In a recent post where I revisited fractional reserve lending, I explained how as one goes below 10% reserves that small percentage changes result in drastic increases of the money supply. Additional capital can then be had through floating bonds, selling securities, and Federal Reserve bailouts. So we live in a system where people who have motive to borrow and means to pay back will find a loan—the limit is not with banks, but with borrowers.
Now, in recent times, in the latest mania, lending standards fell below even the ability to repay. The preponderance of stated income “liar” loans, negative amortization loans, option arm loans, and the general availability of mortgages over the Internet, seems evidence of that. Mortgages were originated with little discrimination figuring that house prices were only going to appreciate, so even defaults would be profitable. A nice theory.
Neither logic nor reality bears this out. House prices stalled in late 2005 or 2006 and began their descent about a year later. The timing varies by region, and I would argue the rate of correction depends on the economic capacitance of homeowners in the area.
In the end, credit expansion is limited by the ability to repay loans. If lending goes beyond that, defaults erode the capital base of banks. Money is created via credit when deposits are lent out, up to the reciprocal of the fractional reserve. That same money is undone when principle on the loan is paid back. Credit is a temporary increase in money supply that attenuates to zero over the life of the loan; though if rate of loan origination is stable then money supply holds constant.
But when a loan is defaulted, after the bank tries to recover what assets it can, what debt is left is a square hit to the capital base. If a dollar is deposited, and 90 cents is lent, and the loan defaults and only 50 cents is recovered through seized assets, then the bank is 40 cents in the hole on that dollar deposit. It will need to be compensated by successful loans elsewhere. The potential money supply hasn’t changed. Those 40 cents not recovered has been spent and redeposited elsewhere and is still in the banking system.
So if banks lend what borrowers cannot pay back, their capital base erodes. If this happens enough times, their solvency depends on government and taxpayer support. It will eventually become clear that the more the government subsidizes unsound lending practices, the less it will have for its infrastructure needs.
The limit of borrowing is where interest payments equal income minus subsistence expenditures. Credit expansion cannot go beyond that. If interest payments go beyond that, economic capacitance can hold for so long and then it requires a tax base willing to compensate the difference. Bailouts are unstable territory that only goes so far.
Wednesday, November 26, 2008
Tuesday, November 25, 2008
Is the Dollar Headed into the Toilet?
I've never said the inflationists are wrong about inflation. I do think the inflationists are wrong if they say the dollar is absolutely going to inflate; and likewise I'd say the deflationists are wrong if they are certain about their perspective. With inflationists, you do tend to see more unsubstantiated and absolute belief in their position than you do with deflationists. I've only said whether the dollar inflates or deflates is a policy decision, and that it is my belief those in power would rather see deflation. But I may be wrong or not have the whole picture.
The vertical expansion of base money supply is worrisome at this point; base money supply has nearly doubled since September after being flat for years. Not dividing cash investments into other stores of wealth such as gold would be ill-advised at this point unless the vertical trend flattens very soon.
That said, given that money supply in any fractional reserve system is the sum of printed currency and credit, and that fractional reserves set by the Fed are at 10% and have probably been whittled down over the last few years, then at least 90% of the total money supply would be credit. Now say there is a 20% contraction of credit, and printed money doubles: then overall money supply has still dropped by 8% since the 18% loss to general money supply through credit contraction is compensated by only a 10% increase in printed money. Similarly, if credit drops by 50%, then even tripling printed money would not be enough to compensate a system which has been "credited out."
As has been argued by me and others before, as money supply tightens, prices need to fall to compensate, and hence deflation, where a given dollar can buy more and more.
So where the value of the dollar goes from here is a guessing game, and only the federal regulators know the answer.
The vertical expansion of base money supply is worrisome at this point; base money supply has nearly doubled since September after being flat for years. Not dividing cash investments into other stores of wealth such as gold would be ill-advised at this point unless the vertical trend flattens very soon.
That said, given that money supply in any fractional reserve system is the sum of printed currency and credit, and that fractional reserves set by the Fed are at 10% and have probably been whittled down over the last few years, then at least 90% of the total money supply would be credit. Now say there is a 20% contraction of credit, and printed money doubles: then overall money supply has still dropped by 8% since the 18% loss to general money supply through credit contraction is compensated by only a 10% increase in printed money. Similarly, if credit drops by 50%, then even tripling printed money would not be enough to compensate a system which has been "credited out."
As has been argued by me and others before, as money supply tightens, prices need to fall to compensate, and hence deflation, where a given dollar can buy more and more.
So where the value of the dollar goes from here is a guessing game, and only the federal regulators know the answer.
