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The article below was written by David Malone of the Golem XIV: Author of the Debt Generation, website, and was submitted to this blog by ELLEN BROWN
Ellen is an attorney and the author of eleven books, including Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free. Her websites are webofdebt.com and ellenbrown.com. She is also chairman of the Public Banking Institute.
Securitization – The Undead Heart of The Shadow Banking Machine
At the centre of all debates about the Banking crisis, the shadow Banking system and the bank bail-outs is Debt. For a long time I have been arguing that what this debt is, is in fact a new, bank created, bank issued and ultimately bank debased debt-backed currency. And the collapse in value of this unregulated currency IS the crisis. Its cause and its logic.
In order to explain why I think this and why I do not think ‘fixing’ the banking system back to any semblance of how it was, just prior to the crash, will be anything other than a disaster, I have to explain how debt is turned into money. And how, clever as this process is, it also contains within it the seeds of its own undoing.
To do so I have to take you into the undead heart of the machine – securitization. Securitization is what animates the global financial and shadow banking system in whose shadow we now live. It is how modern finance turns debt into money. It is the impious alchemical dream of turning lead to gold, water into wine.
When Securitization was invented it soon wrested control of the money supply away from nations and gave it to the banks. Nations still printed and controlled their currency. But securitization gave banks the ability to print their own currency. And this new securitized currency, based on debt, was theirs to print, control, spend, and ultimately to debase. In short, it gave banks a power to rival nations. It is worth, therefore, understanding its outlines at least. Please don’t panic. Like most financial stuff its not nearly as difficult as the priesthood would have you believe.
So here we go into the hocus-pocus world of debt finance.
The Banker’s problem.
We start with a debt. It could be a loan extended to a corporation or a mortgage. We’ll go with a mortgage. A mortgage is a debt and a promise to pay that debt. This was the bedrock of traditional banking. The bank lent out cash in return for a greater amount to be paid back, but in installments over 25-30 years. Of course over the years there were risks of inflation and default if the debtor lost their job or died. These are ‘credit risks’ that were the stuff of traditional banking.
Traditional ‘credit risk’ banking was a slow business – and that was the problem.
All debts were ‘held to maturity’ (to the end of the mortgage) by the bank. All the debts/mortgages were therefore dead end deals. In that they generally did not, could not, lead to anything else. Money went out. A debt was held in its place and the money slowly came back. The bank’s profit came from what was and is called, ‘the spread’ between the rate of interest the bank charges on the money it has lent out and the interest the bank pays on the money it borrows. The main places the banks ‘borrowed’ was from central banks, from investors – either share holders or bond holders and most importantly from their own depositors. You can see that the scope for banks to grow in size wealth and power, was constrained by the rate of flow of real money in to the bank and the turn over of loans.
For banking to really grow the amount of money to borrow and the turn-over of loans had to be increased. Securitization did both these things. It cut the umbilical to an older gentler age.
The last hold-out of the barter system.
In a funny way banking was the very last hold out of the barter system. The bank gave you money – very modern – but in return you gave the bank a lien/a claim on your property. You bartered your house and a promise to give a steady stream from your income as collateral for cash. You got cash from the deal which you could spend – and used it to buy the property. But the bank did not get cash. In fact it got something it could not spend. It got an agreement to pay. And you if the debt defaulted then the bank got a house. Now that is barter.
The genius of securitization finally did away with the barter element of banking. It did so by turning mortgages (debt agreement) into money. Nothing short of modern alchemy.
This is how it works.
The key difference between debt and money is that you can spend money. So what do you have to do to debt to be able to spend it?
Three things: Standardize it and Guarantee it and when you have done these two, the third, Liquefy it, will follow of its own accord.
So first -
Think of a pocket full of coins. What makes them work is that they are all the same. Same metal, same designs, same issuer, same bank behind them, same value. Everyone knows what they are getting when they accept a standard coin. So everyone is happy to accept them knowing that the next person will also be happy.
Now think of a mortgage. Now imagine you have a pocket full of these. Which banks do. Each one is unique. Unique amount, unique collateral (the house) and unique credit risks of the particular person paying back the loan. The skill of the banker was to assess all these variables. The short-coming was that the end product was a pocket full of different and unique debt agreements. Like having a pocket full of different coins in different currencies. Very difficult to get people to accept random coins as payment.
Step one in securitization is to deal with that problem. Basically by melting the mortgages down to their base metal and recasting them.
And recasting them does one other critical job. The problem with mortgages its that sometimes the borrower defaults and the bank loses some of the money it lent out. To put it in terms of our coin analogy, in every pocket-full there will be one which turns out to be a tin plug. But which one?
Securitization solves this problem.
The failure rate of mortgages, any loan in fact, is a matter of probability. Melting down and recasting the mortgages spreads the loss evenly. If you expect one mortgage in every hundred to default that would mean anyone buying a mortgage from you would have a one in a hundred chance of getting the one that will deafult and end up with a worthless piece of paper. But in securitization all hunderd mortgages are sliced in to an hundred peices and each securitiy gets one piece each from each mortgage. Now when that one in a hundred defaults the loss is evenly spread.
Suddenly there is no unknown. There is a mathematically expressible probability that the whole pool will lose one hundredth of its value. That is easy to calculate into the value/worth/price of the bundle. And one hundredth of that loss will turn up in each of the recast slices. Mortgages go in. Securities come out. Each made from the melted and recast value of all the mortgages in the pot. Each is stamped into the same form with the same worth. You have convert unique debt agreements into a standard coinage of known value. Suddenly you have a pocket full of money.
