A Mother of a Low Hanging Fruit

I am always amazed by the popular slogans. I wonder if the “low hanging fruit” slogan is still in use. “Green sprouting” is the latest craze but the low hanging fruit which I will be discussing will not excite the green sprouting crowd.

First a basic economic rule. The price of a fixed rate bond is inversely related to the interest rate. Thus the price of a fixed rate bond goes up when interest rates fall but the price decreases when interest rates rise. Nothing spectacular but for the reality of interest rate calculations of time value of money and a massive oversupply of government debt. A bubble market always finds its nemesis in the law of supply and demand.


Component One: An explosion in supply of Central Government debt (Over supply).

USA Central Government debt growth is now in an exponential curve. The Japanese experience was similar for about 15 years but they had a Current Account Surplus to generate a cash flow to finance the expansion of their Central Government debt. The USA does not have that luxury.


USA



It is also clear that the Japanese expansion in Central Government debt has stopped and levelled off at about 4 times the amount prevailing at the start of the Japanese crisis. It is of interest that this phenomenon coincides with a mild decreasing trend in the absolute level of USA Treasuries held by Japan (See Major Foreign Holders of Treasuries in Component Six). An inability to fund more Japan national debt coincides with an inability by Japan to fund more USA debt.


Japan


The projections by the British Government follow a similar patter. Unprecedented expansion of the Public Sector Debt. It must be very disconcerting to have experienced their first failed bond auction at such an early stage in their planned expansion of Public Debt. Perhaps some price (interest rate) competition with other national governments may help to sell more UK Public Debt. That will not necessarily be in the spirit of international co-operation on maintaining low interest rates but then again the UK government answers to the UK taxpayer.




United Kingdom





The race to increase Government spending is on. Will price competition only rear its head when the forces of supply and demand deny a government access to the funding markets? Which nation will place national interest first and be the first to break ranks?


Component Two: Historic low interest Rates

The inverse relationship between the price of bonds and the interest rate translates into very expensive Government Debt at a time when they all have plans to expand government debt exponentially. Extreme demand for debt at near zero interest rate levels must surely be another economic absurdity. Can it be possible that they actually believe that they can happily print any shortfall at the Central Bank without destroying their ability to attract any investors to their bond auctions? Better yet, can the printing press be a substitute for bond investors?



USA



The prevailing Target Rate in the USA is Zero to 0.25% (see also the chart in Component Four). The Japanese equivalent is 0.10%, the European Central Bank equivalent is at 0.25% and the UK equivalent is 0.50%. These rates are all in that interest limbo state called the zero bound. The question still to be answered is can they fund their public debt expansion plans at these absurd interest rates?


Component Three: Divergence in long term yields.

The failing bond auctions were not the only signal from the market. The market does not like the heady mix of expensive pricing and an explosive over supply and is reasserting a term premium. Oops, here is a green sprout for higher interest rates. There is no guarantee that interest rates will not rise in spite of depressionary conditions when Central Governments suck every last saved global penny into their debt expansion plans.


USA





Component Four: The interest burden is rising.

Actual interest costs are rising in spite of historic low interest rates due to the exponential growth in supply of Central Government debt. Observe also the interest rate trap. Can Central Governments afford any rise in interest rates? Do taxpayers have the spare cash to service higher interest costs should interest rates rise? That pesky law of supply and demand which eventually got the housing bubble will also get this supply, demand and interest rate structural distortion.

Long term interest rates just do not want to co-operate with Governor Bernanke’s promise to “keep interest rates lower for longer” a long standing proposed strategy of his. Does he have the power to hold long term interest rates down with the printing press or will the market call his bluff. The now well established divergence in the 30 year treasury rate and the acceleration of the trend to diverge since the beginning of 2009 indicate that the market is calling his bluff. I suspect the market will win in the stare down just as the debt bubble eventually had to succumb to market forces.



USA


USA






Component Five: Lambs to the slaughter.

Private Investors have grown their Central Government Debt portfolio at an unprecedented rate. Who will they sell to when the market asserts the law of supply and demand to re-price these bonds? Even more compelling is the potential losses baked into this cake of historic exposure to treasuries when interest rates start to rise. Can the Global Economic Crisis absorb a Global Bond Crisis?

