Failure of comprehension: Part 2

Continuing the discussion from Part 1 and assuming some familiarity with the concept of unsustainable wealth extraction and illusory wealth, from previous posts, we can take a look at the fractional reserve banking and the phenomenon leveraging through risk reallocation (credit default swaps -CDS)

Example B (the decrease in apparent wealth)
Let's suppose everything starts like in the previous example. Person A deposits all real wealth excess stored in money existing in the kingdom, (100 gold coins). The bank (operating at a 20% reserve limit), keeps 20 in reserves and lends the rest (80 coins) to person B ( a captain who wants to set sail in a trade expedition). B uses the money to buy trade goods from the C (the local camel caravan chief). C deposits the 80 coins back with the bank. Out of his deposit 16 coins (20%) are kept in reserves, and the rest (64 coins ) are lent to D (the captain of the guard) who buys a house, from the home builder E.
Homebuilder E was supposed to deposit his 64 coins with the bank, but house he was building caught fire and the total loss incurred was of exactly 64 coins. He uses the 64 coins to cover the loss. As a result, the high-priest banker remains perplexed when his balance sheet expansion stops after after only 2 deposit-lending cycles, and nobody else wants to deposit money. It is like being all dressed up with nowhere to go . If nothing changes and no new deposits are made, the bank will produce a profit of only 41.4 gold coins. In the previous care when all 100 coins were recycled as reserves the profit of the bank was 115 gold coins.



The Sacred Tablets of Bernankus (the Babylonian god of banking) cannot be wrong when it says (in the First Psalm of Bleeding Dry a Kingdom), that:

After a sufficiently large number of banking cycles, the system reaches the limit of monetary expansion, when the volume of the reserve becomes equal to the total amount of surplus wealth (stored in money/currency) available in a society.

After reading more about the magic of the "consumer economy' from the Tablets of Greenskam, realizes what happened. When that home burned down, real wealth worth of 64 coins was destroyed in the fire. The real wealth excess remaining in the system is (100-64=36) which is exactly the level of reserves when the lending cycle stopped. Through the magic of macroeconomics and banking, a part of the available amount of surplus wealth stored in money, went from the account of the apple farmer to pockets of the builder (without changing the value of the A deposit), and the loss of the homebuilder went became the debt of the captain of the guard (in terms of real wealth). Sometimes the 'sufficiently high number of cycles' required to reach the limit of monetary expansion may be just 2.

In this case the loss was caused by fire, but due to the magic of fractional reserve banking the loss can be actually the illusory wealth component created by the financial sector going up in smoke.
Apparent wealth = Real Wealth + Illusory wealth

The source of the illusory wealth can be:

• -deferred transaction. The home builder had to pay an invoice (64 coins) for building materials he got for building the house. During the time between he getting the supplies and paying them back, the apparent wealth increased with 64 coins
  
• -price fluctuation. Housing market crashed and he had to sell a home at a loss
  
• -capital misallocation and waste. He build a house in a flooding area, and nobody wanted to buy it
  
• -investment capital outflow. He uses the money for starting a brick factory in an Asian Province, where is a severe shortage of housing and they don't have the advanced technology of brick making.
  
• -trade imbalance. The bricks made in the Asian Province (in that new factory) are cheaper than those produced in the kingdom (due to lower wages and an undervalued currency in the Asian Province). For some strange reason, the Asian Province keeps accumulating Babylonian gold coins. In order to get the money back, the high-priest/banker thinks of inventing a some miraculous clay tablets called "treasuries" . The Psalms of Greenskam tell that the strange people from the Asian Province will give back gold coins in return for this magic clay tablets, so that the homebuilder can keep buying bricks from them. Until this miracle occurs (some 200 years later), the trade deficit will suck the amount of kingdom's real wealth stored in money.
  

In the case of fractional reserve banking, losses of real wealth or the collapse of the illusion of wealth, can occur at the both ends of a balance sheet. Most people think of loss only as loan defaults, but lack of deposits (money lent and recycled back into the financial system) is as least as dangerous.

