Friday, April 09, 2010

4 Trillion Dollars worth of Inflation

Let’s examine the housing bubble. For this example, we will use a million dollar home (before the bubble it was worth 300K). The buyer secures a 30 year loan for one million dollars. The home's seller puts the untaxed windfall gain in the bank.

The housing market tanks and now million dollar homes are worth 300K again. Each homeowner signed an agreement with the bank, to pay on the loan for 30 years. Assume these home owners walk and send the keys to the bank. The homeowner’s loss is probably negligible.

The bank now has a problem. Instead of a steady income stream for 30 years, they have many 300K homes and a loss on each home of 700K. The bank is now insolvent and the FDIC insurance will step in to make good on the bad loans.

At this point, two things are evident. The money that was to be paid back by the buyer, was to be done with earnings over 30 years. The money paid by the FDIC to the bank to cover the bad loan was printed money paid immediately. So the contract to pay on the home for 30 years has been canceled, this money if it had been paid, would have been real money, i.e. earnings.

In our example, the bank now owns the house worth 300k and receives from the FDIC the other 700K. Instead of the banks getting 1/30th of their investment (plus interest) back every year, they get 7/10ths back right away and the rest when they unload the home.

When you realize that a 30 year home loan has a payoff of 2 ½ times the amount borrowed, the 4 trillion dollar loss currently projected would represent 10 trillion of real earnings over 30 years. This would have been money that could not be used for consumption, it was already under contract. Under the FDIC plan, the banks get immediate remuneration with printed money and their depositors are still whole. It’s painless; no one had to work for it.

So, everyone that sold their house before the bubble popped is a winner, everyone that walked away from their bad investment, after the pop, is a winner and everyone with money in the bank is a winner (A real fairy tale ending). The government pours 4 trillion dollars into a banking system that expected that sum back with interest over a 30 year time frame. Now the bankers have all of this money to lend with no one credit worthy enough to loan it to. Where do the banks go next to lend money? Greece, Portugal, Spain, Ireland—they can’t lose, they’re FDIC insured. And of course there is no inflation, the person who sold his house for 700k more that he paid for it, gets to keep it. The bank that lost the 700k (when the new buyer walked), gets reimbursed by the FDIC. We have a bank owned house still worth 300k and 1.4 million dollars of new money in the banking system.



The thing to realize here is that the new homeowners never really had the earnings to pay these loans off, 30 years down the pike. But our government will pick up the tab on this failed dream of riches. Real estate was a get rich quick scheme and an obvious bubble. America is the new Wonderland; you wonder how we will pay for all of this. You won't have to wonder long.

14 comments:

frakrak said...

There is an article in "The Market Oracle" about U.S. banks investing in the stock market, dated the 8th of April. That could be where a lot of your government bail out money went! From bubble to bubble. It all has such a dream like quality about it, to get a grasp of reality you need to encounter all this with an opium pipe!!

A.O.C.M. could have been right re capital flows out of your country, from the banking perspective at least.

Jim in San Marcos said...

Hi Frakrak

Greece is experiencing capital flight and it's going to get worse.

I think we are looking at 10 different things all going off in different directions. You have banks, housing, politicians, governments, individuals, corporations etc each focused on a different goal. It's like a bunch of dogs all pulling the same towel in different directions. When the dynamics of one sector changes, all the rest have to change their game plan.

Capital outflow in this case could spell the end of the Greek government. The rich people there are not stupid and poor people are only dumb by choice.

Jeffrey said...

The FDIC guarantees deposits, not loans. I think you meant FNMAE, at least if the loan was insured by them.

Jim in San Marcos said...

Hi Jeffrey

Sometimes I lose some meaning when editing to keep it short.

From my perspective, if a bank makes a lot of bad loans, it goes out of business. Without FDIC insurance, the depositors would get back pennies on the dollar. With the insurance, they get their full deposit back.

The full cycle would be issuing the loan and paying the seller. Then going bankrupt and having the FDIC cover the cash not recoverable because of the drop in housing prices.

In the 1930's the banks collapsed and the depositors lost about 90%of their deposits. It was after the loss that the FDIC insurance came about.

