This is the second article in a series of three. The first article was published last night. In it, we looked at the concept of leverage, and how consumers' use of credit expanded. Briefly, banks moved from assessing the credit-worthiness of the individual consumer to using credit insurance as a hedge against default. This allowed them to greatly increase the type and quantity of the credit facilities they offered, and consumers took full advantage.
Tonight, I'd like to consider how and where banks and other financial institutions came up with all the money they were lending to consumers in ever-increasing amounts. It also involves leverage, but this time of the banks' funds instead of those of consumers. (Again, please note that in a simple blog article like this I can't get too technical or go into too much detail. I'll inevitably have to over-simplify some issues out of sheer necessity. I apologize to purists who might otherwise object to this.)
Traditionally, banks could lend to consumers a portion of the funds deposited with them by other consumers. They accepted deposits for varying periods of time, so that they had some certainty that a long-term deposit would not be withdrawn until its deposit period was over. They could then lend part of that money to other consumers, charging them a higher rate of interest for the loan than they were paying to the depositor. The difference between the interest rates gave the bank a profit margin.
However, as consumer demand for credit increased, the banks faced a dilemma. They only had so much available in depositors' funds. If they wanted to lend more, they had to somehow find more money to lend!
They did so in three ways. First, they expanded and modified the concept of fractional reserve banking. Wikipedia explains it thus:
Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators, and by the excess reserves kept by commercial banks.
Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This both limits the amount of money creation that occurs in the commercial banking system, and ensures that banks have enough ready cash to meet normal demand for withdrawals. Problems can arise, however, when depositors seek withdrawal of a large proportion of deposits at the same time; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis. To mitigate this risk, the governments of most countries (usually acting through the central bank) regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.
There's more at the link. Banks expanded this concept by pressuring legislators and regulators to reduce the reserves they were required to maintain, thus making more money available to lend to consumers. They also modified it by changing the definition of what constituted appropriate reserves. Initially (and logically) these were cash or hard assets. In some countries, banks succeeded in changing the regulations to permit properties on which they owned mortgages to qualify as reserve assets, even though the precise value of such properties was hard to assess. Effectively, if a bank asserted that property X had a market value of one million dollars, and could produce a certificate from an 'independent' valuer (who might not be as 'independent' as one might wish) to that effect, the regulators would allow that bank to include the value of property X in its reserves.
This affected banks' leverage. If, for example, a bank was required to maintain reserves equal to 50% of its depositors' funds, it could only lend out the other 50%. It was thus 'leveraged' at one-to-one; one dollar of assets or reserves for every dollar it lent out in loans. However, if it could reduce its reserve requirement to only 25%, it could lend out three out of every four dollars; or, if it could reduce its reserves to only 5%, it could lend out 19 out of every 20 dollars. Clearly, lower reserve requirements were highly desirable - and banks used their influence to obtain them, as we'll see shortly.
(Some banks have become horrifyingly over-extended in this way. For example, as we pointed out on Tuesday, it's been claimed that French banks may be leveraged at close to 100-1; in other words, they may have only one unit of reserves for every 100 units lent out or invested elsewhere. A drop of a mere one per cent in the value of those loans or investments would thus wipe out the value of their reserves, rendering them insolvent.)
Secondly, banks began to move money around between themselves. Bank A would deposit some of its funds in bank B, which would use them to make loans to consumers. It would then claim the value of the properties against which those loans had been made as part of its reserves, thus artificially boosting the latter and freeing more of its cash to use for loans or other purposes. It would then use some of that cash to refund the deposit of Bank A, and the rest to deposit in Bank C, which would use it in the same way that Bank B had used Bank A's cash. It became a vicious circle; a 'you scratch my back and I'll scratch yours' incestuous relationship between bankers. Almost all of them were doing it, and they were all growing rich on the proceeds - even though the underlying assets that allowed them to maintain the facade of growing wealth were becoming less and less 'real'.
Thirdly, banks found that legislators could be
(Another thing that banks and financial institutions did in recent decades was to establish the so-called derivatives market, which is probably the single most important contributor to the current financial crisis; but that's so vast a subject that it deserves its own article. We'll discuss it tomorrow night.)
