The Martenson Insider - July 15, 2010

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In This Newsletter
  • About those bank profits…
  • Debt-Based Money Is The Problem

About those bank profits…

Thursday, July 15, 2010

It’s earning season again, and ‘investors’ are going to be fueled by reports of strong earnings and earnings growth in the banking industry, especially among the giants.

Some of these gains will be real, and some will be due to accounting gimmicks that are quite difficult to assess by any but fully-dedicated analysts.  For example, massive swings in provisions for loan losses are now a normal part of the bank-earnings management cycle, which makes accurate comparisons between periods quite difficult.

JPMorgan Profit Rises, Beating Estimates

JPMorgan Chase & Co., the second- biggest U.S. bank by assets, said profit rose 76 percent, more than analysts estimated, as a reduction in provisions for soured mortgages and credit-card loans buoyed results.



Second-quarter net income climbed to $4.8 billion, or $1.09 a share, from $2.72 billion, or 28 cents, in the same period a year earlier and from $3.33 billion in the first quarter, the New York-based company said today in a statement.

Of course, left out of the first few paragraphs is the fact that JPM also reduced their provisions for future losses in their retail division by more than $2 billion.



That’s an odd thing to do in this environment, unless they vastly overestimated their losses earlier.  Things are still pretty dicey out there in retail-land, as evidenced by such stories as this next one:



U.S. Home Seizures Rise 38% to Record as Banks Process Backlog

A record 269,962 U.S. homes were seized from delinquent owners in the second quarter as lenders set a pace to claim more than 1 million properties by the end of 2010, according to RealtyTrac Inc.



Home seizures climbed 38 percent from a year earlier and 5 percent from the first quarter, the Irvine, California-based data company said today in a statement. More than 1.65 million properties received a foreclosure filing, including notices of default, auction and bank repossession, in the first half. That was up 8 percent from the first six months of 2009.



 “Foreclosures haven’t peaked yet,” Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts, said in a telephone interview.

The important item here is that "foreclosures haven’t peaked yet."  This means more stress is going through the credit system.  The major banks are exposed to this in a variety of ways, both direct and indirect.



However, one oddity in all of this is that consumers seem to have completely inverted their debt repayment priorities, as credit cards are now being paid back in preference to mortgages:

Credit Card Delinquency Rates Continue to Fall

June 24, 2010



Credit card delinquency and default rates continued their general decline in May, cheering investors and signaling overall economic improvement. Despite banking industry concerns about a new wave of government regulations that could limit profits, easing of 30-day late accounts and charge-offs helped credit card issuers retain more revenue compared to the previous month.



Capital One reported that only 4.8% of its cardholders fell more than 30 days behind on minimum payments during May. Chase reported a similar delinquency rate of 4.22%, and Discover's 30-day-late percentage fell below 5% for the first time in months. Likewise, most credit card issuers have been forced to charge off fewer accounts, sending fewer cardholders into collections activity. Capital One, American Express, and Chase reported declines in defaulted credit card accounts, while Discover reported a slight increase. ***

Even as mortgage default rates continue to climb and joblessness remains stubbornly high, credit card delinquency rates are easing, indicating that people have decided that being liquid and having access to credit is more important than owning a home.



This makes a certain amount of sense.  It is one of the elements of moral hazard that are a predictable outcome of various programs that reward the reckless and imprudent at the expense of everyone else.



What results is the idea of strategic defaults; of gaming the system when the incentives are there to do so.  I’m not saying that it is immoral or even amoral to walk away from a mortgage contract that no longer makes financial sense; that’s just good business.  But the people who have calculated that the odds favor them being able to live rent- and mortgage-free in their current domicile, due to the immense backlog of delinquent mortgages and government programs that freeze or otherwise delay the seizure process, are taking more than they are otherwise due from the situation.



It is perhaps not surprising, then, that the wealthy have the highest default rates, as they are more likely to have second homes and good financial planning.

Mortgage Default Rates Highest Among the Rich

Wealthy homeowners are more likely to default on mortgage payments than suburban middle and working classes.



More than one in seven homeowners with loans in excess of a million dollars is seriously delinquent, reports the New York Times. In contrast, about one in 12 mortgage holders below the million-dollar mark have stopped payments to lenders.



