the United States, there are once again TV commercials advertising Adjustable
Rate Mortgages (ARMs) for residential real estate. Today, I saw one
from Quicken Loans (http://www.quickenloans.com/home-loans/adjustable-rate-mortgage?code=587L) promoted with the tagline
“why pay more in interest charges now just to know what rate you will
have in 2018?” (they are offering a 7-year “teaser” rate
and then the loan adjusts after that.
sort of promotion should have made people nervous even before the residential
real estate bust in the US in 2006.
has this got to do with Fractional Reserve Banking (FRB)? Banks often
commit the same kind of sin. Read on.
is a common misconception that via FRB, banks lend out more money than they
have. But the very definition of fractional reserve banking is that the
banks lend out less than their deposits, though they keep less than 100% of
their deposits on “reserve”. This misconception comes from
the failure to distinguish between money and credit. This is
particularly easy to do today because our perverse fiat system has banished
money altogether. Gold and silver have no official role.
Everything that remains is credit.
“dollar bill”, aka Federal Reserve Note is the liability of the
Federal Reserve. The Federal Reserve has “assets” to back
these dollars, namely Treasury bonds (and mortgage back securities, and the
Red Roof Inn, and shares of GM, such is the new post-2008 reality). If
you have a dollar bill, you have a credit obligation of the Federal
Reserve. If you use it to pay a debt you owe to someone, then you
transfer the debt from yourself to the Fed. If the recipient deposits
the dollar “in” the bank, he is lending it to the bank, and now
the bank has a liability to him.
banking system can create credit. When the bank receives a dollar of
deposit, it will often lend $0.90. It still owes the dollar to the
depositor. It keeps $0.10 as its asset, and it lends the $0.90 to a
borrower. This loan is also the bank’s asset. The borrower,
of course, can pay someone and that recipient can deposit the money in the
same or another bank. The process can be repeated, and assuming 10%
reserves, the total credit in the system can be expanded to a maximum of 10
times the original deposit (the sum of the series 1 + .9 + .81 + .729
difference between a gold coin in your hand, vs. a piece of paper from a bank
promising to pay is made obvious if the bank ever becomes insolvent.
The piece of paper is then realized to be a credit instrument in default.
is a more subtle distinction that few today, even in the Austrian School,
make. The difference between: (1) a bank takes a 1-year CD on deposit
and lends to a real estate buyer for 30 years; and (2) a bank takes in a
1-year CD and lends to a manufacturer to finance receivables for one month.
difference is that in one case, the bank’s liability is due before its
asset matures. This is similar to what the homebuyer does with the
ARM. He may or may not be ready (or able!) to sell the home in less
than 7 years. But the loan could be repriced such that it is not
economical to hold. At least with residential real estate loans in the
US, the loan cannot be called before the final maturity.
bank that “borrows short to lend long” has no such
protection. And in fact this is one of the principal risks that such a
bank faces. The depositors can demand their money when their CDs mature
(or for demand deposits, they can demand their money at any time). But
the bank has issued a loan that it cannot call.
bank can try to sell it, if there is a bid in the loan market at that
moment. If the run on the bank is large, and if the same thing is
happening to other banks, the banking system could in its entirety be forced
into bankruptcy, with immeasurable damage to depositors. One kind of
depositor is the corporate payroll account…
short to lend long, also known as “rolling” one’s
liabilities, is fraud. No legitimate bank would engage in this activity
in a free market (as opposed to our centrally planned central bank based
system with bailouts and other forms of “moral hazard”).
temptation is great, because the rate on short-term borrowing is much lower
than the rate on longer-term lending. This is the same temptation faced
by the home buyer comparing an ARM to a fixed-rate mortgage.
just as with stealing, this temptation must be resisted if one is to stay out
of trouble, or in this case bankruptcy. For a bank engaged in this practice,
collapse is inevitable. It is only a matter of time.
not Fractional Reserves per se, is the real problem and the real risk.