When the US economic establishment swallows their pride and allows a foreign sovereign investment fund to bailout Citigroup - you can be sure that the sub-prime credit crisis is causing someone to lose sleep.
Citi Sells Stake to Abu Dhabi Fund
Tuesday November 27, 2007 5:16 pm ET
By Joseph Altman, AP Business Writer
Abu Dhabi's Sovereign Fund Agrees to Invest $7.5 Billion for a 4.9 Percent Stake in Citigroup
NEW YORK (AP) -- The Abu Dhabi Investment Authority will invest $7.5 billion in Citigroup, offering the nation's largest bank needed capital to offset big losses from mortgages and other investments. ---
What is happening here? The sub-prime crisis appears to be overwhelming the American monetary authorities. My suspicions are that the sub-prime credit crisis is expanding into a general crisis of credit. With the world's money supply based upon debt that would be a crisis of a different order of magnitude.
To understand the sub-prime situation, one has to understand how credit is created, traded and destroyed. Fortunately, the credit market's basic operations are simple to explain and understand.
There are people who have money to invest (this is capital) but they themselves lack a profitable idea, or necessary business skills to make the profit they desire. They need to find and then be willing to surrender control of their capital to someone who has the profitable idea but is temporarily in need of money. The act of temporarily surrendering control of money from one person to another creates a debt. The creditor gives credit by lending money (the principal) to a debtor who the creditor believes will return the principal with an additional interest payment during a specified period of time (the loan's term). Credit is largely an act of faith.
In this way a debt is formed between the two parties. The debt created has the following basic features:
The debtor will spend the creditor's money as a capital investment, for example on materials and labor. It is important to understand that the creditor's money is now gone and owned by a third party who is not legally obligated to return the funds to the creditor or debtor. After this capital investment for goods and services, the debtor has to make a profit on his enterprise. Unless the debtor is successful in making a profit on the creditor's capital, the debtor will default on his debt to the creditor.
This is the risk all credit has for its owners - will the debtor pay the creditor's money back? Here is the root cause of every credit crisis, money was lent to people who will not or cannot pay it back.
Using a construction loan as an example, we can see how these three parties cooperate in successfully constructing a new house for sale and paying back a debt.
That is how credit built one house, but why is there a credit market?
The loan's term was for one year, but what if the banker needed his money after only six months? This often happens. A bank can demand its money back from a debtor before the term of a loan expires. This is called "calling in a loan." Unfortunately the builder spent the $200,000 principal for lumber and subcontracting services. The bank knows that until the house is completed and sold at a profit the builder has no money to return.
Fortunately the bank does not have to "call in" this construction loan as there exists a credit market where banks and other financial institutions (creditors) can buy or sell credit assets. These credit assets are called different things, but "paper" is universally used. So from this point, we will call credit assets traded in the credit markets - "paper."
Our bank is a well known bank with an AAA Rated reputation in the credit markets. On the strength of our bank's reputation, financial institutions such as mutual & pension funds, insurance companies and other banks will give "credit" to its paper as being as good as money.
"Good as money" is not the same as money. But on a good day in the credit markets, it is good enough for "paper" to trade for cash.
Our bank sells the paper, but at a discount. The paper would pay $216,000 at the end of loan's 12 month term; however as only six months has lapsed the bank must sell the paper at a discount of slightly less than $208,000 to the paper's new owner, a mutual fund. When the builder finishes the home and receives $250,000 from the buyer, he will send $216,000 to the bank to pay his debt. The bank will send this payment to the mutual fund who six months earlier bought this paper from the bank for $208,000.
There is an essential point in the credit market that is missed by 99% of the investing public that is essential in understanding any credit crisis:
Paper credited as "good as money" is not the same as money.
A credit crisis arises when credit paper becomes no longer "good as money." One year ago the big New York investment bank Bear Stearns' portfolio of sub-prime mortgage paper was valued at hundreds of millions of dollars, if not more. When offered for sale in the credit markets, this paper would have found many willing buyers. But one year later these "assets" became "liabilities" and so are no longer tradable. Why would another financial institution offer to pay good money for someone else's losses? This made Bear Stearns sub-prime paper, "toxic waste" as it was no longer "good as money." These are real losses that can bankrupt a financial institution.
What happened? Take for example our construction loan, now the property of a mutual fund. What if the house could only be sold for $200,000, the mutual fund bought this debt for $208,000. The paper becomes bad paper. And if the house burns down with no sale possible, this is a total capital wipeout. The paper purchased for $208,000 becomes toxic waste in front of the mutual funds officers' eyes.
"Bad paper" and "toxic waste" has macro economic effects that spread far beyond the offices of a mutual fund that has lost money on a home construction loan they purchased from a bank. After a credit expansion where significant credit was extended to debtors who later defaulted on their debts, the inevitable bad paper and toxic waste threatens the economy's actual money supply.
The reason why central bankers are managers of bank reserves, interest rates, and also the economy's money supply is because interest-paying debt is by far the largest component of our money. For nineteen years Alan Greenspan muttered incomprehensible mumblings before congress about interest rates and money. How many federal elected officials, had a clue what he was talking about? Not many, but as long as things went smoothly, congress was more than happy to let the bankers and academics have their way with the dollar.
As the money supply is a measurement of both coins and paper Federal Reserve notes (money plain and simple) and paper as "good as money," credit defaults reduce the credit paper component of the money supply. So the current sub-prime crisis is a money supply crisis. In other words, sub-prime defaults are reducing the money supply by destroying wealth worldwide. Within the past year, huge investment banks and their clients took hundreds of millions (billions?) of dollars losses to their investment portfolios as debtors walked away from their debts. The Federal Reserve's monetary measurement, M3 was reduced dollar for dollar with the destruction of this wealth.
Below is a chart and table for the last great period of deflation, 1929-1933.
The effect of a reduction in the money supply is deflation. When economists discuss the need to combat the effects of deflation, "deflation" is a "policy maker's" code word for uncontrollable, large scale credit default sufficient to reduce the money supply to a point of wide spread economic pain and political difficulties for incumbent politicians.
With a monetary system that has 90% of its money as debt, deflation at a sufficient scale can call into question the viability of 100% of that system's money. This is the war the monetary "policy makers" are waging, a war that threatens the viability of the American Dollar as an international economic asset.
The current front of this war is where millions of sub-prime "homeowners" are walking away from usurious mortgages that are breaking their financial backs. Had these "working slobs" did the right thing and got a second job to service the $250,000 mortgages that bank gave them on their $100,000 homes, Bear Stearns and Citigroup would not need to ask for a bailout from the US Federal Reserve or Abu Dhabi.
Let us look at the M-3 and CinC.
The chart has plotted the following US monetary measurements.
Note: The Fed may have discontinued publishing M3 in Feb 2006, but the items it contained are still traded and used for "good as money" assets on financial balance sheets worldwide. It is the money you, I and Fortune 500 companies have in our money market and bank accounts. I used M3 as it was the largest measurement of money "plain and simple" plus paper as "good as money."
The mathematics of M3 is simple addition and subtraction. When the credit system creates more "paper" than debtor default destroys, M3 rises. When debtor default destroys more "paper" than the credit system creates, M3 falls. The mathematics of economic boom and bust is simple arithmetic.
The extent of damage to the credit system, and the economy's money supply caused by sub-prime write offs can be measured by simply noting how far the Green and Blue (paper good as money) plots fall towards the Red (CinC) plot. As the M-3 plot terminates in February 2006, we would not see these write downs in the above chart. However, it appears that investment bankers like Bear Stearns and other financial institutions are * not * being forced to take their losses with a marked to market liquidation of their bad paper. If this is so, the money supply figures published by the Federal Reserve are questionable and will remain so for the foreseeable future.
There is an irony to what has happen to our money since the US Congress gave bankers and academics day to day management of the US money supply. As hard as the "best and brightest" of Wall Street and Harvard have fought to demonetize precious metals, they've actually have spent many more times that effort monetizing garbage like sub-prime mortgages. We then see surprise in the official sector at the weakness of the US dollar. Are these educated economists and "policy makers" really that stupid? Well as Forest Gump would have said, "stupid is what stupid does."