interest rates

[dmp]

And the overnight lending rate that the Fed sets is the interest paid on the reserve deposits of banks.

 

[john12ax7]

Are you really telling me no one could come up with another scheme mathematically that would make the interest and principal payments equal?

It already exists.  Fixed principal loan payments is one example.  Loans can be structured in a number of ways and do not need to amortized. It's just that many people want amortization so they can buy bigger houses.

Make a spreadsheet of fixed principal,  amortized, and any other loan structure you might want, then compare.

 

[Matador]

For some historical context, most mortgages in the 80's and 90's were granted under a 'Rule of 78'.  This weighted interest payments toward the front-end of the loan, which penalized pre-paying the loan and allowed the bank to collect more interest in the beginning (the total interest over the life of the loan would be the same however).

Fortunately these types of loans were technically made illegal, but lenders can still work in pre-payment penalties in the form of fees if you don't read the T's and C's carefully.

 

[Phrazemaster]

Yeah, and that gets into fractional reserve banking and why the Fed sets an overnight interest rate in the first place.
I swear there is more misunderstanding of what this is than just about anything on the internet!
People love to demonize the Fed.

The way it works is the Government says banks can only lend 10% of what they have on deposit.
Say one person (frank) deposits $1000. The bank has to keep $100 on reserve (10% on deposit with the Fed) . They lend out the other $900 to another person (wendy). 
Now say wendy buys a boat from mark for $900 and mark deposits the money at the bank. The bank puts $90 on reserve and again lends out the remaining $810.  So now the bank has $1900 in deposits, $1710 in loans, and $190 in reserve.
This continues through a bunch of people... 
You'll find that the original $1000 grows to $10000 in deposits, $1000 in reserves, and $9000 in debts. Money is conserved, but the bank only has $1000 in reality (on deposit at the Fed) while the rest of the money is out in loans.  I repeat, no money is created out of thin air!
So the reserve rate sets the multiplier of the money supply (in this case 1/0.1 = 10). In good times this works fine and is very stimulative for the economy.  But in bad times (i.e. recession), a high money multiplier leads to instability.  If Frank, Mark, etc all go to the bank at the same time to get there deposits, the bank does not have the money for them.  This is a 'run on the bank' scenario.
Another detail is the US Government insures deposits when the banks obey the reserve requirement, i.e. the gov acts as the lender of last resort, when depositors all come for their money.

The upshot of your thoughtful explanation is that the banks lend out 10x more money than they have - isn’t it?

How can they “lend” money they don’t have? They couldn’t if it was physical money. This only works on paper or digitally. Hence the phrase, “banks create money.” Because they do. Or credit rather. But which must be repaid with money. Same difference.

It’s a fraudulent house of cards. If everyone asks for their money, the bank doesn’t have it - because they never did. It’s not that they merely lent it out - they “lent out” money they don’t have.

Or am I missing something here?

 

[dmp]

The upshot of your thoughtful explanation is that the banks lend out 10x more money than they have - isn’t it?

How can they “lend” money they don’t have? They couldn’t if it was physical money. This only works on paper or digitally. Hence the phrase, “banks create money.” Because they do. Or credit rather. But which must be repaid with money. Same difference.

It’s a fraudulent house of cards. If everyone asks for their money, the bank doesn’t have it - because they never did. It’s not that they merely lent it out - they “lent out” money they don’t have.

Or am I missing something here?

It is the concept of 'debt' - which is a human invention (I think)
Money is conserved but there are I.O.U.s throughout the system that make it seem like there is 10x money than there actually is.
People lending money to one another, through banks or peer-to-peer, does create a house of cards.
The modern method to make it work is fractional reserve banking and the government as lender of last resort. And fiat money, which opens another can of worms.
hundreds of years ago, Usury was illegal for Christians which effectively made lending money & debt illegal.

https://en.wikipedia.org/wiki/Usury

 

[JohnRoberts]

we have well discussed this before too in the brewery but perhaps the more appropriate wiki link

https://en.wikipedia.org/wiki/Fractional-reserve_banking  that explains how banks can lend more money than they have.

on the subject of interest (thread topic) and religion.... Shariah law prohibits "riba" (usury).
https://en.wikipedia.org/wiki/Islamic_banking_and_finance

The wall street types have worked to make shariah compliant investment vehicles.

JR

 

[Phrazemaster]

we have well discussed this before too in the brewery but perhaps the more appropriate wiki link

https://en.wikipedia.org/wiki/Fractional-reserve_banking  that explains how banks can lend more money than they have.

on the subject of interest (thread topic) and religion.... Shariah law prohibits "riba" (usury).
https://en.wikipedia.org/wiki/Islamic_banking_and_finance

The wall street types have worked to make shariah compliant investment vehicles.

JR

Thank you for the link JR.

The first sentence tells it all:

Fractional-reserve banking is the practice whereby a bank accepts deposits, makes loans or investments, but is required to hold reserves equal to only a fraction of its deposit liabilities.

They lend out more money than they actually have.

That’s Fraudulent Reserve Lending.

 

[dmp]

The first sentence tells it all:
They lend out more money than they actually have.

