How money works today

Our economy is based on fractional reserve banking. Long before fractional reserve banking, savers, looking for a safe place to keep their money, deposited it with a goldsmith or other businessman and would receive a note for the deposit. Eventually these notes became a medium of exchange or as money (i.e. they were used to purchase items instead of using the actual gold on deposit). Also, these notes were never redeemed all at once, so the businessmen started to loan the deposits out to other people, collecting interest as profit. Further, they would loan the deposit out many times over. If one in ten loans defaulted, they could cover that loss with the interest collected from the other nine loans given out. All the while, they still only had one deposit to cover the ten loans given out. Eventually these businessmen became known as bankers. And fractional reserve banking was born.



This is one way money is actually created in our society. Your $100,000 deposited at the bank is lent out to multitudes of people. All those people suddenly have (and spend) money that didn't exist before your deposit. And the businesses that receive this lent out money in exchange for goods and services, book it as actual money. The number of $100,000 loans the bank hands out based on your deposit is called leverage. And today many of our banks are "officially" (on the balance sheet) leveraged 30 to 50 time over. Unofficially, or off the balance sheet, they are leveraged 100+ times over. At lease Chase, BofA and Citi are.



Now all of this has worked wonderfully for so long because of the math. If I am a bank and I loan out $2 million based on your $100,000 deposit (20 to 1 leverage) in ten year terms at 7% annual compounded interest, I will make $1.4 million in profit. If three of my 20 loans default, that will only cost me $300,000. Add to that the original deposit and I still profit by $1 million. In fact I could cover the default of 13 of the 20 loans without suffering the loss of the original deposit. And even if I did have 13 defaults, I would still own the property purchased with that loaned out money. Which (as long as there are buyers of land) will still net me a profit. Really wonderful since historically, even the riskiest loans (made to people with a questionable credit history) have not defaulted at even close to a 65% rate. Of course the riskier the loan, the more you charge in interest to mitigate the amount of profit with the expected loan default rate.



Naturally it costs more than nothing to run my bank over ten years, so to cover the salaried employees, the building costs, etc. I would need to have a lower default rate, charge more interest, increase my leverage, or some combination of the three. And if I pay myself handomely today with all that profit I expect to earn tomorrow, but that profit doesn't materialize, I could be in trouble and may have to ask the government for assistance.



Now this is a simplified explanation of how it all works, but I don't think the complicated explanation is even necessary to help understand the trouble we find ourselves in today.



Our banks today book those loans as assets and value them at the amount loaned out plus the interest they will collect. (of course they "write down" the value as the defaults increast, too)Then they resell those loans to other banks and brokerages who then package them into collateralized debt obligations (CDO's) and in turn re-sell them to retirement funds, pension funds, 401k funds, municipalities, state treasuries, and anybody who is willing to buy them. And of course these "investments" are rated by credit rating agencies so the investor can know how safe or risky the investment is compared to other investments. So essentially everybody is loaning money from their savings (weather deposited at a bank or invested in a debt fund) to everybody to buy homes and cars and TV's. And as long as there are buyers for all this stuff, everyone is happy because the value of the loans is equal to or less than the value of the assets they represent.



Our banks and investment houses today have also been buying (and selling for that matter) "insurance" against massive default of these loans by purchasing credit default swaps (CDS's) from other companies. They will pay a fee to a company, who will in turn pay down the debt obligation if the default rate exceeds a certain threshold. But these companies who sell the swaps (including both insurance companies like AIG and investment banks like Bear Stearns) don't want them to be called insurance because insurance is a regulated (by the government) industry. Being regulated would mean they would have to hold x dollars in reserve to pay out claims. Which would mean less mean less money available for houses boats and TV's. So these tools were called "swaps" to get around this issue. And our government has been inclined to de-regulate financial markets the past twenty or more years anyway. So the companies who sold "swaps" were not keeping really any money in reserve in case of massive default rates on these debt obligations.



Which leads us to where we are now. There is alot more to why our economy has no hope of recovery. And much of it has to do with the steps the government is taking to avert "recession." But that is for another day. More to come.