Credit 'Crunch' or Credit Collapse?

By: Alex_Wallenwein

How can you protect yourself during the worsening credit crunch?

To figure that out, we first need to understand what this 'credit crunch' really is, from the most fundamental perspective possible. For, it's root cause is not the sub-prime mortgage default crisis as financial pundits like to claim. It goes far, far deeper than that.

We all know by now that the entire world financial structure is dependent on one thing, and one thing only. That one thing is the very brick from which the splendid looking but dangerously tilting edifice is constructed:

Credit.

Fundamentally, however, that term is nothing more than a dressed up word for:

Debt.

The world's financial system is held up and powered by banks, and banks are in the business of loaning money, which means they are in the business of getting individuals, companies, and governments into debt.

That would be okay if there was a way to retire this debt, but unfortunately the very 'money' we all use is itself a creature of debt and consists of nothing but debt.

How is that possible?

It is possible because the very definition of money (i.e., "M1" or the most liquid form of a country's total money supply) includes bank deposits - and bank deposits are created when someone borrows money from a bank.

When you loan your neighbor a cup of sugar, you go and get some of yours and give it to him, hoping he will return the favor some day. As a normal human being, you cannot loan what you don't have. That's pretty obvious.

A bank, however, is a special creature. It is legally authorized to create what it loans you right then and there on the spot. Any funds credited to your loan account by the bank are immediately counted as part of your country's money supply.

In other words, the bank parts with nothing of its own - but you now legally "owe" the bank the amount money you just borrowed.

Neat, isn't it?

The bank now has a legal right to your future productivity as either an individual or business earning money in return for what is essentially - nothing. That means the money you just borrowed has no real existence, no real value, other than your promise to "repay". That promise is what the bank now carries on its books as an "asset."

There is another way to look at this.

The "money" that circulates throughout individual countries and the global economy is a legal fiction, backed up only by the issuing government's license to the banks allowing them to create it in this fashion while at the same time giving banks the legal right to enforce your promise to repay against you in a court of law.

Physical cash (i.e., coins and central bank notes) circulating only constitutes a very small fraction of the total money supply, usually about five to ten percent. Most money circulates in electronic form, transferred by checks or EFT technology.

The Bargain

Now, guess what the issuing government receives as its consideration (a legal term for counter-promise) in this bargain?

The issuing government essentially gets a perpetual blank check from the central bank.

The central banks get authority to operate by promising the government in question that they will loan the government whatever "money" it needs to pay its ever-rising bills (at interest, of course).

That way, the banks make both us as individuals as well as our national government their debtors.

You and I, on the other hand, are promised by our government that we will be able to spend this debt. They do this by passing and enforcing a law that requires anyone to whom we offer this debt-money in payment for any debt to accept it - or else the debt is wiped out. The legal term for our offer is called a tender of payment (not "payment" itself). Hence the phrase "legal tender".

Debt - as payment for other debt.

This system has its own tricky checks and balances consisting of bank reserve requirements and "money multipliers" etc., but there is no need to go into these right now to understand what the true origin of this so-called "credit crunch" is.

The True Nature of the Credit Crunch

Mortgages are really nothing more than another type of promise to repay.

When you take out a mortgage, the bank clerk types a number into the bank's computer that showsd up in the system as a "credit" on your account. This is done in return for your promise to "repay" the bank. That way, the bank gives you a legal fiction and your government backs up the bank's claim against you, in case you default, with the banks right to sue you in court.

In essence, it is you - not your government - that backs up your country's money supply. In truth, it is your future productivity that creates the money that "makes the world go 'round" as the popular ditti says.

You are Atlas holding up the financial world, and the banks are riding on your shoulders.

The banks, though, have now finally shot themselves in the foot.

Their quintessential need to get more and more people into debt so that the banks themselves can prosper, has led them to generate more and more creative ways of finding more and more potential borrowers.

Their last resort was to make loans to home buyers who really didn't qualify for a mortgage. They felt constrained to loan to people who really didn't demonstrate the requisite future productive power they could pledge in return for the "credit" the bank created on their accounts.

So, when times eventually got a little tougher as interest rates rose, they began to default on their mortgages - in growing numbers.

Those borrowers didn't have much to lose. They got their homes for zero or near-zero down payments, based on fictitious "stated income" figures which the mortgage brokers were encouraged to dream up for them in order to make it look on paper as if the loan was justified. The loan broker's supervisor closed both eyes, issued the loan, and bagged his bank-sponsored bonus vacation for having found yet another sucker who would go for this gambit, and the world kept spinning.

These mortgages are now the epicenter of the so-called credit crunch.

But they are no different in nature than the very "money" that everybody earns and spends, the very money that governments, banks, and businesses now fear may one day stop flowing as abundantly as it has so far.

The sad truth is that both the mortgages and they money they are supposed to be repaid with are nothing more than - debt.

When Banks Don't Trust Banks ...

Normally, banks fear that individual or business borrowers won't be able to repay them in time. Now, they are afraid of each other because no single bank knows what the other's real exposure to the credit crunch really is.

You have read about the gragantuan losses of the biggest financial houses in the world. Some of these losses go into the tens of billions of dollars. Smaller banks have similar problems albeit on a smaller scale.

