd like you, Dear Reader, to consider the "worthless" derivative Smith noted. "The client was paying $4 million a month for three years for the privilege of having an utterly worthless contract." What if that was the point?
Bear with me. Let's say not only the banker who created and sold this "worthless" contract knew it's true worth, but so did the buyer. What if the buyer had been another proprietary trading bank investor? Furthermore, what if there existed a very similar contract — worthless, but costing $4 million a month for three years — that was bought by the original seller?
Here's what would happen. The commercial bank lends that $4 million a month, creating the money through the prop trading subsidiary's line of credit. In another transaction, $4 million a month flows to the prop trading subsidiary as cold, hard cash. After the paying the banker who made these transactions, the bank pockets the difference, depositing this very real money in its vaults.
Two banks have just created money, in this case a cool $4 million a month, and given it to themselves. Yes, the instruments that backed that money creation were worth exactly zero, but they also carried exactly that much risk. Zero. It would be like money laundering, if washing machines could somehow be built to actually make clothes out of nothing.
I hope I just blew your mind. If I haven't, let me continue to try.
Most of us are familiar with lines of credit through personal experience. We must never borrow more than the limit, and we must always pay the monthly charges and the interest. What we never encounter in our personal experience is money that is lent without interest. There's no law governing how much interest banks must charge on their lines of credit. Since the prop trading desk is sitting in the bank itself, why would they charge any interest at all?
Thought of in this way, any purchase made by a commercial bank's prop trading unit becomes profitable even if the purchase loses money. Why? As long as the prop trader sells the asset before it loses 100% of its value, the difference becomes equity that can be applied to the commercial bank's reserves. Wouldn't this explain the quirky computer-generated high-frequency trading where assets are sometimes held only for a split second?
Furthermore, consider the now-infamous credit default swap. The wiki article points out that a "credit default swap is a bilateral contract between the buyer and seller of protection," meaning that two parties agree to "insure" each others' assets for an agreed price. (I put "insure" in scare quotes because banks never held the kind of reserves actual insurance companies are required to maintain; if they had to pay out on a contract, the bank would be unlikely able to pay.) If one party had stock in GM and another in AIG, for example, they would swap protection money, agreeing by contract that if either company folded (or the stock price plummeted) the value of the failed stock would be compensated by the issuer to the holder.
What very few reporting on this practice bothered to consider is that most of the CDSs issued were protection for companies that just about everybody considered too big to fail. Here's a question: If you thought General Motors would always be a dominant car company or American Insurance Group would always be an enormously profitable insurance leader, why would you bother paying millions each quarter for insurance against its demise? Wouldn't it be a better practice to buy protection for assets everyone considered likely to fail?
The CDS makes sense, though, if the money paying for this protection came from a line of credit, and if matching amounts returned to the issuing bank from the selling bank . . . exactly like the "worthless" contract noted by Smith. Sadly, though, as everyone now knows, some companies were not invulnerable.
Unlike fancy derivatives with dizzying complexity and zero worth, CDSs proved too volatile in the end. They actually had risk of payout. It took only one or two firms to default, and the entire interlinked edifice threatened to collapse.
If this theory I've outlined it true, wouldn't there be evidence to support it? A good question. It turns out there is evidence. After noting that "Wall Street money flow is 58 times the size of Main Street," Steve Roth explains:
[I]t's clear that this disparity has grown hugely since the 80s, driven by credit issued by the financial industry, to the financial industry, with the money circulating in the financial industry.
This self-created financial wealth leaves its mark. Just about every asset bubble since the 1980s has been explained in every detail save one: Where did the initial money that inflated the tech bubble and the housing bubble come from? If I am correct, it came self-created from banks to banks. The only limit was the difference between the bank's required reserve amounts and what was left over for the prop traders after regular lending. Yes, the created wealth can leach into the Main Street portion of the economy. After all, inflating the money supply causes, well, inflation. Roth elaborates here:
It’s no surprise that all that newly-printed money in the financial industry 1) drives up prices of existing assets, and 2) prompts the creation of new financial assets that can be sold to get a share of that money.
My gentle readers will no doubt remember that credit issued to buy inflated securities — causing them to inflate further before de-inflating — is what precipitated The Great Depression. (At least the main proximate cause.)
The traditional source of funds to purchase financial assets — personal and business savings from income and profits — don’t even begin to account for the runup since the ’80s. . .:
Roth provides a graphic example of how enormous this disparity between things of value and the financial instruments supposedly represented by things of value has gotten:
It boggles the imagination.
Now that you have witnessed here what could bring down the economy again, what conclusions should one draw?
I have to say that I'm ambivalent. No, I don't think that banks should be able to create money just for the sake of creating money. Banks perform a service for the societies in which they operate — they assess the value of assets and through lending create money reflecting that valuation. They really shouldn't put their own profits above the value this service provides society.
On the other hand, the disparity between asset value and the money reflecting that value has gotten so large that an adjustment will undoubtedly prove catastrophic. Let's face it, in this case "adjustment" means removing incestuously created dollars from the economy — deflation. If this removal happens slowly, the value of everything we own will only fall over time. If it happens quickly, the value of everything we own will plummet. Either way, life as we know it will suck as a result.
Furthermore, the banks have the ultimate defense for what they are doing: It's perfectly legal. Please, leveling the accusation that some actions are legal but still should be condemned as abhorrent or indefensible or immoral (take your pick) is only so much childish stamping of feet and holding of breath. If a society cares enough to recognize the harm caused by an action, it has the option of making it illegal. Let's face it, folks: If you want something to happen, make sure it's legal. If you want it to happen slightly less often, make it illegal.
Senators Glass and Steagall sifted through Ferdinand Pecora's hearings and crafted the Banking Act of 1933, complete with its famed (but poorly understood) firewall separating different types of banks. We find ourselves today with the firewall gone and as a result smack in the middle of the next (and even larger) Great Depression even before we have recovered from the deflation caused by the last asset bubble pop, and quite un-ironically the only thing preventing a slide into a catastrophic meltdown is incestuous money creation propping up the commodities markets and the banks that buy the commodities offered thereon. Maybe we should take aim at preventing the more egregious abuses of money creation, or simply looking at the bright side of legal but unproductive action, perhaps finding a way to use them to benefit more than just an issuing bank. Society at large could easily benefit and profit from this method of reproduction through masturbation.
But I'll speculate on that future later.
Addendum: Some verbiage cleaned up July 1, 2011.