Saturday, December 18, 2010

Macroeconomics 101

I've always wanted to do an article explaining the basics of economics in terms my daughters could understand and why I'm so grim about our future. Being severely overcaffeinated this morning, I've decided to let my fingers fly..

Banking System 101: We now have what's known as a "fractional reserve system". What this means is this: lets take "JeffBank", which has $10mm in the vault. Most people in America believe that this means JeffBank can loan out $10mm. Not true. In 1913, they insitituted the fractional reserve lending and the 10-1 leverage ratio rule, which means that banks can lend out ten dollars for every dollar in the bank. Therefore JeffBank can loan out $100mm.. but if 1/10th of these loans go bad, JeffBank is toast because he only has that $10mm in the bank. Beginning in the early 1980's, regulators threw out the 10-1 rule (especially for bigger banking institutions) and essentially let them loan out whatever they wanted. Big US banks wound up with 30-1 leverage, and so if only 1/30th of their loans went bad, these big banks were either forced into finding cash to cover their losses or go under. In Europe, the banking system is even worse; most bigger banks in Europe are leveraged at like 60-1 these days.

Credit Default Swaps (CDS): Credit Default Swaps are a form on insurance written on many things such as Certificate of Deposits (CD), simple savings accounts, bonds, etc. Here's an example: Lets say that you have $1 million ($1mm) in JeffBank and lets say that its in the form of a 5 year CD, therefore you cannot simply walk into the bank and cash out any day you wish.. you have to wait the 5 years to get your million out. Lets say that JeffBank had loaned a huge amount of money to Lindsay Lohan, and as Lindsay gets dragged by the cops to yet another rehab clinic, you begin to worry about the whether JeffBank is going to survive Lindsay's antics.. and specifically worry about the fate of your $1mm CD. Therefore you turn to "JennyBank" (which is the exact same size of JeffBank and therefore has $10mm in the vault) and ask them if they will write an insurance policy on your $1mm CD in JeffBank.. so if JeffBank goes under and your $1mm CD is gone, JennyBank will pay you the $1mm as long as you pay JennyBank a monthly premium for this insurance. This insurance policy is known as a Credit Default Swap.

There is also something called a "naked" Credit Default Swap, and here is what this is: lets say that a month after you get the CDS from JennyBank on your million CD you get a call from a loan officer at JennyBank who says: "Ya know, if you really think JeffBank is going under, we can write you another Credit Default Swap for $12mm if you want to make the monthly premiums".  This new "naked" CDS isn't really protecting an asset like the first one is.. it is, as it's heart, essentially a bet. Most big US banks write these naked CDS for anything under the sun.. the biggest ones are for interest rates. For example, "LisaBank" is worried that if interest rates go up, their costs also go up and they might become insolvent, so LisaBank contacts JeffBank, who agrees to underwrite a big "naked" CDS for LisaBank just in case interest rates go to 9%. The big US banks have written naked CDS's for the City of Detroit, the Greek Government, GM, and most commonly on each other. When Lehman Brothers went under on September 15th 2008, it triggered an avalanche of CDS's. The very next morning, AIG.. who had underwritten hundreds of billions of CDS on Lehman, was toast. The rumor was that if AIG had not been saved, their collapse would've taken down Citibank, RBS (England's biggest bank) and UBS (Switzerland's biggest bank). They were essentially dominos thanks in large part to these CDS's. There are still hundreds of trillions of them laced in the system, thus making the failure of any bank, big company or government four or five times as bad as it need be.

So now lets go back to JeffBank, who now has a 25-1 leverage ratio (ie he's loaned out $250mm and only has $10mm in the vault). JeffBank has also underwritten a slew of naked CDS's worth another $250mm to LisaBank in regards to interest rates. Overall, JeffBank has a 25-1 leverage ratio.. and possibly 50-1 thanks to the CDS's. Because LisaBank and others pay JeffBank monthly premiums, bank profits are skyrocketing !! Hurray Happy Day !! But if interest rates go up to 9%, JeffBank will be forced to pay LisaBank the $250mm.. and JeffBank only has $10mm in the vault. Whoops. If JeffBank bites the dust, JennyBank is now on the hook for the $12mm CDS you got from them. The problem is, JennyBank only has $10mm. Therefore JennyBank also bites the dust. JennyBanks's failure then triggers other CDS's, destroying other banks. The Domino Effect. This is what was happening in September of 2008 and why it's so dangerous. If you are p!ssed that such an inherently dangerous system was allowed to become reality, you should be.

United States: In the 1970's and before, most Americans could'nt get loans for anything except a house.. and even then you needed at least 1/5th down and had to show you had savings just in case. The 10-1 leverage ratio on banks essentially meant that they did'nt have tons of money to loan out and therefore had to be careful about who they loaned to. Home ownership in the 1970's was about 33%.. the other 2/3rds of people rented. But with the arrival of Alan Greenspan in the early 1980's, the 10-1 rule was tossed aside. Soon enough, we as a nation began living a pretty nice lifestyle.. the Reagan years, the Clinton years, the Bush years.. this was a prosperous 30 years. The problem was, it was built on a mountain of debt. As a nation, we essentially spent six dollars for every five we produced for thirty years. By 2008, over 70% of adults owned houses. In 2005, a friend of mine got what was called a "no doc" mortgage.. she did'nt even have to prove she had income !! Are you serious ?? Banks were loaning anything to anyone with a pulse. The banks found themselves leveraged 25 and 30-1 in most cases. By 2007, the party was ending. Foreclosures and losses began skyrocketing. The banks, which had loaned out way too much, were beginning to totter. Americans began defaulting on credit card debts, car loans and mortgages because they had gotten themselves into too much debt. These losses began taking their toll on banks, and in 2008 we had a banking crisis caused by too much debt, and multiplied many times over due to the above mentioned CDS's.