USA





Component Six: Reliance on foreign funding flows to fund treasury purchases.

Japan’s Foreign Trade flows can no longer support new purchases of US Central Government Debt and China seems to be heading in the same direction. Can the rest of the world keep up purchases of US Central Government Debt? What happens when countries in distress have to cash in their holdings of USA Central Government Debt? Who will buy the securities from them?


USA

Data Source: Department of the Treasury/Federal Reserve Board
Note: Series revisions in each year in May/June from 2002 onwards and Jan 08 data omitted between the current and historical series data.


Component Seven: Diminishing international trade and falling Global Foreign Exchange Reserves.

We can already observe signs of distress in Global Official Foreign Exchange Reserves. The IMF’s data on Official Foreign Exchange Reserves is signalling that total global reserves are falling and have been falling for two quarters. Again, a well established trend. Perhaps it would not be wise to rely on foreigners to buy into the explosive growth in Central Government Debt.




Let’s add up the Seven Components:

1. Over Supply of Central Government Debt - Prices must fall.
2. Historic low interest rates. The probability of interest rates rising is much higher than the probability for a further fall.
3. Divergence in long term yields points to rising interest rates and distressed bond auctions confirms this trend.
4. The actual interest amount payable is already rising sharply even though yields are still low and sticky. This poses an incredible risk of funding distress should investors fail to keep absorbing the explosive growth in Central Government Debt. Central Bank purchases of own Central Government Debt cannot take the place of investor money, or will they risk hyperinflation? The failed bond auctions indicate that this activity is probably already capped.
5. Who will buy from “Private Investors” their holdings of Central Government Treasuries and save them from further losses?
6. Relying of “Foreign Holders” to accelerate their purchases of US treasuries at a time when trade flows are falling and each nation has to deal with their own national economic distress would be perilous.
7. Who will buy USA debt from distressed countries when they cash in their reserves?


My cat gets convulsions in its jaw and makes agitated mewing sounds at the sight of a bird which he thinks it is within striking distance. Bond traders are also snapping their jaws and salivating away when looking upon the evidence of the bubble in Government debt. Let no-one shout “fire” in this crowded theatre for bond investors may get trampled as they run for the exits.

Watch for the next billionaire in the making when this mother of a low hanging fruit is plucked.



Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
17 April 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

The Misery of Unproductive Consumption

We celebrate productivity increases. You do not need to be schooled in economics to understand the basic truth that productivity increases are beneficial to humanity on many levels. It’s not just that the ultimate products will be cheaper. It inherently is a saving. A saving of energy, or resources, or pollution and it always contributes to a better world for all.

Daily we are bombarded with terms such as “Productivity of Capital”, “Productivity of Labour” or “Productivity of Production”. We praise those advances and award them productivity prizes. As we should.

But what about “Productivity of Consumption”. Is that not also a laudable achievement? Let’s have a closer look. Say my household switches off unused electricity using appliances, lights and equipment to reduce the household’s consumption of electricity by 20%. That would translate into the economics of productivity of consumption. My household would have increased our productivity of electricity consumption. Now many benefits accrue to my household. We obviously saved some money and as we literally did not sacrifice utility by simply excluding waste, we are on a pure winning streak. We made in a small way a contribution to preserving our planet. We basically did good, not so?

Let’s escalate this to a macroeconomic scale. Let every household around the globe carefully review its spending patters. Evaluate every expense for maximum utility. Do we need a new car or can we increase the productivity of our utility of our existing car. Same with the house. Do we scale down and still achieve a better utility? How high is the productivity of fuel consumption when driving a huge SUV? It is sad that the world needs a global economic crisis to refocus consumers on their productivity of consumption.

When it happens it has a profound economic impact. A good example is the oil crises of the mid 1970’s. I will not dwell on the excessive political undertones to this oil crisis but want to focus on the behaviour of consumers. Governments in this case intervened in the utility of gasoline to actually encourage, sometimes with extreme regulation, an increase in the productivity of consumption by consumers. Productivity of consumption was forced upon consumers when a national maximum speed limit of 55mph (1974) was enacted. Next Corporate Average Fuel Economy standards (CAFE) were enacted (1975). Even motor car racing activity was altered to recognise the need to increase productivity of gasoline consumption. Commuting to school before sunrise was another peculiar regulation imposed to presumably improve productivity of consumption but the unpopular daylight saving time measure had a too high utility cost and only prevailed from January 1974 to February 1975. Macroeconomic substitution away from oil based energy consumption took place on a large scale.

