You see, our banking, financial, and economic system(s) are highly leveraged—meaning the fractional margins used to enhance the transactions allow one to make the big bucks in an upturn, but cause one to take equally huge hits/losses in any contraction. This newest “accommodation” by the FED was not to get the declining (in value) derivative paper off the books of the banks—much like ENRON’s tactics, to obfuscate the losses by warehousing them elsewhere until a turnaround or some other “miracle” happened. There was really a far greater clandestine agenda at work here.
A write-down/write-off of this “CRAP” paper by those holding the items was only a few general ledger tickets and adjusting journal entries away from hitting their regulatory capital. This not only might force an “insolvency”; it would, at the very least, impact the allowable amounts of their outstanding loans. By assuming the warehousing of these, the FED forestalled a ballooning contraction for 28 days. Of course, the presumption is that the FED will roll them over and over and over until a time when the institutions can redeem them and write them down/off on their own.
Under the concept of fractional reserve banking, with the current multiplier of 10, banks need only hold 10% of their regulatory capital/deposits in reserve for cash payouts to depositors. The rest can be loaned out to borrowers. While this does not directly mean that banks can immediately (or directly) loan out 10 times what they have in deposits, the recycling of the money in the system effectively yields that result. It would take the fictional math geek Charlie Epps of CBS’s hit show "NUMB3RS" to explain the calculus behind the ten-fold magnification from deposits to loans.
Please bear with me in my highly simplified explanation of how $200 BILLION becomes $2 TRILLION!
To bring the levels of outstanding loans back in compliance/sync with a reduced regulatory capital, the banks would contract their loan portfolios. They’d start by voiding the unused lines and outstanding letters of credit. As the short-term commercial (lending) paper came due in 30, 45, 60, or 90 days, they would not be renewed. This would (more than likely) be done against the most creditworthy accounts—not those in financial difficulties. (I mean, it’s hard to get blood from a turnip, right?)
This would cause those whose loans were “called” to put the screws to those parties who owed them money, who would do the same to those who owed them—and so on and so on and so on. Do you see where this is headed? In short order, the $200 BILLION becomes a $2 TRILLION contraction.
Bernanke, Paulson, and the FED Governors literally had a gun to their heads regarding this “accommodation.” Of course...they didn’t explain the rationale behind it like I just did. How could they? A $2 TRILLION contraction of outstanding loans would be devastating in the best of times. In this environment of declining employment, the questionable status of the US dollar, and record levels for the EURO, the Yen, the Pound, and a barrel of oil—well, I don’t even want to go there!
I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.
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This story was published on March 17, 2008.