You must know that the US and the world is in the midst of a financial crisis. If you’re like me, you’re very confused. I’m a little less confused but I’ve been asking questions and doing research. I’ve spent a lot of time on why credit is so hard to get. I hope this article will help you understand more about this very complicated process. Even the experts are often wrong, sometimes even the interpretation of what the economic numbers mean.
Have you asked where the money went? Why do the banks suddenly not have the money to loan? Did you assume like me that the banks have money but were afraid to let it go? That is a part of it but not the whole story, not even the biggest part of the check.
If the banks loan money to other banks, that bank may fail. If they loan it to a business that business may fail. They may need cash in their vault to weather the storm that could be coming their way. That is likely a part of the credit crunch. A bank that is hoarding cash for the reason would make matters worse, much worse because banks are allowed to loan more money than they have.
This article is not written for the financial guru and I’m not a financial guru. The recent problems have sparked my interest, recalling fondly my college days in finance classes. And I’ve been in touch with the professor that challenged me to learn so much back 20 years ago. He and the crisis at hand have caused me to delve in again to the economics that will give any normal human one massive head ache. :) But I love it. So if I fret about it enough, research enough and ask enough questions of the experts, I get that light bulb to go off every now and then. I get such a “rush” out of that. For me, learning is the reason to live.
So I’m going to attempt to write an article for people like myself and explain what is going on to myself, which I hope will also be of use to you. I would really love to be challenged on what I say here. When I’m wrong, I want too know but tell me why or I wont believe you. :)
The Velocity of Money and the Effects on Credit.
When you deposit a paycheck in your bank, the receiving bank clears through the issuers bank but they don’t load up cash from one bank and actually send it to the other bank. It is transferred by paper or really electronically.
For each dollar you deposit, the bank can loan out more than a dollar. How much a bank can loan out per dollar is determined by the Federal Reserve Bank (FRB). They do this because they insure the banks through the FDIC. All cash deposited below $250,000 is insured in the US by the federal government. This is called the reserve a bank must have on hand to loan out X number of dollars. I don’t know the number that can be loaned out at any given time as it is a rather complicated computation. If you would like, you can visit the FRB Reserve Requirement web page.
The amount that can be loaned per dollar changes often. My first alert that indicated something was going wrong occurred when I read that the FRB quadrupled the amount of money that could be lent for each dollar held. This amount includes both the cash in the vault and the paper transfers between banks that occur when you deposit your pay check.
So, if I take a dollar into the bank and the bank lends out five dollars they are creating money. I sure wish I could do that. Actually I could, I just need to setup a bank and then I get to create money. Lets assume the reserve rate is setup so that I can loan $5.00 for each dollar taken in.
Your bank is Bank A. Lets say Bank A takes the five dollars you just created with your deposit and loans out $5.00 to Bank B. Now Bank B can loan out $25.00 (I may actually be a dollar per multiple off here but it is hurting my brain and this is just for learning purposes, I’m not trying to compute the money supply). Over time, this $25.00 gets spent and re-deposited enough times that Bank B now has $40,000. This same dollar getting re-spent is called the velocity of money. Or how many times a dollar changes hand.
Say Joe SixPack wants to buy a home. He found one he really likes. Housing prices have really been on the rise as the Federal Government has been encouraging banks to make loans on homes. Thus, a house has been selling more times than normal. Each sale tends to push the price up. Joe buys a house that is valued at $200,000. The bank would only need 40,000 in reserves to do that. So they decide Mr. SixPack should get the loan, they give him some extremely complicated loan with a variable interest rate.
That rate rises to a point where Joe can’t pay it, he tries to re-finance but can’t because others had the same problem and had their loans foreclosed on. This puts a surplus of homes on the markets and prices have fallen because of that. The 200,000 home is now worth only $80,000. A paper loss of $120,000.
Joe cannot sell his house and he cannot refinance because the price of housing has fallen and it will not appraise at $200,000 now. Maybe it wasn’t over valued before, perhaps it is under valued now. His house is probably worth more than $80,000 but with so many homes on the market, it is a buyers market.
So the bank forecloses on Joe and now they have a house they can sell for $80,00. This doesn’t take just $120,000 out of the market. It takes out some unknown amount between $80,000 and 600,000 ($120,000 * 5.00).
While Bank B could not make a loan based on that $200,000 value because it is not a liquid asset but Bank C would be willing to loan Bank B more money if it has assets valued at $200,000 rather than $80,000.
Also, Joe has stopped sending in the payment every month. When he sent his payment in, a bank could loan out 5 dollars for each dollar of the payment. If his house payment was $2000 a month the bank could loan out an additional 1,000,000 with EACH payment Joe made!
He stopped making the payment so now the bank must reduce the amount they can loan in the future so they will be back within the reserve requirements of the FRB. If they don’t get back within the reserve requirement the FRB comes in and takes the bank over and gives the assets to someone else. Anyone with over $250,000 in the bank looses that. That is what happened with a popular online bank known as NetBank. I’m sure this is greatly simplified but I’m trying to get at the substance of what happens.
