Tuesday, May 31, 2011

The Moral Hazard of Modern Banking: How Banks Create and Destroy Money

The Money Lenders by  Quentin Metsys - 1466
"I'm just a banker do doing God's work."  Lloyd Blankfein

Much has been said about both the moral hazard of banks being bailed out and people bailing out of mortgages. The major question raised was, would this ‘bailout’ contagion infect the integrity of our economic and political system?  But far more interesting and much less discussed are the mechanics of modern banking and their moral implications.

During the housing boom trillions were loaned out in mortgages creating a housing bubble and the eventual collapse of the financial markets. But where did all that money come from? The vast majority of people think that banks borrow money from the Fed or depositors at one rate, lend it at another and make a spread. This concept is completely false. Banks create money, loan it out, make their margin through compound interest, and destroy the same money that they created as it is paid back.

The Mechanics of Fractional Reserve Banking

The mechanics of modern banking are opaque, misunderstood and arguably dishonest. Modern fiat money, the dollar, euro, yen etc are all based on debt. For every dollar in existence, there is somewhere an IOU for the same amount. This is best illustrated with an example of a typical mortgage.

Imagine Jack wants to by Jill’s house for $100,000 and he has no money to buy it so he goes to his local bank and asks for a mortgage which is approved. The bank will ask Jack for a promissory note, an IOU, for the $100,000 and once he signs it, they open an account in which they create from nothing $100,000 for Jack in exchange for his IOU. That $100,000 is a liability for the bank, their asset is the IOU. The bank just ‘created’ $100,000 which is backed by the good faith of Jack to pay it back as well as the deed to the house he bought.  Now the bank loans that money to Jack, with compound interest. The interest is the fee the bank charges for monetizing the debt. Jill would not have wanted an IOU from Jack for the 100K, so the bank did him the service of converting his IOU into dollars, and for this service they charge him interest. As Jack pays down his mortgage principal, the value of the IOU will be drawn down as well, until all the money ‘created’ is destroyed, and the IOU is worthless.

The money never existed before Jack signed his IOU. It was created entirely and only as an expression of his promissory note. All car loans, student loans and personal loans are created in this way, and it is the exclusive right of banks and the Fed to create money except for coinage which is handled by the Federal Government. Banks are restricted as to how much money they can create by the amount they have on reserve with the Fed. The formula is complex, but, for simplicities sake, it is around 10 times as much as they have on reserve, (actually more). If the bank has 1 million dollars on reserve with the Fed, for which they are now paid interest, they can create and loan out about 10 million dollars. Banks are paid for the privilege of creating and leasing money. This is our modern, fractional reserve banking system.

How does this differ from how other things that are borrowed or leased? When a house is leased, the owner must buy the house, then rent it, forfeiting his capital in exchange for an asset, the house. The typical return on residential real estate is about 5%, anything with a return of 10% would be snapped up in an instant. So how much do banks make when they loan their ‘created’ money out? Let’s assume Jack has been a good boy, and gets a fixed rate loan of 5% on his $100,000 mortgage for a period of 10 years. The bank is obligated to leave $10,000 in reserve, or 10% of the amount loaned out, but they do not give up the money, and they are now paid interest on it, so the bank now has no borrowing cost, only an opportunity cost. The return on the bank’s $10,000 is Jack’s compound interest payments of 5% on $100,000, or $5,000, a neat 50% return on their money. As he pays off  the principal, the banks also frees up the corresponding amount in reserves, so the margin stays the same. On a 20% interest credit card with an outstanding balance of $10,000, the bank is holding $1,000 in reserve on which it is making 200% a year. Of course the bank has salaries to pay, rent, administration fees, marketing etc. but it is, nonetheless, a very lucrative business model.

What is special about banks that allows them such profitability? First, what is money? Money is two things: a store of wealth, and a means of exchange. Many would define money as human labor. Let’s say Jack is a truck driver and makes $50,000 a year, (very close to median US household income). Jack has recently married, bought a house and become a good boy and doesn’t pitter his money away anymore on wine and women, he now saves $1,000 every month, about one week's work for Jack and the average American family (before taxes). When he asks his bank how much they will pay him on his saving account, they say 1%. This seems legitimate to Jack, since they loaned him $100,000 at 5%. In fact, it seems like a very low margin to him as he assumes that the banks are loaning the money that other people like Jack have on deposit. Banks do not loan out deposits, deposits are used for reserves.

