Banks, Central Banks, And Economies Of Scale

To continue our discussion on banking and finance we must move to the present.  The old rules and regulation, the laws that provided decent definitions and even some protection for the public as well as the banks have become undone, much to our present sorrow.  The very upscale department stores allowed their upper middle class and even the middle class customers to buy on credit.  The stores kept their own accounts and decided who was credit worthy and who was a high risk.  They expected the account to be settled each month.  If one didn’t pay for purchases by the end of that period, one’s account was closed and the consequences soon followed.There were no “Credit Card” companies, issuing cards for individuals same as cash.  After world war two that would change.  Your bank went from issuing letters of credit saying you were “good for so much” to eventually issuing plastic.  Most department stores went from issuing their own cards to placing their name on a card issued by a credit card company.  The company would receive the payments and take their due off the top.  If one wasn’t a chain retailer, then by allowing the use of major credit cards the retailer would pay as much as 3% per transaction.,  The credit card company assumed the risk and went after dead beats.  The other thing that the credit card companies did was to constantly upgrade your credit amount.  It is not unusual that when first obtaining a credit card one has a limit of several thousand and then after years of paying on time that limit can reach to $50,000 or more.

Of course the credit card business went through several “improvements” over the decades.  The eighties saw the abolition of the interest on credit card loans dropped as an income tax deduction.  We also saw a continual rise in interest rates from the late sixties as inflation started to consume income in general.  Finally, the rates that credit cards companies became unfettered and one could see 25% being applied in many cases.  It use to be that 10% was considered usury, now we don’t even know the meaning of the word.  And local banks were bought or expanded into state wide banks (the states gave up their right to regulate the industry) as the federal government obtained greater control over the banking system.  Savings and Loan banks, credit unions, and other small local and state banks found it difficult to compete with interstate banking corporations.  The pre-depression federal legislation, FDIC, would garner control by requiring any bank that subscribed to ins program to follow federal banking laws.  The year 1913 saw the creation of the Federal Reserve System and the Federal Reserve Bank with its 13 regional banks.  We have the Panic of 1907 to thank for that creation.

This Federal Reserve System is a quasi private banking system.  Every bank is a member and each has voting power to elect the officers of their regional bank, or if they are interstate, the officers in all thirteen regions.  Each bank must keep on deposit with the Federal Reserve Bank a deposit, usually a percentage of its capital, as an insurance policy against failure.  The Fed can require higher deposits or lower them as it suits their standards and purposes.  In return, the depositing banks are given interest on such deposits at the Fed funds rate.  These banks can also borrow temporarily at the discount window instead of borrowing from other banks.  These are known as overnight rates.  In theory, if banks were run efficiently and kept their risks conservative, they would not need this function.  What had been stared as a solution to prevent bank runs and insure liquidity, that is for the general population the availability of cash, has morphed into a credit creation monster.  Commercial and investment banks have been allowed to cross over into retail banking and retail banks have crossed over into the investment sector.  The FDIC insured account has gone from $10,000 limit to $100,000 limit.  And we have seen the growth of Hedge Funds whose sole reason for existence is speculation, for money can be made rigging the game.  These hedge funds and investment banks, such as Goldman Sachs, use computer algorithms in high speed servers co-located in Wall Street so they can execute orders milliseconds and microseconds before the public brokerage houses.  It allows them to front run the market.  How is this done?  One can issue a thousand 100 share orders that increase the price to sell or lower the price to buy and then cancel those orders the next microsecond.  This allows these traders to drive prices up or down for their advantage.  the profits may be in one or two pennies per share but multiply that share number by the hundreds of thousands and one can become a billionaire in a few years of successful HFT (High Frequency Trading) operations.  Some days the only volume of trading is among the HFT hedge funds.  This, by the way, is also illegal but the SEC and the Justice department refuse to even investigate. Hillary and Bill are giving too many speeches that support their incomes while peddling influence.,

