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Where has all the money gone?

by rdf Sun Jan 18th, 2009 at 01:01:12 PM EST

With all the talk of "toxic" assets no one ever asks where the money has gone. I'm going to lay out an oversimplified scenario and hope this will explain why the bailout plan won't help the general public.

Even thought I think housing was a small part of the problem, I'll use this since it is easy to visualize. A similar story can be told about commodities, and counterparty insurance schemes. The difference being that nothing tangible is behind these transactions.

Joe Homebuyer buys a house that costs $200,000 and puts in $10,000. The bank lends him the rest which he uses to payoff the prior owner in full. The bank had to get the money to lend so it either uses deposits, or, more frequently lately, issued bonds to the public. The "public" in this case was most frequently mutual funds, pension funds and other allegedly prudent investors.

The score at the end of round 1:
Prior owner - $200,000.
Joe - 1 house, -$10,000 in cash, $190,000 in new debt.
The bank - a claim on one house, $190,000 in "assets"
The bond holders - $190,000 in bonds and a promise of interest and eventual repayment
The "public" - their retirement funds $190,000 via the bond holders

Now the price of the home declines and the homeowner gets foreclosed. Suppose the bank can resell the house for $100K.

The score at the end of round 2:
Prior owner - unchanged
Joe - no house, -$10,000 in cash, liability for unpaid debt $90,000
The bank - $100,000 in cash from the foreclosure sale, a bad debt of $90,000
The bond holders - $190,000 of bonds, worth really $100,000, impaired interest stream
The "public" - retirement funds worth $100,000 although they may not know it (yet)

At this point the story can go two ways. Let's take the case where the homeowner goes bust. He will never repay the $90,000

The score at the end of round 3a:
Prior owner - unchanged
Joe - no house, -$10,000 in cash, no debt, no assets
The bank - $100,000 in cash, a permanent write down of $90,000
The bond holders - $100,000 real worth in bonds, impaired interest stream
The "public" - a retirement fund now worth $100,000

$90,000 has permanently "vanished" and it is never coming back. Even if the house goes up in value sometime in the future that will only benefit the new owner, not Joe, nor the bank, nor the bond holders.

Another possibility is that Joe enters into some sort of adjustment with the bank and promises to pay back the lost $90,000 (although it is usually only a faction of this).

The score at the end of round 3b:
Prior owner- unchanged
Joe - no house, $10,000 in cash, paying $90,000 out of future earnings "forever".
The bank - $100,000 in cash, a revenue stream to recover the missing $90,000 spread over many years.
The bond holders - $100,000 real worth in bonds (maturity value is less important than current prospects), slightly less impaired interest stream
The "public" - a retirement fund worth $100,000 with lower income for the foreseeable future

Now the "public" is not all saving for retirement, some are already retired and expecting the investments to yield the promised return and to be available to redeem at the issued price. Their income is now impaired in either step 3 scenario. The money has "vanished" from their savings.

The bailout is trying to shift as much as possible from 3a to 3b, on the theory that getting your money back later is better than not getting it back at all. But this can only be partially successful. The home is not going to appreciate in the near future and even if it does it doesn't help Joe or the bank. Joe paying off the debt will lower economic activity for decades to come since he can't use his earnings for new purchases but must turn it over to the bank, which in turn has to set it aside to repay the bond holders.

Making the process go slowly may avoid a panic and the need for some to sell even on more distressed conditions, but the money is not really going to come back.

So "toxic" assets, aren't toxic, they are worthless (or worth less, if you prefer). Whether these assets are held by the bank, the government or sold off to new speculators makes no difference. Their value is permanently diminished.

One of the ideas was for the government to buy these as if they were still worth their original value. This would help the banks, the bond holders and the "public". But in order to do this the government would need to print money to pay for them. Printing money lowers the value of all the existing money. This is the inflation that no one wants to talk about. So the permanent losses get spread over the entire population as their savings become worth less. Usually banks don't like inflation since they get paid back on their loans with watered money. But in this case get the full value now and avoiding bankruptcy is seen as a good gamble compared to the risk of inflation later. In fact since the are selling the "toxic" assets to the government, they aren't even the lenders anymore.

This plan was killed off because it was too expensive, no one could determine which assets should be covered, and how they should be priced. It may resurface if things keep getting worse, however.