Extreme politicising of a commodity, the excesses of the go-go years of the 1960’s and not to forget the prevalence of price controls gave rise to a Global Oil Crisis. Thus it is no surprise that extreme politicising in the monetary economy, the bubble years post 2000 and the prevalence of price controls over the price for the use of money (interest rates) gave rise to a Global Financial Economic Crisis. The structural price distortion introduced by the Oil Crisis encouraged a steep rise in the productivity of consumption of oil based products globally. This “good” economic effect was retained in the economy and even the advent of a credit boom of cheap and easy money did not alter the once burned consumers. The truth is these twice shy consumers improved on their previous performance.

View the chart from a “Productivity of Consumption” perspective while being aware of the fact that the prices were controlled and the quantities were rationed during the adjustment process.



The first Oil Crisis in this chart is the period 1973 to 1980 and it is clear how productivity of consumption improved dramatically (by about 54%). The lesson was taken to heart and consumption remained flat for most of the 1980’s and 1990’s. The excess capacity of the previous period now combined with productivity of consumption to ensure relatively stable prices for 20 years. Investing in oil did nothing for investors who preferred the hot and sexy technology sector. Increased productivity of consumption did more for stable gasoline prices than any monetary policy ever did.

Consumers did not react immediately to further improve productivity of consumption when prices started rising towards the end of the millennium. Again it took the bubble pricing of another Oil Crisis, this time brought upon via a debt bubble, to drive home the need to further improve productivity of consumption. Again the ultra high prices altered consumption behaviour in a market which has a tradition of productivity of consumption. The USA economy had experienced inflation and growth over the 20 year period in which the consumption of petroleum products remained constant. That in itself is a significant feat. To top it of with a further drop of about 26% in consumption is breathtaking. Thirty six years later and the collective residential consumer consume only about 42% of the petroleum products they collectively consumed in the early 1970’s. Are we going to scold or praise the American consumer for this tour de force?

Here is proof of the paradox of credit booms. The consumption of petroleum products decreased right through the post 2000 bubble years and accelerated at the height of the credit boom.

It is incredible to note how tenacious the lesson of productivity of consumption is applied after such a crisis. We need to ask ourselves how a general change of behaviour by consumers towards a general increase in productivity of consumption will play out as a result of the Global Financial Economic Crisis. Can it be possible that consumption be reduced by 26% or even 54% generally and remain there for the next 20 or perhaps 36 years? The 1973 Oil Crisis says that it is not only possible but actually probable.

I would assert that the increased productivity in Oil consumption was without a doubt good for all the peoples of this planet. Yes, the initial adjustments were painful and finding the right mix of consumption and utility after the crisis took a while but in the end it was worth it. I would hold it as an absolute truth that an increase in productivity of consumption is good for all the inhabitants of planet earth.

Contrary to the increase in productivity of consumption which accompanied the Oil Crisis, we see that the current political response to the Global Financial Crisis is policies encouraging a lowering of productivity of consumption. The hypocrisy of sermons on Global Warming and a bone or two in the direction of green issues in the bailout packages opposed to extreme encouragement of a culture of lowering the productivity of consumption must confuse any half intelligent person.

Whenever I access my internet news channels, open my newspaper or switch on my TV, I am bombarded with almost fanatical encouragement by “leading” economists, political leaders, Central Bank Governors, and especially from the distressed banking sector all insisting that I must spend, spend and spend. Spend to save the economy. Here is a tax refund, please spend it. We are going to unfreeze lending so we can spend our way out of this economic crisis. Credit must flow so folks can get money to buy cars and houses. Wait one moment, what’s happened to productivity of consumption? Scrap that they say, all savings are bad for the economy and all efforts must be focused on stimulating demand.

Not even a moment’s thought has gone into contemplating productivity of consumption. Spending our way out of an economic crisis is paramount to proposing that we waste our way out of an economic crisis. It just cannot be a valid proposition. Yet it is taken one step further, “Please everybody go out and borrow money so we can waste our way out of this economic crisis.” Can it be taken even further? You bet.