For Jack to earn $100,000 would take him two years of driving a truck, for which he would be paid by a bank a few thousand dollars in interest a year.  For a bank, however, $100,000 is created digitally in milliseconds, and they are paid $5,000 a year in interest and if the borrower defaults, the bank will foreclose on the house with the full force of the law.  Jack drove a truck for 2 years to make 100k, it is a store of value of his work, but what did the bank do in exchange for the interest on the 100k they loaned Jack?

Money is human labor transferred to a store of value, like dollars, euros, gold or silver. For example, when someone pays $30 for a kilo of fish, they are not paying for the fish in the ocean, they are paying for it on their plate. The difference between a happy fish swimming in the deep blue sea and a grilled halibut glistening before you is human effort. All other businesses that want to get a return on an asset must first buy the asset with money earned through work. This is not the case for banks. They earn interest on something they don't create.

In fact, a Minnesota Judge, Martin V. Mahoney, and a jury threw out a foreclosure on defendant Jerome Daly for just that reason. Daly argued that the there was no consideration in the contract between himself and the First National Bank of Montgomery. Consideration means both parties must give up something for there to be a contract. For example, if Jack offers to paint Jill’s apartment for free, there is no contract between them. If Jack bails on his offer to paint, Jill cannot sue him. Judge Mahoney ruled the bank gave up nothing in the contract.  They created the money out of thin air hence they did not commit anything to the contract; there was no consideration and the bank could not foreclose.

For everyone except banks, money is an expression of human labor, creativity, or even luck.  But for banks, money is something they simply 'create' in exchange for IOU's.  What Jack works ten years to pay back  should not have the same value as what the bank created in the blink of an eye.  They are two different things, yet they are treated as one.

How do Banks Lose Money?

It seems incredible with such a business model how banks could ever lose money, but they do. The problem for the banks is always the IOU’s. Fiat money is based entirely on outstanding debts.  Modern money is based on debt and every dollar must be tied to outstanding IOU. But when the underlying IOU that backs up the debt becomes worthless, the bank must back up the ‘created’ money up with real money: deleveraging.

Let’s say Jack loses his job and stops paying his mortgage, and his $100,000 house is now worth $50,000 due to a crash in housing prices. Once Jack has been found to be certifiably broke, the bank must replace the IOU with reserves in the amount of the loan outstanding. Assuming Jack never made a payment, the bank must now add $90,000 to its reserves which, plus the original $10,000, will constitute the full amount of money they created. Once they foreclose on his house and get the $50,000 the bank is now in the whole for 50 grand. This is why banks traditionally only loaned 80% of the value of a home. The 20% was calculated to pay for expenses and fees, leaving them in a breakeven scenario in the case of  an initial default.

But the bank's bag of tricks seems to have no end, according to Forbes:

"They (the commercial banks) are allowed to accrue interest on non-performing mortgages until the actual foreclosure takes place, which on average takes about 16 months.  All the phantom interest that is not actually collected is booked as income until the actual act of foreclosure. As a resullt, many bank financial statements actually look much better than they actually are. At foreclosure all the phantom income comes off the books of the banks.  This certainly explains some of the reluctance of banks to speed up the foreclosure process."

The same leverage that allows banks to make 50% returns on mortgages, and 200% returns on credit cards works in reverse when people default on loans, and it sucks up the bank’s liquidity like a thirsty sailor.

The liquidity problems of banks are directly tied to the very same leverage they use to make their immense margins. Banks are given a machine that makes money, for which they must leave deposit of 10% of the money they want to ‘create’.  When they give the machine back, they must show that all the money they created has been ‘destroyed’ (paid back) or they must make up the difference.

Banking is a fabulous business on the simple condition that risk is always controlled. When greed trumps risk, banks go south.