Currently there is another plan being promoted - to have the banks suspend the interest on the bonds that they have issued. The idea is that since the income stream from Joe doesn't exist or is impaired then they can't really afford to keep up the payments. They must be getting the money to do so from the bailout, and why should the government pay interest to the bondholders? Of course the bondholders are really us, in our retirement funds so stopping the interest payments will lower the value of these bonds even further, force mutual funds to dump them and cut income available for payouts. (Technically most of the talk has been about preferred stocks, many of which permit suspending dividends, but even so if this happens there are implications for the firm, usually restrictions on raising new funds and sometimes the requirement to add stockholders to the board). It isn't greedy bankers, but investors that will be harmed just like all the other scenarios. This one will just unfold faster.

So what's the bottom line: In every scenario the ultimate losers are the public. Their retirement funds are diminished and/or their buying power will decline in the future due to the issuance of excessive new money.

Is there any way out besides the public taking the hit? No, and the fact that the politicians won't discuss this shows whose side they really are on - the banks.

I think you're missing something, rdf. The prior "owner" ends up with $200,000, probably much of which was itself mortgaged. So we need to explore the populations A of recent sellers and B of recent buyers. If the nature and ownership patterns of the financial instruments used by A are qualitatively different than for B, the vanished money was transferred from one group of owners to another. That is to say, from pension funds and mutual funds to some other groups. I wonders who they might be.

The second complication is that for much of the recent sales, there was no owner A. The houses were newly built in new subdivisions. The group here who made off like bandits were probably the land developers.

I think issue of where did he money go could be determined, but we'd have to do more digging.

by PIGL (stevec@boreal.gmail@com) on Sun Jan 18th, 2009 at 02:33:34 PM EST
Who is a recent buyer (new construction) or residual buyer (existing stock) calls for misplaced precision in characterizing the market operations, except in counting instances of and calculation of interest rates applicable to HH mortgages, e.g. NINJA, fixed, OptionARM.

The prior "owner" ends up with $200,000, probably much of which was itself mortgaged.

Prior owner's (seller's) financial position:

  1. NOT a HH mortgagee --> pockets $200K unobligated

  2. IS a HH mortgagee --> pockets ($200K - "equity") = $100K (for demo purposes). Note that $100K is insufficient replacement value. HH mortgagee (a) acquires new mortgage; or (b) exits capital market, acquires $100K shack.

  3. IS a DEV mortgagee -->pockets ($200K - corp. debt) | $200K = "margin" + corp. debt.

IF DEV mortgagee corp. debt = 0, DEV mortgagee pockets $200K. See (1).

IF DEV mortgage corp. debt = lien > 0, DEV mortgagee pockets margin, retires debt. See (2).

IF DEV mortgagee corp. debt = RMB bond > 0, DEV morgagee pockets margin, collects HH mortgagee payments for distribution to RMB bondholders.


DEV mortgagee pockets margin, sells RMB bond | price = HH mortgage NPV + payments + margin2. DEV mortgagee pockets margin2.

Yes, the conditional statements of (3) are complicated in so far as the cost of the HH mortgagee default(s) is apparently < the cost of compounded security interest obligated and paid. The fact remains, the US central bank insists payout of securities interest is an appropriate resolution of non-performing, secured AND unsecured corporate liabilities.

Diversity is the key to economic and political evolution.

by Cat on Sun Jan 18th, 2009 at 04:27:03 PM EST
[ Parent ]
Uh, thanks. I wish I understood you completely. Obviously the real situation is very complicated. You've forgotten the inter-generational aspect, for example, when owner A dies or otherwise exits the market, leaving the $200,000 to his or her heirs to pay down their mortgage perhaps.

Do you think there is any way to come up with an estimate of transfers from one population to another? Or did the money literally combust?

by PIGL (stevec@boreal.gmail@com) on Sun Jan 18th, 2009 at 04:37:14 PM EST
[ Parent ]
Whenever a loan is written off, money is destroyed.

