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ikkyu2 (93.86)

Deflationary Defaults

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November 08, 2007 – Comments (6)

Ordinarily when someone says "D.D.", they mean due diligence, which is still important even though it's hard to come by with these balance sheet boondoggles lately.

But I want to talk about a different D.D. - deflationary defaults, something I hear very little about.  I hear about housing and the wealth effect, I hear about dropping housing prices and defaulting CDOs related to resi mortgages, but Bernanke is worried about inflation at a FF rate of 4%.

How are banks different from other businesses?  Banks are the only businesses that are allowed to create money.  When a bank lends a resi customer money to buy a house, they don't have that all that money on their books.  They are allowed to create money out of thin air.  Since we have a fiat currency, this is not only permitted, it's encouraged - it's a regulable way of stimulating economic growth.

But if the money is loaned irresponsibly to most of the homebuyers on the market, stimulating an artificial and unsustainable demand for houses among people who really can't afford to own, the result is an inflation of housing prices.  All that new bank-generated money goes to pay for houses which really aren't worth the prices put on them.

When the $500,000 house with $480,000 owed on it goes into default and foreclosure and the bank sells again for $350,000, where does that extra money go?  It goes right back where the bank got it from in the first place.  That is, it leaves the money supply entirely and disappears.  This is a significant deflationary pressure on the economy and I am surprised we don't hear more about this; except that if we did, it would expose all the Fed's jibba-jabba about inflation as smoke and mirrors.  They have room to cut more and they will do so. 

 

6 Comments – Post Your Own

#1) On November 15, 2007 at 1:33 AM, abitare (99.51) wrote:

I do not think you understand this fully. You have to differentiate between banks. There are many different types of banks. The only bank that can create money is the Federal Reserve. Most banks are commercial banks and cannot "create" money and must maintain reserve requirements in order to lend money or be able to package loans to sell in a secondary market.In order for a bank to lend money, it has to have a cash reserve in order to have FDIC insurance or package the loans and sell the loan packages.Some banks have been loaning money, then packaging the loans and then selling the packages, and passing the problem on to the buyers of the loan packages. Since so many loans have gone into default the market for these loan packages, has dried up. Hence Jim Crammers famous tantrum, hoping a rate cut would loosen the market.Mortgage banks like CFC and AHM relied on the ability to sell the packages. They do not have the cash reserves to lend and hold loans like other more traditional banks. Unable to sell the packages or refinance or hold the loans = bankruptcy. Etrade has been playing lender and may not have the reserves to "eat" or hold all of the mortgage resets and selling the loan packages has dried up. Etrade has reserves, but there might be a bank run by those accounts over the FDIC requirement."where does that extra money go?  It goes right back where the bank got it from in the first place.  That is, it leaves the money supply entirely and disappears.  This is a significant deflationary pressure on the economy and I am surprised we don't hear more about this"You do not hear more about this, because this is not what is happening. Banks have to write off loses and some are going to go BK. The money does not "disappears".  In a recession all asset prices decline, real estate, stocks etc…. Printing money is not going to change anything in the long term, accept to push the US dollar out of it Worlds Reserve currency status. Jim Rogers points out the British pound lost 80% of its value, when it lost its status as the worlds reserve currency.No, REC for you unless you do your homework.

 

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#2) On November 15, 2007 at 1:53 AM, ikkyu2 (93.86) wrote:

Unless the reserve requirement is 100% - which it isn't - the bank expands the money supply when it lends.  When these loans go into default, all that loaned money disappears off the bank balance sheet and out of the money supply.  This is basic Economics 101 - where I went to school it was Ec 10, taught by some people you may have heard of, called Friedman and Feldstein - and a lot of people, including the above, apparently need a refresher course on these basic principles.

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#3) On November 17, 2007 at 8:48 PM, dwot (99.98) wrote:

The asset price inflation was never included in data on inflation in the first place so deflation of housing isn't going to change those inflation figures.

I think you two are talking about technically different things, one about increasing money supply and the other actually creating money.  The federal reserve creates the money and the banks increase the money supply on that money by lending it out, but the reserves do put a limit on how many times they can lend it out.  Banks can not loan out 100% of their deposits, but they loan what is allowed and then who ever that money is paid to can potentially redeposit the same money back into the bank so it can be loaned again, less the reserve amount.

So, the feds create the money and the banks leverage crap out of it... 

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#4) On November 18, 2007 at 2:54 AM, abitare (99.51) wrote:

"When these loans go into default, all that loaned money disappears off the bank balance sheet and out of the money supply."

It is funny we are having this discussion. As I am lucky enough to have a dart throwing stock picking monkey that has landed me SCORE LEADER of both Etrade and Radian! Can you believe it? What does RDN do? "Radian mortgage insurance (MI) helps lenders across the United States close more loans and compete in their markets by providing the coverage that protects lenders against borrower default." - I guess RDN fills the gap before the money "disappears", which is why RDN stock is down 80%!

Wow! A university with two letters and two numbers, it must have been expensive and famous!  I am just a regular guy from a boring school. However, I did learn about practical and common things like mortgage insurance and not to speak about issues I do not know or understand.

I found a song for you to dance to also: Ron Paul for the long Haul  

http://rattube.com/blog1/2007/09/23/ron-paul-for-the-long-haul/

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#5) On November 18, 2007 at 3:02 AM, abitare (99.51) wrote:

I forgot to tell you. Stop using my icon. Now go back to dancing to Ron Paul for the Long Haul.

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#6) On November 19, 2007 at 6:29 PM, ikkyu2 (93.86) wrote:

The factor by which the money supply is expanded when banks loan out money is a simple ratio: the reciprocal of the reserve requirement.  For instance if the reserve requirement is 10% and the Fed loans $1000 to a bank, and the bank loans out as much as it is permitted to do, the money supply is expanded by $10,000.  $10,000 is ( 1 / (0.10) * $1000).  

There is no difference between 'creating money' and 'expanding the money supply' from a macroeconomic perspective.

Price inflation is one thing; money supply inflation is another thing, but they are inextricably and tightly linked.

A lot of people can parrot what they read yesterday in the "OMG HOUSING COLLAPSE" blog; understanding these fundamental economic principles is no more difficult, and that's why it confuses me that so few people bother. 

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