Some experts suggest the trend is a purposeful tactic by the upper class to dump sour ventures, particularly investment and second homes, with little concern for the civic good or potential lawsuits by lenders, according to the Times.



 “The rich are different: they are more ruthless,” said Sam Khater, senior economist at real estate analytics firm CoreLogic, which compiled data for the Times.

So it is a mixed bag out there right now for banks, with credit cards being paid off by consumers while mortgages fall to second place in the priority list.  All in all, that’s not a great thing, because revolving debt stands at a bit over $2.3 trillion, while mortgage debt is over $10 trillion.  You’d think that banks would want the situation reversed.



Finally, banks will be banks.  Their earnings are especially tricky to decipher under the best of circumstances, but even harder to gauge when they resort to this sort of trickery:

Bank Profits Depend on Debt-Writedown `Abomination'

Bank of America Corp. and Wall Street firms that notched perfect trading records in the first quarter are now depending on an accounting benefit last used in the depths of the credit crisis to prop up their results.



Bank of America, the biggest U.S. bank by assets, may record a $1 billion second-quarter gain from writing down its debts to their market value, Citigroup Inc. analyst Keith Horowitz estimated in a June 23 report. The boost to earnings, stemming from an accounting rule that allows banks to book profits when the value of their own bonds falls, probably represented a fifth of pretax income, Horowitz wrote.

The abomination here is that the bank’s restatement of their own bond values changes neither the interest nor principal payments due.  There is absolutely no impact to the cash flows that comprise earnings.  It’s the same as a guy with a big credit card balance claiming that he earned more in a given quarter because his card company decided he was a bigger credit risk.  It’s just razzle-dazzle.



Or nonsense.

Conclusion

I think that banks should be reporting huge earnings here.  They’ve been given loads of free money by the Fed and the government, and they have been allowed to keep a lot of bad assets off the books and out of view.



If you can’t make money by borrowing at (almost) 0% from the Fed and then leveraging that up to buy government paper paying 3%, then you really shouldn’t be playing the game at all.  Most banks have proven themselves to be more than capable of taking advantage of this free money machine, and their results show it.



While I understand the government's desire to get these "too-big-to-fail" banks back on sound financial footing, I lament the wasted opportunity (and taxpayer money) that this represents.  We’d do better by investing in industries that will help us transition to a very different future – one characterized by low growth and depleting resources. 


Debt-Based Money Is The Problem

Saturday, July 10, 2010

Note:  I am thinking this may be a good post for the front of the site, but am looking for your feedback here in the enrolled area before 'going live' with it.  Can you spot any weaknesses in it?  Have I made my case?  Is anything unclear? 


Recently there has been a very engaging discussion going on over in the forums [LINK] that puts forth the argument that there is no logical reason why a system founded on debt-based money must grow exponentially.

Clearly such a claim cuts right to the very heart of the Crash Course and all of its implications, so I decided to, once again, wade into these messy waters before too much more confusion is sown.

Poster Darbikrash said, "the material and thesis proposed by poster “diarmidiw” clearly show major holes in the debt based currency construct as outlined in the Crash Course," while member Farmer Brown said in response, "It is a logical and mathematical fact that money/debt growth is NOT required for debt-based money to work."

So I need to address this before it goes much further. 

It is absolutely true that money/debt growth is required for our debt based money system to work, at least if we include just a few elements from how the real world actually operates.

Here is the main thesis put forward by Diarmid Weir in the initiating forum post.

The concern about the repayment of debt interest is actually based on a confusion of stocks and flows of money. The money issued in a loan contract is a stock, which can support a theoretically unlimited flow of transactions, including interest payments, over time.

Since the money collected by a bank as interest flows out again in the form of wages, dividends and payment for physical capital, it can return to borrowers and form part of the final repayment. No further loan is necessarily required.

Of course the money stock does grow exponentially, because transactions are increasing exponentially, but this doesn't in itself mean that debt can never be repaid.