Because >97% of the money we use is created as interest-bearing debt by credit institutions aka banks

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sun Jan 18th, 2009 at 05:01:17 PM EST
[ Parent ]
stupid question :

does it mean that FED/ECB need to print as least as much as the amount written off to keep the quantity of money even ?

therefore there is very little risk of inflation in a "foreseeable " future, isnt it ?

by fredouil (fredouil@gmailgmailgmail.com) on Mon Jan 19th, 2009 at 02:34:29 AM EST
[ Parent ]

However, since the newly printed money is growing exponentially at each new bailout wave, at some point it will reach the same level as the pre-existing (and now defaulted) debt. My guess, it will only take 2-5 years in the US. And then, because of the shotgun/rush-to-print approach being employed, it overshoots.

Printing doesn't cause inflation in an economy with a developed financial system: the financial system multiplies money anyway with debt, and it acts like a gearbox featuring a damping inertial mass an a viscous coupling to the base money. There is deflation in the face of printing if the financial "gearbox" is shifting gear to a lower multiplier.

Printing causes immediate inflation when there is no such gearbox between base money and main street: e.g "primitive" economies like Zimbabwe.

However, I guess the future trend in developed countries, is all about shrinking the financial system, making them look more like Zim. So the FED is bound to overshoot. It actually did in 1937, and then panicked in the face of inflation, raised rates, and crashed the economy again. Fine tuning interest rates while maintaining the pretense of a free capital market just isn't possible, when the capital market has been wiped out.


by Pierre on Mon Jan 19th, 2009 at 07:35:57 AM EST
[ Parent ]
My new understanding is, money is "destroyed" when a debt is repaid.

Returning slightly back to rdf's scenario:

The bank had to get the money to lend so it either uses deposits, or, more frequently lately, issued bonds to the public.

It is misleading to say than a bank uses deposits. In principle, a bank loan does not diminish any deposits by a cent. A bank loan is just a new money created our of thin air (which comfortably goes to the "prior owner" in this scenario). The are rules for this money creation out of thin air - see Fractional reserve banking. Roughly speaking, a bank can legally create 90% (or 80%) of its existing deposit volume in new money. But as the new money comes back in deposits somewhere (be it in the same bank), the total new money originated from an original deposit "reserve" may aggregate to several times more than an original "real" money deposit.

The compound interest does not play a role in money creation. All it does is requires extra more money to be created somewhere, for the loan to be repaid fully.

A bank needs to issue the bonds to the public only when its loan volume approaches the deposit volume - normally quite an extreme utilization. But with the quite recent demand of more loans (during the boom), and probably with even more recent demand of deposit withdrawals (during this bust), banks may indeed be forced to raise all their value through public bonds.

In rdf's scenario, new money was created with the loan, and on aggregate there was less money destroyed with the default and bankruptcy of Joe. The monetary volume is increased precisely by the amount of debt not repaid, minus the interests already paid. I know, the natural instinct to look for a more sane circulation of our wonderful monetary system. But the system indeems seems to be that crazy after all, even if appearances were probably kept skilfully very normal for quite long.

by das monde on Mon Jan 19th, 2009 at 03:20:26 AM EST
[ Parent ]
das monde:
My new understanding is, money is "destroyed" when a debt is repaid.

Correct. Writing it off is in accounting terms the same as repaying it.

It is the case that banks create money when they create loans and instantaneously create a matching deposit. So the reverse is also true.

Banks also create money when they pay their staff and any other costs add also in paying dividends, again instantaneously creating deposits in the system.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Jan 19th, 2009 at 06:07:26 AM EST
[ Parent ]
Writing it off is in accounting terms the same as repaying it.

In accounting formality, yes. But if some credit "created" some monetary volume, and then a portion of it was written off, it sets borrower's account from negative to zero, freeing him up from draining his productivity to repay the debt. What a bank writes off in his books is its claim on debtor's money - the money that was never created in the real world. This kind of default leaves some fiat money in the system that is unmatched by contended debt.

by das monde on Mon Jan 19th, 2009 at 06:27:42 AM EST
[ Parent ]
inter-generational aspect, for example, when owner A dies or otherwise exits the market, leaving the $200,000 to his or her heirs to pay down their mortgage perhaps.

To my mind, the "inter-generational aspect" is a political or social conflict related to how our government(s) legitimize economic extortion. Representatives (a) enact law to encourage debt production; (b) pay for the cost of externalities ("political conflict") by continually "injecting" credit instruments into the money supply available to payout in wage/salary income.