One of the rationalizations for big banking that there projects in the world that require vast amounts of funds in financing.  An individual bank must be able to raise and loan multiples of billions of dollars or euros or pounds.  The Chinese are now getting into the act by trying to be the new reserve currency and embarking on world wide development costing hundreds and thousands of billions of dollars worth of development.  This is possible because around the world the central bank rates are close, at, or even below zero.  A negative interest rate is when you pay the bank to hold your deposits and they pay you to buy a house.  I would love to have a negative interest rate on my mortgage.  That would be bad enough since the world has gone off the gold standard (not all countries have, by the way and not all countries have central banks), banks discovered “financial engineering”.  This “engineering” came in the form of creative bank products.  As the expansion of credit increased the amount of inflation in the individual countries and the world regions, so the problem of debt service encountered new “solutions”.  Things like credit swaps, credit default obligations, and many more “colorful” names and services that go by the general term derivatives have become the weapons of mass financial destruction. You see, if I sell you a fire insurance policy for your house but do not have any reserve to pay on that policy should your house actually burn down, that is a naked bet on my part.  There is an international commission that decides when there is a credit even or when your financial house of cards has burnt down.  If they declare that something such as the 2012 Greek Government Bonds restructuring  is not a credit event (actually the creditors took small haircuts on their restructured bonds) then all those derivatives that were issued as “insurance” against a future credit event don’t collect against their losses.  The lunacy of the derivative issuance is that there is little or no reserves set aside for such credit events.  There is only the assets, assuming the liabilities aren’t greater, to pay out on such derivative issues.  Are we having fun yet?

Back to the central banks and in particular our Federal Reserve Bank.  The Fed has two mandates, to guide monetary policy by use of interest rates and the guard against higher unemployment.  Monetary theory says that one can guild a countries economic growth by controlling the money supply.  Allowing more money into the system provides the boost to the economic engine.  Reducing the money supply reduces the activity of the economic engine.  If this were true, then we would seldom have economic problems such as recessions and depressions.  But the Fed lost any control over monetary policy because it could not and cannot control the creation of credit.  I have said this many times and I am not alone in this thought.  The creation of credit is the creation of money.True, the early forms of credit given by retailers did little to create money in that sense.  The credit was against existing assets.  But a future wage or profit is non existent until that future arrives.  Credit given for future events such as that paycheck next month after you have earned it is the creation of money.  Credit when uses brings that money into the immediate present and places a claim against future earnings.  The use of credit steals money from the future.  Now a mortgage on a house may be secured by a lien against that house for the amount of the value left on that mortgage.  But that house is not a “liquid” asset, it must be converted into cash and thus its value greatly diminished.  Its price on the market may reflect a drop in its value relative to when it was first purchased.  There may be few, if any, willing purchasers.  In short, such an asset has risk in conversion to cash or liquid assets.  Do you see the problem?  The Fed can’t control the real estate market because it has no means to do so.  We can put limits of the issuance of loans, particularly those secured under Federal mortgage insurance.  One must the the principle resident, one must own the house for a certain time period, etc.  This stops the churning in the market by those using some forms of credit like federally insured mortgages programs.  But for the cash buyer there are no rules.  One can buy and flip to one’s heart delight and supply of money.  True, no credit is created by the buying of real estate with cash.  But most individuals seldom have the means to pay cash,  Cash buyers sell to mortgage buyers.  There is usually a net increase in the money supply.  Do you see how all that works?

Now when the Fed reduces its rates ti make borrowing cheaper.  You would rather pay a mortgage of 12% or one of 3%?  The last mortgage I obtains was at 3.75%, very nice deal.  1% would have been better.  That interest is the cost of renting the money from the future and the less rent I have to pay the less future money is taken from me.  Cities and businesses like to borrow when the money rent is cheap.  If one can borrow at a quarter of a percent as a bank and then buy an income producing asset that returns one or two percent as a profit of that asset, well, one makes money.  But not everyone wants a conservative return on income.  After all, if inflation is running the same as your return then you are standing still.  By the way, the manner in which inflation is measured can be totally misleading and our federal government has been misleading us for decades on that score.  When one starts playing the substitution game with cost of living items then one is cooking the books and Uncle Sam has been doing that for a very long time, since 1934.

