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When bank loans are paid off, deposit money is extinguished. This is in contrast to an individual who extends a loan with money he possesses where a payoff is a return of transferred funds. This is because the banking system creates deposit money when it extends a loan, and extinguishes that deposit money upon pay off of the loan.

So what happens in a situation with massive loan pay offs such as several million foreclosures?

Answer: Money is drained from the system.

The Fed has been preventing money contraction from the recent financial correction. There are four issues.

  1. Bank capital is lost from bad loans and when bank capital is exhausted, the bank shuts down reducing the generation of new loans.
  2. Depositors (especially large corporations) can lose their money unless the government increasingly bankstops insolvent banks.
  3. Loan payoffs in greater dollar volume than new loans is a de-facto shrinkage of the desosit 'money supply.'
  4. Existing banks have a cash-flow problem even with support because operational cost in some cases exceeds diminishing income.

#1 and #2 were handled by various means: FASB changing the rules on non-performing loan pools so that a mark-to-market insolvent bank can continue operations and depositors are backstopped by various capital injections and FDIC expansion. (Capital injection was by no means the best course of action. Deposits are only 65% of liabilities and the authorities could simply have let a number of banks go into BK, converting the non-deposit liabilities to equity and then providing support for the stronger banks that remained. This would create a more prudent banking system in the future.) #4 we'll skip.

Let's focus on #3.

For #3, the Fed must create as much 'new money' as is being extinguished by mass loan payoffs. If a bank lends 100K and loses 40K, the losses are absorbed by bank capital and then covered by government support. However, the payoff of 60K by foreclosure is a drain of funds unless a new loan is generated that replaces the 60K.

Just how large is this effect? Consider what happens if 10% of the $14.4 trillion mortgage universe were to foreclose at 50% of the original loan amount and no new loans replace the payoffs. 10% x 50% x 14.4 trillion = $720 billion. In other words, the mass payoffs that occur when foreclosures start moving can be a huge money drain as existing deposit money is extinguished from loan payoffs.

The Fed's willingness to monetize is what will relieve this pressure so that more cash buyers will enter into the foreclosure market, as there is no longer a drain of funds that would put further downward pressure on the market.

That promised $300 billion in monetized funds which has so far stimulated a growth of 19% in M1 ($245 billion) doesn't look so big, does it?

Assume with 3 million foreclosures 10% are bought with cash at 200K each. That's $600B. In all likelihood, we will see far more foreclosures than that. So the total 'monetization' might indeed be higher, depending on the technical factors of loan issuance.

And consider this, the Fed has liquified some of the banking system's interbank lending market so instead of banks borrowing reserves from each other, some have reserves at the Fed on account. Since CHIPS clears north of 2 trillion per day, that is going to soak up some of the reserves. While we could have a real problem in the future, the 'hyperinflation' isn't so clear now, is it? Nor is it clear that the Fed is forced to keep rates low and thus cannot continue to sequester the reserves.

Without a real breakdown of composition, limits, and purpose, it's hard to get a handle on how much support is being offered and to whom, and thus it is not very possible to look at the Fed's balance sheet and get an idea how tight or loose they are. The only real possibility is looking at deposits and cash and estimating the monetary effects given current production and psychology.

Let's take this one step further.

Consider the banking system to be one big bank. You bring money to the bank and the bank owes you back the money. However, since everyone is banking at this 'one big bank', all payments are simply transfers from one account to another.

This bank will extend loans by creating new account balances rather than acting as an intermediary between a saver and a borrower. Why? Because the bank makes a higher profit by offering new loan money rather than having to pay a saver a (higher) yield. The value in the new money is gotten by diluting the existing base of money ... the bank is in essentials extracting wealth from everyone and lending it, irrespective of whether those people save or not.

Question: Then why would such a bank pay interest on deposits?

Answer: To reduce the amount of transactions money so that deposits do not devalue against goods (price inflation). That would invoke a (political) backlash against the bank.

This accurately describes our present banking system if it were looked at systemwide, especially since the Fed now pays interest on reserves.

So as you can see, as the underlying monetary contraction from these events play out, the Fed is responding with an opposite policy. While we may indeed suffer major price inflation some time in the future if the government continues to prevent losses and makes other policy errors, that has not been made clear. Current policy is not as price inflationary as many have said.

But as always, it is a good idea to hedge both sides - just in case.

Disclosure: No positions (stocks, bonds, etc) in regards to this article.

Source: Expect a Huge Money Supply Contraction