If one cannot identify the source of an "inter-generational" problem, the problem cannot be solved.

Do you think there is any way to come up with an estimate of transfers from one population to another?

Everyone has an estimate of the total value of the RMBS money marketing. The true question is, what is my portion of it?

HH mortgagee dies, leaving an obligation valued $200K: Laws require the estate executor ("trustee") to resolve all HH mortgagees liabilities. According to HH mortgagee beneficiaries' instructions, executor will choose (a) retire the lien using income of estate assets, e.g. insurance proceeds; (b) continue to make mortgage payments from estate or other income, e.g. rental, dividends; or (c) sell the property for the value of the lien or a greater amount so retiring the debt to the mortgator.

HH mortgagee dies, leaving cash or liquid asset valued $200K. See (a).

HH owner dies, leaving unobligated property valued $200K or more. Beneficiaries, assuming title transfer, may dispose of property however they like.

[DISCLAIMER: Nothing above neither may nor should be construed as tax or legal advice. These remarks are commonsensical.]

The point of the matter is that default of financial obligations --for whatever reasons-- is not supported by economic activities in the US.

Diversity is the key to economic and political evolution.

by Cat on Sun Jan 18th, 2009 at 05:29:48 PM EST
[ Parent ]
I have the following issue with rdf's scores: he awards the Prior Owner the full $200'000 in the first round, then declares that his fortunes are "unchanged" later. That is highly misleading, especially when Joe's minus $10'000 score is kept underscored in all rounds. The thing is: the Prior Owner gets the full $200'000 and leaves the game, as much as this transaction is concerned. He may use that money to pay off his other debt (that is, the created money gets immediately "destroyed"), or may put it in a bank which uses it as a resource for more loans (so inflating the money supply), or do whatever else. But the point is: in the balance of this story, the Prior Owner gets $200'000 - nothing more or less.

I am also pzzled, what is the distinction of "The Bond Holders" and "The public" in rdf's accounting.

When a bank "uses" public bonds rather than deposit "reserves", no new money is created with the loan. (Neither compound interest generates any money by itself.) What is happening then, is that public "bond holder" money goes to the lucky Prior Owner, with merely an expectation that the same money (plus interest) will be returned by the poor Joe Homebuyer. In this scenario, the lost money is indeed the unpaid debt. This kind of credit (be it interest bearing or not) does not create any money, but it sucks money out of the public, and possibly returns "nothing" if the economy goes wrong.

It seems then that the inflationary lending (via fractional reserve rules) was so utilized that it was no longer possible, and then the sucking "vampire" lending took over. Extra fun comes from the fact that these crazy implications of "normal" monetary rules are apparently not understood or imagined by a vast majority of smart dealers/traders, or even by big bankers. There are layers of misleading interpretations...

by das monde on Mon Jan 19th, 2009 at 03:40:52 AM EST
[ Parent ]
A "decision tree" is a graphic representation of ethics, events and conditional statements ("branches"), each terminating at a desirable or undesirable outcome ("moral"). Computer software --high- and low-level programming languages-- is a scripted decision tree.

RDF: Joe Homebuyer buys a house that costs $200,000 and puts in $10,000.

What rdf didn't script:

1. Buyer's "down payment" or "minimum investment" = $10K. See Chris Cook, "sunk cost", in principle.  Also the amount of literature available to justify price discrimination in consumer credit markets is mind-boggling, if you've got the time.

The source of $10K is either (a) Buyer's savings from wages; (b) gift of savings to Buyer; or (c) "closing costs" financed by seller; a commercial law/tort controversy is whether this amount by a DEV seller or third-party is a gift or an undeclared loan, ergo institutional implications ("moral hazard") of foregone interest payments --and a remedy for this "loss"-- since any default is the anethema of financial capitalism.