The next step up is that we the government will borrow money and waste our way out of the economic crisis when you clearly fail to adhere to our requests to spend more. Surely it cannot get any worse? It can. We the government will print money and waste our way out of an economic crisis.

It requires a mental paradigm shift to observe the folly of present monetary and fiscal policies against a macroeconomic test of productivity of consumption. First a credit bubble is created through excess monetary liquidity provision and artificially lowering interest rates to encourage an extreme lowering of productivity of consumption. Politicians fall in love with the policy of wasteful consumption for it generates a fantastic tax income stream albeit temporary. They want it back and they want it permanently.

The debt bubble just can’t and certainly should not return. Debt saturation collapsed the credit bubble and consumers are faced again with a requirement to increase their productivity of consumption. Any other productivity increase would be lauded, celebrated and prized. Not this one. Oh no, this productivity increase is vilified. This productivity increase is bad for the economy, so they say. This productivity increase must be attacked and corrected using the concerted full might of all the governments around the globe. Productivity of consumption is a menace to the national interest.

The saving grace of the global economy, the utility of the resources of our planet and the long term survival of our species is rooted in productivity of consumption. Productivity of consumption should be elevated to a top priority and not be warred upon. Policies of wasteful consumption for the sake of saving a financial economy built upon an extreme lowering of productivity of consumption will only extend the period of wasteful consumption.

Economics, contrary to what is currently propagated, abhors waste. Every human action has a strong bias towards productivity and maximising utility. Wasteful behaviour is unnatural to economics. The current policies aimed at minimising productivity of consumption and minimising utility in the interest of saving the global economy is hocus-pocus, snake oil economics which will do nothing to cure any economic ills. The economic patient will die of maltreatment and neglect while these policies will be preached with the fever of faith healers.

Bottom watchers, “bottom pickers, top pickers and in the end all become cotton pickers” was a refrain around trading desks, will tell you that persons will repent from increasing their productivity of consumption if only bank credit can be “unfrozen”. That is, turbo-charged-on-super-steroids bank credit distribution policies must be returned to save the global economy. Productivity of consumption had an economic lesson for OPEC and OAPEC. Perhaps the lessons of 1974 during the Oil Crisis are long forgotten and the political economists of today may have to be re-educated on the principles of scarcity and productivity of consumption. Filling the shelves with printing press funded debt products priced at zero interest rates is not going to reverse the trend to improve productivity of consumption as the burden to repay excessive capital on boom priced assets has re-taught the virtues of productivity to consumers.

Current leading global economic policies will heap more misery of unproductive consumption upon the global economy. So “caveat emptor”, let the buyer beware when the bottom pickers bear messages of debt paradise.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
27 March 2009


© Sarel Oberholster

General information on the 1973 Oil Crisis was obtained from "1973 Oil Crisis" at Wikipedia.


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Fat Chance

As a boy I attended an agricultural Secondary School, that is it specialised in agriculture (it is strange grounding for becoming an economist, I know). We had a teacher who would tell a wayward boy, “You’re taking a fat chance”. The reckless economic experiments to avoid the consequences of decades of money creation and monetary policy abuse are similarly taking a fat chance.

The same teacher gathered a number of older boys together at the request of a local farmer. He proposed to the school an educational real life opportunity to prune his orchard. The older boys (no child labour here) had to complete a course in pruning and do a practical evaluation in the school’s own orchard. The group of budding arborists were taken to the farmer’s orchard to fulfil the contract. Each boy was allocated a row of peach trees to prune. Each row had about 50 trees in it. Each boy was paid per tree pruned. It was a good workable system and the pruners were clicking.

Then the cheating started. The bullies quickly worked out that a row would randomly contain smaller trees easy to prune, average trees and other monstrous trees growing wild which could take hours to prune. They then formed a group, we called them the “Group of Rocks”, for they gathered rocks and set forth to mark all the small trees in the orchard with a rock in the first fork of the tree. Soon work was subdivided into all the small trees for the Group of Rocks, while the rest of the group had to content with normal and monstrous trees.