If those 100 gold coins were real stored wealth, at a reserve ratio R=20%=1/5, the bank would create deposits worth 500 coins. Basically a bank multiplies, real wealth with the inverse of the reserve ratio, which is called Multiplier Constant (MC=1/R). Contrary to the common perception, the Multiplier Constant is not the same with the Money Multiplier. The monetary expansion that stops before reaching a complete number of lending cycles is described by the Money Multiplier. Check this wikipedia picture. The Multiplier Constant is gives the expansion at the end of the scale (after Z cycles) while the Money Multiplier describes the expansion at a certain point which can be anywhere between A and Z. The Money Multiplier describes the expansion of Apparent Wealth.

One can calculate the content (percent) of real wealth in the apparent wealth in the system. In our Example B, the Multiplier Constant (MC), given by the 20% reserve ratio (R), is 5. The Money Multiplier (MM) is only 1.8 (180 coins deposits created by 100 coins of apparent wealth reserves). In our case calculate the real wealth content (RWC) of the apparent wealth used as bank capital. In our case:
RWC= 100*MM/MC = 36% (or RWC= MM*R)

Assignment: Considering the reserve requirement in US is 10% (MC=10) use the following official money multiplier (MULT) data published by the FED:
M1 money multiplier
1987-03-11 3.110
2008-03-12 1.612
2009-03-11 1.002

, and calculate the real wealth content RWC of the bank capital in US assuming that:
- the official indicator MULT, is as realistic to asses the real multiplier as the CPI is for assessing the real inflation
- while in 1987 the real average reserve requirement in the economy was close to 10% (MC=10), the excessive bank leverage produced by securitization resulted in real reserve ratios of 4% in 2008 and 3% in 2009. Recalculate the RWC according to this assumption.

If you thought that was bad then take into account that government intervention can bring illusory wealth into the system ( aka TARP, bailouts, stimulus packages or alphabet soups), which in times of crisis is indistinguishable from real wealth. These artificial injections can stop sharply the decay of the Money Multiplier, having an apparent beneficial effect,... as long as the new illusion lasts. If we look to an official MULT chart it seems the fall in the money multiplier was promptly arrested.


Example C (an injection of illusion)
If the case above (Example B) we assume that the 64 gold coin loss was not caused by a fire, but by the house collapsing due t the fact it was build with those cheap bricks made in the Asian Province, and those cheap bricks turn into dust in the hot and humid Babylonian weather. The high-priest banker realizes he has a big problem. It is just a matter of time that another number of houses built with the same bricks will collapse, and the loss of real wealth stored in housing may increase well beyond the 36 coins he has as banks reserves and possibly beyond the 180 coins he has in deposits. The whole banking system may collapse. Therefore he runs to the treasury of the kingdom crying for help. Help arrives from the treasury because the treasury master is one of his former bank tellers who got his job only because the high-priest has bribed the King and the Council of Advisors. The treasurer (who owns himself shares in the bank) agrees to take decisive measures by providing money for a bailout. He borrows 200 coins from other kingdoms and gives it as a very low interest loan to the bank that will do directly to the reserves. In fact the state (treasury) becomes almost the main depositor (investor) of the bank.



One may say that since the gold from the treasury is made of real gold coins, it is real wealth, but I would disagree. The treasury was just an intermediary between foreign banks and each individual subject of the kingdom. The subjects will have to pay for the bailout through future taxes, and this will drain their income, spreading the loss over the next 10-20 years. Obviously, since the tax rates (capital gains) are smaller for the rich subjects, the losses will be paid by the poor.

Few more observations for our example:

• the losses in the system are absorbed on the liabilities side and we can see that only a fraction (~0.7) of the money lent our returns as deposits
• the Money Multiplier looks abysmal (MM=300.61/300=1.002), but a lower Money Constant (MC=3.75), implies that the bank operates at a effective reserve ratio of 27%. That means the real monetary expansion is still slower than before the crisis.
• the reserve created by the bank rescue plan represents only 12.06% of the total bailout money, that means that only 12.06% was actually used to help the economy, the rest (87.84%) was used only to cover the ass of the high-priest/banker and prevent a rebellion of the people.
• based on the balance sheet results and applying the deposit and lending interest, the profit of the bank will still be lower than during the "good times before the criss (93.14 gold coins compare to 115 before)
• the low Money Multiplier value results from the fact that money is stuffed into the bank much faster than the ailing economy can absorb it in new lending (Chart)
• the force feeding with bailout money creates a huge cushion of excess reserves, and thanks to the taxpayer's gift and charity even the real reserves (non borrowed reserves) may start to pick up, but if the losses keep coming and surfacing, then the forced-pumped reserves will start decreasing without generating new lending (Chart) and soon the high-priest will ask for a new bailout.
  