And here we are.. we as a nation are still way over our heads in debt due to Greenspan's policies. What would you do if you had a $50,000/yr income and debts of $285,000 (your mortgage is $220,000 of this) ? This is the position we as a nation find ourselves in. Realistically, we can do two things.. tighten our belts and slowly pay down the debts or default (which would crash the entire economy in days). In 2009 and 2010, we as a nation chose a third path.. the US Government began borrowing trillions of dollars and the Federal Reserve began printing trillions more to try and ease the pain that needs to come and try to get people to borrow and spend like they did in the past to kickstart the consumer economy. The problem is.. thanks to high unemployment (and under employment) and people defaulting on their debts, there just are'nt that many credit worthy people out there to loan to anymore. We as a nation will one day feel the pain.. and the pain we are feeling today is only a small, bitter taste of what needs to come. We cannot forever kick the snowball down the hill by borrowing money and handing the bill to our own children. Here's my favorite video.. it's an interview with Kyle Bass a few months ago, who's pretty much the smartest economist on this continent, on the US economy:

Europe: The problems in Europe are very similar to the ones described above.. too much debt, overleveraged banks, credit default swaps. The difference is, their problems are much worse.. the European banking sector is on average twice as leveraged as the American banks are. Worse, in many cases, the size of these banks dwarfs the nations where they're located. The most dangerous example here is Ireland, a nation of only 4 million souls, who has titanic size banks that have loaned out way too much to way too many. These banks are in serious trouble, and the government of Ireland is trying to prop them up. Because of their size, however, Ireland's government has had to borrow vast sums of money.. for every dollar the Irish government took in tax revenue this year, they are spending four dollars.. most of this to prop up these rotten banks. It's rather like watching a dirt squirrel trying to catch a falling hippo. Switzerland, with only six million souls, is also in this boat. Now the Irish Government is having problems financing itself. The EU's answer ? Yes you guessed it.. more loans !! Greece is in a similar position. Spain is getting there. But when the IMF and the EU give Ireland and Greece loans, they demand that these governments cut spending somewhere.. usually this means slashing the jobs and wages of public employees. Ireland in particular has suffered from this. Worse yet, as time goes by, their economies continue to shrink {caused in part by these spending cuts), and so these nations' tax revenues shrink as well, forcing yet more cuts in government spending. It's called a deflationary death spiral. Ireland's unemployment rate is 14.1% and soaring. Spain's last summer went over 20%. Strikes and riots are occuring in Athens as I type this. This is Bernanke's worse nightmare, and its why he's printing money. My fear here is that one day, the people and/or government of one of these nations will simply say "Screw This" and will let their own banks fail.. and we have another Lehman style crisis thanks to the trillions in CDS's.. Spain is particularly worrysome because of the size of their banking sector's debt ($1.8 trillion), their already high unemployment, and the inability of the other EU nations to deal with a problem of this size. Spain will need to borrow $400 billion in 2011, and their rates have been rising. Left alone without help of some sort, I highly doubt Spain makes it this year. Portugal will not make it this year. If Spain begins to totter, be afraid.. very afraid. Oh yes.. and Europe's Central Bank, the ECB, has a leverage ratio of.. get this.. 331 to 1. Yesterday it was leaked out that the ECB needed a $10 billion credit line from the Bank of England. The answer is the EuroBond, which essentially means Germany will be helping their southern neighbors in perpetuity.. but will they agree ? 2011 could be very interesting.

Japan: Japan's economy is the first modern economy to suffer a real estate/banking crash, which happened in the 1980s. The response of the Japanese Government was much the same as we are today doing.. have the government prop up these rotten banks at all cost. As a result, Japan's government is severely over it's head in debt. For example, Greece is Europe's most overindebted government.. it owes 120% of it's GDP in debt and spends about 1/4th of their government revenues just to pay the interest on this debt. The figure for Japan you ask ? 210% as of this year. There is, however, a major difference.. Greece relies on foreigners to supply the loans to it's government. Japan, however, is very lucky in that their own people supply their government with the needed loans. Because of the amount of debt the Japanese Govt does owe, any rise in interest rates will hit their government's finances very hard. For example, a rise in interest rates of 2% would force the Japanese Govt to halt all funding to their Defense Dept and Medicare. So far, the Japanese people have been willing and able to finance their government. My concern here is that Japan as a nation is getting very old very fast. Fewer and fewer younger people are expected to not only pay down this debt but provide for the huge and growing elderly population. Japan's government this year spent two dollars for every dollar they took in as tax revenue. One day, something's gotta give.


  1. HI Mr Kowalski much enjoy your articals also vistit Queen Bees blogg and Mish. You sure do get it. I have not posted much best to learn and not be heard. Thanks again keep up the good work sprig1

  2. Mr K Very well stated. 2011 will most like be similar to 1932 and we all know how that turned out. The second Great Depression is upon us. I see wars on the horizon. A gold back currency maybe?

  3. It's just a Depression, don't be depressed.

    I don't know if you follow the Kondratieff Wave theory, but it seems to me to be fully correct and is coming ashore now in this cold Winter of our discontent.

    The good news is that it should be about finished rolling over us by about 2016-2018, and that will be the real bottom of this sorry period. Getting from here to there is a bit of an issue.

  4. Kondratiev's predictions were startling, especially given when he made them.

  5. Ace! Thanks much!