Knowing this, and knowing that these losses stem from banks' exposure to disappearing mortgage assets, no bank in its right mind would loan to the other money that the lending bank itself sorely needs to fund its own operations.

That little problem has made the interest rate at which banks loan each other money shoot straight up.

By now, not only subprime mortgages are at risk, but even prime borrowers with sterling credit are defaulting. Their mortgages (debt) were sold by the originating lenders to other outfits called "SIVs" or 'specialized investment vehicles' - a fancy term for what boils down to sham corporations set up to buy the mortgages.

Remember that mortgages constituting promises to repay are "assets" in the debt economy. The originating banks sold these to investment funds like hedge funds and to SIVs so the mortgages wouldn't appear on the originating bank's balance sheet.

That, in turn, was important so that the banks could make more money by making even more loans. A bank is required to keep a certain "reserve to loan ratio". When it originates a loan and keeps servicing it, the loan show up on its books as both an asset (the right to receive future payments from the borrower) and a liability (money loaned out). Assuming the ratio is one to nine, for each $100,000 of reserves, the bank is "only" allowed to make $900,000 in new loans.

By selling the loans to other entities, a bank can turn the formerly balancing asset-liability pair into a pure asset. Once it receives payment for the mortgage (at a discount, of course), its "reserves" increase by that amount.

The bank can then go and loan out up to nine times of that new reserve amount.

That's how the original mortgage mushroomed into the financial equivalent of nine other mortgages, each for nearly the same amount. Take this process and repeat it thousands of times, every day, throughout the entire US economy, and you have a pretty good picture of the amount of default risk that has been created in the process.

The really big problem is, however, that many banks gave the buyers of their mortgages an open line of credit on which the buyers can call if they run into financial trouble. These backdoor agreements are now being called in by the buyers of these mortgages who are not receiving what they bargained for. The reason: the mortgage-"assets" they bought are being defaulted upon by under-qualified homeowners.

It is this exposure that now makes banks very, very leery of each other.

Banks regularly loan each other low-interest money to finance their daily operations. Without these loans, they cannot operate profitably. Without them, they must either use their reserves to pay for expenses or pay higher interest on their day to day operating cash. Both of these options shrink the amount of new loans they are allowed to make,

That is the truly devastating effect of the credit crunch.

When banks can't make loans, borrowers who need to borrow can't get what they need, so they can't spend it, so that flow of money is not available to the economy, so the economy eventually slows and then shrinks when gross domestic product goes negative - and that's what we call a recession.

The Mutant Recession

Just as viruses mutate to become resistant to lower level antibiotics, we are now seeing new types of recessions brewing that will no longer respond to the usually prescribed "treatment" of lower interest rates.

Under normal circumstances, recessions can be temporarily alleviated and even turned into another boom by injecting more "credit" (debt) into the economy. This is done by lowering interest rates, and central banks have a number of ways of achieving that.

But when banks don't trust each other and stop loaning money to each other, that's when you have a real problem on your hands.

If they don't trust each other, you can bet that they trust their customers less. We are already seeing mortgage lending standards tightening up - and that is happening even though interest rates have been lowered 75 basis points since the credit crunch hit this past summer, and further significant rate cuts are expected.

This puts banks in a bind: They can't trust borrowers to pay their loans back as they did in the past, but making loans is the primary way for them to make money. The result: They end up making fewer loans.

Fewer loans mean they make less money.

Fewer loans also mean that the rate at which credit (the money supply) grows begins to shrink.

When this gets to a point where not only the growth rate of credit shrinks, but where the total amount of outstanding credit shrinks, we have a full-blown credit contraction in the making - and the name we usually pin on credit contractions is "Deflation."

The only 'solution' to this dilemma is for the Fed to inject more money (debt) into the system.

That is the root cause of the entire problem.

Debt must be created in order for money to even exist. To repay that debt, more money must be created, and that requires even more debt. Debt piled on debt, and then more debt piled on top of that. It's an inverted pyramid of debt creation, and you know that structures like that cannot stand on their own. They must be propped up - but the system is rigged in such a fashion that only more debt can prop it up, which only exacerbates the entire problem.

You, as a business owner, private citizen, father, mother, employer, or whatever, are carrying this inverted pyramid. Picture Atlas himself, carrying an inverted pyramid on his back,except that Atlas' size is about the same in proportion to the pyramid he carries as your size to the great pyramid of Cheops.

That's you, functioning in this economy.

How do you get out of this situation? Is it all gloom and doom? No. There are ways to escape this crushing load - but that's the subject of the next installment of this mini-series.

Alex Wallenwein
Editor, Publisher
The EURO VS DOLLAR MONITOR

Copyright © 2007 Alex Wallenwein - All Rights Reserved

Alex holds a B.A. degree in Economics and a juris doctorate in Law. His forte is research. In late 1996, he began to research how money is used by some to exert political and economic control over others' lives. In the process, he discovered that gold (along with silver) is the common man's antidote to this effort. In writing and publishing the Euro vs Dollar Monitor, he explains the dynamics of this process and how individuals can harness the power of gold in their efforts to regain their political and financial autonomy.

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is the golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

© 2005-2012 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

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