The death knell for fractional reserve banking
WHY A DEBT BASED ECONOMY WILL INEVITABLY LEAD TO DEPRESSION
Being away in China was a welcome change and did I enjoy my stay in Beijing. One cannot but feel a sense of optimism and confidence wherever one goes in China – a hard working people, collectively on a march to become a global economic power. The dynamism and vibrancy is palpable, the moment my plane landed in Beijing.
China’s economy is built on the sound principles of hard work and prudent financial management, the cornerstone being savings – on a massive scale. This is reflected on one level, in the massive foreign reserves amounting to US$1.5 trillion accumulated in the last ten years. Household savings are at an all time high. The people are just loosening their purse strings to enjoy the benefits of a vibrant economy without being indulgent.
China has recently launched a Sovereign Wealth Fund amounting to US$200 billion! Just pause and think –in just under 30 years, China has been transformed from a rural agriculture based economy to become the world’s factory. The West took over 200 years to become an industrial power, and in the process plundered the world’s resources through wars of conquest. The West’s economic and military power was built on the sweat, broken bones of the millions of slave labour from Asia and Africa.
China’s transformation is therefore unique, a change brought about without wars or colonial exploitation. No wonder, the United States and Britain fear China’s rise. The recent intense disinformation that the global imbalances is the result of China’s growing surplus is an attempt by the G7 countries to white wash their fail edpolicies and to cover up their fraudulent global banking Ponzi schemes.
Read the latest in Fortune – Why Jim Roger’s is so bullish on China and why he is getting out of USA!!!!!!!!!!!!
What a contrast to the state of the economy of the so called superpower, a nation buried in debt and with zero savings!
And for those financial analysts, bankers, especially investment bankers and arm-chair critics in Malaysia who still think that the current financial crisis is merely a storm in the tea-cup and will have no impact on Malaysia, I have come to the inevitable conclusion that they are stupid and morally bankrupt – stupid because they chose to ignore reality, and morally bankrupt because they have no ethical principles whatsoever.
Notwithstanding, my previous article, “Booming Market For Structured Investment Funds”, which exposed the fraudulent scheme of a Malaysian banker, who was touting SIVs when the same has been discredited in the United States and Europe, Malaysians continue to believe in such lies. I have to admit that this is a sad reflection of the mentality of Malaysians, generally unsophisticated in matters financial, and mostly ignorant of fundamental economic principles, even those in regulatory bodies such as Bank Negara and the Treasury. If this is not so, how else can we explain the stupid nonsense that are being reported in the mass media?
This was the question posed to me by a dear friend who then invited me to write another article on the present global financial crisis. His plea was – “Matthias, don’t assume that they know the basics i.e. DEBT 101. They can’t compute how debt is related to the global financial crisis. Maybe, you should write an article on DEBT 101.”
Having written over 30 articles in less than six months, each, way ahead of events that was unfolding, I told my dear friend that I have done more than my fair share of warning fellow Malaysians to prepare of the financial tsunami, and that there is no point in belabouring the issue, especially when Fortune and Forbes although belatedly have finally acknowledged the seriousness of the crisis.
My dear friend retorted, “You have written everything that can be written on the crisis, but you have not written anything on DEBT 101. If after writing on DEBT 101, and these a@#h*@les still don’t get it, then forget them for good!” It was a challenge, I could not refuse.
DEBT 101
Part 1 – First thing first!
Do you know that in law, when you deposit moneys in a bank, you are the CREDITOR and the bank is the DEBTOR? Yes, the bank in this transaction, in law is defined as the DEBTOR. In plain and simple language, the bank owes you money.
But the bank behaves like the Lord Almighty! This is the psychological con that has been perpetrated by banks since banking was first created.
The word “con” is short for “confidence.” And a confidence trickster is one who abuses your confidence in him. Bankers, especially investment bankers, are confidence tricksters par excellence.
LOCK THIS CRITICAL CONCEPT IN YOUR MIND AS IT IS FUNDAMENTAL TO THE CONCEPT OF FRACTIONAL RESERVE BANKING.
Additionally, memorise this quotation.
“If the American people ever knew what we have done, we would be chased down the street and lynched”
President HW Bush (1992) to journalist Sarah McClendon.