With all this extra money available to lend to consumers, banks embarked on a campaign to persuade them (both individuals and businesses) to use credit facilities rather than save up their own money and use it responsibly. The widespread availability of credit insurance meant that even less credit-worthy consumers could now be granted loans, because if they defaulted, banks' potential losses were covered. Businesses were easily persuaded to distribute their cash reserves to shareholders and executives (the latter both through dividends on their shares, and by increasing their compensation). As a result, the majority of businesses today don't have much in the way of cash reserves at all. They take a short-term loan or use a revolving credit facility to buy the materials needed to produce their goods; sell those goods to buyers (who are probably going to use their own credit facilities to purchase them); and use the proceeds to repay the loan or reduce the balance on their revolving credit facility. They then repeat this cycle ad nauseam to produce and sell more goods. They're never free of loans, and are always paying interest and other charges to the financial institutions that provide them. They pay still more service charges to financial institutions that process credit card payments by consumers. Finally, they're often charged fees by the banks who handle their financial accounts. They pay coming and going.
The credit insurance market also grew exponentially. Today it's a multi-trillion-dollar business on an international scale. Credit default swaps, export credit agencies, the reinsurance market . . . all are merely international, large-scale manifestations of the smaller, local operations that probably insure the mortgages and credit lines of many of my readers.
The net result of all this manipulation has been an explosion in the availability and use of credit by consumers on a national and international scale. Consider the following graph of US household credit use from 1950-2010:
(Also note, as we showed yesterday, that savings decreased as use of credit increased.)
Use of credit by consumers (both businesses and individuals) in other countries followed broadly similar patterns. Governments eagerly followed suit, financing current expenditure by borrowing money instead of increasing taxes (which would have made them very unpopular with the electorate). Indeed, governments have become at least as guilty of excessive use of credit as have businesses and individuals.
The net result of this explosion in borrowing is that the world is today awash in credit, to the point where it's become a millstone around the necks of individuals, corporations and entire economies and nations. Consider, for example, the per capita national debt load (i.e. the amount each citizen of each nation must pay to discharge their government's debts alone, excluding their private debts) on the citizens of the following countries as of 2010 (it's gotten much worse since then, believe me!):
Next, consider something we discussed last month - the ratios of different kinds of debt in various countries expressed as a percentage of their Gross Domestic Product.
Note how some countries' banks (particularly, for example, those of the United Kingdom) are over-extended financially, exposed to greater risk of failure. Remember what I said earlier about banks depositing funds in other banks, or "scratching each others' backs"? That's been extended to co-operation between banks in other countries in recent decades - and the resultant risks have been magnified accordingly. The next graph shows how banks in various countries are exposed to risk from banks and investments in other countries.
Of course, if the underlying assets against which banks had lent all this money were fairly valued, their loans would be secure. However, if consumers could no longer afford to pay off those loans, the banks would have to repossess those assets and sell them for what the market would bear. In the economic crisis that's hit us since 2007/08, this has become extraordinarily difficult. Consumers are 'tapped out'; they can't afford to take on massive amounts of new credit, so they aren't prepared to pay inflated prices for property and other assets. A home that sold for $1 million in 2006 might now fetch less than half that on the open market. However, banks daren't sell it for so low a price, because they've marked the property on their books - i.e. as an asset in their reserves - as being worth $1 million. If they sell it for less, they have to reduce the value of that asset on their books, which means that they then have to find other assets or funds to bring their reserves back up to the levels required by regulators. When most of their 'assets' are no longer worth what their books say they are . . . you get the picture, I'm sure. They're effectively bankrupt.
It's not far-fetched to say that many of the world's banks are, right now, fundamentally insolvent. To name just a few examples:
- The 'shadow inventory' of houses repossessed (or in the process of repossession) by US banks and financial institutions amounted to some 1.6 million units in October last year. They dare not sell those properties at 'fire sale' prices, because that would mean they'd have to mark down the value of their reserves, rendering themselves bankrupt. This 'housing overhang' is depressing real estate prices and values across the nation.
- The Telegraph reports that UK banks are sitting on £40 billion [about US $62.2 billion] in undeclared losses.
- Spain's beleaguered banks require so much capital to rebuild their shattered reserves that the country's central bank can't supply it. Foreign creditors are so wary of a Spanish economic collapse that they're demanding unacceptably high interest rates as a quid pro quo for buying Spanish bonds (i.e. funding Spanish government debt). As a result, the nation is being forced to appeal to the EU for a rescue package for its banks. Meanwhile, bank runs are spreading across several troubled European economies (including Spain).
There are many other examples I could give from around the world. Essentially, the assets on many banks' books aren't worth anything like what they say they are. If they told the truth and acknowledged this, they'd go bankrupt overnight. The only reason they're allowed to get away with it is that governments and politicians dare not allow their banking systems to fail. They're turning a blind eye to this financial shell game, hoping desperately that the economy will improve enough to allow the banks to recover. That's not going to happen, of course.
In the last article in this series, we'll talk about the catastrophic derivatives market and how it overshadows all the other debt issues we've discussed so far - so much so that it has the potential to cripple the economy of the entire world. We'll also discuss the question of money supply.