This astounds me. How could banks think it was OK to buy these assets when they themselves were issuing them, specifically because they were too risky?

Sounds like there’s plenty of blame to go around here: a dumb federal lending policy that opened the door to a problem, compounded with crazy circus speculation, and hypocritical idiots managing bank assets.

I recognized the problem with the market in 2006 when I heard an advertisement on the radio for “a jumbo loan of $500,000 for only $700 a month!” Plug in a $500,000, 40-year, fixed rate mortgage into Excel — even at 0.1%, with no PMI or property taxes (which is absurd), the payment is still well over $1,000 a month. At a more accurate 4%, the interest alone on $500,000 is over $1650 a month!

AND NOBODY FREAKING SAID ANYTHING ??

The banks bought each other’s mortgage-backed securities at a level that they thought was safe, but the risk models turned out to be badly wrong and the banks had much more exposure than they thought. So much so that when all was said and done they had effectively lent out well over 100% of deposits – maybe (we may never fully know) over 100% in ‘toxic assets’ alone. So, that’s why you’re now hearing people saying banks and investment firms should be (re)separated, as well as more than a little upset over the bank bailout in general. It’s the old “screw up a little and it’s your problem, screw up a lot and it’s everyone else’s problem”

Mark Herpel: “Get rid of the dollar and bring back honest money or at least allow the states to use it”

Well that would be Federalism in action, though I certainly hope Virginia won’t be the state to try such a retrograde system.

Mark

// So my point stands – even with a gold-backed currency, the money supply expands and contracts on its own due to lending. The more lending goes on, the more money is in circulation. When lending contracts (or stops, like right now) the money supply suddenly drops. //

Yes. The sudden contraction of the money supply kicked off the Depression. Even Bernanke admits it was a colossal mistake. However, hyper-accelerating the money supply is _also_ a mistake, just for different reasons.

// If banks lent out 100% of deposits, then a credit freeze would completely wipe out the money supply. That’s why the government regulator makes banks maintain a certain ratio of actual cash in the vault compared to the total value of loans they make. //

Agreed. Even more strongly than you put it; the banks are supposed to have enough money to cover expected withdrawals of deposits. If they lent out 100%, nobody could take out their deposits (unless the bank borrowed). I believe they have to keep at least 10-15% of deposits on hand, so they only lend out 85-90%.

// That system broke down in the subprime mortgage market because the risk models for the mortgage-backed securities turned out to be very, very wrong. //

No argument here. Lending money to people who can’t pay it back and then securitizing the payment streams (of the thing that won’t get paid back) is a bad thing. I’m confused why banks are failing though, shouldn’t it be more hedge funds and investors? If banks securitized the loans there should be no risk to the bank, just the certificate holders – because default risk and pre-payment risk is passed on. Or at least that’s how these things were structured when I was doing my MS in finance…

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“Huh? If the bank starts with 100% of the money and you loan out 50% of it, how is 150% in circulation? I can see how 150% of _value_ might be in circulation but not of deposits.

Also, a strange phenomenon of fiat currency is that it’s all debt.”

Well, call it value if you want. The point is that as far as anyone is concerned, both the bank deposits and the loans exist and can be used on demand, even though a lot of the lent-out money is just a double-count of the bank deposits. So my point stands – even with a gold-backed currency, the money supply expands and contracts on its own due to lending. The more lending goes on, the more money is in circulation. When lending contracts (or stops, like right now) the money supply suddenly drops.

If banks lent out 100% of deposits, then a credit freeze would completely wipe out the money supply. That’s why the government regulator makes banks maintain a certain ratio of actual cash in the vault compared to the total value of loans they make. That system broke down in the subprime mortgage market because the risk models for the mortgage-backed securities turned out to be very, very wrong.

I can think of at least three examples where essentially this happened: the Continental Dollar, the Confederate dollar, and the Zimbabwe dollar. I’m sure there are others. I’m not sure a complete collapse has ever happened to anything as relatively powerful as the USA; the best analogy for that might be the Japanese yen in the 1990’s, which took a pretty big hit.

// So for example, if the bank keeps 50% of all deposits in the vault and lends out the other half, the economy now contains 150% of the original deposits. //

Huh? If the bank starts with 100% of the money and you loan out 50% of it, how is 150% in circulation? I can see how 150% of _value_ might be in circulation but not of deposits.

Also, a strange phenomenon of fiat currency is that it’s all debt. If all loans were paid off tomorrow, there would be no money in circulation at all (John Adams pointed this out as far back as 1787!).

// And whatever money is in circulation is always “backed” by the total value of goods and marketable skills present in the economy. //

Yes. Although given that the national debt ($10 trillion) is 60% of GDP, and total unfunded entitlement liabilities ($60 trillion) are over 400% of GDP, this is where we are running into danger.

Also, as you print money, you lower the value of each unit, unless you can increase the total national wealth by the same amount. Because we’ve had reasonable growth, we’ve mostly gotten away with it; however, right now we are contracting sharply and STILL printing money, which is a recipe for inflation run amok. This, much more so than corporate greed (not that they’re helping either), is responsible for the decline in real wages among the working and middle class.

// More philosophically, fiat money isn’t really money ‘just because someone says it is’ //

Actually, that’s literally true, that it’s money because a government (or someone) says it is. Even if I were to dig up a Continental dollar and take it to a store, it would only be money if the shopkeeper and I agreed it was. But then it would only be money if he could find another taker. If nobody wants it, it’s worthless.

I liked Ron Paul’s idea of competing currencies because then there is more of an incentive to manage them responsibly.

Aside – the biggest weakness of a gold standard is when people who use fiat money perform currency exchange with a backed currency, and then call in their certificates for gold. This is why Nixon moved us to pure fiat money (admittedly, because they were printing money to pay for the Vietnam War, but I think the point still stands).

// Money – paper or gold – exists for good natural reasons //

Agreed. I am just saying that if it is improperly managed, those good and natural reasons become warped, and bad things happen.