Night of the Living Bailouts
Just when you thought it was over...
The Fed has pledged another $800B today hoping to keep the credit monster alive. $600B will be used to purchase troubled mortgages from Fannie Mae and Freddie Mac. Of this, $500B would buy mortgage backed securities, and another $100B would buy debt directly; I take it, the Fed would become homeowners. I can understand them not going to Congress for this money because they just approved $700B for that exact thing last month, and then the Treasury Department went ahead and did something completely different.
On top of that $600B, another $200B will be available for the general credit industry, which includes car, student, small business, and credit card loans. Non-recourse loans would be provided to these agencies, with (supposedly) highly rated securitized debt as collateral; if banks default on them, the Fed cannot recoup the money. The Treasury department will throw in $20B of TARP money to back the Fed in the event of defaults.
Obama is speaking as well of a $500B stimulus package. Given the pace of financial events, I'll wait until he takes office and this is passed before commenting in more detail.
...Actually, probably nobody thought it was over. That $700B lasted all of a month before the economy is in hot water again.
We're talking tens of thousands of dollars from every taxpayer going to the private interests of highly unprofitable and misguided financial firms. Currently, the justification is that this is all just loans, and the Fed and Treasury Department anticipate it will be reimbursed. We'll have to see how long this fantasy lasts.
The Fed has pledged another $800B today hoping to keep the credit monster alive. $600B will be used to purchase troubled mortgages from Fannie Mae and Freddie Mac. Of this, $500B would buy mortgage backed securities, and another $100B would buy debt directly; I take it, the Fed would become homeowners. I can understand them not going to Congress for this money because they just approved $700B for that exact thing last month, and then the Treasury Department went ahead and did something completely different.
On top of that $600B, another $200B will be available for the general credit industry, which includes car, student, small business, and credit card loans. Non-recourse loans would be provided to these agencies, with (supposedly) highly rated securitized debt as collateral; if banks default on them, the Fed cannot recoup the money. The Treasury department will throw in $20B of TARP money to back the Fed in the event of defaults.
Obama is speaking as well of a $500B stimulus package. Given the pace of financial events, I'll wait until he takes office and this is passed before commenting in more detail.
...Actually, probably nobody thought it was over. That $700B lasted all of a month before the economy is in hot water again.
We're talking tens of thousands of dollars from every taxpayer going to the private interests of highly unprofitable and misguided financial firms. Currently, the justification is that this is all just loans, and the Fed and Treasury Department anticipate it will be reimbursed. We'll have to see how long this fantasy lasts.
Monday, November 24, 2008
Credit Expansion 101—A Primer
Since credit is the last leg of economic capacitance, or nearly last, I’d like to revisit the creation of credit and its limitations before considering the timing of deflationary downturns.
Money supply is the sum of base money and credit. Credit is created from deposits through fractional reserve lending—which allows money to exist in two places at once: deposits are available to the depositor on demand, and at the same time all but the fractional reserve may be lent out. In this way, money has been created through lending. This is the first step in the expansion of money supply through credit.
If the fractional reserve rate is 20%, then 20 cents of every dollar must be kept in the bank while 80 cents can be lent out. Ultimately, through spending and re-depositing this 80 cents again and again through the fractional reserve system, that deposited dollar has been expanded five-fold. Every dollar lent can expand money supply by as much as $4 in a 20% fractional reserve system. Exactly how lending 80 cents of every deposited dollar expands money supply by a multiple of 5 was reviewed in this post, and links within explain it in more detail still. Similarly, lending 90 cents on the dollar, with 10% fractional reserves, expands money 10-fold, and lending 99 cents on the dollar expands money 100-fold, and as you go to 0% then money expansion points hyperbolically skyward to infinity. That is, assuming all money that can be lent out has been lent out.
So, with small changes in fractional reserves from 10% going toward the 0% range, we can get asymptotically huge increases in money supply so long as the banks desire to lend and borrowers want to borrow. If interest rates are suppressed by central banks, that will sweeten the pot. Money supply can easily be expanded to ones hearts content by reducing fractional reserve limits—until you run out of borrowers.
Capital that banks take in through the sales of commercial paper and securities vary from deposits in the sense there is no reserve, but it cannot exist in two places at once either, so no money creation can come of it. Same with TAFs and any other low-interest capital injections that banks get from the Fed. They allow additional lending from banks outside of the deposit base, but do not expand money supply.
If the Fed and the FDIC are willing to back deposits, which they are, fractional reserves can drop as necessary to allow money creation though credit to expand to the degree that society desires to borrow. The only limitation is what people are capable of borrowing. The next theory post will consider the limits of credit expansion from that perspective.
