credit money system question

Someone defaults on paying a mortgage, but the bank created the money out of thin air... how is this a loss for the bank, if they created the money from the 10% reserve they should have? I don't get it.

Someone deposits 200,000. Bank keeps 20,000 as reserve (10%) They loan out 180,000 for a new home. People get paid the money for the home (those who constructed it or who owned it), and they deposit it in banks.

scenario 1: Loan gets paid back.

200,000 + interest still exists: it's in the banking system. People get dividends, and they spend the money: amount of money in circulation increases.

scenario 2: Loan does not get paid back (default on mortgage) Banking system still has 200,000, plus they own a home as well. They sell the home. People get dividends, and they spend the money: amount of money in circulation increases. They don't sell the home: amount of money stays constant, until they sell the home.

As long as not everyone asks to withdraw their cash, everything is fine, right?

I don't get it. This has to be wrong. Can someone clarify?

Reply to
Spacey Spade
Loading thread data ...

That is the key problem -- when events happen such as the credit crunch last fall, large numbers of people rush to pull their money out of the bank. Once 10% pull their money out, the reserves are gone, and the other 90% are out of luck. That is a very thin reserve level before the bank goes bankrupt.

To prevent this from happening, banks can borrow from the federal reserve. If the bank is too far gone to save due to having too many bad loans, and thus cannot repay the fed, then the government takes over the bank and the FDIC covers the depositors.

-john-

Reply to
John A. Weeks III

But no matter what happens: money stays in the bank! Because anytime someone deposits it, it's still in the bank! If someone defaults on a loan, the loan money is out there, and it's in a bank! By averages all banks should have plenty of money. People are deleveraging, whatever that means... but I think that means it's going to the bank :-P Where is the mechanism by which a bank doesn't end up with the money?

======================================= MODERATOR'S COMMENT: Please trim the post to which you respond. "Trim" means that except for a line or two of the previous post to add context, the previous post is deleted. Thank you.

Reply to
Spacey Spade

Here's my latest version:

formatting link

======================================= MODERATOR'S COMMENT: Please trim the post to which you respond. "Trim" means that except for a line or two of the previous post to add context, the previous post is deleted. Thank you.

Reply to
Spacey Spade

In your example the first depositor gave the bank $200,000, and expects to get all that money back. The second depositor (the person who sold the home) gave the bank $180,000, and also expects to get that money back. So the bank owes a total of $380,000. Those are its liabilities. (make it the same bank, to keep it simple).

The bank's assets in this simple example are its cash on hand and its loans-receivable. It has $180,000 in cash from the home-seller, plus the original $20,000 it didn't loan out - $200k total cash. And it has a $180,000 "mortgage receivable." So obviously if that is replaced with a house that is worth only $130,000 when converted to cash, the bank has a problem - it's in fact insolvent in this very simplified example. It owes $380,000 to depositors but has only $330,000 to pay them back.

This is ignoring that the bank has its own capital to leverage and tap into, but that muddies up the example. The point is, banks don't really create money out of thin air, they borrow it, and then loan it out at a higher interest rate. They still need to pay it back and that relies on the creditworthiness of the people they've lent money to, and the assets securing those loans.

-Tad

Reply to
Tad Borek

What makes you think these last folks deposit the money in banks?

-Will

william dot trice at ngc dot com

Reply to
Will Trice

Banks don't create money out of thin air. It is the customers who create the money (by behaving as if checking accounts were the same as cash), the banks are just the bean counters.

Where did they get it?

Half of all the M1 money supply (at least until recently) is in circulating bank notes, not demand deposit accounts. Obviously not all money gets redeposited. But let us assume that it is.

They have $200,000 in cash ($20,000 reserve plus $180,000 redeposited), and a nearly worthless house. They owe others $380,000 ($200,000 + $180,000 redeposited.)

To whom, and for how much?

Xho

Reply to
Xho Jingleheimerschmidt

Or they spend the money on a car made in Japan or a hot tub made in China, and the money ends up in a Japanese or Chinese bank or in cash (USD, JPY or RMB doesn't matter it is not available to the US banking system)

snip happy scenario.

They don't pay back, but bank sill has to pay depositors. Bank gets house in foreclosure with all the fixtures ripped out. House is now worth 100,000. Bank is toast. Homeowner is toast (loses house and down payment but recovers tiny fraction from stripping the house and selling fixtures for 5 cents on the dollar).

Reply to
TheMightyAtlas

Where else do people keep money? If they put it in the stock market, then that is not a bank, right? A brokerage or investing firm?

Reply to
Spacey Spade

I think the initial money would come from the Fed.

Ok, this makes more sense now. Thanks!

Reply to
Spacey Spade

No, the bank's start-up money comes from shareholders. Additional money comes from depositors. The fed doesn't hand out money to start a bank.

Elizabeth Richardson

Reply to
Elizabeth Richardson

Ok, but how does the Fed put money into circulation? Someone has to take out a loan right?

BTW, I've updated my post here:

formatting link
And another example where the Bank does create money out of nothing is here:
formatting link

======================================= MODERATOR'S COMMENT: Please trim the post to which you respond. "Trim" means that except for a line or two of the previous post to add context, the previous post is deleted. Thank you.

Reply to
Spacey Spade

I suspect you got the phrase "out of thin air" from a popular You Tube video that tries to explain the fractional reserve system. It doesn't do a great job, by the way.

The most direct way the Fed can add money is to buy treasuries. By buying treasuries, the money is put into circulation, and have the multiplier effect of the fractional reserve system. They can also tinker with short term rates, although at or near zero they have little room to move.

Reply to
JoeTaxpayer

Yeah, the zeitgeist people. I like their idea for panacea. Would be nice.

I read somewhere that only 70% of Euro bonds got sold in a recent selloff. Not enough people wanted them. But here in the states, if the Fed is buying bonds, then it adds to the central reserves (hope I'm saying it right). So the bailout will be funded by the Fed if no one will step up to buy the bonds?

Reply to
Spacey Spade

BeanSmart website is not affiliated with any of the manufacturers or service providers discussed here. All logos and trade names are the property of their respective owners.