Gadget’s Airstream Chronicles

Here’s the scoop in a nutshell. The dollar is backed by debt (US Tresuries), and the debt is backed by the dollar. The dollar had previously been backed (partially) by gold. That all changed in 1971 as we went off the gold standard.

From that point forward, debt backed the dollar and the dollar backed the debt.

Is that a head scratcher? Paper backs paper. It’s all about a promise to pay, nothing more.

If it makes you a little nervous, then I’ll let you know, it gets worse. Let’s talk simply about these credit derivatives that are causing problems for banks now.

Each bank is only allowed to lend a certain percentage of their assets. Pretend it’s 90%. And pretend the bank in question has $100 on deposit. That means that the bank can lend $90. Once they’ve lent up to the percentage allowed (the percentage is basically set by the Fed) they’re done. No more lending. No more cashing in on the housing boom.

Oh, woe to the banks. How can we cash in further? Ah, how about creating some derivatives?

The debt the banks held (from their lending) in the form of mortgages gets packaged up with magical paperwork, and is sold out as an asset. See, if you bundle enough debt paperwork it magically becomes an asset. The asset is a “derivative”, and there are institutions willing to take these blocks of debt and pay you for them. They’ll get a percentage of the returns when the debt is paid off (these derivatives are viewed as “bonds”).

Now the bank has more money on hand. What to do with that money? How about lend it out, and then repackage those loans as derivatives too? Sounds like a good plan. You can keep lending beyond what you’re allowed to. Brilliant!

This of course is an extreme over simplification. It gets deeper, and there are more layers to the derivatives. But if you’ve followed so far you understand….Banks were lending way more money than they should have thanks to these magic derivatives. In essence, they were creating an expansion in our money supply (the Fed’s job) in an unchecked fashion. Really nice!

Recently we’ve all heard that the Fed is going to inject $200bn (that’s billion guys) into the banking system. How are they doing it? Giving it out free and willy nilly? Of course not. The “loan” into the system will come at a cost. The banks will be turning over current debt as an asset to the Fed.

Alright, let’s stop for a moment. The dollar is backed by debt, and the debt is backed by the dollar. Credit derivatives are basically debts already loaned out, but then considered an asset. Money is given for them, so more of the same cycle. Now, with a few layers of debt backing cash, we’ll do a little more with the Fed’s move.

I ask you….if you went to your personal accountant with a scenario like this, would your accountant resign? Would they run fast? Maybe a few words would escape their mouth mentioning “fraud” and their fear of being implicated along with you…..just a thought.

The easy money, loose rates, structured finance, etc., are what brought both the dot com bubble and the housing bubble. Instead of unwinding all of this nonsense our course has been laid out to save the system. We’re going to get a little deeper with a little more of the same.  Do you think it will keep the inevitable correction at bay?  Business cycles still exist.  Maybe instead of digging a deeper hole we should let the cycle play out, clear out the bad paper and companies in the system, and gear ourselves for the recovery down the road……  just a thought.

Sure it would be painful, but often times doing the right thing isn’t the easiest thing to do.  Here’s my question for the finance folks out there…..  Where’s a Paul Volker when we need him?  The guy willing to do the tough stuff (even if it means recession), be disliked by the finance community, but is still willing to do it to hasten the system’s correction (read what he said back in 05′).  Think Mr. Volker would volunteer a second time at the Fed???

PS…..I’m not the only one who thinks we need a Volker.  As I was writing this post I googled Mr. Volker, and found a NY Post article from March 4th pointing at the same thing.  Read it, the John Crudele is dead on (and a good finance columnist).

This entry was posted on Thursday, March 13th, 2008 at 7:27 am and is filed under Economics.You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.