2. RE Price = $200K. Depending on the financial position of the seller ("prior owner") Price represents either (a) appraised market value, seller is clear of lien, mortgage free; (b) unpaid principal of lien, seller is mortgatee with no margin ("profit") expectation;  (c) upaid principal of lien plus margin, seller is mortgatee with profit expection based on appraised market value, see (1a); or (d) full unpaid principal of lien, see (1c) case of the so-called subprime, first-time buyer.

rdf "score" notation properly recognizes "sunk cost" (- $10K). This amount is spent (according to GAAP), unrecoverable by buyer or seller actually, and in circulation --whether its source were credit or residual currency notes.  According to tenets of financial capitalism, new owner may replaces $10K by establishing some enterprise. The income produced by the asset purchased, in this case the RE unit, derives from one of two customary decisions by owner: (a) lease at a rate exceeding lien plus $10K; or (b) unit resale at a price exceeding lien plus $10K or more.

The seller ("prior owner") becomes a prospective buyer. Does rdf need to reiterate the buyer "decision tree" to illustrate disposition of the $200K "award" received by  "prior owner"? No. But here and here, I do in order articulate the unstated assumption (prior owner is a prospective buyer), disabuse reader presumption ("Prior Owner gets the full $200'000") and to differentiate individual and corporate agent "decision trees". These are identical to a point, where    loan origination, default risk, and lawful obligations diverge.

RDF: The bond holders - $190,000 in bonds and a promise of interest and eventual repayment. The "public" - their retirement funds $190,000 via the bond holders

rdf makes no distinction between private and public money markets. In either case, you are correct, the debt offering --also called security interest, capital raising, etc-- "sucks money out of the public" savings. It also invites money created for "intermediary's," e.g. charter banks and securities brokerages, that  borrow from the FRB cartel in order to fulfill credit of prospective bond buyers of the bonds. These include other lenders who also sell consumer and commercial mortgages, "retirement fund" managers seeking income, and the bank's own trading business units! and governement sponsored entities (GSEs) who speculate according to yield (bond pricing).

Money is created for and returned to secondary market credit activity. Far and away from the primary market transaction. A theory of the velocity of money predicts, what is "lost" or "destroyed" in a loan default is mearly the income stream produced by wage labor that would fund other investment choices by "savers", i.e. persons possessing surplus capital convertible to cash or credit in the secondary market.

So we see, capital raised by a bond or security sale funds the primary market buyer who transfers the funds to "lucky Prior Owner" who must first retire the lien (plus incurred "pre-payment penalty" fees for terminating interest payments) in order to (1) collect any proft from the sale price buyer accepts; and (2) "pay off his other debts" from those proceeds as you suggest. New money (credit) and residual money (saving) passes through debt creation.

I disagree, decision (2) doesn't destroys money in circulation. Prior Owner's profit conpsumption impairs his ability to reduce the amount of credit he requires to purchase another home. Thus he creates "wealth," adding his increasing demand for credit to the money paid that "recapitalized" a consumer creditor's liquidity and capital stock. So I hear.

Given these decisions, probability "lucky Prior Owner"  like Buyer is and remains a mortgatee is high. According to fed statistics, one in three "homeowners" services a mortgage. Seller is lucky to meet a buyer willing and able to pay the debt and more  --  to pay in the form of ever larger, "jumbo conforming" mortgage terms -- to the extent creditors exist to collect interest (price of default risk).

Diversity is the key to economic and political evolution.

by Cat on Mon Jan 19th, 2009 at 02:12:51 PM EST
[ Parent ]
European Tribune - Where has all the money gone?
Is there any way out besides the public taking the hit?

Well, I would like to think that


is a serious way out.

Investors swap a non-performing loan for a tradable Unit in a Pool of property rentals which bears a reasonable index-linked rate of return. The affordability of the rental means it is by definition more likely to be paid - therefore justifying a more reasonable rate of return.

Such a Debt/Equity swap maintains the Quantity of financial claims - rather than wiping them out - but changes their nature or Quality.

Instead of repayment risk, there's liquidity risk.

But note here that it would be possible to create large, continuous, pools of liquidity which are not fragmented by a myriad different, counterparties, repayment dates and rates of return.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sun Jan 18th, 2009 at 02:53:47 PM EST
I was trying to oversimplify to get to my main point that sticking it to the current bond and preferred stock holders is not going to make the right people "suffer".

There is an important technical difference between money raised through conventional bank deposits and the off balance sheet financing done to excess in the past decade. Furthermore, investment banks don't even have depositors, all their funding comes from bonds or their equivalent.

The non-depository money is lent out (I'm not sure, but I suspect with zero need for reserves) this is not "fractional reserve" banking it is borrowing from Peter to lend it to Paul.