So how does one prevent or ease higher unemployment?  By the creation of jobs.  And one would hope that such jobs pay more than minimum wage.  But the Fed, or any central bank, for that mater, directly hire or create jobs for the unemployed.  We could be like France and indulge in setting up fake corporations with fake products and no production.  This is called job training and is suppose to keep individuals current in their job skills.  It is just another creative waste of money.  Some of those people have spent close to two years on the fake company payroll with no job offers in sight.  So much for socialism as an efficient alternative to capitalism.  The Fed answer is to use Quantitative Easing.  First you lower the Fed funds rate and when that doesn’t create enough demand of cheap money for investment, you start buying treasuries (bonds, T-bills, etc) and work your way through mortgage backed securities, many of which are full of non performing loans and half of them may become noncollectable.  Then you start buying less secure corporate bonds.  What you are doing is forcing the financial community and the retail investment individuals to buy much higher risk investments.  This is called chasing returns. Can’t find any good 4 or 5 or 6 percent bonds, then one has to buy the 8 and 9 and 10 percent bonds and the only people who borrow money at such rates are those in financial difficulty.  Even if one is buying a 10% coupon bond at a steep discount, let’s say 50%, if that bond defaults one is out the investment.  It’s one thing to not be able to collect that coupon, it is another to lose your entire capital.  Tight now the Fed’s balance sheet is in the trillions.  This has never happened before.  It was unusual in the past for the Fed to hold more than a hundred billion in assets.  Now those assets are in the trillions.  Some of them are repurchase agreement.  That is a bank may have sold a block of MBS (mortgage backed securities) to the Fed with the promise to repurchase that same block of MBS.  Well, what happens when it comes time to sell and that block isn’t worth what you paid for it and the seller doesn’t really want it back?

That is one small problem for the Fed.  Interest rates are another.  The Fed funds rate has been lowered ever since 2006 and we have been at ZIRP, or zero rates for several years.  The world is awash in debt and the only way to start cleaning up the mess is to raise interest rates.  By raising rates one cuts down on credit creation and its conversion to debt.  But the problem there is that too many credit unworthy individuals and corporations and governments, including state and municipalities have been borrowing to pay their bills.  One can only borrow so much to pay one’s present bills before on runs out of lenders.  When your city bonds are sold at discount and with 6% or better coupon rates, you better have the income to service those bonds and run your city services.  Ah, but that is just the problem with cities like Chicago.  It can’t increase taxes enough, especially property taxes (that rate is set by the state) and the defined pension benefits keep rising and the retirees keep increasing.  Those pension funds are underfunded by roughly 60%, if one looks beyond the rosy expectation of 8% return on investment.  Yeah, in your dream, mayor.  So if interest rates are raised by 1%, and this applies to Japan as well, the government debt becomes unsustainable and the cost of servicing that debt becomes a huge burden.  We have, when correctly accounted, over 16 trillion in debt or liabilities.  Debt is a liability.  Raise interest rates and the interest alone become close to impossible.

Ah, but the straw that will break every central bank’s back in this world is the pile of derivatives floating in the ozone waiting for that wonderful credit event or events.  The reason why the Fed can raise interest rates more than a quarter percent is because there are over 550 trillion dollars worth of derivative and more are being written every day.  Well, what’s 550 trillion dollars worth of claims?  Not much, only 70 times the world’s GDP.  If you borrow 70 times your income and had to pay it back tomorrow, could you?  Do you start to see the problems of the entire world.  Excessive credit creates excessive income disparity, it creates acute wealth inequality in an accounting sense.  But all those billionaires are not sitting of multiple billions worth of gold and silver.  Like the rapacious fools they are, their assets are mostly paper.  They own stocks and bonds, much of worth isn’t worth what the world believes.  They own corporations that make billions but that is because there are customers to buy their goods and services.  When the electricity stops flowing how much will Apple be worth?  How often will you use your iPhone when you have no electric power to charge its short life battery and the mobile services its use is predicated on?  So much of the world runs on credit and that credit has turned into unmanageable debt.  That will kill of a great many corporations, companies, and worthless start ups from Silicon Valley.  Yes, we will still have electric power and enough oil for limited transportation.  We will still have food supplies.  But expect a much higher unemployment rate.  Expect your universities and college to come close to a standstill as enrollment is greatly slashed.  And expect public service unions, teacher unions and many other unions to collapse under this weight.


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