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Monday, August 13, 2007

The Subprime Mortgage Lending Scam

On Thursday, August 9, European central banks announced they had injected $130 billion of liquidity into the European financial system. (It was 94.8 billion euros; I'm quoting prices in dollars so it's a valid comparison for US-based readers.) The Federal Reserve announced it had injected $24 billion of liquidity into the US financial system. On Friday, August 10, European central banks announced they had injected another $83.8 billion of liquidity, for a total of $210 billion. The Federal Reserve announced it had injected another $19 billion of liquidity, for a total of $43 billion.

Let's translate from economic nonsense to English. "The European central banks announced a $210 billion subsidy to banks in Europe. The Federal Reserve announced a $43 billion subsidy to banks in the Unites States."

That's slightly inaccurate. There's a fractional reserve banking system. When a central bank injects $1 billion of liquidity, and the reserve ratio is 10x, that's actually a $10 billion subsidy. The new money gets multiplied by fractional reserve banking.

Translation 2nd attempt: "The European central banks announced a $2.1 trillion subsidy to banks in Europe. The Federal Reserve announced a $430 billion subsidy to banks in the United States."

The European central banks issued their loans at a 4% interest rate, which is a further discount to the current EU target short-term interest rate. The Federal Reserve did not change its interest rate target; the $430 billion subsidy was required to maintain the current target of 5.25%. The $430 billion gift represents the amount of debt the Federal Reserve had to repurchase to keep interest rates at a level of 5.25%, plus the ability of fractional reserve banking to multiply this newly printed money. Before the Federal Reserve intervened Thursday morning, interest rates had shot up to 5.5%! How high is the free market interest rate, if interest rates can go up 0.25% overnight!? The free market interest rate is what interest rates would be if the Federal Reserve didn't fix interest rates.

Why was it necessary to subsidize the financial industry on Thursday and Friday? Banks were losing money on their subprime mortgages. Why are so many subprime mortgages defaulting? The correct answer will probably never be stated anywhere else, unless someone reads and cites my post.

The reason for the subprime lending problem is one of my favorite topics: The Compound Interest Paradox. Due to the Compound Interest Paradox, the amount of debt increases exponentially faster than the supply of money. With debt-based money, money is only created when someone borrows. When someone takes out a loan, only the principal is created. The money required to make interest payments is not simultaneously created. This guarantees that debts grow exponentially faster than the money supply. It is a statistical necessity that during the bust phase of the economic cycle, the weakest debtors will be forced into bankruptcy.

We are currently in the bust phase of the business cycle. Who are the weakest debtors? This time, it's people with subprime mortgages. They're the ones who get the shaft. Their wealth is being confiscated. The bust phase of the business cycle means it's hard for them to get money to repay their debts. The bust phase of the business cycle means that many of their houses are no longer worth what they paid for them.

Someone had to get screwed over; it's a statistical necessity built into the financial system. I wasn't expecting it to be subprime mortgage borrowers. I was expecting it to be the leveraged buyout firms. However, those leveraged buyout firms are run by billionaires; it wouldn't be proper for them to lose money. It's important to increase the money supply before they feel the pinch.

Ten million people might lose their homes. Let's see: $430 billion divided by 10 million is $43,000 per defaulted debtor. If you include the European central bank subsidy, it's $2.1 trillion divided by 10 million, which is $210,000 per defaulted debtor.

How come this wasn't the headline: "The US government announced a $43,000 credit to every homeowner who has currently defaulted on their mortgage." How about: "The European central bank announced a $210,000 credit to every US citizen who has defaulted on their mortgage." This fantasy headline would solve the subprime lending crisis just as much as a massive subsidy to the financial industry. Who cares about what happens to the average American? The US government is not looking out for them. (As I pointed out to TZ, a payment of $43,000 or $210,000 directly to the people is what "Social Credit for Wimps" advocates like C. H. Douglas or Bryan Monahan would want.)

I was watching CNBC. Someone suggested that maybe the government should provide aid directly to the people who are defaulting on their mortgages. Someone pointed out that was just encouraging irresponsible behavior. People who took out mortgages they can't afford deserve to lose their homes. However, what about the bank that issued the loan, or whoever bought the loan after it was issued? Don't they also deserve to lose money? No. They are fully deserving of a government bailout.

When banks start losing money, that's a serious problem.

How did banks wind up losing money? These mortgages are pooled into various bonds of varying degrees of risk, yielding 6% or more. The banks and investment firms were borrowing from the Federal Reserve at 5.25% and buying bonds that yield 6% or more. They use a leverage ratio of 10x or 20x or more. With a 1% interest spread, a leverage ratio of 20x translates to a profit of 20%. This type of transaction, borrowing from the central bank and buying other loans, is called "Illicit Interest Arbitrage". Profit is made, but no real work is performed. The actions of a central bank make this arbitrage riskless; the central bank will always increase liquidity (i.e. print money and give it to the banks) if there's a problem.