Those who invest in such entities may be superwealthy people and thus bear the scorn of populists, but as the recent Bernie Madeoff fiasco has shown many times the investors are charities, educational institutions or others who didn't think they were gambling.

I don't want to get in a discussion of the misunderstanding of the "fractional reserve" system, but those who insist that money is created out nothing are only partially correct, they ignore the time factor and also conflate book entries with real economic activity.

The entire US banking crisis could be eliminated in a second if the rules were changed so that banks could carry "toxic" assets at their original value and only take the loss (if any) when the debt was closed out through default, repayment or sale of the asset.

Instead they have to guess what the underlying asset is worth now and treat the loss as realized now. Paul Krugman approaches this topic from a slightly different aspect in his NY Times op-ed column Monday.

To summarize: suspending interest payments to preferred stock and bond holders will create a bigger problem for the larger economy while doing little to improve the balance sheets of banks. It will make spiteful populists feel better because they are sticking it to the "fat cats".

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Mon Jan 19th, 2009 at 08:42:33 AM EST
This is a good thought-process, but let's look at few things:

First, in round 1, you list both the Bank and Bondholders as having assets or claims.  That's not true. Where banks have sold the mortgages as mortgage backed securities, which I take to you to mean by bonds, then the bank no longer has it as an asset -- that's what "off the books" means.  The bank already made all of its money on the deal by making the initial loan and then selling that loan at a profit to an mortgage-backed-security investor.

When you finish it all, the "lost" money all goes to the prior owner who sold his house at too high a price.  It doesn't disappear -- it goes into the pocket of the lucky fellow who last sold the property before the prices fell.  There is a net transfer of income from the suckers who paid too much to the lucky ones who sold at the peak.  Where the suckers who paid too much are borrowers and default on their loans, there is a net transfer of wealth from the lenders (banks or bondholders, but not both) to the prior owner.

by santiago on Tue Jan 20th, 2009 at 12:57:35 AM EST
There is more than one separate deal tied to mortgage-backed securities.

  1. Bank or Lender sells whole loans originated by it ("lot1") to Investor or Servicer or both by splitting lot1 ("tranche"). Record: loans "off the book", profit or loss in the P&L.

  2. Servicer issues bonds to open market to "raise capital" to buy Bank lot1. Record: Bonds on the book (liability), lot1 on the book (asset), lot1 expenditure in the P&L.

  3. Bank or Lender holds whole loan ("lot1") sells interest payments ("lot1.a") to Investor or Servicer. Record: Write down lot1 (asset) "on the book" by amount of interest payments lost, lot1.a sale in the P&L

  4. Investor sells security interest in lot1.a on open market (lot1^n). Record: lot1.a "on the book" (asset),  lot1^n available for sale (asset), outstanding lot1^n  payable interest (liability), sale of security interest in P&L

(ditto Servicer. ditto Bank holding whole loans.)

5. Bank holds whole loan ("lot1"). Record: lot1 "on the book," interest income in the P&L.


I'm pretty sure what the business press means by "off the book" is NOT a sale of lot1 or lot.a which have no marketable value for resale and are non-performing, i.e. produce no income. Such statements refer to FASB accounting rules and US Tax Code which permit a holding company to transfer ownership interest in these non-performing assets to subsidiaries, special purpose entities (SPEs) or remove them to a government sponsored entity (GSE) rather than record the "impairment" on revenue and credit (or market value of the holding company) attributable to the assets "on the book." Unloaded thus, market value and balance sheet of holding company "equity" appears cleansed, and SPE losses earn holding company a tax benefit.

At some unspecified later date sale, magically, that asset ("lot1") representing foreclosed mortgages (terminated whole loans) will produce income, ergo marketable value of lot^n securities for sale or redemption by BankA, InvestorA, and ServicerA.

The volume and value thus far of such transfers, called collateral by the FRB (plus capital "injections" or purchase of preferred shares in insolvent corporations, secured by this collateral) is $350B. Mr Bush requested the balance of $350B, and Congress has already authorized this Treasury debt to release FRB proceeds of t-bill sales up to that amount.

Meanwhile corporate issuers still owe bondholders principal plus interest until the maturity date on the coupons.