That’s Fraudulent Reserve Lending.

I understand that as saying the bank can lend out less than they actually have. If they have $1000 on deposit, they are allowed to only lend 90%, or $900. They are required to keep $100 on reserve.
If they weren't allowed to lend more than they held on reserve, they wouldn't be able to lend any money at all.
i.e. if a bank had $1000 on deposit and had to always keep that $1000 in cash on hand, it couldn't be lent out.  Prohibiting all lending and debt.
The money 'creation' (money multiplier) works as I described above. It is just a circulation of debt to make it seem like there is more money than the basis.

The only reason you can earn any return on savings, whether it is a savings account, CD, or bond, is because the money is being used (borrowed) by someone else.

 

[Phrazemaster]

I understand that as saying the bank can lend out less than they actually have. If they have $1000 on deposit, they are allowed to only lend 90%, or $900. They are required to keep $100 on reserve.
If they weren't allowed to lend more than they held on reserve, they wouldn't be able to lend any money at all.
i.e. if a bank had $1000 on deposit and had to always keep that $1000 in cash on hand, it couldn't be lent out.  Prohibiting all lending and debt.
The money 'creation' (money multiplier) works as I described above. It is just a circulation of debt to make it seem like there is more money than the basis.

The only reason you can earn any return on savings, whether it is a savings account, CD, or bond, is because the money is being used (borrowed) by someone else.

It’s very simple. If I have $1 and I “lend” you $10 - digitally or on paper - and you then pay me back $10, I have gained $9 plus interest.

The fraud is, I didn’t have $10 to lend you.

Wouldn’t you like to be able to pay your mortgage that way? You only have $250, but you get to “pay” the bank $2500?

What a scam.

 

[dmp]

It’s very simple. If I have $1 and I “lend” you $10 - digitally or on paper - and you then pay me back $10, I have gained $9 plus interest.
The fraud is, I didn’t have $10 to lend you.

Wouldn’t you like to be able to pay your mortgage that way? You only have $250, but you get to “pay” the bank $2500?
What a scam.

I don't think that is how it works, based on the reading I've done. Nobody can 'create' money (except the Fed). A bank cannot lend out money it does not have. There's a whole lot of misinformation on this around though.
If a bank has $1 they can lend $0.90 and they are required to keep the other $0.10 on reserve
The example I did above goes through how it works and shows the money multiplier effect. A bunch of people have debt and a bunch of people have savings, but when you add it up, there is the same net amount of money. 

 

[JohnRoberts]

Thank you for the link JR.

The first sentence tells it all:
They lend out more money than they actually have.

That’s Fraudulent Reserve Lending.

We have debated this extensively right here over the years... (maybe I've been posting here too long).  :

Fractional reserve banking creates new money/capital based on the statistical likelihood of deposits remaining untouched, so they can be put to work elsewhere to expand the economy. 

The bank lends money to Joe homebuilder to buy land and build a new house, creating jobs and wealth, as the new house is worth more than the undeveloped land, and more jobs allow wage  wealth to spread through the economy.

Of course there is no free lunch, and this is a bit of a confidence game, as depositors need to trust the bank that they always can get all of their money back if/when they want their money back.  If all depositors want their money back at the same time, this run on the bank could end badly... that is why the government provides depositor insurance to keep the confidence game working with the backing of federal government guarantees.

You can argue that it adds risk, but it also adds growth to the economy that has proven worth the risk (GDP growth is good).

This is not a new concept, and pretty well managed, but regulators need to insure that bank balance sheet assets are worth what they say they are...  If those fractional reserve assets are dicey, the house of cards can collapse.



JR 

 

[Phrazemaster]

We have debated this extensively right here over the years... (maybe I've been posting here too long).  :

Fractional reserve banking creates new money/capital based on the statistical likelihood of deposits remaining untouched, so they can be put to work elsewhere to expand the economy. 

The bank lends money to Joe homebuilder to buy land and build a new house, creating jobs and wealth, as the new house is worth more than the undeveloped land, and more jobs allow wage  wealth to spread through the economy.

Of course there is no free lunch, and this is a bit of a confidence game, as depositors need to trust the bank that they always can get all of their money back if/when they want their money back.  If all depositors want their money back at the same time, this run on the bank could end badly... that is why the government provides depositor insurance to keep the confidence game working with the backing of federal government guarantees.

You can argue that it adds risk, but it also adds growth to the economy that has proven worth the risk (GDP growth is good).

This is not a new concept, and pretty well managed, but regulators need to insure that bank balance sheet assets are worth what they say they are...  If those fractional reserve assets are dicey, the house of cards can collapse.



JR

So...looking past your eloquence - and you are incredible JR - basically it is what I said. But you add this is a good thing as it created economic growth...

I still can’t wrap my head around this being right...it is a house of cards that not only is waiting to fall, but fall again and again as it has so many times in the past...

When will they ever learn?

Where has all the money gone? Long time passing,
Where has all the money gone, long time ago...

 

[john12ax7]

Phrazemaster,  some of your details are off,  but your underlying thinking is correct.  It is basically a house cards that will inevitably fail, mathematically that is the only possible outcome.  Essentially banks do create money out of thin air which they then loan out with interest. Money is created through debt, and since that debt carries interest it can never fully be repaid.

