Sunday, February 21, 2010

Banking, lending . . . and government bond auctions

I've been talking about--and sharing my concerns surrounding--massive inflation.

Bob Prechter
, co-author of Elliott Wave Principle: Key To Market Behavior and founder/publisher of The Elliott Wave Theorist, suggests that it is not inflation we need to worry about. It is deflation.

Whether he is correct or not, I think his analysis of the fractional reserve banking system as it is practiced in the United States, is quite astute.

Are you familiar with how fractional reserve banking works?

If not, I encourage you to begin your education!

Join Club EWI (no charge) and read the September 2008 Elliott Wave Theorist.

Basic idea:

Compare what happens to money you lend to your neighbor and what happens to money you lend to your bank.

Suppose you have $20,000 in hand. Your neighbor comes to you and asks if he might borrow $10,000 for a year. He says he will pay you 6% interest for the loan.

Once you pass him the money, how much money do you possess?

$20,000? $10,000? Something else?

In reality, you have $10,000 and (hopefully you have this in writing!) an IOU for $10,000 plus 6% interest.

Now suppose at the end of the year your neighbor came to you and said, "I'm sorry. I lost your money. I invested it foolishly. It went to nothing."

How much money do you have?

Well, you definitely don't have the $10,000 you loaned to your neighbor. It's gone.

Change the scenario.

You start with $20,000; you keep $10,000 on hand (under a mattress? out in the backyard?) and you put $10,000 into your local bank.

How much money do you have?

Prechter suggests you have "only" $10,000 . . . plus an IOU from the bank for $10,000 . . . plus whatever interest they will offer you.

Why is that? Because the fact is, the bank doesn't hang on to your money. If your neighbor goes to the bank and asks for a loan of $10,000, and the bank lends it to him, that money is just as "gone" as if you had loaned him the money directly. The only difference is that the bank has agreed to serve as your lending middleman.

Interestingly, U.S. banks are supposed to maintain some kind of minimum reserve amount of cash on hand. Traditionally, I am given to understand, that reserve would have been 3%. I.e., for every dollar you deposit, they were supposed to keep 3 cents on hand. They could lend out 97 cents.

Functionally, however, according to what I'm reading, they are operating without reserves. Indeed, Prechter wrote in September 2008, "At latest count, U.S. banks report $6.942T in deposits and $6.945T in loans. In other words, the average bank in the U.S. has lent out 100 percent of its deposits. The money is not there. It is lent out."

And now, perhaps, you can begin to understand the problem.

If your bank has lent all your money to others, then it has no money. And you have none of that money, either. And if the bank's debtors fail to pay the bank back, the bank has no money with which to pay its IOU to you!

And so, if you will, the modern fractional reserve banking system--or should we call it "no reserve" banking system--is really a kind of musical chairs game in which we all keep dancing while the music plays . . . and we all have to hope the music doesn't stop playing so none of us gets "caught out."

The problem is, the music stops every now and then. And some of us find there is no chair in which we can plop ourselves down. Our banks don't have enough assets to repay us what we have loaned them . . . which is kind of what has happened here in the States over the last couple of years: so many borrowers (mortagors) have been unable to pay their contracted obligations that banks have been pushed into bankruptcy.

But here's where it gets "interesting" to me . . . and I don't know if I'm competent to evaluate this statement.

Prechter says that, because there has been so much default recently, "the purchasing power that everyone thought he had [has] evaporate[d] into the nothingness it truly was" . . . which means we are faced not with (what I've been afraid of) inflation, but, rather, deflation, fewer dollars chasing the same number of goods--i.e., currency worth more than it used to be!


I said I'm not sure I'm competent to evaluate what I just said. But I'm going to try.

I think where Prechter's analysis goes wrong, and why we aren't likely to experience deflation, is because the Federal Reserve keeps creating dollars, and the federal government keeps replacing the dollars that the FDIC keeps replacing in the banks where dollars have been lost. More than that, of course, the federal government keeps authorizing the Federal Reserve to create dollars out of thin air.

It will be . . . uhhhh . . . interesting to see where this leads when we consider that lenders who are willing to purchase federal government debt may be disappearing.

As Martin Weiss of Weiss Research brought to my attention: in the government's most recent sale of 30-year bonds, "the group of bidders that includes foreign governments and investors bought 35% LESS of these long-term Treasuries than they normally do." He went on to suggest that "prices plunged" and "yields surged."

I'd say that's a bit of an overstatement. (Ahem!) Bloomberg reported that "30-year securities drew a yield of 4.720 percent, compared with an average forecast of 4.687 percent in a Bloomberg News survey of 10 of the Federal Reserve’s 18 primary dealers." Moreover, "The price of the 4.375 percent security due in November 2039 dropped 18/32, or $5.63 per $1,000 face amount, to 95 6/32." Both changes are significant, but I would hardly describe with such words as "plunge" and "surge."

On the other hand, the shift in who did the bidding is rather startling. Again quoting Bloomberg,
Indirect bidders, an investor class that includes foreign central banks, bought 28.5 percent of the bonds today. They purchased 40.7 percent of the bonds at the last offering. The average for the past 10 sales is 43.2 percent.
Divide the most recent percentage of indirect bidders--28.5%--by the average over the last 10 sales--43.2%--and you find only 65.97% of the average. Or turn those numbers on their head; they're more shocking. The previous 10 auctions have had, on average, over one and a half times as many indirect bidders involved as this most recent auction did.

Want to guess where prices and, therefore, interest rates are going if future auctions attract even fewer bidders?

Remember, prices are always set by the relative abundance or scarcity of bidders/buyers/money vs. sellers/products for sale. (And in this case, we're talking about lenders-with-money vs. bonds-needing-to-be-sold.)

If there are fewer lenders, prices of the bonds have to go down/interest rates on the bonds have to go up (to attract more lenders). And if you combine the lack of potential bidders with a concomitant increase in bonds-needing-to-be-sold (which, we are assured, absolutely will be happening, because the federal government is running at record deficits even while it is finding itself required to roll old debt into new), then we can expect significantly lower prices for the bonds and, therefore, significantly higher interest rates. [In case what I've just said sounds like gobbledy-gook to you, please see this article on the relationship between bond prices and interest rates. Try to ignore the anti-capitalist rhetoric. For a more technical explanation with lots of interesting math, check this out.]

I "just" wonder how quickly all the foreign buyers are going to disappear and how soon, therefore, those interest rates are going to spike.
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