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July 20, 2007

Money is Also Destroyed
by M.A. Nystrom

If money can be created from thin air, the opposite is also true: it can be destroyed as well. Usually it is the Federal Reserve System that does the creating, but the destruction comes by other means. Bear Stearns' hedge fund investors have found this out the hard way. Two of its funds recently went belly up, taking 100% of investors' capital with them. One of the funds, the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage fund, reported $638 million of investor capital in the first quarter. Today nothing remains.

How can money so quickly and effectively be destroyed? To understand this, we have to understand how the money was created in the first place. According to news reports, the underlying securities in the hedge fund in question were subprime mortgages.

Mr. Jones Takes out a Sub Prime Loan
Let's say it's 2003, and Mr. Jones, who has less than stellar credit wants to buy a house. He goes to the bank to get a mortgage. The conventional wisdom is that the bank loans him money so he can buy the house. In reality, Mr. Jones is actually borrowing the money from himself, -- or rather against his own future earnings. The bank simply facilitates the real estate transaction between him and the house seller. It does this by writing a note that says 'we've loaned Mr. Jones X dollars and he's promised to pay us the money back over 30 years. We are holding his house as collateral until the money is paid back.' This note is called the mortgage, and it becomes the bank's asset. Under Federal Reserve rules, it can use this asset to create the money to pay the seller of the house.

In reality, the bank has no money, and the mortgage has value only because of Mr. Jones's promise to pay back the money. As long as Mr. Jones's promise is good, the mortgage will retain its value and the bank can sell it to another investor - for example a hedge fund.

The Hedge Fund Buys Mr. Jones's Mortgage
The hedge fund bought thousands of mortgages like Mr. Jones's, with the hope of collecting a steady stream of income as borrowers paid off their mortgages. That sounded like a good idea, and a solid bet. People traditionally are very good about paying their mortgages back. No one, after all, wants to lose their home. In fact, it sounded like great idea - so great in fact, that Bear Stearns took the $638 million of its investors money, borrowed $10 billion more, (yes, that is a b) and put it all into subprime mortgages.

Mr. Jones Defaults
As it turned out, Mr. Jones, and many more like him were unable to keep their promises to pay the money back. Maybe Mr. Jones lost his job in this terrible economy; maybe he got sick and couldn't work; maybe he didn't understand that his mortgage payment was going to jump to something he couldn't afford; maybe he thought he could sell the house for more money, and never expected to hold on to it this long; maybe he just wasn't a good credit risk to begin with.

Whatever the reason, Mr. Jones and millions like him had to break their promises about paying back the loans. In the end they'll just give their keys back to the bank and say, "Thanks, but no thanks. I can't afford it."

The banks in turn will say, "Don't give us the keys. We sold your mortgage a long time ago. We don't even know who owns your mortgage now, and frankly we don't care."

Until now, his debt was an asset of the fund, and was being used as collateral against loans ten times its value. But the moment that Mr. Jones gave up on the idea of home ownership, the value of his mortgage simply disappeared. The paper asset, which derived its value from Mr. Jones's promise, was destroyed. This had a cascading effect, since Mr. Jones's mortgage was being used as collateral to borrow money to buy even more subprime mortgages, many of which were also defaulting. Assets purchased on borrowed money were now worthless. Only the debts remained, and suddenly there was more debt than the original amount that investors had put into the fund. These original funds would be needed repay the debts incurred by the fund. Nothing is left to return to investors. This is the process by which money is destroyed.

What about the houses, you ask? Yes, they have some value, but not nearly as much as when they were first purchased. Again, it was not the houses that had the value, it was Mr. Jones promise to pay a steady stream of high interest income over 30 years that was valuable to investors.

American Dream, Up in Smoke
Not only is the money gone, but so are the dreams of those millions of homeowners. The decision to purchase a home is not made lightly, and is usually accompanied by great hope and optimism. Defaults are the opposite. As the collective mood of millions of people like Mr. Jones, (not to mention the investors in the hedge funds who also lost everything) shifts from exuberance and optimism to negativity and pessimism, it is reflected in the larger economy as financial losses. This is a major aspect of the Wave Principle, which predicts tough times ahead.

Inflation and Deflation
The Federal Reserve System has systematically inflated the money supply since 1987, causing tremendous inflation. Along the way, money has also been destroyed, most memorably during the dot.com collapse of 2000-2003. This process of destruction is part of the reason why the economy has not experienced true hyperinflation.

In fact, a key point here is that the Fed is not really creating money, but credit. In truth, money is a physical commodity. Credit is simply the ability to buy something. Today credit functions as money, so it is difficult to tell the difference, but this was not, and will not always be the case.

If the Fed had actually printed bills (rather than made electronic book entries) for each dollar it created, those dollars would still be circulating in the economy and inflation would be much higher. As it is, the Fed can create credit, and those closest to the source of that credit creation - banks and government contractors - reap the greatest benefits. As the credit works its way through the system, it 1) causes general inflation, and 2) finds its way into weaker, less experienced hands - the likes of Mr. Jones and his subprime mortgage, or the average investor chasing internet stocks. In these weak hands, it can easily be manipulated to destruction.

Through this process of destruction, runaway money supply growth can be controlled. But if the destruction process gets out of hand, it is possible that we could see the reverse of what we have seen over the past twenty years - a prolonged period of sustained deflation. This could happen if people's preference for assets over debt shifts along with the social mood. Recall that the value of paper assets is only as good as the promise standing behind them. Bear Stearns promise to investors rested on the promises of millions of people like Mr. Jones to continue paying their mortgages. Its not that they didn't want to pay; economic conditions and the way the mortgages were written made sure that they couldn't. If people like Mr. Jones become unwilling or unable to borrow, and if hedge fund investors who lost everything become to skittish about borrowing, the Fed will have a more difficult time increasing the money supply, since all credit creation today comes via debt creation.

The most recent issue of the Elliott Wave Financial Forecast, which remains a steadfast proponent of deflation, (available here, sign in required) made this observation earlier this month:

"When Merrill Lynch announced that it planned to sell the securities in [the Bear Stearns hedge fund] on the open market, Bloomberg reported that the "threat is sending shudders across Wall Street." Why? "A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark."

Later that day, Merrill decided against an open market sale. Retuters described the episode this way: "If word of the exact nature of the losses became public, it would have forced many other funds to revalue their holding and perhaps lose money, setting off a domino effect that could rattle markets globally."

How much value, based on how many broken promises, has already been lost but not yet revealed? As long as financial prices rise (as they have continued to recently) no one is interested in such questions. But in the end, an ever inflating money supply is simply unsustainable. Money must also be destroyed to maintain equilibrium.

In his most recent testimony before Congress, Chairman Bernanke reiterated that inflation is the Fed's foremost concern. For the time being, the Fed is holding interest rates steady. If it can hold the line, and allow the market to continue on its destructive path, inflation can be contained. The risk is that the destruction gets out of hand, and becomes full blown deflation.

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Michael Nystrom
Editor
www.depression2.tv
www.bullnotbull.com

M.A. Nystrom is a private investor and consultant currently living near Boston. He earned his MBA from the University of Washington with a specialty in International Marketing. Following his retirement from the US securities industry, he picked up the hobby of web design, a trade he now plies at his big-picture investment oriented website www.depression2.tv.