A chronicle of repurchase agreements (RP) and other paradoxical property ownership contracts - www.omo.co.nz

 

 

Money From Nowhere?

15 November 2004

'ASB Bank is firing both barrels at other big banks in the fixed mortgage price war, offering 6.95 per cent for two years, but the Bank of New Zealand is firing back with a new 6.9 per cent rate.' - Stuff, 15 November 2004.

Since I posted my article entitled Reserve Bank Governor or Just Another Impotent Empiricist? on 8 November, wherein I referenced the Bank of New Zealand's "unbeatable" two-year fixed term mortgages campaign, ASB Bank has obviously decided to join the fray.

Coincidentally, ASB Bank may have planned to bolster its Tier 1 capital base prior to joining this so called 'home loan war' - see below:

ASB Bank plans up to NZ$350 million tier one
(10 November 2004)

ASB Bank is believed to be planning the sale of up to NZ$350 million of perpetual preference shares. The tier I deal, to be self-led, is expected to be launched on 24 November and will target New Zealand retail and institutional investors. Although structure details remain to be disclosed, some expect the new deal to be similarly rated to the bank’s NZ$200 million tier I notes rated A- by S&P and sold in November 2002. The perpetual preference shares, then paid a margin of 130 basispoints over the one-year interest rate with a first reset date of15 November 2003. (Insto, 14/11/04)

Readers may find it instructive to review the mortgage issuance possibilities extra regulatory capital confers upon ASB Bank and their competitors alike.

The Reserve Bank of New Zealand oversees the capital adequacy ratio rules that apply to New Zealand banks. In short the only mortgage lending limitation is the retention of capital adequate to cover the risk adjusted amount of outstanding assets in this class. Since household mortgages attract a risk adjustment of 50% only 4% retained total capital has to be in place to back each mortgage.

But more compelling themes are outlined in the following edited extract ( section 3.3 (pages 87 to 101 inclusive) taken from Harald Haas's dissertation - 'Money upside down - a paradigm shift in economics and monetary theory?':

'A very special feature of the banking system is that out of nothing, by granting a loan, additional money, additional property rights are created. The debtor can immediately use this additional newly created money for buying existing physical goods. This remarkable feature of the banking sytem can be proven by simple microeconomic analysis of money focussing on a bank’s simplified balance sheet. Assume the following balance sheet for start off and a cashless e-economy with electronic accounts or a total cheque system:

($ )                   Assets                       Liabilities
Loans                  20
Deposits                                                  20
Buildings                1
Equity                                                         1
Total                     21                                21

If a loan of $ 3 is granted to a new customer, a debtor, who runs a deposit account with the bank, the following bookings are posted: $ 3 are credited to the customer’s deposit account and $ 3 are debited to the general loan account of the bank.

( $ )                   Assets                       Liabilities
Loans                   23
Deposits                                                   23
Buildings                 1
Equity                                                         1
Total                      24                               24

The customer can now spent his new $ 3, e.g. the customer buys goods for $ 3 and transfers the $ 3 by electronic money order or internet banking to the seller’s deposit account, which is in the same general deposits ledger of the same bank. The circulation of created money in trade and commerce of the economy does not affect the bank’s balance sheet. There are regulations and laws restricting unlimited creation of money. Most observed rules are at present the minimum balance sheet ratios required by the Bank for International Settlement in Basle.

Assume the bank purchases something, e.g. buys a government bond for $ 3:

( $ )                    Assets                      Liabilities
Loans                    23
Deposits                                                   23
Buildings                  1
Equity                                                         1
Total                       24                              24

The bank purchases the $ 3 government bond, with the government depositing the $ 3 in its bank deposit account.

( $ )                    Assets                      Liabilities
Loans                    23
Deposits                                                   26
Government bonds 3
Buildings                  1
Equity                                                         1
Total                       27                              27

This type of balance sheet lengthening transaction could be repeated in unlimited amounts, besides BIS restrictions. Bank deposits - which are in this simplified model all the money circulating in the economy - are only destroyed whenever
– a loan payment is made,
– an interest payment is made, or
– a bank sells an asset.