First, I find the notion of breaking money down into "stocks" and "flows" to be confusing rather than helpful.  Money is utterly and completely fungible at all times.  Principal money can (and usually does) "flow" and interest payments can (and often do) become "stocks."  So I really do not see how segregating money in this way serves to clarify anything.

Second, the money stock is increasing exponentially, but not necessarily because transactions are increasing exponentially.  Here I will note that credit/money growth has reliably exceeded nominal GDP growth for over thirty years by an average rate of 0.73%

If 0.73% doesn't seem like a lot, note that it is a quarterly value compounded over thirty years. What it means is that while nominal GDP has grown by 520% from 1980 to 2009, total credit market debt has grown by 1205%, or by 2.3 times as much.

Clearly, credit is accumulating a lot faster than can be explained by transactions, although that is certainly part of the story.

Brass Tacks

I will readily concede that it's possible to construct a very small model showing money circulating around in a tiny debt-based system which appears to require no further money creation to work.

However, such a model is just too entirely simplistic to have any use to us, either from an explanatory or a predictive standpoint, and this is what I aim to clear up in this article.

Before we go further, I think we really, really need to agree on a few very basic concepts.  My intent is not to lay them all out at once, because people seem to skip over too much material, so I will constrain this article to just two points.  Here's the first one:

Number 1:  All money is loaned into existence.

This a very basic and elementary point.  If there is another way for money to get into the system, it needs to be dragged out for all to see, right here and right now.  The first question up for debate is this:  "Can anyone reveal a mechanism by which money gets into our current system besides it being loaned into existence?"

If nobody can lay out an alternative, then we've got agreement on item #1:  "All money is loaned into existence."  By way of short-circuiting the inevitable, let me state right here that Fed money is loaned into existence, so even their thin-air POMO money does not count as "debt-free money."  The Fed balance sheet consists entirely of debt instruments in equal proportion to the money/credit issued (at least initially, before the debts they accumulated have either gained or lost value).

Anybody?  No?

Then let's move on.

Number 2:  Debt-based money grows exponentially

In the real world, we can readily observe the fact that, for more than six decades, money and credit have been growing exponentially.

The explanation for this rests with a simple understanding that combines the fact that money is loaned into existence with a modest appreciation for how money moves through the real world.

To explore this, let's walk through a very simple table.

In this example all we need is a $1000 loan, a 10% rate of interest, and a few time periods.  No other loans will be made through these time periods, in order to keep this example simple.  Further, we are going to ignore bank capital and fractional reserve and other such complicating issues, because they do not add anything helpful to our understanding.  We can add them back in later, but for now, we're leaving them out.

Here's the table:

In this example, before t=0, there is no money anywhere in the universe.  At t=0, a loan is made for $1000 at 10% interest.  At that moment in time, there is only $1000 in circulation (and existence).

Now let's move forward one period of time to t=1 and work down the first complete column.  Here we find that the principal is still $1000 and the interest due (and paid) was $100, which had to come out of the original $1000 loan.

In case #1, we recreate the idea that the bank puts all of this interest back out into the world - and it flows back to the original borrower.  What happens in this case?  Well, there is still $1000 "out there" in circulation, consisting of the remaining $900 from the initial loan plus the $100 of recirculated interest.  So apparently there is no debt-repayment problem, because there's $1000 owed and $1000 floating around.  If we carry this behavior along, note that at the end of four periods, the loan can be paid back in full, but the money in circulation will go to $0 upon repayment of the loan.

Unfortunately, in this highly theoretical example, there are a number of unrealistic conditions which have to be true for it to work.  Namely:  (a) all the loaned money has to go towards the increased production of goods and services, which must then be purchased by the bank and its stakeholders (meaning that no consumptive debt is allowed, only productive debt), and (b) nobody saves or otherwise sidelines any of the interest payments over any of the time periods, and (c) there are perfect flows between the borrower(s) and the recirculated interest payments from the lender(s).

To recap, this model assumes (and requires):

  • No consumptive debt (e.g., home mortgages, car loans, credit cards, etc)
  • No savings or other accumulations of interest
  • Perfect flows

These points are so far out of the bounds of what we know to be true about the real world, I hesitate to spend much time debating whether they are "logically" or theoretically possible.  In the real world, some people are always going to be much more productive than other people, which will tilt the flows into some coffers more than others.  Another truism is that individuals have different savings preferences, with some, especially the already-wealthy, having very high savings levels.  This, too, will stymie the theoretical system by plugging the perfect flows necessary for it to truly operate.