Part 2 – Savings
It follows that when you deposit moneys in a bank, be it a savings account, current account or by way of a fixed deposit, you are saving your hard earned money.
The return on your savings (deposit) is the interest the banks pay you at the prevailing rate.
Another way of looking at this transaction (the correct way) is that the bank borrows money from you and in so borrowing pays you an “interest” for the use of that money.
Savings is therefore fundamental to banking. Literally, if there is no savings there can be no “banking”. In plain and simple language, if you and all the bank customers stop depositing money with the banks, the banks have no moneys to lend – NO MONEYS TO CREATE DEBT.
LOCK THIS CRITICAL CONCEPT IN YOUR MIND AS IT IS FUNDAMENTAL TO THE CONCEPT OF FRACTIONAL RESERVE BANKING.
Part 3 – Fractional Reserve Banking
Creating Money Out of Thin Air
By law, all banks must keep certain amount of the moneys deposited by customers as “Reserves” to meet the eventuality of withdrawals by customers. The amount of the reserve is A FRACTION OF THE TOTAL DEPOSITS made by the customers. The Central Bank of each country determines the amount of this reserve e.g. 10% of total deposits.
Thus, if the reserve is 10%, then a bank receiving a deposit of RM1,000.00 need only set aside RM100 as reserves. The bank can lend out to people seeking loans the remaining RM900.00. The banks can do this, because the banks know that at any one time, not all customers will withdraw the full amount of the money deposited.
This is Fractional Reserve Banking. The bank borrows your SAVINGS to lend to people who want to borrow moneys for their businesses, pay for their children’s education, buy a house etc.
Please read Part 1 again.
When you deposit RM1000 at “Trustworthy Bank”, the bank pays you interest, say 3%. When it lends to John Doe your RM900, it charges say 7% interest. The profit is the difference in the rates i.e. 4%
Now multiply that in billions and you can see how much moneys the banks are raking from your deposits.
Part 4 – Debt & Creating Money Out of Thin Air
This part is the fun part and that is why banks love DEBTS.
Recall that your RM900 has been lent to John Doe (RM900 debt) who uses the money to pay Jane Doe, who credits her banking account with the said RM900 at the same Trustworthy Bank or at “Solid Bank”.
Applying the fractional reserve principle, RM90 will be allocated to reserve. If Jane Doe account is with the Trustworthy Bank, then the said bank can lend a further sum of RM810 to Ali Doe. Alternatively, if Jane Doe has an account with “Solid Bank”, then Solid Bank can lend RM810 to its customers.
Please take a piece of paper, and slowly calculate each time, moneys are lent out to borrowers of the bank.
You will soon discover that your original RM900 has snowballed into thousands of ringgit of loans to various “borrowers” of different banks.
And that is just your RM900. Pause and think. Your RM 900 is an absolute figure. Yet, by the magic of Fractional Reserve Banking, that same RM900 is transformed into thousands upon thousands of debts.
Part 5 – More Debts, More Money Can Be Created
It follows from the example in Part 4, when there is an abundance of savings banks have more money to lend.
But the banks, especially banks in the United States and Europe were not content with this windfall. They wanted super profits.
So they created news ways to create money other than the above traditional method.
The most efficient and lethal was to CREATE DEBTS.
The Story of Joe Six-Packs
Joe is your average wage earner who into his tenth year of employment bought a house worth US100,000 and was working hard to pay off the housing loan over the loan period of 15 years.
Over the loan period, the value of is house appreciated and is now worth US160,000.
His friendly banker though slick advertising and “personal service” enticed Joe to take on a “consumer loan” of US50,000 to renovate his house and buy a second car for his wife. His reservations were laid to rest when the bank manager said that his house is worth US160,000 and therefore his equity in the house was more than enough to secure the loan. Interest on the loan was low, at teaser rates of 2% and only after the 3rd year would the rates be adjusted to a higher rate of 4%. Joe was assured that his salary would be sufficient to pay off the instalments.
[Recall Part 4 – now calculate how this US 50,000 loan can in turn be snow balled into thousands as loans]
Next the friendly banker, approached Joe and with slick marketing convinced him that his present financial status was such that he was entitled to a credit card, with a credit limit of US30,000 which he could spent on a well deserved holiday and the belated solitaire diamond ring for his beloved wife. Why not! There was still sufficient equity in the house to secure the borrowing.