This is why Bloomburg has pronounced Mr Obama "Banker-in-Chief."

Diversity is the key to economic and political evolution.

by Cat on Wed Jan 21st, 2009 at 03:15:04 PM EST
[ Parent ]
I've said before that, in these matters, I'm a Bear of Very Little Brain, so please Bear with me. ;)

$90,000 has permanently "vanished" and it is never coming back

I don't get it. Santiago's right, that sum has gone to the former owner of the house, as part of the $200K. And, for the purposes of this argument, it doesn't matter what he's done with it, whether it's on deposit in the banking system, gone on a new house and feeding the bubble, or spent on pizza. That's where the $90K have gone, and they have not disappeared: one way or another, they're in circulation.

Or so it seems to me <scratches head>.

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 21st, 2009 at 11:24:05 AM EST
Try this as a simpler case.
You buy a piece of land and building supplies, say for $50K. You plan to build a house by yourself, but you go to the bank and they lend you $100K because that's how much the house will be worth when it is completed.

You build the house and try to sell it, but the most you can get is $50K even though it is completed. Where did the other $50K go?

This way there are no prior owners, no intermediaries, only money lent against collateral that was overvalued. For CDO's and other derivatives, there isn't even any tangible property behind the deals.

See my prior posts:
The end of an era - The Ponzi Age


The Crisis Explained - Really

Much of what was called investing was just gambling. Unlike in casinos where one side loses and the other wins (and the house takes its cut), this type of gambling involves a lot of welshing on bets.

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Jan 21st, 2009 at 11:47:07 AM EST
[ Parent ]
I quite agree that a great deal of what was called investing was gambling, what's more highly leveraged, that the whole scheme of mortgage-backed assets was a scam that was bound to collapse the instant real estate prices stopped rising. But these simple examples that purport to show how money "disappears" don't convince me.

In this example, supposing $50K are enough to build the house, the buyer pays that down when buying. The builder remains up $100K, but he owes that amount to the bank.

land and materials50
bank loan100
house sale50
loan repayment100

That seems to me to balance out. I don't see $50K disappearing anywhere. What am I not seeing?

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 21st, 2009 at 03:25:46 PM EST
[ Parent ]
The builder used $50K to buy the lot and materials, even though he borrowed $100K. Perhaps he took the other $50K and spent it on his daughter's wedding or on a trip to Tahiti.

Now he sells the house and only gets $50K. He can only pay back half the $100K. Either the bank takes on a loss or he has to work off the debt for an extended period of time. Now if you want to argue that the other $50K didn't "disappear" that it went to the caterer or the cruise line, that's fine, but economic modeling won't get anywhere if we have to treat the whole world as a unit.

The essential point is that the bank is out the money. That's what the various bailouts are trying to replace (or hide).

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Jan 21st, 2009 at 04:20:31 PM EST
[ Parent ]
economic modeling won't get anywhere if we have to treat the whole world as a unit.

Oh boy. This was economic modeling and I didn't know it ;)

But you just added the new bit about spending $50K somewhere else. And even if you decide, to make your model draw the conclusion you'd like it to, that there are new transactions in there that are all the same extraneous to the model otherwise it won't work, well, there's still no money "vanishing". It's just the bank putting money out and not getting it back.

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 21st, 2009 at 04:46:32 PM EST
[ Parent ]
It was consumed, you know that newspeak for "trickled down", that is, most of it was spread thin all over the planet (pocketed by sweat shop owners), with small part of the whole being "superconcentrated" in the pay of financial system executives - concentrated because there are fewer finance whizz kids than pizza boys and sweat shop owners (and of course also because banks get a fee whenever they help money move from A to B).

by Pierre on Wed Jan 21st, 2009 at 12:22:56 PM EST
[ Parent ]
OK. In which case it went somewhere, it didn't disappear.
by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 21st, 2009 at 03:27:58 PM EST
[ Parent ]
But some of it will in the near future: some was saved in aggregate form in the chinese banking system, which put it in treasuries (will default some day), and even earlier than that, anything that now gets paid down in the US doesn't get relent, so the credit multiplier is going down (financial institutions are deleveraging). This means money disappears faster than Ben can print it.

by Pierre on Thu Jan 22nd, 2009 at 03:46:06 AM EST
[ Parent ]

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