derryl

Advice for Renters: Wait Until 2010 to Buy

There are upper limits on total bank lending based on the bank's capitalization. If the value of the bank's capital--it's total stock valuation--is $1 billion and the legislated assets to capital ratio is 20, that bank can make a maximum of $20 billion in loans. During the Greenspan low interest bubble there was demand for new loans well beyond what total US bank capitalization would support. This restricted bank profits, but prudence born of hard-earned experience prevented any largescale relaxation of capital requirements.

("fractional reserve" requirements are something else entirely. These are cash reserves that banks must keep in order to supply cash-on-demand to their depositors. The reserve "requirement" is real, based on banks' experience rather than legislation, and is about 4%. If a bank's depositors have a total of $1 million in checking and savings deposits, the bank will need about $40000 cash on hand to meet its customers' cash needs. Depository institutions like banks MUST meet these needs, but there is no set rate telling them what those needs are.)

Already in the 1970s Fannie and Freddie had invented mortgage loan securitization. They packaged mortgages and sold ABSs into the open market, which served to freeze up excess liquidity that had been put into the system by mortgage borrowers: that money was now owned by the sellers of real estate to those borrowers. As long as ABS buyers were Americans this was a good way to internally finance a level of real estate activity that banks alone could not legally finance. Banks who had made the original mortgages could collect fees for continuing to administer the collection of mortgage payments, refinancing as mortgage terms came due, and making new mortgages which were promptly packaged into ABSs and sold, which gave banks a new expandable source of revenue and profits beyond their allowable loans portfolio.

Regardless what you think about the way the banking/finance system is designed (there's lots of criticism about fiat money, fractional reserve and central banking), the system attempts to coordinate new money circulated to finance new production with savings from past productions and with existing stocks of goods-for-sale. The idea is that whoever wants to take something for themselves has to at some time put back in an equal amount. Too much new money too fast causes inflationary bubbles and related problems that we now see in their gigantic unmistakable form.

By securitizing American mortgages and selling ABSs to Americans the finance system was working as it was designed to. American liquid money made a good rate of return by investing in ABSs. But securitized American mortgages were eventually sold en masse to foreigners. This left excess privately held liquidity (i.e. money) in American hands and that money was looking for a rate of return on investments. But the money had already produced the investments--all the real estate that was mortgaged.

The financial system only works properly if the total stocks of money and goods-for-sale remains within a more or less closed loop. Imports of money must be balanced by exports of goods, or else you end up with an economy that has too much money in it for the amount of goods that were produced. Securitization of mortgages and later securitization of American consumer and corporate debt that was sold all over the planet caused the import of vast amounts of foreign money into America which released vast amount of American money to inflate US prices of all the existing stock of goods and investments that were available to absorb that money.

I think the correct way out of this situation is to repay alll the foreign money with US exports and to refinance all the American real estate and corporate debt with all the liquid American money that has been playing a non-productive numbers game on the financial markets instead of investing productively in the real economy real estate and stock markets.

There's nothing wrong with globalized investments as long as your nationals are exporting as much US money into other economies as foreigners are injecting into your economy. Otherwise international financial flow imbalances cause problems: starved-out investment in donor countries and inflated investment in recipient countries. Eventually the music stops and the fallout starts.

Rebalancing is easier said than done, but I think this is what should be the target. Hopefully the recent G7/IMF emergency meetings are looking at something along these lines.