Assume the bank sells a government bond of $ 1. It is - reverse to the purchase of the government bonds beforehand - a “balance shortening” transaction:

( $ )                    Assets                      Liabilities
Loans                    23
Deposits                                                   25
Government bonds 2
Buildings                  1
Equity                                                         1
Total                       26                              26

Assume a $ 2 principle loan (re-) payment is made. The depositors account is debited by $ 2 and the bank’s general ledger loan account credit by $ 2. It is a simple “balance shortening” transaction:

( $ )                     Assets                     Liabilities
Loans                     21
Deposits                                                    23
Government bonds 2
Buildings                  1
Equity                                                          1
Total                       24                               24

Assume an interest payment of $ 2 is made. The depositors account is debited by $ 2 and the bank’s equity account is credited by $ 2:

( $ )                      Assets                     Liabilities
Loans                      21
Deposits                                                    21
Government bonds  2
Buildings                   1
Equity                                                          3
Total                        24                              24


As the payment of interest inevitably destroys money, it is proven that a banking system is an unstable financial system. Its system inherent instability is comparable with a Ponzi or pyramid scheme or a chain letter system. It is self-accelerating and by the passing of time destined to collapse.

It is important to note, that the bank’s equity position does not affect the bank’s ability to make loans or purchase assets. The increase in equity through profits or additional stock offerings does not affect the bank’s ability to create loans or purchase assets. It may be useful that a bank maintains certain
balance sheet ratios for fulfilling external financial regulations and laws, technically however, it is irrelevant to the creation of loans or to the purchase of assets. Since each time a bank purchases an asset or creates a loan, an equal and offsetting deposit is created, these transactions can continue to
occur regardless of the equity level of the bank.

In this context, the importance of a bank’ equity position asks for clarification. In accounting terms, the equity, which is provided to a company by the shareholders, is posted as equity under the liabilities side and has an equivalent, offsetting position on the assets side of the balance sheet. It is obvious that a positive equity position does not have the character of liabilities, although it is posted under the liabilities side. A positive equity position has the character of an asset position buffering against insolvency, which is especially true for banks and central banks. Thus, central banks liabilities side is often entitled with “liabilities and capital side”.


In any banking system charging interest payable in money - money is created by interests and destroyed with the payment of interest.

The complex and abstract character of creating new credit in a banking system is disguised by the fact that banks also borrow money themselves, i.e. banks also engage in trading debt. In a balance sheet on the first look, it is impossible to distinguish between these two types of credit granting, because ex post these two different types of credit cannot be clearly separated. The effects for the economy are however very different.

This accounting analysis reveals that the common perception – the perception that the borrower is borrowing money, which the owners of the bank have invested in the bank beforehand, or that the borrower is borrowing money from a pool of funds that depositors have entrusted to the bank beforehand – is wrong. When a bank gives a loan, the bank completes two bookkeeping entries. The bank credits the borrowers account with the amount of the loan and debits a general ledger loan account by an equal amount. What has happened is that the bank has created money out of nothing, and this is money.

The amount of money available in the economy equals the amount of money created exclusively through bank loans Thus, the amount of money available in the economy is always less than the amount of money required to repay the loans (principal plus interest). In simple terms, by agreeing to pay interest in money, the debtor agrees to the impossible. The missing “interests” in the economy always require continuous additional new creation of credit to keep the system running. If the creation of new credit should be stopped all over, money would completely disappear within a few years depending on the nominal level of interest rates. Should the money in the economy be kept stable, the sum of all outstanding loans must grow by the amount of interest paid, leading to a continual increase in loans for the same money supply.

However, these loans are neither self-sustaining nor repayable, and the system must eventually collapse. Collapse means that loans must turn sour in the end and debtors must default. This is an inherent part of a banking system, which is based on the logic of inservability of interest obligations over and in time.'

 


 

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OMO Matters

US Federal Reserve Reference Publications

"The market for repurchase agreements on US government securities is of vital importance to the New York Fed, and the whole Federal Reserve System, because it is where virtually all of our monetary policy operations are conducted."- Peter Fisher, Manager, System Open Market Account - 15 January 1997.

"Open market operations are not another weapon in the Fed's arsenal, but the only weapon in its arsenal." - Monetary Trends, St Louis Federal Reserve, August 2003.

Repurchase Agreements with Negative Interest Rates - FRBNY - A primer detailing how short sales of Treasury securities can lead to protracted RP fails and consequently negative rates to address capital requirement issues.

Reserve Bank of Australia repo eligible, basis swapped, foreign issued AUD debt - read here.

"Good News" Macroeconomics

OMO-Repo Misuse - Letters to Hon. Dr. Michael Cullen, N.Z. Minister of Finance.

Repo Transaction Accounting. Letter to Mr A Orr, RBNZ.

IMF Repo Accounting Examples, Full Article

Credit Creation, Letter to Iris Claus and Arthur Grimes.

NZ Debt Management Office Uridashi issue and associated EuroKiwi letters to Hon. Dr. Michael Cullen, N.Z. Minister of Finance.