In part two I talked about derivatives being at the heart of the problem and to explain the concept of derivatives fully, would occupy this blog for a year, so you can conduct your own research to understand further.
The real issue with derivatives is that you can literally create money out of thin air and it is lending without 'lending'! Banks are governed by strict rules that dictate to them how much reserves they must hold in relation to the amounts they can lend. So if the capital ratio is 10, then the bank can lend monies equivalent to 10 times the amount of reserves – if the bank has $100M in reserves, then it can lend up to $1billion.
But, the banks are lending without really lending and this creates the term 'notional lending', which using the analogy of a poker game, the notional sum is the chips and you can keep playing with the chips until of course, it is time to cash in and you have to come up with the 'real money'.
Over the last years, nobody has had to come out with any 'real money' to pay off losses as counter parties have allowed them to roll over debt, but in doing so, charging an interest penalty for compensation.
So why have things now come to a head?
In simple terms, because a package of loans, including the sub-prime loans of the housing industry defaulted into billions, which could not be rolled over, because the counter party was insolvent!
If you look at a traditional mortgage portfolio, you would see lending restricted to a maximum percentage of the asset (house) value, say 80%. This afforded some protection to the lender, but we are now in an economy of hyper competition – some lenders will go to 90 or even 100% and also greed.
Greed is the whole game and over the last fifty years our society has promoted a lifestyle that is based on consumption – mankind has been indoctrinated to work harder and consume more and when do not physically have the cash to spend, there is always a bank willing to extend a loan and that of course created a credit based society.
Now putting this altogether, we have the creation of a credit based economy, which of course leads to huge amounts of consumer and corporate debt, we have a banking system that has changed into something akin to gambling and finally, the 'straw breaking the camels back' – the recent sub prime crisis!
So what about the future?
Well we could look at the fact that it is the central banks, working with the consumer banks that have created the boom and bust cycles of capitalism and the answer may well be in abolishing the central banking system. Whatever it is, one thing is for certain, the financial architecture of the world will definitely change.
~Neil