The rest of the group went to Mr Fat Chance and complained but he did not wish to disturb the status quo as the Group of Rocks was also the group normally considered “leaders”.

The next day only half of the remaining group of boys reported for pruning. The Group of Rocks were in full force. On the third day it was only the Group of Rocks who reported for duty. It now became clear that they would have to do all the work and the rock marking system collapsed. This did not please them so on the forth day nobody reported for duty.

The educational objectives of the school and the farmer all came to nothing. The farmer hired professionals and the school went back to teaching only in the classroom. I would have had an entirely different story to tell had the Group of Rocks failed in their bid to control the allocation of the pruning purse.

Macro evaluations and micro events are interchangeable. The economic playing field is now dominated by the “too big to fail”, the Government Supported Entity, the Public Private Partnership, organised labour and the Siamese twin of Government and Central Bank. This Group of Rocks has control over the national purse in the national interest. They get to allocate the national purse to themselves at the expense of all others. They do not have to suffer the discipline of market principles. The harsh reality of penalty for mistakes and reward for getting it right does not apply to them. They get the personal reward when the going is good and the public purse when the going gets rough. They live and operate on favour and the public purse; rather than live or die by the merits of the market.

Zimbabwe did the same. They printed money and handed it to their Group of Rocks. Ruthless Central Bank activity was combined with ruthless and determined Central Government policies. In the end we see that the Group of Rocks in Zimbabwe owns everything. Everything of hardly anything. Zimbabwe recently reported 94% unemployment so the printing presses were engaged in the national interest, not so? The printing presses averted unemployment in Zimbabwe, not so? The entrepreneurial incentive has been removed from the economy. The risk reward relationships of economic activity have been perverted.

There is a simple but profound lesson in the Group of Rocks. People will labour willingly and with enthusiasm while assuming the risks of randomness in a system based on merit. Is this not a principle inherent to the “American Dream”?

Favouritism and control over the public purse will enslave those outside the inner circle. Debt is but a result of this enslavement. Favouritism destroys the co-operative specialisation inherent to free markets, destroys initiative and encourages unemployment. Thus a belief in bailouts for the Group of Rocks; so called stimulations funded by monetary theft of the savings of the rest; and an explosion of the Sovereign debt funded from the printing press will not save the economy, nor is it in the national interest or international interest.

The printing press is the route to depression, unemployment and social unrest. This is the road to Zimbabwe. The debate about a deflationary depression or a hyperinflationary depression is of interest to those with a desire to protect their savings but let’s not forget that a depression is a horrible economic event. Yet, a deflationary depression is preferable to a hyperinflationary depression. A suitably determined Central Bank and Central Government can convert a deflationary depression into a hyperinflationary depression. Still the actual problem of a depression has not been attended to. Inflation or hyperinflation is not a remedy for a depression or unemployment. Fear not the deflation, or inflation, or even hyperinflation for these are merely symptoms of the control over the national purse. Fear depression for it does not care which flavour of flation accompanies it.

Free market principles where merit allocates the national purse in a fair rule of law system will restore the economic structural imbalances. This option does not suit the Group of Rocks and no prizes for guessing who gets to decide.

I find it incredible and disturbing that access to debt to be created with public debt is offered and praised as a solution for overindulgence in debt. Debt consumption is simply spending the future today and at some stage there is just no future left to discount to today. Does anyone really believe that the Group of Rocks will forgive the debt? The Group of Rocks will shackle you with debt and collect your labour or your assets, you choose.

Thus the economic world travels the road to Zimbabwe which on the economic roadmap is on the other side of Japan. Distances are measured in unemployment. To those with an unholy faith in printing presses I say; “Fat Chance” and prepare myself for the economic and social consequences of a printing press global economy.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
22 February 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Capital Risk Weightings for Crash Test Dummies

Illustration to ring-a-ring-a-roses in Kate Greenaway’s Mother Goose, taken from the Project Gutenberg version project gutenberg: www.gutenberg.org/wiki/Main_Page in the public domain.


Children cling to their blankies and you cannot part them with the Disney printed fluffy blanket even when dirt, food and unspeakable things disguise Eeyore’s picture for all but the tail. Sometimes I think economists have a blanky relationship with reserve and fractional banking.