Banks that have ability to loan are become reluctant to do so. They just saw some of what happened to Netbank and I’m sure they looked very hard into what happened there to make sure it didn’t happen at their own bank. What is the normal reaction for the spectator banks, stop loaning out money so we can be ready to meet our reserves when Person X defaults on his loan with us! They will have adequate reserves to handle the hard times and losses they may encounter. The banks will begin to invest in more liquid assets such as precious , stock options, and the proverbial pork bellies. (BTW, pork belly is really good and common in the Philippines.)
Is this financial crisis going to get better?
Yes but…. There is going to be pain. The federal bail out bill will help but it wont cure everything and it will take some time for the funds to be used and we are all assuming the funds will be used in a way to help. For example Fox News is reporting that
the Fed’s plans to buy massive amounts of corporate debt. The goal is to jump-start lending in the markets where many companies turn for short-term loans. Credit markets are showing some signs of easing
For now, the FRB and other authorities are trying to improve the consumer and businesses confidence in the economy. When people are afraid, they wont buy anything they don’t have too. Less money is created through loans as there is less spending. Consumers and business are also building up their own personal reserves.
Others can influence the recovery. The central bank reduced its interest rate yesterday. That is the rate it charges banks to borrow which usually will help increase the funds available to the reserves and thus able to loan additional money. The more money that is lent, the more money that is created. The more created the more that can be lent.
We are not yet in recovery. The stock market usually goes up or down before the majority of the economy is. The stock market has been doing awful. That is a signal that things are going to get worse before they get better.
But they will get better and we are likely to enter into a long recession but not a depression.
Tagged with: Credit Crunch 2008 • Federal Reserve Bank • Financial Crisis 2008 • Lending
Filed under: Economics and Finance
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Nice writing style. Looking forward to reading more from you.
Chris Moran
I wrote an article about what all this means to the expat’s dollars that may be of interest to you. The article also give additional information about why a download slide grows like a snow ball going down a hillside. This should increase the dollars value for the expat.
This situation is absolutely frightening, and very confusing too! I think we are in for a long downward trend.
Hi,
I am regular visitor to this your blogs and we got more information from this blogs. Really it is very nice blog, good keep up it.
Thanks.
Hey Bob, yea it wont turn around any time soon. It will turn around but it will likely take a few quarters. The market is showing signs that it has hit bottom. It kept going up and down yesterday. Now would probably be the time to buy some stock though that might be risky. If not now, it wont be long. This shouldn’t last longer than six months though. But it is hard to say for sure.
I think the best fix would be for the Treasury to take the 700B and guarantee the loans the banks make to each other.
Hi Mr. Loan, glad it has been helpful.
The Wall Street journal is reporting that the FDIC is expected to insure loans between banks. This should have a major effect on creating money and thus allow the economy to recover. Perhaps faster than many first though. The treasury department plans to buy preferred stock in banks. Preferred stock is non voting stock, thus keeping the government out of direct control over the board and executives. This will give the government less of a voice in running the banks but will also allow the bankers to make mistakes. I hope the Treasury uses a stick and carrot approach. Overall, I’d have to say Uncle Sam is doing an usually good job, at least on paper.
You are right about the way it works.
But money has a false value, true we use it with a true value but its false. When you look at you 401 or stocks, you see a number $1234.00 it has meaning but its false, because its not there until you call for it, so if it fails you only loose the number you inserted so therefor the other numbers were false and brought false hope & false pride, therefor false
Its crazy because the only thing we see as worth is false, its like a drug and when its taken away we cry, but drugs are also false, what do humans crave more than money, to be saved, also false
So everything we know is therefor false until we understand that its false, then we understand we all live a great big lie.
Have a nice day
John,
I’m sure you’ve earned this negative feelings on life. It is hard to get out of that once your in it.
There are some truths in life and in death. You might enjoy a philosophical conversation in my Faith section. It’s near the top of the page. Maybe I should rename it to Faith and Philosophy.
Negative feelings on life, no Rusty they are not.
Our religious system is now outdated and needs to change for the better
Our money system is old and out dated and needs changing for the better
Neither will save us form death or life or afterlife
It only numbers after all, whats the big deal.
Example- China makes our trinkets, we buy them with numbers from the place we call work in turn we grow China’s food they in turn buy it with numbers from the place they call work, thats why we call it trading. But someone got gold trinkets that because God said gold is good, people believe it has value which in fact has no value, just another rock, that has limited use outside of jewelry, why is wood not worth more we live in homes made of wood, but God said we would have houses made of GOLD when we die, so is that’s why we know God is false like money
Have a nice day
Hello again John,
First I don’t think God said we would have houses made of gold. Second, the bible often uses symbolism. If you try to read the bible in a literal way, I think you’d have to conclude it is false.
The value of an item is determined by its demand vs supply. There is much demand for gold, that gives it a value. If changes occur in our society, causing gold to no longer hold value then it will have none. Considering how long we’ve been chasing gold, I don’t see that as too likely though.
What you’ve said is the best argument I think I’ve seen for abandoning the gold standard. The demand for money gives it a value.
Using your logic, that must mean that both God and money is true. But to use only logic to prove God misses a huge part of God.
Have you ever been in love, felt love? Regardless of your answer, I will call upon you to prove it. If you have felt it, how do you know it is love? If you have never felt it, how do you know it doesn’t exist. A does not always imply B.