The Lure of Sub-prime

Banks will often package loans, securitize them into mortgage backed securities, and sell them off. The principal money is destroyed and the IOU is passed on to the buyer of the security. The banks keeps the margin they make on the deal, plus whatever interest had been paid before they sold the loan, along with fees etc. The problems began when greedy souls noted the difference between a 5% mortgage and 8% mortgage. For the Ivy league trained, this is no mere 3%, but a healthy 30% (10 leverage * 3%). Over a ten year period, the difference in the amount of interest paid on a 5% $100k mortgage ($27K) and an 8%  $100k mortgage($45K) is a whopping 66% increase in ROI. Jack sees 3% and says big deal, Lloyd Blankfien sees 66% and gets himself into a frenzy doing God’s work...

Combine the greed with a rising prices that kept foreclosures to a minimum (who defaults on a house they can sell and make money on?) and it is clear how the leveraged orgy began and what kept it going. As Citibank's Charles Prince put it “you have to keep dancing while the music is playing”.

Perfect Games and Rigged Games

From The New York Times :

"Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball. On Sunday, Dallas Braden of the Oakland Athletics pitched what was only the 19th perfect game in baseball history. But Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase Company produced the equivalent of four perfect games during the first quarter(2010). Each one finished the period without losing money (trading) for even one day."

Did the same "beautiful minds" doing "God’s work" that blew up the world financial system suddenly find their fast ball? More like Vaseline and a razor blade, or in banking lingo, the carry trade.

The Fed Discount Window was a mechanism used by the Fed to make very short term loans to member banks facing liquidity problems, the loans where generally paid back within hours and the rate was 100 basis points (1%) above the Fed funds rate. During the credit crunch in 2008 the Fed loosened the terms on the Discount Window, extending the terms up to 90 days (one quarter) and reducing the rate to 25 basis points (.25%).

So how did the banks turn this into a money machine? They borrowed from the Fed using around 30 times leverage at .25% and immediately bought US Treasury 10 Year Notes at 3.5%. Doesn’t seem like a big spread? Imagine that you start with $10 million in assets. You borrow $300 million, you make 3.25% (3.5% - lending cost .25%) on 300 million dollars. The banks interest earnings are $9.75 million a year, or about $800K a month on an initial outlay of $10 million, 8% return a month or 97% a year. One hell of a big strike zone.

This begs the question of how interested are the banks in stopping wars and reigning in the federal budget deficit. The moral hazard here is twofold as the banks reap risk free, incredibly high returns from budget deficits and all the destruction they entail and the taxpayer ends up paying the spread. The Fed charges banks .25% and the Treasury pays the banks 3.5% and the difference is paid by Jack and Jill.

In the current PIGS crisis, Portugal, Ireland and Greece are being 'bailed out' to insure that the banks receive full payment on the bonds they hold.  At least one generation will live and work in austerity in order to pay back banks with 'real' money raised with hard earned taxes to pay for that which was created without a drop of sweat and with a few clicks of a mouse.

The New York Times

In May of 2010, two months after the banks ‘perfect’ quarter, The New York Times ran a front page piece about a middle class family in Florida that had opted without qualms for strategic default on their home .

“Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino.”

The article had over 800 comments, a lot even for The New York Times. The blogoshpere lit up with outrage over these ‘deadbeats’. But how many people understand how banks actually work? Would there be the same outrage if people understood that the money they were given was made with a few clicks of a mouse? You don’t see cover stories in The New York Times on the mechanics of banking.  It just doesn’t happen.

Everywhere banks are foreclosing on homes and even forcing austerity on entire nations as payment for the money they loaned, and the risks they assumed. But did they actually lend real money? Was the money they lent created through work or was it simply a slight of hand for which they now demand their pound of flesh? As the entire world financial system becomes undone people will begin to understand that money as a store of value and work and the money banks lend are two very different things for which the banks want you to think they are one and the same.