The primary purpose of FDIC insurance was to keep a "run on the bank" from collapsing good sound banks. I don't believe the creators ever designed it as a back stop for the banking system. They were trying to restore confidence in a bankings system when there was none.

When it's all over, we will have lost 90% just like the 1930's. It's just going to take you longer to count it.

Jeffrey said...

Jim:

One aspect of the crisis that few people understand is that nature of fractional reserve lending by today's shadow banking system. Most people believe that a bank lends deposits and earns income on the spread between the interest it pays its depositors and the interest it collects on its loans. This is the Jimmy Stewart "It's a Wonderful Life" lesson, i.e., the depositors' money isn't in the bank because 90% of it has been loaned.

Prior to the current crisis, our major banks long ago abandoned such a staid model. They took deposits, of course, but the vast majority of the lending was funded by loans, not deposits. Loans from other banks, loans in the commercial paper market, loans from investors, loans in the form of preferred stock, etc. They often used the very "assets" these loans funded, MBS, to collateralize the loans that funded them, i.e., they leveraged their balance sheet.

What happened in 2008 was a classic bank run, but not by depositors. As you note, FDIC kept depositors from running to their bank. Rather, it was the holders of the short terms loans --- often other banks --- that began the run. Collateral was called, but just as the use of 10% margin on Wall Street in 1929, the calling of collateral dropped its value, thereby causing a vicious cycle of default, collateral call, default, collateral call, etc.

Paulson and Bernanke made a judgment in September 2008 that we were suffering a liquidity crisis not an insolvency crisis. In other words, that if the Fed provided temporary liquidity on an enormous scale the vicious cycle would stop and the markets would cease panicking.

The fact that this has worked so far leads some to believe that Bernanke's judgment was correct. I suspect it is too early to tell. At this point in the cycle, I would not expect the market outcome to be much different whether it was originally an issue of liquidity or insolvency. Either way, the market would have stabilized. The more important question is what happens next.

As complex as the mechanisms are that created our present crisis, the fundamental issue is rather simple. Can the developed countries repay their sovereign and consumer debts in full? The answer is clearly no, particularly when we include unfunded liabilities such as social security, medicare and public pensions. At some point we will all reach Iceland's decision to cast away creditors to save the next generation. The only question I have is whether our political system will first destroy our currency in a vail effort to avoid default.

Anonymous said...

Jim mentions that there should be 9 trillion sitting in banks from real estate sales. But what percent of those gains were actually saved and not used to buy a bigger house (which ment the money vaporized) or speculate (theres that vapor trail again)in real estate or just blow on vacations and fancy furs? 10%? does anyone know? Am I in error when I think the road to inflation or deflation hangs on the answer?

AIM said...

Next lifetime I'm coming back as a bank.
AIM

Jeffrey said...

Anonymous, I need a definition of money before I can answer your question. Let's keep it simple and compare two scenarios: 1) the seller of the overpriced home puts all the money under his mattress, the buyer defaults on his $1 million loan and the bank forecloses and now owns a home that can only be sold for $300k. The seller now buys the home back and has $700k in cash and the bank has $300k (the $700k cash equals the $700k bank loss so there is no new money in the system, it's just changed hands); or 2) the seller bought another home which fell by the same amount. But the seller of home #2 now has the $1 million cash. Either way, the transaction doesn't create or destroy any cash because under scenario #2 the cash just goes to the seller of home #2.

Now, if "money" includes credit as well as cash, then the expansion and contraction of credit constitutes an expansion and contraction of money.

Jim in San Marcos said...

Hi Anon 4:35

There are two different things going on here. The banks brought money and a house together and passed it on to Fannie or Freddie. they got a management fee of say 1% for managing the loan. Do that 100 times in a year, and you have a real profit.

There is probably 4 trillion dollars in bad real estate loans and I doubt very much of it is in the banks. They unloaded the "hot potatoes" and bought higher returning CDO and other synthetic derivatives that turned out to be even more worthless.

The 4 trillion dollar contraction in the value of real estate is real. Who owns it, isn't. We can assume the home seller at the top of the bubble made 700K per home in Kalifornia. So the unearned windfall to property owners was 4 trillion. The holders of the loans have a 4 trillion dollar loss. This is the baby boomers IRA money. These funds are not FDIC insured.

