Once upon a time there were gold ounces below a dime

It should be time to speak about fractional reserve banking. This is the system that allows commercial banks to create checkbook money, money that has never been issued by the central bank as notes and that only exists in bank's accountancy books. The idea dates back to the time when goldsmiths could store in their safes both the gold used as reference deposits and the notes that were issued on that gold. Assets were correspondingly increased and so was the capacity to pay out new loans, as the volume of deposits was accounted on the basis of the volume of assets, even if these assets are counterbalanced by liabilities.

We can take the example explained in the Workbook on Bank Reserves and Deposit Expansion published first in 1961 by the Federal Reserve Bank of Chicago and subsequently revised a number of times, the last revision being done in 1992 by Anne Marie L. Gonczy. The example starts with someone (agent A) who buys $10,000 of Treasury bills from a dealer in U.S. government securities. Nowadays this means that agent A pays for that securities with an "electronic" check guaranteed by a bank that will call B0. This check is deposited in another account designated by the dealer in another bank B1. Agent A has added $10,000 of securities to its assets, which has paid by creating a liability on its account in B0. We simplify this introductory part of the example by saying that agent A deposits $10,000 cash in bank B1, which is equivalent but simpler (Treasury bills are chosen in that example due to its high liquidity, well, we chose bank notes). Now, banks must maintain reserves in a vault or in the central bank that equal only a fraction of their deposits. This fraction is called reserve requirement or required reserved ratio and it is basically set to 10% in the US and 2% in the Eurozone for most transaction accounts. Reserves in excess of this amount may be used to increase earning assets: loans and investments. If business is active, the banks with excess reserves will probably have opportunities to loan the excess $9,000. As the Worbook states on page 6: "Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrower's transactions accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system". This means that banks do not expect the withdrawal of that money in cash from the final payee of the loan, but to receive a deposit of this payee for that amount. Thus, total assets amount to $19,000 and total liabilities amount to $19,000 as well. However, only $10,000 correspond to fiat money, issued by the central bank. The dealer may come and try to withdraw his or her $10,000 cash, and simultaneously the final payee of the loan may do the same. This potential situation is unlikely to become a problem if we consider a situation in which bank B1 has many customers, both borrowers and depositors. As unlikely as high the percentage defined by the required reserved ratio stands, or the voluntary reserve ratio for those countries where no compulsory one exists (In 1998 the average cash reserve ratio in the UK banking system was 3.1%). This process can go on: B1 can make further loans for the new deposit of $9,000, retaining $900 for its reserve and lending $8,100. We find ourselves in the same situation as before, where both the amount of assets and liabilities rises by $8,100 this time. This procedure converges finally to having $10,000 reserves, $90,000 in loan assets (or investment assets, if we wish) on the one hand and $100,000 liabilities on the other. Banks have created $90,000 which are backed by some secures, theoretically provided by the borrower, if at all. On top of that, interests must be paid by borrowers. However, according to the description of this system, there is not enough money created to pay both the principal and the interest of these loans. In effect, loans repayment means that the corresponding principal, as checkbook money, disappears into thin air but interest must be taken from the deposits of other customers as a return for working hours, for example. This net withdrawal precludes economic growth. Therefore, additional money must be created by new loans so this money gets injected in the system. New borrowers feed prior borrowers in the economy as a whole, like in a pyramid scam.

One would say that this only works if we have just one bank. Well, actually it still works if we have just one big banking system of individual banks interconnected by interbank loans or instruments such as the floating bank notes at an advantageous interest rate, lower than the one applied to external borrowers. The amount of economic activity which can be supported, in the example above, is $100,000 worth since loans and investments are financial negotiable instruments for which banks act as intermediaries. This is why banks are such an important player in our economy, they decide how much economic activity takes place, i.e. how goods are produced and distributed and how much we consume again as goods or as services. And this is why governments are bound to help them not to default. If they defaulted, ecomony as a whole would collapse.