Example D (leverage and credit default swaps)
Let's suppose we go back in time before the crisis. There is no house crumbling and houses sell pretty well. The high-priest banker find out his monetary expansion stops only after 3 cycles. He makes inquiries to see what happened, because there was no disaster. He finds out with surprise that the real wealth loss in the economy was caused by imbalanced trade with the Asian Province. The home builder was buying bricks Made in Asia with Babylonian gold coins, which were exchanged by the Asians for those magical clay tablets called "treasuries".... There were two problems with this new international economic model called "economic gomorization". (The name came from a small town in the middle east, called Gomorrah, where the first ancient free trade conference was held. Initially they wanted to name it after Gomorrah's sister town, but it would have been to obvious for the masses what this free-trade model would do for them):

• out of 64 coins paid for importing each load of bricks from the Asian Province, only 50 were exchanged to treasuries (only 50 gold coins were returning back to Babylon.) The difference (14 coins) was used by the Asians to subsidize the brick export and to build new brick factories, after stealing the designs of the Babylonian investment in Asia.
• because the domestic industry could not cope with the competition from the Asian Province, the only 2 remaining brick factories in the kingdom were closed. The real wealth revenue stream from brick production was lost and 10 well paid industrial workers were laid off. They had to take shitty jobs as "sales associates" in a warehouse selling bricks and other stuff Made in Asia. The whole kingdom became a little bit poorer.

Since the real surplus wealth, stored in money, was decreasing slowly, day after day, so where the profits of the bank (only real surplus wealth can generate monetary expansion and increase bank profits at a fixed reserve ratio). The only way to prop up banking profits was to increase leverage (go below the minimum reserve requirement), but for that ,a high-priest banker would have to circumvent the edicts of the central religious authorities. After a lot of offerings to the Great Geenskam, the Council of the 30 High Babylonian Gods (which was set up by the hidden god Rockfallus) came with the derivatives solution.

The minimum bank reserve limit offers a modest money buffer for absorbing losses. If the high-priest/banker could convince someone to take the risk for a potential loss of assets (bad loans and defaults), then his bank could move both liabilities (deposits) and assets (loans) of the balance sheets in a faith based financial entity operating at almost 0% reserve rate (virtually unlimited monetary expansion). Such a miraculous creation would be known, from that day on, as a Sacred Inexistent Value (or SIV). The high-priest/banker would be able to get a lot of money, if his low profit bank, with a decent required reserve ratio, will start feeding the 0% reserve SIV with loans to be sold to suckers investors. If one would do the sacrilege to bring the bank's and the SIV's balance sheets together, it may look as the hypothetical example presented in Table 4.



If in the 'healthy bank' part the high priest get a modest profit of 56.12 gold coins, in the SIV area he can offer 5% interest on deposits while keeping 30% on loans he can make 156.24 . The whole Bank+SIV (Jekyll&Hyde) finace operates like a bank with only 5.12% (20:1 leverage). In modern baking, leverages of up to 50:1 (2% Reserve Ratio) did happen, but as long as the SIV assets were off the bank's balance sheet everyhting looked OK. Moreover, increasing bank profits through leverage created a massive monetary expansion resulting in a string of assets bubbles.

The true genius of the derivatives drive resides elsewhere though. For centuries bankers have played the inflation-deflation scam to strip all real wealth from a society like money farmers. They start with low interest rates, exaggerated inflation (monetary expansion) -planting the seeds and growing the financial crop- then they produce deflation -harvest time- by raising interests rates and buy all assets at a fire sale price. This method was obvious and may times bankers saw themselves as the target of enraged crowds. In 1929 the deflation was not only created by FED raising rates, but also by priming the deflation shock through the recall of margin loans for shares (show shine boys and house maids were deleveraged, while Warburg and JPM, Lehman and others were shorting stocks at peak).
This time, the inflation and deflation was produced by leverage and deleverage. And the deflation produced by deleveraging happens now even in a ZIRP environment. The Average Joe is not only fleeced directly by the banks, but also indirectly through the increase in public debt for which he will have to pay later... This is simply brilliant.

