muses of the moment

March 11, 2009

It’s Built into the System-Part 2 (updated)

Fiat currency’s partner in crime is the fractional reserve banking system.

In order to understand how a down turn in the US housing market has caused an implosion of the banking system, you will need to understand how fractional banking works. The crisis is built into the system and should be no surprise to anyone.

Fractional reserve banking is a banking system in which a bank can loan out more than the reserves, or deposits, it has available. The national banking regulators periodically change the percent of reserves required, but usually it’s around 10%. It is never 100%.

This is how it works in its simplest form.

An individual gets paid $1000 and goes to Bank A and deposits that money. The bank in turn may lend out $900 of that $1,000 to another individual (B) as a loan and collects interest. That individual B with $900 goes to Bank B (or it could be the same bank A), and deposits his $900, and Bank B loans out $800 of that $900 to individual C. And so on.

If this continues, it is possible, very probable, that the original $1,000 can create $10,000 in created money within the economy!
The problem: if any one of the loans in the chain defaults, the entire chain can collapse. If the individuals decide to take the cash (their original deposits) out of bank, the chain collapses. The interest payments to the bank also play a role here, but for now, we will stick to the basics. Interest payments are how banks make their money.

A minor downturn in the market can cause the chain to collapse, but the bank will just refrain from lending for a while until more individuals pay back their loans or deposit more money.

What makes this time so much worse?

The banks took the loans (most of them home mortgages from the housing bubble) and sold them off to Wall Street and hedge funds as CDOs and SIVs (types of securities based on the buying and selling of debt). Thus removing themselves from a vested interest in whether the loan gets paid back or not. They do not own those loans anymore, Wall Street does. They simply broker the deal and pass the interest payments to Wall Street or whoever purchases the security.

This is why home owners in foreclosure are demanding to be shown who owns the loan. The bank does not and should not be able to foreclose in the court system.

The banks decided that CDOs were a great deal, because they get paid up front from Wall Street for a large portion of the loan amount and can take that money and loan it out again. Normally, they would have to wait 30 years to get paid back from the home owner or at least until they decided to sell.

CDOs accelerated the implosion, because it is debt upon debt. This new chain reaction has also caused the defaults in home mortgage market to effect the Wall Street market. Normally, something like this would be contained to the banking system.
There are many other details that helped make this the worse financial crisis in history, which I will go into in later blogs. For now, it is important for you to understand that this crisis is built into the system.

The Federal Reserve Bank is the ultimate in reserve banking. They loan the US government money, just like a bank would loan an individual money. The Federal Reserve Bank has an IOU from the government for a loan, they collect interest on that loan from the government. The Federal Reserve puts money into the government’s account at their bank and the government spends that on programs, war, and running the day-to-day operations.

Where does the Federal Reserve get this money?

They create it out of thin air! Yes, that’s what I said. It is perfectly legal and was voted into law by the Federal Reserve Act of 1913. Now the Federal Reserve does have some reserves like other banks, however, they have the same amount of dollars in reserves as they did in 1913.

In light of our discussion in part 1, the real value of those reserves are 93% less, so they really have zero dollars.

A couple of things to take away from this post:

  • Money is created out of thin air. As we have seen, it can evaporate just as quickly.
  • The US Government must continue to borrow money from the Federal Reserve Bank.
  • The US Government must borrow from the Federal Reserve at least the amount of interest due to the Federal Reserve on past loans. (They tend to borrow much more.) At some point in the future, the government will only be able to pay the interest. This is exactly like you paying only the minimum payment on your credit card. If you continue borrowing and only paying interest, you will never pay your debt off.

It is built into the system.

Now that you understand two key concepts, fiat currency and fractional reserve banking, and how the current crisis is built into the system, what can you do about it?

Get out of the way of the freight train.

Stay tuned…..

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