After World War II, the Bretton Woods system was in some sense a come back to the Gold standard as it obliged each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and gave the IMF the ability to bridge temporary imbalances of payments by carrying out gold reserve exchanges or by loans. This system collapsed when the United States government decided to end the convertibility of the US dollar for gold in 1971. Nowadays, the reference -at least in theory- is the fiat money, not the gold, i.e. banknotes backed by central banks as an instrument of payment. Yet, other finantial instruments have come along that are starting to lose its meaning in terms of fiat money, just as banknotes lost its reference to gold in the past. These financial instruments stem from loans as explained above, but not only from them. Loans and investments have given birth to other generations of financial products (derivatives, structured finance instruments, hedge funds, etc) to become a family that is becoming more and more distant to the actual fiat money whose amount is supposed to be tuned by governments and central banks. Money is therefore created not just by loans but also by these financial engineering instruments.

Floating rate notes. Reading the Wall Street Journal Europe on 27 August 2008

I was flying from Munich airport on 27 August when I was struck by an article on the Wall Street Journal Europe bringing up the issue of the floating rate notes that are due basically now and during the forthcoming fifteen months. It reported about Alex Roever estimates, a J.P. Morgan Chase & Co. analyst who foresaw the credit crunch starting this month, September 2008, when banks were due to pay back $95 billion in floating rate notes. Fannie Mae and Freddie Mac have been both important issuers of these bonds. We know they were placed into conservatorship, a mild word for nationalisation, by the Federal Housing Finance Agency (FHFA) on 7 September.

Fannie Mae (FNMA) was born in 1938 as a government-founded agency as part of Roosevelt's New Deal to provide liquidity to the mortgage market. Until 1968 Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States. That year, and to help balance the federal budget, Fannie Mae was converted to a private corporation. This measure was accompanied with the creation of Freddie Mac and its chartering by the US Congress as a competitor in the secondary mortgage market, so that the actual monopoly would end. Their role was to provide liquidity for what are referred to as conforming mortgages, i.e. mortgages meeting certain minimum standards designed to reduce risk to the lender. Banks and other lenders would be able to sell conforming mortgages to both companies so they could replenish their funds and keep making mortgage loans without worrying about raising money to fund those loans. This way mortgage interest was kept at a much lower rate than it otherwise would have been.

What did Fannie and Fred do with these mortgages? They have been packaging them into the so-called mortgage backed securities and selling them on the secondary mortgage market with a guarantee that the interest and principal would be paid, whether or not the original borrower paid. At least as long as they had the financial solidity to cover these guarantees, of course. In addition to selling mortgage backed securities they also kept a number of mortgages for their own portfolio, which they were funding with a variety of debt securities. In particular they have been important issuers of floating rate notes, a type of bonds usually issued from one bank or financial institution to the other which have a variable coupon or interest given by the federal funds rate in the US or the LIBOR in Europe. All in all, Fannie and Fred were designed to make profit out of:

1. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they write on the aforementioned mortgage backed securities -which is inferior because it is a guaranteed security-,
   
2. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they have to pay to the holder of the debt security with which they fund their portfolio.

However, profit is not a compulsory outcome of the (quasi-) free market and Fannie and Fred have been suffering a negative net growth during the current economic cycle, driven to a large extent by the subprime mortgage crisis. As a consequence of their loss of solidity, liquidity in the mortgage market came to a halt. Also, debt securities issued by these two companies started being scarcely competitive, compared for instance to US government securities. To compensate for this, Fed interest rates are to be cut. Debt securities issued by Fannie and Fred can be found everywhere in the global markets, with a special mention to Chinese banks.

There have also been a few scandals in the management of these two companies that I will analyse in future posts.

What about Europe?
In Europe the main issuers of floating rate notes are banks. The stress they are going through at the moment has to be related to the due date of the floating rate notes mentioned by Mr Roever. The dubious ability of these banks to meet the deadline this month is probably an unconfessed reason because of which the European Central Bank and the national Central Banks are now going to the stake for them. I am afraid they fear the exposure of lack of liquidity of European banks which would spin out of control if savers panic.