Therefore, we could readily predict that interest flows are not ever going to balance out perfectly, not even under the most fantastical framework of Marxist command and control ever envisioned.  There will always be accumulations and hitches, money will always pile up here and there but be in shortage elsewhere, and these facts will lead the theoretical model to break down.

So let's trundle a little closer to the real world, which we can find even in our highly-simplified table model above.

Please review case #2 above, where the bank (or its shareholders, workers, or other recipients) hold onto the interest payment, for whatever reason (it goes into capital, savings, or is otherwise parked and does not flow).  Here we have an immediate problem in that there is now only $900 in circulation and the loan obviously cannot be paid back.  It only gets worse at t=4, with a $400 deficit.

It is in the CLAIMS row, however, where we see the reason that under real-world conditions, debt-based money always grows, which is apparently where the breakdown in understanding is occurring.

Recall that money and debt are claims on (pick one:  wealth, goods/services, human labor). What's important in this story is to note how the claims change over time, not to get confused over flows and stocks and other such distractions.

Note that at the end of the first period of time, the bank has a claim on $1000, which is the principal balance that it is owed.  Further, the final recipient of the interest has a claim to $100.  Together, these represent claims on $1100, although we only started with $1000 in money at t=0.  By the end of four periods, there are now claims on $1400, where we only started with $1000, representing 40% growth in only four periods.  Even if the loan is somehow paid back in full at t=4, there is now $400 in circulation where there once was $0.

That is how debt-based money grows.

The Real World

Now clearly there's a middle ground in here; neither the 100% flow scenario nor the 0% flow scenario describe the real world, so the answer must lie somewhere between them.  Evidence suggests that it lies quite a bit closer to the 0% mark than the 100% mark, but that's for another day.

As long as you agree that savings, consumption, and imperfect flows are components of the real world, then you (hopefully) can see how money will grow as a result of increasing claims over time.  If we add in purely consumptive debt, especially debt where the interest accrues over time instead of being dutifully paid and recycled, then the growth will happen even faster.

We can also run through this from a different angle; I could show you how real world conditions will cause debts to inevitably increase, but I'll save that for another day, too.

For now, I am content to note that money has been growing exponentially with a "fit" of 0.98 for many decades.  So, too, has debt, but with a nearly perfect fit of 0.9935.  I've never run across a better fit in all my days as a scientist.  This aligns with and supports my logical and theoretical understanding of how debt-based money works.

It leads me to claim that exponential growth is a requirement of our modern money system.  However, in thinking this through more fully, I am less clear on what the requirement is for monetary growth in relation to total interest payments, so if I were to redo the Crash Course chapter on money, I think I would amend my statement in there to say, "In order to remain stable, the money supply must continue to grow by some amount every year."

There are a lot of subsequent details to delve into next, involving such things as debt rollovers, zero-coupon bonds (where the interest "flow" = 0 by definition), non-self-liquidating debt, balloon loans (very-low-interest flows over multiple periods), credit card balances, auto loans, student loans, and myriad other credit products that can dramatically ratchet up the rate of money/interest accumulation.  So, too, we'll have to discuss what happens when wealthy people (and pension funds, etc.) can no longer consume their interest receipts and have to begin stockpiling the interest 'flows' in compounding amounts.

The bottom line is that our money system is growing exponentially and has been for many decades.  Such growth requires at least some corresponding amount of growth in the real economy or else bad things will happen.  Things like debt defaults and/or inflation.  That's what happens when claims on money outstrip the real economy.  I just don't see any realistic way to fashion a workable system out of debt-based money.  Instead, I would support thinking about creative ways to use debt-based money while we transition to a mélange of other monetary systems that can operate in a stable and sustainable fashion.

This happens to be the predicament that we are in.  I hope the effort that I have put into this explanation allows at least one more person to now say, "Ah, I get it; I can move on now," so that their attention can be turned to becoming more resilient.


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