The fact is reserve banking hardly features in debt formation decisions. It was fundamentally and decisively replaced with a system of Capital Risk Weightings as introduced in Basel I and refined in Basel II. The Bank for International Settlements is very aware of risk in international settlements and the name of the money game has always been to receive settlement (or to get it back if you’ve lent it out). Capital Risk Weightings is a magnificent distributor of debt yet when you mention Basel II or Capital Risk Weightings, economists seems to prefer the blanky. The reality is that reserve requirements are so easy to meet, banks run out of capital long before they have problems with reserve requirements.

It can get complicated but let’s discover the basics of Capital Risk Weightings through Sarel’s Bucket-shop Bank Inc (SBBI for all your Debt needs).

I convince family and friends to hand over their savings say $100,000 and I issue ordinary shares of $1 to each of them (100,000 shares in total). Time to go shopping.

Office Furniture $30,000
Computer Equipment $60,000
Office equipment and Counters $20,000
Stocks of Consumables $10,000

Oops, I spent too much. No problem, I’ll just borrow $20,000 and I’m ready for business.

Here then is the Balance Sheet of:

Sarel’s Bucket-shop Bank Inc





Having only tier 1 capital is totally inefficient. I can get some tier 2 capital by issuing long term bonds (normally 5 years or longer) and I need an equal amount of tier 2 capital. So let’s go ahead and issue long term bonds for $100,000.

Now I need some Central Government Bonds and treasuries to manage my liquidity access so I buy $100,000’s worth of Government Bonds, which thankfully has a Capital Risk Weighting of 0% and have no impact on my qualifying capital. You noticed off cause that we could run an infinite Ring a Ring o’ Roses here borrowing from the Central Bank and lending to the Central Government with absolutely no limitations other than that dictated by the Central Bank. Until we all fall down, that is.

My new dressed up and ready to go Balance Sheet looks as follows:


Sarel’s Bucket-shop Bank Inc



We are now in the banking business. First question, how much can I lend out (we’ll worry about the liquidity a little later)? The Basel II Concordat would generally require a 4% tier 1 primary share capital requirement against the Capital Risk Weighting. (Allocations of Capital Risk Weightings may differ for different countries and split at 8% primary capital and 4% secondary for up to 12% total capital allocations but the calculation method will remain the same.) The tier 2/3 requirements can range from another 4% to 8% but let’s just work with 4% tier 1 and 4% tier 2.

Here is the Capital Risk Weightings table.


Data Source: Bank of International Settlements.

One more risk weighting which is important, Qualifying Residential Mortgage Bonds at 35%.

Now to answer the question, “How much can we lend out?” The math is not complicated.

1. AAA to AA : No limit - as much as we can get in liquidity.

2. A+ to A- : Step one is to calculate the capital co-efficient, easy 8% times 20% and it is equal to 1,6% (0.08*0.20). We have $200,000 in qualifying Capital so we just need to divide $200,000 by 1.6% to tell us that we can lend out = $12,500,000-00. That is a tidy sum of money. Let’s check the calculation. We need to hold 1.6% in qualifying capital against out lending activity. Thus $12,500,000-00 times 1.6% is equal to $200,000 and we’re all filled up with lending. Say we can lend out the money at 4% and get deposits at 2.5%; then we can make 1.5% gross profit on $12,500,000-00. That will give us $187,500-00 pa in gross profit for a Gross Return on Shareholders Capital of 187,5% ($187,500/$100,000).

3. The next best capital allocation lending to engage in would be Qualifying Residential Property. Here goes: 0.08*0.35 = 0.028 (2.8%). Now $200,000 divided by 0.028 = $7,142,857-14. We need to get a better profit margin than A+ to A- lending so let’s say we get deposits at 2.5% and do mortgage lending at 5.5%. That’s a 3% Gross profit margin for a gross profit of $214,285-71 (7,142,857-14*0.03) and Gross Return on Shareholder’s Capital of 214.29%. We can obviously now calculate at which level of lending rate we will prefer A+ to A- lending above Mortgage lending.

There is no need to continue the math as the principles have been demonstrated. Let’s say we’ve decided to concentrate on Mortgage Lending. We convince depositors to give us the $7,142,857-14 and we pay 2,5% interest pa. They have deposit insurance, no risk and should not have any problem to give us the money (not so?).