The role of Credit Default Swaps (CDS)
Most media commentators believe CDS are a form of bond insurance. IMHO that is misleading. Those who were dumb enough to believe CDS are bond insurance, payed dearly for this mistake (AIG for example). I believe CDS are actually an risk transfer intermediation instrument which provides easy(free) money for dealers. Buying CDS protection means buying insurance, selling CDS protection means acting as an insurance broker. In a typical bond insurance transaction we have:
Bond holder <---- Bond Insurance Company

When CDS are involved the transaction is different:
Bond Holder<--- CDS Swap Dealer 1 <--- CDS Swap Dealer 2 <---[,,,]<--- CDS Swap Dealer x<--- AIG

Each Swap dealer makes a few bps only for transferring the risk to someone else. It's like a game of musical chairs. As a another effect they are responsible for moving reserve requirements off the balance sheet of banks. In our case, if the high-priest has bought CDS protection for all SIV assets there is no need for keeping reserves and the SIV can leverage to the sky. Why were the CDS needed? The answer is very simple: because there is not enough real wealth reserve in the system , to act as bank reserve and collateral. Everything is bled dry. Let's see how the game works. To make things simpler, let's assume the loan SIV H was given to a wannabe ship captain to buy a galley. In his first trip the galley sinks will all hands and merchandise. Total catastrophic event and capital destruction. Credit event with complete irrecoverable loss. In the arbitrage ballroom of musical chairs game we will find the following architectures of CDS:
a) the conga of love: 11 players 10 chairs:
High-priest (bondholder)<--K<--J<--[...]<--B<--A (sucker)

Loss in the economy: 100 (the galley went U-boat)
Netting: 100 gold coins (A pays the high-priest 100 gold coins)
Notional value: 1000 gold coins

b) starflower: 16 players, 11 chairs
Among the Babylonians there is a guy called Lahdus who realizes the captain of the galley is incompetent , the ship with sink, and SIV H is a gonner. Lahdus decides to take advantage of the stupidity and greed in the system. He has nothing to do with SIV H but he starts buying protection as a normal swapper... and he buys a lot of protection ;)
Lahdus<--Z<--Y<--X (sucker)
Lahdus<--W<--V<--U (sucker)
Lahdus<--T<--S<--R (sucker)
Lahdus<--Q<--P<--O (sucker)
Lahdus<--M<--L<--K (sucker)
Loss in the economy: 0
Netting: 500 gold coins (500 gold coins transfered from X,U,R,O,K to Lahdus)
Notional value: 1500 gold coins

c) circle of joy: 6 players, 6 chairs
J<--K<--L<--M<--N<--O<--J
Loss in the economy: 0
Netting: 0
Notional value: 600 gold coins
------------------------------------------------------
Total CDS session of musical chairs game:
Loss in the economy: 100 (value of the sunken ship paid by A to the bank, nothing added) Netting: 600 gold coins
Notional value: 3100 gold coins

So, there is no big deal and the system works fine. Well, ... not so fast... Apple farmer A is rich (his net worth is 900 gold coins), but he doesn't want to sell a part of his orchard therefore, he transfers 100 gold coin from his bank account to ... the high-priest. Now, if there were two banks in the kingdom, and A had to pay a SIV loss to the other bank... then the high-priest would go the Dick Fuld way (because he has only 48.8 gold coins in reserve). IMHO the problem is not with he gazzilion dollar in notional value outstanding. That gazzilion CDS cannot amplify the losses in the system. They just move money around, while the total net losses remain virtually unchanged. But the CDS fest was instrumental to hide the lack of capital in the financial system and allow for the unchecked growth of an unstable shadow banking sector. The CDS can produce, by toppling, wobbly banks, a domino, effect which will leave only a few, well hedged banks , still standing when the dust settles (the masters of the derivatives game with support from the FED). Whole fortunes will be lost and we will hear Madoff clients and Greenbergs crying rivers. The big mystery is, what will happen with the financing provided by our Asian province...? I would like to end this entry with another quote from Cicero about the systemic risk:

"If some lose their whole fortunes, they will drag many more down with them . . . believe me that the whole system of credit and finance which is carried on here at Rome in the Forum, is inextricably bound up with the revenues of the Asiatic province. If Those revenues are destroyed, our whole system of credit will come down with a crash."
-- Cicero, 66 B.C. (Translation by W.W. Fowler, 1909)

(PS sorry for spelling mistakes, but I was kindof busy and had to finish in a hurry)