Economical Equilibrium

by Ilya Kuntsevich

  Appraisers start valuing old houses at higher prices, because their owners immediately refuse to sell their houses to the newcomers with “debt” money. Once the higher value of old houses is “confirmed” by the appraisers, the old houses’ owners are offered a Home Equity Line Of Credit (HELOC) of $30 for the previously uncapped “new value” of their properties. Upon origination of debt financing, the central bank decides to charge interest on the debt in the amount of $10 and put it in its pockets.

  In the aftermath, the economy and housing market are booming, because the central bank lent $50 to build new houses and lent an additional $30 as HELOCs. GDP had a one-time increase of $80 because all the money was spent on the economy. The central bank really likes the result, especially that now it made a profit of $10, and decides to take the frenzy to the next level. It invents a term “securitization” (a mechanism that allows it to sell debts, secured by the increased “values” of real estate, to other villages). Neighbor villages buy $80 worth of debt from our village’s central bank, as a value preservation asset. Given neighbor currencies cannot be circulated in the local village, the central bank had a choice of either printing another $80, backed by the neighbor currencies, or buying valuable goods and services from the neighbors at a later time.

  Due to these perturbations, the central bank ended up with an extra $90 or equivalent in its vaults ($80 issued from neighbor currency conversion plus $10 profit). The central bank’s ego got really big from the success of such an undertaking, and it decides to lend both the old $80 and new $80 again in order to build even more houses and provide even more HELOCs and maximize its own profit. By a certain point of this housing and securitization frenzy, the local village’s housing market quadrupled, oil prices increased tenfold and luxury industries excelled beyond imagination. Everyone in the local village was excited to be able to enjoy the lifestyle they couldn’t afford previously, although not everyone knew at that time what was really going on behind the scenes.

  Only the central bank knew that it was able to recognize an “undervalued” real estate market by exchanging (monetizing) it with debt. Had no debt been involved, houses wouldn’t have gone up in price, and vice versa. To the logic of the central bank, the housing market represented extra capacity that, if tapped into, could make the economy boom by spending the debt money.

  The reversal of the process occurred swiftly and resulted in a deep crisis for all the parties who enjoyed the benefits of the economic spike, which was not matched with the actual contribution. As a result some villagers could no longer afford debt payments because the cash they were paid previously was provided not by real demand, but with debt money. As many people walked away from their mortgages or defaulted on HELOCs, the central bank took over the houses and recorded them instead of debt on its balance sheet at cost. This caused significant distress to its liquidity, because the central bank could not sell them instantaneously on the one hand, and securitize more debt on the other, so the villagers allowed it to print another $100 in order to bridge the gap and keep liquidity in the financial system (for lack of a better phrase, they called it “quantitative easing”).

  The central bank could not sell the properties at significantly reduced new market “values” in order to keep at least some book equity (because, in fact, it would have gone bankrupt had it sold all properties at significantly decreased prices). In order to keep face and explain the gradual sale of the properties, the central bank came up with a fancy word “deleveraging”. The villagers also had to borrow from neighbors in order to bail its central bank out, because they were worried about their standing with other villages and ashamed of what their banker did.

  When the villagers called the central bank to explain what happened, it had nothing else to say but “it never happened before”.

  In the aftermath, the central bank had $320 value of debt ($80 was reinvested 4 times), the liquidation value of which was around $80 at best, solely due to the fact that some houses retained a higher value through the wealth distribution mechanism, while others became worthless. As I will show in the next chapter, banks can reinvest the same money multiple times via debt instruments, which causes exponential growth of debt and high leverage. In this example it was fourfold ($80 x 4 = $320). In addition the banker had $40 it printed to pay itself profit and finally received the extra $100 it needed to bridge the liquidity gap when the crisis started – debt borrowed by the local villagers.

  The big question is – what to do with the new $320 value of the real estate on the books of the central bank? The answer seems obvious, but the central bank simply cannot do it, because then it would have to default on the bank’s deposits, thus causing real anger from its villagers. The central bank simply cannot let this happen.

  Concluding this chapter, the use of debt to recognize value that others cannot afford (thus causing distortions in the contribution and demand equilibrium) is an ultimate contributor to the most recent economic booms and busts. Debt is also a way of deceiving developing economies to buy developed economies’ goods and services in exchange for their natural resources, a high price of hard work and environmental pollution. Debt-fueled growth also results in distorted values of real estate and/or other assets that are usually illiquid and thus cannot be easily monetized with cash. While I agree that some real estate could be undervalued in the first place, measurement of new values with debt money is more than questionable.

  Debt is also an instrument to make people work harder, make them consume more and exploit more natural resources using both existing and “to be created” technology. Hypothetically, if people refuse to work harder than they do already and thus refuse to buy the corresponding benefits of modern civilization, the majority of consumer debt (e.g. credit cards) will become worthless instantaneously, because debt derives its value from future value only.