  1. Robert,
    Excellent article, and something that would no doubt have a large impact on our economy if it was more widely understood by the general public. I've always realized that the largest banks did this, but I have a question about your Jack and Jill example.
    If the money is truly created out of thin air, where does the cash come from at closing to pay off Jill's (or the lien holder's) interest in the property?
    Greg W., Tucson, AZ

  2. Robert. I am a Canadian University student. Do you believe that a government operated national banking system is possible? Do you think it would solve any problems, or be an even bigger mess than we currently have?

  3. Ladies and gentlemen, this is how the story goes. So, why should anyone worry about anything in this world, even less for money. Obviously we need money to make transactions but there are far better things for life to live see and enjoy: a wonderful family, a lovely view, the galaxy and the apparent complexity of the whole Universe... so let's not waste time in useless worries. Let's keep it marching on with a smile in the face and a firm step-by-step.

    God bless you all

  4. Hi Greg,

    Thanks for the kind words. Once the bank credits Jack's account for the loan amount, they then write a bank check for the amount needed to close for Jill, Jack never gets access to the money..once I saw a bank manager come in with cash. Whether it is cash or a check, or transfer really doesn' matter.

    Tyler, good question. I lean toward the Libertarian side of things, so I would prefer a private banking system where the banks where basically money agents. Of course in this case, loans would be significantly more expensive, but, we would eliminate the inflation caused by this system. Remember, the monetary inflation caused by fractional reserve banking robs us all of probably close to 5% of our money each year..creating the rat race of always needing more.

    But, if you put a gun to my head and forced me to nationalize one industry, the first one I would nationalize would be banking. Check out Herman Daly, interesting economist who has written on this topic.

    But remember, the big gorilla no one wants to face is what to do with all the debt, public, private, and unfunded liablities. They cannot be paid, so their will either be a default, or massive inflation. This is the question we must all face, and soon.

  5. Agree with Mr.Castellano.The fractonal reserve banking is run by the world elites that neither we nor Mr.Bonomo will ever belong to........ it is not in our power to change a thing.Why worry about it? There are better thing in life than worry about changing a system where nothing depends on you!

  6. Are these banking practises legal? If not, who is going to file a lawsuit against bankers in general?

  7. The issue here is the complexity language terms when applied to a real-world idea of economics rather than a simple case of apparent 'bank irresponsibility' for creating money 'out of thin air'. The moral hazard lies equally with both the borrower and lender who are required in an 'act of faith' to speculate on future exchange of value between the borrower and his peers and the initial guarantor, the Bank. Potential for moral hazard lies with all parties, as much borrower as lender! What is the alternative though? A socialist-style system where individuals are allotted housing by the State? The moral hazard mentioned in the article always lies with the real-life sense of responsibility held by the individual. Banks do not force loans onto people, people should be responsible for how much they take on in terms of debt. People may say 'house prices are ridiculous', 'debt levels are insane', but, as the article rightly states, debt is a set against a store of value! Debt, call it what you wish, works!

  8. 'All Fiat money returns to its intrinsic value.


  9. Banking cartels, yet another violation of our rights. Add it to the list of gov’t violations of our rights:
    They violate the 1st Amendment by placing protesters in cages, banning books like “America Deceived II” and censoring the internet.
    They violate the 2nd Amendment by confiscating guns.
    They violate the 4th and 5th Amendment by molesting airline passengers.
    They violate the entire Constitution by starting undeclared wars for foreign countries.
    Impeach Obama, vote for Ron Paul.
    (Last link of Banned Book): iuniverse.com/Bookstore/BookDetail.aspx?BookId=SKU-000190526

  10. Gold is no answer either, it has huge storage costs, high buy-sell differential, isn't convenient, and is easily counterfeited, stolen, seized, or confiscated. And it can't be eaten or put to good use or earn rent.
    The problem is people have been lazy and stupid and covetous - they worked the company job for years and have hundreds of thousands saved up in the bank or on wall street which they hope will retain its value. It won't, those phantom "savings" will all evaporate to zero when the dollar crashes. They will tell us the problem was too many different central banks and too much fraud -- the solution is one world currency and a secure biometric financial ID tattoo on the right hand or forehead for all buying or selling. Where did we hear that before? (Hint: Revelation 13:18).

