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Minyan Mailbag: Who Is Affected When Borrowers Default?


In today's world if a bank takes in $1,000 in deposits they will lend out $10,000!

Mr. Practical,

I believe I remember from Finance 101 how banks create money (I deposit $1,000, they lend out $900, I've still got my $1,000 and the recipient of the loan has $900, $900 "created"). My question is if the borrower defaults, does it "destroy" money or just the bank's balance sheet? Or perhaps the damage to the balance sheet is where the "destruction" happens? I've gathered from your missives that when debt's destroyed, deflation may/will ensue. I'm just trying to understand the mechanics.

Thanks for your insights,
Minyan DKB

Minyan DKB,

Unfortunately, you probably went to school before the Fed (who has the authority) basically reduced margin requirements to zero.

In today's world if a bank takes in $1,000 in deposits they will lend out $10,000! Welcome to our brave new world of ponzi finance. On top of that no one really knows nor understands how much additional leverage is stored up in derivatives through interest rate swaps (when you swap out fixed for floating rates you get more leverage) or credit options.

When the borrower defaults there is basically no relative capital at banks to absorb the loss. The first hit goes to bank shareholders, who watch the stock go to zero. The second hit goes to those lending to the bank directly through CDs (unsecured). They are toast soon after. Then the depositors over FDIC insurance lose their money on deposit. Then all those secured lenders, like other banks and the Fed, begin to lose as they take their collateral back and try to sell it. This is when systemic risk really kicks in.

The point is it is all connected. There is no insulated bucket of risk (like when the pundits say "it is contained in sub-prime") where these things can stop on a dime.

This is why I recommended so long ago that the best thing Minyans could do was to get out of debt, so they would not be caught up in the loop when the ponzi-like financial structure we have created begins to unwind. Being in debt means someone else owns your assets when you cannot service that debt.

-Mr. Practical
No positions in stocks mentioned.
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