  Another conclusion is that mindless pursuit of corporate profits is very harmful for our planet (cars, coal-based electricity, chemistry, etc.) due to pollution and increased pressure on natural resources. In addition, increased consumption, fueled with debt money and overall economic frenzy, puts unnecessary burden on wild life, crops, oceans, etc.

  Therefore, it is wiser to use debt money not on consumption of the daily necessities (i.e. to boost GDP), but exclusively on future technology and repair of the harm caused to our planet to date. Expansion of modern “cannibalistic” technology using the debt mechanism to boost local economic growth should be discontinued. Such measures will not only bring humanity back to our world, but will also allow restraint of monetary inflation and changing of bad technologies for good ones.

  Banks, Loans and Interest

  A question no accountant can answer: if there is only $100 in the financial system, and somebody borrowed all the money at 10% interest rate for 1 year, where will the extra $10 come from when due? I can understand that if someone borrowed 100 golden coins and used them to pay workers to dig more gold, he could find enough gold to make 10 more golden coins, but it doesn’t work that way with money – you will have to do something and get paid an extra $10 in order to return the additional $10 to the bank. By the way, the same logic is valid for a thousand, a million, a billion and so on. Therefore, unless new money is printed, it would be impossible to return interest to the lender and thus make banks continuously profitable.

  The banks make money on top of what they pay on bank deposits, by charging higher interest on originated debt. Time value of money, a concept used in finance to discount future cash flows, indicates that money loses its value over time. One could make a hypothesis that the worldwide economy grows by the net weighted average rate interest on loans (aka monetary inflation). Accordingly banks are literally “money making” machines.

  Banks have many options to apply accumulated profit money and boost its value using debt, securities, real estate and other assets multiple times. Banks 2.0 – Investment Banks – manage profit money and buy assets because this is the only way for them to con
tinue making money – the horizontal expansion growth model. If the local economy is saturated, then international expansion is pursued as the next best option. As the international assets base increases, the investment banks generate profits by exploiting natural resources and human labor, which were conserved (not monetized) previously. This is a modern form of colonization – bringing local profit money (excess capital) overseas and making other countries work and give up its natural resources in order to pay it back.

  Money Circulation

  The banking financial system can lend the same $100 a number of times. The same $100 can generate multiple debts at 2, 3, 4, …. N times and thus increases the value of respective collateralized assets if debts are defaulted upon. In other words, debt on banks’ books has an infinite multiplier of money present in the financial system.

  For simplicity imagine if there is only one bank in the entire United States and all it has is $100 cash. A borrower takes a loan of $100 and agrees to pay it back in 1 year. After the loan is granted, the borrower spends it to purchase equipment to manufacture tables. The money, after the borrower pays a vendor for the equipment, goes back to the bank on the vendor’s deposit account. As a result, the bank has $100 cash plus $100 loan on its assets, $100 equity and $100 deposit. Accordingly the bank increased its balance sheet by $100 after granting a loan and recording a liability (deposit account) on its balance sheet.

  The amount of a bank’s assets to its equity is called leverage. As the lending cycle repeats itself over and over again, the bank’s leverage increases. For example, Bear Stearns had $11.1 billion in tangible equity capital supporting $395 billion in assets, a leverage ratio of more than 35 to one, prior to its collapse.[2] While Bear Stearns was not your “regular” bank, commercial banks have a regulatory restriction of “Tier 1 Capital Ratio” not to be less than 8% to be “Adequately Capitalized”[3]. Keeping 8% capital ratio means a bank can lend the same $100 about 12 times (100/8).

  If we combined all the American banks’ balance sheets, we would see that cash (money) is just a fraction of their assets while the rest is either in loans, foreclosed properties or other “valuable” financial instruments. This is because when a bank originates a $100 loan, the borrower spends it and money goes back into the financial system. It does not matter whether it is the same bank or another bank. When another bank receives this $100, it uses it again as a loan to another party and the cycle continues.

  One could make a hypothesis that if the banks run out of options to invest because they are fully leveraged to their respective regulatory limits, money will sit idle on their balance sheets. As of February 2013, the Federal Reserve kept over $1.7 trillion dollars of banks’ reserves[4], a record high amount in the entire history of the U.S. I should clarify that banks’ reserves kept at the Federal Reserve represent approximately 10% of all banks’ deposit accounts as a security measure against an unexpected run on the banks. In other words, this is all the cash that the financial system has, while its balance sheet is at least 10–12 times that value, based on the most stringent regulatory requirements of Tier 1 Capital Ratio. Therefore banks’ assets represent value that cannot be immediately cashed out at once. Recent Quantitative Easing measures by the Federal Reserve serve only this purpose – deleveraging the banks and boosting liquidity.