Many mortgage holders are already in default. However, these large banks are stuck holding these bonds. Large banks can't lose money. What's the central banks' purpose? The central banks increase the money supply. All that new money has to go somewhere, and some of it is used to purchase these struggling bonds. When interest rates are lowered, the price of these shaky bonds is raised. The default risk of the loan has increased, driving down the bond price. Interest rates have decreased, driving up the bond price. These factors offset, and the bond prices stay the same. The banks don't lose money. The financial system is set up so that large international banks never lose money.

What about the people who can't pay their mortgage? Unfortunately, they don't get the newly printed money. They'll see it in a couple of months, in the form of inflation, after they've already been evicted from their home. By the time these people think about buying a house again, prices will have started rising again. It turns out that all these subprime borrowers will have sold their homes at the bottom of the market. The banks are confiscating their homes. The banks have enough money to survive. By the time the banks sell off the confiscated homes, housing prices will be rising again.

That doesn't necessarily mean it's a good time to buy a house right now. Mortgage rates are rising. The spread between the central bank cartel interest rate and the mortgage rate is increasing. Borrowing money is risk-free only if you're a large international bank.

The large international banks can't lose. The financial system is biased in their favor. Even when they make a bad decision, a central bank bailout is always waiting for them. International banks always have an unlimited free put option. International banks can sell bad loans back to the central banks, in the form of a money supply increase.

Here's my final attempt at translating the central banks' announcement: "Due to the Compound Interest Paradox decreasing the money supply, many poor borrowers were forced to default on their mortgages. It wasn't because they were deadbeats or foolish; the default occurred because of a fundamental structural flaw in the financial system. By statistical necessity, the poorest debtors are forced into bankruptcy during the bust phase of the business cycle. This time, it's subprime mortgage borrowers; who knows who it'll be next time? A lot of banks had invested in these mortgages, and we can't let our friends at large international banks lose money. The European central banks are making a $1.3 trillion subsidy and the Federal Reserve is making a $240 billion subsidy to keep these banks in business. This subsidy isn't free; everyone else is going to pay for it as inflation. By increasing the money supply, we're increasing the price of these bonds so these banks stay solvent. The poor debtors are still going to lose their homes, but who cares about them? Those poor debtors are financing the bailout themselves, via inflation they will see in 3-6 months. Isn't debt-based fiat money wonderful!"

Do you see the fundamental injustice of the current financial system? Does anyone out there have a clue? Is anyone out there interested in setting up a fair financial system? I already told you how to do it. You have to start a Social Credit Monetary System. You have to do work and not report it to the government for taxation, confiscation, and regulation.


TZ said...

I think you are going a little too far by calling Douglas & Monahan 'wimps'.
I agree and understand that which you believe: that reform will not come from those who manage the fraudulent system.
Douglas himself found this out very early in his life when he 'reported' the errors he had found to the unwilling elite of his day.
However, the errors in orthodox economics are correctly identified by these Social Creditors, even if you believe their methods for achieving anything will come to nothing.
Surely you respect them for that?
Their hope for reform (rightly or wrongly) is invested in what might remain of democratic representation, and therefore their tactic is grass-roots education (so that people understand to what extent they have been expolited and the nature of the mechanism which is being used to do it).

These social creditors have a great insight into the subject which we can all learn from, whether or not we choose to agree with their methods of bringing it about.

Douglas is not your enemy!

FSK said...

I do appreciate their analysis of the flaws in the current economic system. However, I disapprove of them advocating that people lobby the government for reform. That's only causing the few people who understand the flaws in the current economic system to waste their time.

Educating other people is not a waste of time. I consider myself to be an order of magnitude ahead of them, because I have a specific action plan.

Lobbying the government for reform is pointless. The Supreme Leader of Humanity is aware of the structural flaws in the current economic and political system. The Supreme Leader of Humanity put them there on purpose!

I'm concerned that people are confused over the multiple definitions of "Social Credit". I make the distinction between "Real Social Credit" and "Social Credit for Wimps" because it appears that two different terms are used for the same idea. The idea that government should solve The Compound Interest Paradox via direct payments to the people is a "wimpy" idea. You can't lobby government to solve a government-created problem.

The idea of people getting together and developing their own private monetary system is a non-wimpy idea. It's risky, due to the uncertain legal status. The government's claim that I cannot work without the government's permission is too extreme for me. That's what I'm really advocating; people develop a private monetary system and do work without telling the government.

The people who think they're running the current financial system had their chance to fix it. People have politely pointed out the flaws to them, and they were ignored. The only fair solution is a complete collapse of the current economic system.

col said...

I agree with most of your blog, but I think some of the banks have lost money and profits in purchasing sub prime debt. For example UBS HBOS and NORTHERN ROCK. In each case the losses have been reflected in the stock price.I agree that the European bail out will eventually enable them to recoup their losses by further geared lending, but this may take some time

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