Soon, Joe realised that his salary was insufficient to meet the loan instalments and credit card repayments. Adding fuel to the fire, since December 2006, house prices began to slide and his house once worth US160,000 was now valued at US120,000 and going down.
The bank has given notice of foreclosure if the loans were not serviced and defaults persisted.
Joe Six Packs nightmare has just begun.
Mulitply this scenario a few million times and you will get a picture of the housing mess in the United States and right across Europe.
Part 6 – No Savings, Debts Piling
For years, the United States have been having negative savings. Thus, no savings (i.e. deposits in banks) banks have less money to lend.
They resorted to debt creation as outlined above to generate their obscene profits.
These debts were secured by mortgages like that of Joe Six Packs. These loans and mortgages were then bundled together and marketed through SIVs as CDOs, CLOs, ABCP etc. to investors, hedge funds. They were then sliced and diced over and over again, so much so that everyone lost track of the original security or its value. It reached the stage that these “bonds” were just paper, improperly secured or not secured at all.
When Joe and millions of borrowers defaulted, and with housing prices falling, the banks found themselves with assets that was insufficient to cover their exposure and worst there were no buyers for these “assets”.
Part 7 – Problem is Not Lack of Liquidity
Therefore the problem facing global banks and Central Banks is not that there is a lack of liquidity in the financial markets.
The fundamental problem and why the crisis cannot be resolved is that:
THE BORROWERS ARE INSOLVENT.
THE “ASSETS” OR “SECURITY” ARE INSUFFICIENT TO COVER THE BANKS’ EXPOSURE.
THERE ARE NO SAVINGS, SO MONEY CREATION FROM THIS ROUTE IS SCREWED!
NO FURTHER DEBTS CAN BE CREATED AS VALUE OF SECURITY IN SUPPORT OF DEBTS ARE FALLING RAPIDLY.
BAD LOANS HAVE TO BE WRITTEN OFF.
LIABILITIES HAVE EXCEEDED BANK ASSETS. THEREFORE BANKS ARE NOW ALSO INSOLVENT.
THEREFORE, THE AMOUNTS KEPT IN RESERVE IN MEET CUSTOMERS WITHDRAWALS ARE INSUFFICIENT TO MEET SUCH CLAIMS.
HENCE, THE CON THAT THERE IS NO BANKING CRISIS SO AS TO PREVENT A RUN ON BANKS, AS HAPPENED IN THE U.K.
THE FED and THE EUROPEAN CENTRAL BANKS PUMPING MONEY HAS NO EFFECT BECAUSE THE LIABILITY OF THE BANKS IS IN THE TRILLIONS, WHILE ASSETS ARE ONLY A FEW HUNDRED BILLIONS. LIABILITY EXCEEDS ASSETS.
NO MORE DEBTS CAN BE CREATED BECAUSE MILLIONS OF JOE SIX PACKS CANNOT BORROW ANYMORE (EVEN IF THEY WANTED TO) BECAUSE THEY HAVE NO EQUITY TO SECURE ANY FURTHER BORROWINGS AND NO SAVINGS TO REPAY PAST AND FUTURE BORROWINGS.
IN A WORD:
BANKRUPT.
THE USA IS BANKRUPT.
THE US BANKS ARE BANKRUPT
THE EUROPEAN BANKS ARE BANKRUPT
This is the main reason why on the 12th December 2007, the Fed, the ECB and other Key European Central Banks came together to inject US65 billion into the global banking system. The only time in which such a concerted effort was made, was in September 11, 2001.
Up to December 12th, the Fed and ECM has already pumped US$500 billion (half a trillion) and it had no visible impact on the crisis. On the 12th December 2007, the collective effort of the Fed, ECB and other key European Central Banks pumping a further US$65 billion coupled with a 25 basis points reduction in the Fed Fund rate and Fed Discount rate did not even spark a rally in the stock market. The opposite took place. The Dow lost ground. Wow!!!!!!!!
This is the surest sign that the day of reckoning is fast approaching. Tighten your seat belts. It will be a stormy ride into 2008.
Conclusion
Enjoy Christmas while you can. Come 2008, the full force of the Tsunami will be felt globally.
MATTHIAS CHANG