Money supply is the sum of base money and credit. Credit is created from deposits through fractional reserve lending—which allows money to exist in two places at once: deposits are available to the depositor on demand, and at the same time all but the fractional reserve may be lent out. In this way, money has been created through lending. This is the first step in the expansion of money supply through credit.
If the fractional reserve rate is 20%, then 20 cents of every dollar must be kept in the bank while 80 cents can be lent out. Ultimately, through spending and re-depositing this 80 cents again and again through the fractional reserve system, that deposited dollar has been expanded five-fold. Every dollar lent can expand money supply by as much as $4 in a 20% fractional reserve system. Exactly how lending 80 cents of every deposited dollar expands money supply by a multiple of 5 was reviewed in this post, and links within explain it in more detail still. Similarly, lending 90 cents on the dollar, with 10% fractional reserves, expands money 10-fold, and lending 99 cents on the dollar expands money 100-fold, and as you go to 0% then money expansion points hyperbolically skyward to infinity. That is, assuming all money that can be lent out has been lent out.
So, with small changes in fractional reserves from 10% going toward the 0% range, we can get asymptotically huge increases in money supply so long as the banks desire to lend and borrowers want to borrow. If interest rates are suppressed by central banks, that will sweeten the pot. Money supply can easily be expanded to ones hearts content by reducing fractional reserve limits—until you run out of borrowers.
Capital that banks take in through the sales of commercial paper and securities vary from deposits in the sense there is no reserve, but it cannot exist in two places at once either, so no money creation can come of it. Same with TAFs and any other low-interest capital injections that banks get from the Fed. They allow additional lending from banks outside of the deposit base, but do not expand money supply.
If the Fed and the FDIC are willing to back deposits, which they are, fractional reserves can drop as necessary to allow money creation though credit to expand to the degree that society desires to borrow. The only limitation is what people are capable of borrowing. The next theory post will consider the limits of credit expansion from that perspective.
Sunday, November 23, 2008
TARP Money and Asset Guarantees for Citigroup
In a timely example of economic capacitance, Citigroup is crashing and burning. Over the last week, despite protests of adequate capitalization, it's stock values are in their final death throes. Admittedly, it probably would be an unwieldy FDIC seizure, so Citibank will be getting an additional $20B in TARP money in exchange for handing the Treasury Department preferred shares at 8%; and in addition Citigroup will pay them $8B for loan insurance on $300B it holds in troubled assets.
It was barely over a month ago that Citigroup was fighting with Wells Fargo over the right to buy Wachovia. How times change. Now, the terms of the FDIC seizure of Wachovia were so favorable for Citigroup that who knows, it might have allowed them to persist a little longer. But that wasn't to be. Their options have run out. Government bailouts I suppose are the last and final leg of economic capacitance.
It was barely over a month ago that Citigroup was fighting with Wells Fargo over the right to buy Wachovia. How times change. Now, the terms of the FDIC seizure of Wachovia were so favorable for Citigroup that who knows, it might have allowed them to persist a little longer. But that wasn't to be. Their options have run out. Government bailouts I suppose are the last and final leg of economic capacitance.
Wednesday, November 19, 2008
Economic Capacitance
Of late, the flavor of financial news has shifted. Much less is there a focus on the shenanigans of Washington and Wall Street, and much more we see reports of job loses, downsizing, and lowered expectations in the retail and manufacturing sector. The collapse of Circuit City, and the pleas by the big three automakers for bailout money, are recent examples that come to mind.
This blog attends to the supply of base money and credit, trends in general prices, and the relationship between the three. The strife that comes of failing financial policy I’ll leave to other sources. But personal case examples I see have started to accumulate over the past month or two.
So, the subject brings up a concept I’d like to introduce: "economic capacitance." Capacitors I know from the physics of electrical circuits—where stores of electricity build between two parallel plates, such that when the energy supply is turned off the capacitor will discharge and continue to power the circuit until exhausted. Economic capacitance behaves similarly, and refers to stored wealth, like savings accounts. In coming posts I will use it to conceptualize the timing of deflationary downtrends.
Prices are, and should be, whatever the seller decides to charge. If underpriced, then inventory will fly off the shelves and be consumed or resold at a profit. If overpriced, inventory will move slowly and accumulate. To reduce prices of a given investment below what was paid, the asset holder must concede a loss. The other option is to cling to an unprofitable business or investment practice hoping for a turnaround.