  Another statistic that comes in handy is U.S. GDP represented by personal consumption expenditures. In 2012 it represented approximately 70% of GDP, where household consumption expenditures for services represented almost 50% of GDP.[5] There was a long decline in the savings rate (Net Savings / Net Domestic Product ratio) from around 12% in the 1960s to only 1% today[6], which means it is not savings that are still being spent, but rather international and local debt money.

  Finally, banks can sell debt off their books through securitization. I should clarify that only debt secured by other assets, can be sold for a profit, while unsecured debt is usually sold at a discount and cannot be packaged to any “securitized” type of product (at least in theory). As convincing as this term may sound, there is nothing secure about securitized debt – securitization is the third iteration of a promise (money – debt – securitized debt). A lot has been written about securitization and its contribution to the 2008 financial crisis over the last 5 years, so I’ll spare the reader from this detail. The above village example gave a good snapshot of how it works.

  Interest Income

  As interest income grows, monetary inflation grows along with it. But is it a sustainable model for businesses, pursuing solely profitable ventures? If there is no other way for money to be increased but by printing it, are paper profits worthwhile as a primary measure of performance and / or an indicator of future performance?

  Concluding my thoughts on banks, their business ethics and transactions should be questioned by the people to a large extent, because banks use other people’s money to make profit for themselves in the first place. Charles Ponzi would be proud of his followers. Bernie Madoff, rightfully accused of what he has done, is no more innocent than Wall Street tycoons, but unfortunately Wall Street seems to have bought the U.S. Government or at least holds it as a hostage. As insane as it sounds, the wealth distribution diagram, discussed in Part III, shows that this can be possible.

  “Valuable” Accounting

  Accounting is about recording business transactions in order to produce financial statements and properly calculate taxes. While business transactions are generally recorded in monetary (cash) value, financial statements have a number of non-cash values in their line items, as required by accounting rules, some of which are extremely complex.

  If value is an elusive concept by itself, accounting value, paraphrasing Winston Churchill’s famous quotation about Russia, is “A riddle wrapped in a mystery, inside an enigma; but perhaps there’s a key”. That key is non-cash.

  Based on the U.S. Generally Accepted Accounting Principles (GAAP), market value of public stocks, bonds (debt), mortgage backed securities (MBS), collateralized debt obligations (CDO), collateralized loan obligations (CLO) and other actively traded investment products is their “fair value”. Formal definition by GAAP states that “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Based on GAAP, in an active exchange market, closing prices are both readily available and generally representative of fair value. An example of such a market is the New York Stock Exchange.

  To an investment professional, valuation expert or an investor with good judgment, such fair value can only be partially true, because it is not possible to differentiate market pricing driven by the investors with cash versus ones using debt and leverage. Accordingly, the accounting profession has no choice but to use market prices as a benchmark, but is it the right thing to call it “fair value”?

  Based on GAAP, if a reporting entity holds a position in a single financial instrument (including a block) and the instrument is traded in an active market, the fair value of the position shall be measured within Level 1 (liquid instrument) as the product of the quoted price for the individual instrument times the quantity held. The quoted price shall not be adjusted because of the size of the position relative to trading volume (blockage factor). The use of a blockage factor is prohibited, even if a market's normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price. In my opinion, the reason why GAAP does not permit recognition of blockage discounts is simply because it cannot quantify it. GAAP also doesn’t differentiate the root cause of market fluctuations, which can be caused by small trading volume, speculation or systematic risk, and have nothing to do with fundamental valuation of companies.

  Imagine your neighbor sold his house in 2006 for $700,000, but bought it for $300,000 four years ago. Based on the above definition of the fair value, your house, comparable to your neighbor’s, is now
worth $700,000 and bankers will be lining up at your door to loan you money on HELOC. After 2008 your house is no longer worth $700,000, because no one would buy it at that price. What is your house’s “fair value”?

  Here’s another riddle. Imagine there’s only $700,000 in the entire financial system, and someone decides to invest all the money to buy your neighbor’s house. Based on GAAP, it means that your house is now worth $700,000, but there’s not enough money in the entire financial system to substantiate this value. The Federal Reserve would have to either print additional $700,000 or circulate the existing $700,000 from the sale of your neighbor’s house, using the mechanism described in the previous chapter.

  If your house is sold through debt financing, the bank would record it at its cost of $700,000, recognizing respective value on its balance sheet as an asset. Accordingly, if your house was financed with debt, GAAP will allow recognition of two houses at $1,400,000 combined fair value, while there is only $700,000 in the entire financial system. Therefore this is a mental trick when we see a dollar sign in the header of the financial statements because we imply these are actual dollars, when, in fact, they aren’t. Is this fair?

  Fair value measurement assumes that an asset or a liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date, in order to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date. I assume you understand this definition, hypothetically, but “where is the money”?