Our impromptu bank is a good little business at this stage.


Sarel’s Bucket-shop Bank Inc




We are certainly not maximising our efficient use of capital. Thus the next business decision is to do an Asset Backed Securitisation. We take $5,000,000 of mortgages, securitise them and sell them off to investors for an immediate $400,000 trading profit. Fantastic, we now have an additional $400,000 in tier 1 capital and we have also released precious capital held against $5mil mortgage bonds. Time to maximise business activity by lending everything we can to build a much bigger Residential Mortgage portfolio.

Say we use the $400,000 to buy Government Bonds again. We must issue another $400,000 to get tier 2 Capital, again we buy Government Bonds with it. I’ve done all the calculations and our bank now looks like this:


Sarel’s Bucket-shop Bank Inc



Can this be for real, you may ask? Certainly, it was exactly how the game was played for every turn of the asset cycle from portfolio, to securitisation, to sell off produced immediate executive bonuses and the tills were ringing, ka-ching.

We are now a bank with $36.7mil in assets and doing very well. Unfortunately we get a Global Financial Crisis. Liquidity is not a problem (access to liquidity is so easy we do not have to overly concern ourselves with any reserving requirements that the Central Bank may impose on us). We just securitise the $35.7mil Qualifying Mortgages and do repurchase agreements with the Central Bank. The real problems are:

1. We can no longer get deposits to grow.

2. We get bad debts exceeding our gross margin of 3%.

3. We basically have only $500,000 of capital for a 1.4% capital protection against the $35.7mil mortgage loans. In banking talk, we cannot survive more than 4.4% bad debts on a Gross basis (3%%+1.4% and it is a lot less on a net basis – we have to live and get our bonuses).

4. What are we going to do when house prices drop by 50% and “home owners” hand in their keys? Half of the 35.7mil is $17.9 mil against only $500,000 in capital. We have a serious collateral problem not only on our books but also in all the securitisations that we have sold off.

5. We are actually impossibly beyond redemption.


Sadly here is where Sarel’s Bucket-shop Bank Inc kicks the bucket (RIP).

I hope that this simplified essay on Basel II based debt allocation will convince more economists to study the Basel Accords for applied modern banking practices and the interaction with Central Banks. Combine Capital Risk Weightings, easy access to liquidity, deposit insurance (explicit or implied) and securitisation for a turbo charged debt distribution channel far superior to any text book description of fractional banking and reserve requirements.

The role of Central Banks in facilitating unlimited liquidity provision to the banking sector has permanently changed the banking landscape into debt driven activity with deposit taking having been relegated to an afterthought. The fixation of deposit driven banking theories simply no longer apply and it is time to retire the blanky.



Sarel Oberholster
BCom (Cum Laude) CAIB(SA)
14 February 2009

© Sarel Oberholster

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Fractional Banking is a Mirage

Some economists call for 100% reserve requirements of demand deposits. Reserving requirements and the money multiplier are often discussed at the same time.

The economic theory in support of increased reserving requirements and fractional banking is the theory of banks as creators of money.

The essence of this theory holds that:-

1. bank credit is accepted as money, and
2. customer deposits can be leveraged to create money.

Perhaps one should differentiate between “bank deposits” and “customer deposits”. The premise is that a bank can give a debtor a credit limit and the debtor can utilise the “credit” as if it is money.

The theory is normally simplified in the Monopoly bank with a 20% reserve requirement as follows:-





The model is static so a new deposit originating outside the construct must be introduced to facilitate the money creation process. This external source could be the activity of a Central Bank but is simply defined as an external source. The absence of a defined source allows the model to be built on fiction and is a logical quickstep required to make this theory work.

Introducing 100 units of deposit from an external source would allow the Monopoly Bank to use the new deposit for reserving requirements and “create” credit for 400 units. The new Balance sheet would be as follows:-





The 20% reserve requirement can be tested at 1500 x 0.2 = 300 units and the model is stable again.

This theory is generally taught as true but with criticism. It is actually fatally flawed and incorrect. The fatally flawed components are disguised in the undefined external source. Even more relevant is the time between the introduction of the External Deposit and the re-balancing of the Monopoly Bank’s balance sheet. The most important omission is that a production channel is accessed in this period.