The outcome of all this is that it syphons money from people at the bottom to those at the top. This is the actual reason for the wealth disparity. It's really one of the greatest con jobs ever,  get the people to choose teams (R or D)  so they will blame each other and not address the real problem.

 

[JohnRoberts]

Fractional reserve banking is centuries old.... While federal depositors insurance isn't (more like only one century old).

The next ice age may arrive before fractional reserve banking collapses and goes out of favor. Of course some specific country banking systems are weaker than others, and stuff happens when bank regulators play fast and loose with reserve ratios and asset quality, to juice growth.

I repeat IMO economic growth is a good thing, but like everything we must manage (regulate) banks to avoid abuse and excesses. (IMO banks are more like a utility than a private business.)

JR

 

[Banzai]

I don't think that is how it works, based on the reading I've done. Nobody can 'create' money (except the Fed). A bank cannot lend out money it does not have. There's a whole lot of misinformation on this around though.
If a bank has $1 they can lend $0.90 and they are required to keep the other $0.10 on reserve
The example I did above goes through how it works and shows the money multiplier effect. A bunch of people have debt and a bunch of people have savings, but when you add it up, there is the same net amount of money.

Banks can and do lend out money they don't have:

In reality they give out loans first, then look for a way to meet their capital/regulatory requirements. Creating money out of thin air is an accurate description for what they do.

 

[desol]

Creating money out of thin air is an accurate description for what they do.

I would like to able to do that. I would be very rich!

 

[Phrazemaster]

I would like to able to do that. I would be very rich!

And full circle, that was also my point...

 

[JohnRoberts]

I would like to able to do that. I would be very rich!

Yes we are all rich (at least the western world)... thanks to things like this.

JR

 

[dmp]

Banks can and do lend out money they don't have:
In reality they give out loans first, then look for a way to meet their capital/regulatory requirements. Creating money out of thin air is an accurate description for what they do.

Phrazemaster,  some of your details are off,  but your underlying thinking is correct.  It is basically a house cards that will inevitably fail, mathematically that is the only possible outcome.  Essentially banks do create money out of thin air which they then loan out with interest. Money is created through debt, and since that debt carries interest it can never fully be repaid.

So I've done some more reading on this to try to understand it. In the USA, individual banks can and do create money along the lines you guys are saying according to the reserve banking rules.
The key detail is money is conserved at the Federal level. The problem I had with the idea was how could this system work if money wasn't conserved? But all banks need to belong to a Federal Reserve bank (12 regional Fed banks exist)  and money is conserved at that level (except when the Federal Reserve changes it's balance sheet).
All payments between banks need to be settled through the Federal Reserve Bank.
So a bank you do business with can create money by giving you a loan. You ask for $1000 and they just credit $1000 to your account. They don't actually need the money on hand. But if you transfer it to someone else at a different bank, the bank needs to have the money to settle that, since it is sent to a different bank through the Federal Reserve system.

And actually individuals can create money also - say I build a microphone and 'sell' it to someone  for $1000 but instead of paying me money, they owe me the money. Now $1000 has been created through that debt.

 

[JohnRoberts]

So I've done some more reading on this to try to understand it. In the USA, individual banks can and do create money along the lines you guys are saying according to the reserve banking rules.
The key detail is money is conserved at the Federal level. The problem I had with the idea was how could this system work if money wasn't conserved? But all banks need to belong to a Federal Reserve bank (12 regional Fed banks exist)  and money is conserved at that level (except when the Federal Reserve changes it's balance sheet).
All payments between banks need to be settled through the Federal Reserve Bank.
So a bank you do business with can create money by giving you a loan. You ask for $1000 and they just credit $1000 to your account. They don't actually need the money on hand. But if you transfer it to someone else at a different bank, the bank needs to have the money to settle that, since it is sent to a different bank through the Federal Reserve system.

And actually individuals can create money also - say I build a microphone and 'sell' it to someone  for $1000 but instead of paying me money, they owe me the money. Now $1000 has been created through that debt.

We have discussed this at length before... "fractional reserve banking" creates money supply and supports faster economic growth, a good thing, but comes with risk, should depositors all want their money back at the same time.  That would create a classic run on the bank, made popular in old movies (like "A wonderful life" with Jimmy Stewart), or more recently in real life (Cypress 2013).

Since fractional reserve banking depends on depositor confidence that they will always get their money back, FDIC (federal deposit insurance corporation) puts the full weight of the US federal government behind guaranteeing these deposits, to prevent bank runs caused by skittish low information depositors. Cypress lacked that 100% guarantee facility and shut down the banks before giving depositors a hair cut. But there were irregular circumstances surrounding many of those Cypress deposits.

Since the federal government is on the hook for insured bank deposits, they are more diligent about vetting bank balance sheets, to avoid overstated worthless assets (like non-performing loans).

JR

[edit- Speaking of interest rates, I was just looking at picking up another CD and couldn't find 3% interest... I thought interest rates were supposed to be going up... not fast enough IMO  : /edit]