Economic capacitance will refer to the ability of an economy— personal, government, business, or otherwise—to persist under adverse financial circumstances before collapsing in bankruptcy and foreclosure. It is the ability to withstand negative cash flows and relates to the amount of savings one has, assets one can sell, and the amount of credit they can borrow. It reflects the duration one can persevere with a negative cash flow.
There has been a tendency over the past few years to put a positive spin on one’s financial status—until overnight suddenly a business is bankrupt. It began with the fall of Enron, and we saw it with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia. The factors that comprise economic capacitance are all private matters that nobody wants to share. Capacitance allows an unprofitable system to appear well until the point of total collapse.
This blog attends to the supply of base money and credit, trends in general prices, and the relationship between the three. The strife that comes of failing financial policy I’ll leave to other sources. But personal case examples I see have started to accumulate over the past month or two.
So, the subject brings up a concept I’d like to introduce: "economic capacitance." Capacitors I know from the physics of electrical circuits—where stores of electricity build between two parallel plates, such that when the energy supply is turned off the capacitor will discharge and continue to power the circuit until exhausted. Economic capacitance behaves similarly, and refers to stored wealth, like savings accounts. In coming posts I will use it to conceptualize the timing of deflationary downtrends.
Prices are, and should be, whatever the seller decides to charge. If underpriced, then inventory will fly off the shelves and be consumed or resold at a profit. If overpriced, inventory will move slowly and accumulate. To reduce prices of a given investment below what was paid, the asset holder must concede a loss. The other option is to cling to an unprofitable business or investment practice hoping for a turnaround.
Economic capacitance will refer to the ability of an economy— personal, government, business, or otherwise—to persist under adverse financial circumstances before collapsing in bankruptcy and foreclosure. It is the ability to withstand negative cash flows and relates to the amount of savings one has, assets one can sell, and the amount of credit they can borrow. It reflects the duration one can persevere with a negative cash flow.
There has been a tendency over the past few years to put a positive spin on one’s financial status—until overnight suddenly a business is bankrupt. It began with the fall of Enron, and we saw it with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia. The factors that comprise economic capacitance are all private matters that nobody wants to share. Capacitance allows an unprofitable system to appear well until the point of total collapse.
Sunday, November 16, 2008
Opening of La Boheme
Today was the opening performance of Puccini's La Boheme at the San Francisco War Memorial Opera House. The opera was quite good and I highly recommend it.
Before the show, director David Gockley came on stage with an announcement that the turbulence in the rest of the economy is affecting the San Francisco Opera Company as well. He reassured us that certain standards would not be compromised, but advised the audience of uncertain times ahead in terms of its finances.
Now, this announcement must sound pretty strange to anyone going to operas there for the past few years. I was there at the performance of Madama Butterfly two years ago when he announced a $30 million gift, and since then even that was superceded by a $35 million donation. You would think that kind of money might last them a couple years. But at the performance today (I wish I had a written script of it) he mentioned problems with the "liquidity" of general funds, and access to capital. He sounded genuinely distressed, rather than the usual perfunctory plea for our donations. Nearly every opera I go to is full so ticket sales should not be a problem, which he confirmed was the case.
So what did they do with $65 million in donations... go out and try to flip houses in Sacramento? If that is the case, I say they can just burn opera scripts to stay warm. Or might certain endowments be (and none were mentioned by name) securities packages based on "mark-to-fantasy" (AKA mark-to-model) values that are really nearly worthless, such that the benefactors can write them off as charitable contributions?
Given how much press there was about the donations, hopefully more information on this matter will be revealed over time.
Before the show, director David Gockley came on stage with an announcement that the turbulence in the rest of the economy is affecting the San Francisco Opera Company as well. He reassured us that certain standards would not be compromised, but advised the audience of uncertain times ahead in terms of its finances.
Now, this announcement must sound pretty strange to anyone going to operas there for the past few years. I was there at the performance of Madama Butterfly two years ago when he announced a $30 million gift, and since then even that was superceded by a $35 million donation. You would think that kind of money might last them a couple years. But at the performance today (I wish I had a written script of it) he mentioned problems with the "liquidity" of general funds, and access to capital. He sounded genuinely distressed, rather than the usual perfunctory plea for our donations. Nearly every opera I go to is full so ticket sales should not be a problem, which he confirmed was the case.
So what did they do with $65 million in donations... go out and try to flip houses in Sacramento? If that is the case, I say they can just burn opera scripts to stay warm. Or might certain endowments be (and none were mentioned by name) securities packages based on "mark-to-fantasy" (AKA mark-to-model) values that are really nearly worthless, such that the benefactors can write them off as charitable contributions?
Given how much press there was about the donations, hopefully more information on this matter will be revealed over time.
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