The Source of all Deposits

There are two sources of deposits:

1. Savings which originates form a production surplus. Such “Savings” are available for a specific time period which can be for an hour, a day, a week a month, ten years or any such period in accordance with the specific needs of the Saver. Thus a person receiving wages on Friday afternoon may allocate his or her wage income over the next 7 days towards consumption yet a portion will enter the pool of savings and an ever diminishing portion will be available as “Savings” for the next 7 days. Note that the wage was earned in the production process. The “Savings” is 100% supported through production.
2. Unfunded monetary credits originating from “an external source”. Unfunded monetary credits are not “backed” by a production input to the economy and as such are imposters pretending to be savings.

Testing the Fractional Banking Model against the origin of deposits.

The receipt of the 100 units of External Deposit by the Central bank as a reserve requirement may have been sterilised at the Central Bank. Let’s make it so for the sake of simplicity but it is not a prerequisite requirement. Monopoly Bank granted credits of 400 units but such credits did not simply go from the recipient of the credit straight back to the Monopoly bank. No, the recipients used the credits for a purpose, to pay taxes (government spending), to buy consumables (consumer spending) or for investment (investment spending).

The 400 units of money entered the economy and the recipients received economic value for the credits. Economic value in the form of production value. Let’s proceed with a short cycle and state that the producers deposit the proceeds with Monopoly Bank.

The fact is that the 400 new units of deposit originating from the bank credits are backed by a production process. This is an absolute truth. To borrow on one hand and re-deposit on the other would only be possible under arbitrage conditions and can never fulfil any role in general economic theory. The application of the 400 units will cause malinvestment and misallocation of resources as it was made possible by a supply of unfunded monetary credit. The external origin of unfunded monetary credits is the malaise, not the banking sector when it performs its functions as expected.

It is therefore not valid or true to claim that the Monopoly Bank had created money. The Monopoly Bank did anticipate the receipt of savings backed by a production process. How was this possible? Again the model is silent. It could only happen if the Monopoly Bank could obtain a “loan” from an external source to fund the process until such time as the 400 units returned from the production process. Such a loan could have no other nature than that of an unfunded monetary credit.

Interventionism
The fractional banking model is incorrect and economically dishonest by omission. It requires two very specific monetary interventions to facilitate debt formation. A pre-existing much more menacing intervention is reserving.

Economists seldom realise that the very act of reserving is a severe intervention. It acts against the interests of the very economic participants it pretends to favour, the Saver. Any form of reserving requires that a portion of legitimate Savings must be removed from the economy, logic enmeshed in true Keynesian tradition. Savings sterilised is the only Savings not available to the economy in the normal course and robs the Saver of potential rent.

The interventions in the relationship between the Borrower and the Bank should receive the criticism of the libertarian economist. Similarly should the interventions in the relationship between the Saver and the Bank be criticised. Proposals to sterilise the Savings in the economy through reserving should not be confused with sterilisation of money creation from nothing. The one is a result of a production process in the economy, the other comes from nothing.

A 100% reserving requirement would entirely remove any rent that the Saver could earn, limit available savings and severely damage the economy.

The problem of money creation must be addressed at the intervention where it happens and not be exacerbated by punishing the Saver, the Bank, the Borrower and the economy. Each of these entities is a legitimate participant to the market and entitled to pursue its own best interests in true libertarian fashion.

The collection of short term savings in demand accounts is still legitimate savings. A discretionary subjective judgement regarding “demand deposits” should not take the place of a functional intent, that is, the bank must at all times comply with such demands of fail as a bank. Such is the nature of free market economics.

It is a fundamental function of banks to manage the pool of all deposits to achieve a transformation of funding time preferences inherent to the management of a dynamic deposit pool. Any deposit pool will have a predictable and stable component which can be utilised across the yield curve to provide much needed term funding. A 100% reserving requirement would destroy this market function of banks, invite the inevitable intervention spiral, impose an economic cost on unsuspecting economic participants, distort the much maligned savings market even further and starve the economy of the largest pool of savings available.

The interventionism of reserve requirements is similar to all other interventions and will generate the usual outcome of unintended consequences.


2 February 2009

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .