This was copied off the Prudent Bear Chat board and posted on a board in China in August 2007. It appears it is about to disappear and I am saving it here. I remember writing this in some context and it was clearly written before Bear Stearns went broke. it follows.......
First of all, I think you need to get your eyes off subprime.This is a scapegoat and nothing else. It just happens to be the first guy at the theoretical poker table I mentioned above to run out of chips and they didn't bring more. Truth is these are some of the better loans out there, not the worst. They just happen to be the worst of the mortgages, but there is some collateral behind them and something to get in the end, even if it doesn't get close to 100%.
What happens in credit? First of all a paradoxical situation occurs. When a credit line is put into an account, both the bank and the borrower are liable. Lets say the bank gives the borrower $10,000 in his account.The bank owes the borrower and the borrower owes the bank. There really isn't any capital involved here, as it is additional liquidity, not capital. The borrower might have put up collateral and that is the capital, but it can only be liquidated, not turned into the loan. Once the borrower spends the money it enters other accounts. The bank is now liable to some unnamed depositor or may in fact have to cash a check,which he pays by selling securities to the Fed. Again, we have 2 entities liable to the depositor now. But, the bank is not only liable,but is owed an amount even greater than he is liable for. On a daily basis, interest is added to the amount created out of thin air, making the amount due greater than the AMOUNT CREATED. Thus the entitiy that owes the debt is also owed the debt.
What really transpires here on a short term basis and to a greater degree ona long term basis is the banks liabilities begin to look real. So do their assets, meaning this credit begins to take on some kind of net worth identity that it really doesn't possess. It really doesn't exist in sum, but is nothing more than liabilities shown as assets. The asset is the net worth of the bank and the collateral, which at the end of a credit cycle is generally inflated well beyond real value. Thus it eventually comes down to the worth of the lender and at what point is that impacted.
I was once exposed to a legal argument that a bank cannot lend its liabilities. It was backed up with one court case after another stating just that fact.So, in order to be lawful, a bank cannot make a loan in excess of its net worth. It cannot put out to any customer more than it can guarantee. If you look at the diagram I started out with, that the bank starts out as debtor and creditor and continues to hold that spot until the money is repaid, the principal is clear that it must have enough assets of its own to pay to the depositors any losses its lending might sustain. This is the crux of the current problems that are so far beyond what is being talked about here and so far misplaced in something called subprime mortgages that few can see what is about to transpire.
Lets start out with what makes banking work and eventually fail, the no mathematical solution of banking. Banks are generally trying to expand their portfolio for good reason. It is the only way over the long run they get their interest or acquire the default property instead. The older system was more elusive for bankers because people knew what the money was, the gold. But, the current system is really no different than the older system, except 12USC95a,which was adopted by Roosevelt denies the depositor access to his gold or for that matter the currency. This trading with the enemy act, which declared war on the US public standing in the way of banking, is now the basis of what many of us see as a facist arrangement between Wall Street, the Fed and the US government. It is an arrangement that is bound to enslave the people of the US and most likely the people of the entire world, if the reach can be extended.
In any case, this act together with the no mathematical solution, has made bank credit the money of the world today. This is as true in Europe, Japan, China and the third world as it is in the US. Because the banks are lending at interest what is considered money today, the borrower always owes more than can be paid, as one balance grows exponentially and the other just sits there. You can bet on a given day without default that the banking system is owed more money at the end of the day, net than at the start of the day. It doesn't matter how much repayment is done on a given day or how much lending, the fact is an amount multiplied by 1.08 is greater than the same amount multiplied by 1.03. There are other factors here, but this is the main one.
But, what transpires over time is the bank goes from owing this money in a round about manner to the borrower who owes it back to the bank to owing the money to unnamed depositors who received the credit from the borrower. Here is where the problem eventually comes back to bite the banks, the initial holder of the credit and the eventual holder of the credit are not the same people. The other problem is that if the borrower fails to get the deposits away from the eventual holders, they have no ability to pay the bank. Thus, the bank becomes liable on its own or it has to continue the shell game the best it can,hoping when it is time to call the pot, the hand has worked out.
What do the banks have forcollateral? Titles, that is what. Courthouses exist as much for bankingas anything else. We could do very well without county clerks if not for liens. Of course the taxing authorities might have a problem. But,the titles only go so far, in part because in this stage of a credit cycle, the price of titles has been bid up so high by those that still have money on the books that their value is really elusive. But, this escalating collateral value gives additional credit to a system that has to have it and in some fashion, allows for higher prices for all assets. Remember, the bad debts are being rolled now in a game of double or nothing where the dice are supposed to eventually bail out the last bad bet.
Now comes this idea that risk is gone. I keep harping on this in the stock market when some ass brings up the idea of buying stocks. I get this crap that I don't trade, but if I never traded, I wouldn't be here. If I didn't understand something about risk and return I wouldn't be here, but be posting on some bull board some pollyanna news. The idea that risk doesn't exist is behind stocks. We never saw a 3% dividend at any point in 2002. In fact, it barely reached 2%. Never in history had the dividend rate on stocks fallen below 3% without some kind of reprecussive move against the holders value. Here it is in our 12th year of uninterrupted dividend yields under 3%, something that had never been sustained for more than 2 months straight at any time previous. The risk is seen as inflation,so the return on a portfolio of stocks can now be accepted to be under the return on treasuries. Everyone is betting on inflation to destroy the value of bonds and keep raising the price of stocks. They forget that corporations can go broke in hordes.
Then we come up with these financing models. Well, the whole damn world has adopted them.What do they mean? Well, they mean that the smart money has gotten on the same side of the trade everywhere, meaning the dumb money is left to bail them out. The risk they have avoided is now in their corner and they are all huddled together as academic geniuses with vicious creatures locked in the room with them. They hold all the positions, so they now hold all the risk. It was okay when this type game was the exception, but the entire industry has adopted it and the risk that was shifted for a fee is now FULLY OWNED. There has been no one paying the fiddler and we are now seeing people laughing at him, like he don't have a 44 magnum in his case that he is about to brandish and demand payment. The party goers spent all their money on booze and goodies and now the fiddler is going to be paid, probably with Rolexwatches and diamonds.
The losses have been going on. The more deposits created, the more losses in the pile somewhere. The more assets are bid up, the more a few people decide to take their cash and get on the sideline. The more cash that resides on the sidelines, the more the debtors are deprived or should I say in a better sense, denied access to what they need to extinguish the debt. Remember the bank acts as surety and also is the true debtor. What is the bank holding?
Doug (Noland) has done such a fantastic job adding to the knowledge I already possessed and the more I have read of what he writes, the more I find I don't know. I hear things like the carry trade, but the carry trade can be hedged and doesn't need to be unwound. I don't see Doug write much about that. What I see him doing is drawing a picture of this old west style of lending that seems to go on without hesitation. What I do understand is finance and accounting and compound values, which history has proven cannot be sustained (take 1.01 to the 2000th power and seewhat you get and take 1% of that figure. That is how much a penny would have compounded to since the birth of Christ. Ask yourself where it all went?). I also understand that the borrowers and the depositors in a bank are not the same and that the value of collateral is fleeting.
There are some arrogant people here. One was talking about buying a $900K house for $300K when it gets there. There is the delusion that we are the ones that are going to have money left to pick this stuff up. If the populace shifts to gold, bet is the bank credit not only holds upin value, but increases relative to all assets. This is an uncertainty that anyone who has a clue what they are facing knows they don't know.Few realize how big a role the dollar and all this lending has played in liquifying credit around the world and what a collapse in banking and lending in the US would do around the world. I think the action of the past week has already shown the weakest links aren't in the US, but in Europe, where they have their own real estate bubble and subprime mess, not to mention a lot of croney capitalism and funny Eastern Europe deals.
I read it somewhere, but we are about to find out who is broke. I think the names are going to shock the general public and a lot of people on this board. Wall Street is likely to holda lot of casualties and the big 3 US banks are going to have to either hold on by the skin of their teeth, operate in insolvency under secret permission of the government, ala Japan or go broke. The fed fund liabiities of Citicorp as reported by Doug were in the stratasphere.This means they are among the biggest credit crammers and holders of uncollectables. It also means they are going to impact the entire banking system. I think BAC and JPM are both in the tank. These 3 makeup a good part of the American credit machine. Lets see how smart the US is in solving their Japan type problem here and if the politicians have the guts to close their handlers? As far as Wall Street? Who have been the high flyers? GS, Merrill, Bear Stearns? The biggest flyers are probably the ones up to their necks in alligators. I am watching the prices on the Dow, with 20 point fluctuations round trip in maybe 90seconds. These guys have a weak grip on the wheel this time and a panic could wipe some of them out overnight. I played some wild markets in 1998, but I didn't see the 2 or 3 second changes in the Dow quotes I am seeing here. Sure if they were headed into a certain direction like the ramps into the close, there were some big changes, but these 4 to 8 point clicks in no determined direction weren't going on. These guys are attempting to shake this market to their advantage and I think they are wounded. They are talking about these outfits selling at low multiples to forward earnings. The idiots on CNBC are trying to let these guys sell their options, as there may not be earnings, but huge losses. The current picture throughout the banking and financial system can be compared to Enron situation, where what has been hidden in the closet is about to come out. Didn't Enron report fantastic profits right up to the last quarter?
It is all a game of who owes who and who can pay? We are about to deflate and it will take more than the Fed providing funds for us to inflate. Easy credit is about to go out the window and someone on the political scene is going to be blamed for what is about to happen. What is about to happen is a house of cards is about to fall around the world, the boy has his finger in the dike and it is drown or pull it out and drown.