Standardizing is the first step towards inventing a new form of money. You have ceased bartering your cash in return for a dead end debt, and instead converted the debt back into money. And rather fabulously this money YOU control. The central bank doesn’t control how much gets printed. You do. All you have to do is print up debt agreements and securitize them. And you can potentially print as much as you like whenever you like. It really is a license to print money.
That is a security in its simplest possible form. But if you would like to be able to spend this money you have to now guarantee it. Step two.
All money that isn’t actually made of gold or silver is actually a promissory note or debt. It is debt issued by the central bank and backed by the CB’s and the Nation’s promise to honour that note. Weird isn’t it. Here we are talking about how to turn debt to money. When all along it’s actually how to turn one kind of debt into another one. The difference between the two debts is how spend-able it is. How spend-able it is, is sometimes called its fungability or liquidity. I only mention this so you know what is really meant when bankers use these terms.
Anyway back to the chase. Money is money because it is guaranteed by the central bank and the state, to be always, 100% of the time, worth what the coin or note says it is worth and therefore will always be accepted as payment. The question here, is how exactly does this promise work? What is it the CB is promising to do.
We often hear CB’s referred to as the lender of last resort. In many ways it is better to think of them as a buyer of last resort. In the final analysis the CB promise and guarantee ultimately means the CB will itself accept those coins from you. So YOU will never be left holding a worthless piece of paper or scrap of metal. You need never fear being left with worthless coins because the CB which issues the stuff guarantees to accept them, buy them back from you. As long as everyone knows this then no one is afraid to accept and hold the stuff. And this is the Liquidity of realm money.
What the CB will give you in return for the money you eventually tender back to them, is another knotty problem. At the least we, the CB would say, will accept our notes and coins as payment for any debts you have. (Now I know this doesn’t make the problem go away. But don’t blame me for the short-comings of money. They were problems before I came along!)
So for the purposes of our discussion here, when you tender a coin for payment, no one is going to say to you, “Oh, no thanks. I don’t trust those things. Haven’t you got something else?”
Except, of course, when the credibility of that CB guarantee itself is called into question – sovereign default. When that happens the spend-able value of those notes and coins evaporates like a kiss on the wind. Which is exactly the risk the Bank bail-outs are forcing on us all. Just ask the Greeks, Latvians and Icelanders.
This problem of a guarantee is a serious problem for securitization and for the shadow banking system. Because the shadow banking system and the system of securitization does not have access to the Central Banks and their ultimate promise ‘to accept as payment’. For the simple reason that the CB did not issue the securitized debt/money. So why should they promise? They do, of course, accept some of the securities as collateral for getting a loan of ‘real’ money. But the promise-to-buy is not without conditions and can be withdrawn. Securitized debt-money does not benefit from the guarantee that the CB will be the purchaser of last resort for their currency. Thus securities are NOT guaranteed the way the CB’s own money is.
So the question is, what promise or guarantee could the bankers come up with to take the place of the CB promise? Who or what could be the buyer of last resort to stand behind their securitized money?
The answer is ingenious and/or foolish depending on your temperament and the situation. In ‘good’ times the answer works. The problem is in bad times it doesn’t. AT ALL.
But in good times, the answer is that the ‘market’ promises to be the buyer of last resort. Now of course the market is also the issuer as well. Which makes it rather circular. But as long as everyone in the market – the banks, money market funds, pension funds, rating agencies will accept the securitized debt as money then there is your promise. There is no promise by one single all powerful God who will redeem all promises. In place there is a promise that in a vast market there will always be enough buyers to buy and redeem whatever the market needs to move. Redemption without God. Good trick.
You standardize the debts, you guarantee someone will always accept them as payment and you automatically get the last ingredient for free – liquidity. And with liquidity the whole thing runs like a mighty river.
The point is that unlike the original debt we now have a tradable asset that is a kind of currency. The more readily it can be sold the more ‘liquid’ it is as an asset and the more it is like money/cash. Which is a good trick. Because debt is a dead end. Whereas cash is the open road.
So in place of a single God-like promise, there is a market of groomed and powdered god-lets who collectively have pretensions to being a god – and this ‘market god’ ‘guarantees’ that there will always be some god-let who wants to buy securitized debt. Now you can see where all the talk of ‘frozen credit markets’ comes from. What they are really saying is that the ‘market’s’, the god-let’s, promise, turned out to be good only as long as it wasn’t really needed, when times were good, but was worthless as soon as it was needed. That detail was presumably somewhere in the very small print.
And indeed down in the small print you find out that the undeclared complication running through all is RISK. It was there when I said ‘one in a hundred mortgages will default’. Seemed so reasonable when I said it, didn’t it? That was where the devil crept in. Who says it is always one in a hundred?
This is where we get to all the AAA rating stuff. This is where the dark side of securitization lurks.
PART TWO TO FOLLOW.
Filed under: bubble, CDO, CORRUPTION, currency, Eviction, foreclosure, GTC | Honor, Investor, Mortgage, securities fraud Tagged: | bailout, barter system, borrower, central bank, credit risks, debt into money, Federal reserve, global finance, lien, money, Mortgage, predatory lending, promissory note, securitization, The Shadow Banking Machine