In my very simplified example, I was trying to demonstrate, that the 4 trillion made on the housing bubble was available for immediate consumption as was the 4 trillion the government is spending to shore up the banking system, Fannie and Freddie. None of this money is being used to finance economic growth, but rather to pay off past excess consumption and gross incompetence.

This is an extremely simplified explanation of what is happening (I could be shot for this). The point to remember is there is no loser in this whole mess yet, and that is impossible. Real money has been lost, and you can't just print it.

So when Congress whines about the price of oil being too high and we have to start drilling--maybe the issue isn't the price of oil, its inflation.

Thank you for your comments.

Jim in San Marcos said...

Hi Jeffrey

Your comments make me wish that I hadn't simplified my model so much. I was mixing banks and real estate loans, trying to keep it simple and avoid the concept of fractional reserve banking.

I tend to believe as you suggested that the AIG bailout in 2008 revolve around liquidity in the banking system.

In the bank runs of the Early 1930's it ruined a lot of people, but a bad investment was a bad investment. In todays scenario, we get to make a bad investment decision twice.

I'm with you, Iceland has the right idea. The trouble is; it ruins those that are retired and destroys the middle class who pay the taxes for the 56 percent of house holds who pay no federal tax. The Democrats will not like this, it gets rid of the free lunch. Actually it doesn't get rid of it, it just points out that it wasn't free.

Thanks for your add in to anon and take care.

Anonymous said...

Jim,
I (anon 4:35) have been trying to figure out what happened and I am still not quite there. Probably because I don't have a firm grasp on the basics...Phantom wealth was created when home values soared. That wealth was not realized until the property was sold. The seller got a big fat check, the buyer a big fat debt. The bank that lent the money either got it from deposits or borrowed the money (from what I gather the latter was usually the case). The loans were sold to Fannie and Freddie.
Am I right so far?
banks had little risk in lending to anyone, especially when they knew Fannie and Freddie would buy the loans no matter what. Hence the bubble.
I am not sure if I am correct but what I understand is that F&F got their funds buy bundling the mortgages and selling them as equities. More paper wealth was created when investors thought those equities were worth way more than they truly were. So the money that was used to buy the equities that flowed on to pay the seller came from somewhere (401Ks, pension plans, amongst others) and is sitting somewhere. AIG guarranteed a lot of the losses and with the US paying AIG and F&F we have effectively doubled the amount of money out there. Am I on the right track?

One other question...and it may make me sound like a troll, but I am only asking because I don't know...if we were still on the gold standard meaning there was a fixed number of dollars available, would that have prevented the bubble?

Jim in San Marcos said...

Hi Anon 4:35

Your view is pretty much how I see it. Most of this new found wealth was spent on consumption or on building more houses that we didn't need. All a bubble is, is a mis-allocation of resources.

Gold couldn't stop most bubbles but it could keep government from spending beyond its means. You can't print gold.

raptor said...

Is thinking in the following terms correct :
1. Inflation is "brewed" at the moment Fed prints & banks lend money
2. Inflation is "enacted/created" at the moment the somebody buys something or service.

and similar for deflating..

Jim in San Marcos said...

Hi Raptor

I don't think that inflation is really that simple. If we examine it in an economic sense, you produce four dollars worth of goods and get paid four dollars. The government comes along and prints four extra dollars. The real price is now eight dollars to purchase the produced item. That's an inflation rate of 100%.

What you are looking at here, is a time line of say a few months. But when you have people putting money into savings there is a delay in realizing the printed money is in the system. The saver is not going to access the money for 20 years. The saver and the government are doing two different things. The net effect is that the government is feeding on the savers retirement nest egg.

As for when inflation will be realized, is kind of like picking the date a bubble bursts. There was no real estate bubble until it burst.

Right now we are experiencing inflation and deflation. The deflation is from producing things we didn't need, like houses. The inflation is in things that we have always needed, gas and food.

Your definition works in any economic text book. In real life, the "when will it happen" part is always a guessing game. When will inflation rear its ugly head? The thing I hate about this, is it is going to be a "Retirement Surprise." You can't afford to retire. Go figure!

To quote Greenspan, "I might not be right, but I am never in doubt."

Thank you for your comments.