  11. Anonymous above says it is a "complexity of language." Actually, it is very simple. We have given private banksters a cartel on creating money. The Federal Reserve is a private banking cartel owned by private stockholders. The government could create money AT NO INTEREST for projects. Lincoln did it to finance the civil war. We have been scammed and because the banksters create the money, they have an ample supply to buy the government, the media, and they run the insurance companies as well as the oil companies. How do you like your serfdom?

  12. Stephen Zarlenga and Dr. Michael Hudson are both economists who have studied this. Unlike the useless economists that come out of the University of Chicago, these men will tell you the truth. If Iceland is in debt, Ireland is in debt, Greece is in debt, the U.S. is in debt--who is everyone in debt to? Just saying.... uhh, watch "Inside Job" for the answers.

  13. What we need is public money. You touched on morality in your piece -- how did you miss WHO authorizes the money printing?

    Banks say Congress gave them the power in 1913. Congress says the People gave them said power in 1789. (American version, other gulags differ.) What do the (sovereign) People say?

    Interest is what has killed the beast, not fractional lending or fiat. No matter what "standard" you use, you still must create money out of thin air -- that's how money works.

    In short, it's the interest that powers the world-wide fascist system that is bent upon enslaving generations to come.

    Think about this: If it's their money, and it is, then you must do what they say in order to get some.

    If it were your money, you might do as you please.

    Usury kills.

  14. "The government could create money AT NO INTEREST for projects. Lincoln did it to finance the civil war. We have been scammed and because the banksters create the money, they have an ample supply to buy the government, the media, and they run the insurance companies as well as the oil companies. How do you like your serfdom?"


    "Interest is what has killed the beast, not fractional lending or fiat. No matter what "standard" you use, you still must create money out of thin air -- that's how money works.

    In short, it's the interest that powers the world-wide fascist system that is bent upon enslaving generations to come."

    Well said...and the solution is so easy, so obvious..imagine, thought experiment, a hacker eliminates all debt in the world, public and private (we put in a caveat for all physical people holding government bonds, they get up to a $1 million maximum cash out, the grandma who bought treasuries etc.) and we replace leveraged money with real money. You want to fight a war, you better raise taxes to pay for it.

    US GDP pays in the range of 3.5 Trillion, or about 10% of GDP in interest, that does not include principal....in a few seconds, you have a balanced budget, and a booming economy, there are other problems, obviously, and a very strict monetary regime would have to be put in place to control inflation.. but more less, we free the world from bankers and the the war mongers they bankroll with fake money.

  15. The bankers greatest fear is getting this in the mail....

    To Whom it may concern:

    I would like to make arrangements to settle the above referenced matter.
    Please provide me with your statement of the amount owing as of ___(pick date 2 weeks out for example)___, together with your assurance that you will accept payment in direct and immediate exchange for the original instrument of indebtedness in its original form.

    Thank you very much.

    by: authorized party


  16. The OP has it wrong.
    Banks do not loan money.
    Never did.
    Banks are in the business of "extending credit".
    The extension of credit is hypothecated through ones signature.
    The bank extends the nominal borrowers credit via a new account opened "through" his name.
    when you pay the bank off then, how come you do not claim the money you just gifted the bank?
    The bank never loaned anything to you of value.
    That is why no bank can show harm when, cornered by someone in foreclosure.
    Judge C. Boyko spoke of this when he tossed the banks out of court on their heads back in '07.

  17. In France, the government (Treasury) can not borrow from the Central Bank of France, but must loan from the commercial banks. It started in 1973, with a law named "Pompidou Rothschild bill". Pompidou was a French president, and was Rothschild bank employee before becoming the president.

    So, from 1973, France is borrowing money and - pays an interest on it. In between 1979 and 2008, France paid the total amount of 1.305 bn of euro as an interest on National Debt. The total amount of National Debt of France was 1.327 bn euro in 2008.

    It means that the total debt of this country equals to the interests paid to the private banks.

    Well done, banksters...

  18. I really appreciate your post and you explain each and every point very well.Thanks for sharing this information.And I’ll love to read your next post too.


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