Thanks for the explanation, rdf. I've always wondered just where the added value came in for MBS. {I'm a financial neophyte.) I understand deposit+interest-servicing=profit for the bank.

But how does this become more valuable than the sum of its parts?

Actually, you share an almost universal misconception as to how banking/ credit intermediation works.

European Tribune - Comments - Real Estate Meltdown!

The money they lent you was obtained from depositors.

It was not.

Banks create credit (by creating electronic obligations) based upon an amount of "regulatory Capital" set by the Bank of International Settlements in Basel.

This credit is >97% of the money in existence (the rest being notes and coin), and the greater part of it is "secured" or "asset-backed" eg by mortgages.

The money created by Banks comprises firstly loans ie money lent at interest; secondly, money created to pay their overheads/costs (eg staff); and any excess is paid out as dividends. Any defaults immediately eat up the Bank's capital base.

Where the misapprehension comes from is that when a loan is created an equal and opposite deposit is created, which very often is instantaneously transferred elsewhere in the system, and this means that Banks do in fact need to "fund" themselves by attracting deposits either "wholesale" or "retail".

There is then a balance of central bank "reserves" aka "high powered money" which affects how much Banks can lend in practice.

One of the problems has been that there has been - courtesy of the "Anglo Disease" - a secular decline in "retail" deposits and a commensurate increase in "wholesale" deposits.

That was fine - and indeed Northern Rock built a very successful business on it - for as long as "wholesale" interbank lending was active.

But it's dried up, and therefore only the Central Bank can make up the shortfall as "lenders of last resort".

The point is that money is created as loans and then redeposited back into the system: not vice versa, as most people think.

European Tribune - Comments - Real Estate Meltdown!

The bank made money by paying interest to the depositors which was less than they charged to borrowers.

Indeed, that is a Credit Institution's business model, and it is also a Credit Union's model. The difference is that a Bank/ Credit Institution is able to multiply or "leverage" its income, whereas a Credit Union cannot.

As I point out in my Peak Credit Diaries, the real value provided by a Credit Institution is that of its implicit Guarantee of the borrower's credit, and Banks became accustomed to "outsourcing" this guarantee to investors through securitisation, credit derivatives and credit insurance.

The result was that a bigger "Capital base" (Banks' Capital plus Investors' Capital) was then able to support a bigger pyramid of credit than Banks alone were able to.

Unfortunately, that capital base has evaporated in two ways: firstly, the Investors have retreated, and secondly the banks' own Capital has been ravaged.

The system is therefore irretrievably fucked, and is in slow motion collapse.

Fannie Mae and Freddie Mae are Credit Institutions writ large, and THEY outsourced their Guarantee to the US government.

European Tribune - Comments - Real Estate Meltdown!

As long as speculators seek 15% return in a world where real returns are 4% the system has to be unstable. Either someone is getting fleeced, or they will be shortly.

You conclude by putting your finger on the key point. That of people's expectations, which are themselves perverted by the phenomenon of inflation.

Firstly, we have to distinguish between:

(a) "Cost of Capital" - ie the rights to streams of productive value, such as land rental values and energy; and

(b)"Cost of Credit" - comprising system costs (ie banks' reasonable operating costs) and defaults.

The two get conflated because our Money actually is (but need not be) Credit/ Debt.

In fact, I think that the "true" market clearing price of Capital for a "risk free" real return is probably 1% or less, since "productive capital has gradually expanded from being purely land, through machinery and buildings, to a new category of "Intellectual" property.

As the Capital stock has grown, we have seen its cost decline from 25% pa in Babylonian times, through 10% pa in medieval times and 5% pa at the dawn of the industrial revolution to maybe 0.5 to 1.0% pa today.

If you want a greater return than that, you're going to have to take risks.

On the other hand, Credit costs nothing to create, and the true "Cost" over time of unsecured credit aka "time to pay" necessary for the operation of the economy and creation of productive assets has probably never been more than 2% pa.

As for inflation, the causes of inflation are:

(a) deficit financing, both fiscal (caused by government) and monetary (caused by "fractional reserve" banking); and

(b) "Equity" financing and the "For Profit" legal entity - because the maintenance of "profits" is as much a "cause" of inflation as the maintenance of real wage levels.

"The future is already here -- it's just not very evenly distributed" William Gibson

the US Government legalized a form of Ponzi scheme.  

The high profit comes from the same place it comes from in any Ponzi scheme, from rapid infinite growth.  New suckers buying in provide the profits for those who are in already.  There is no value added at all.  Not even notionally.  The profit came through unloading these things onto a sucker.  

The mortgage writers would unload these bad debts (bad because unrepayable--the teaser rates would mousetrap most borrowers hopelessly) onto an investment bank (greater fool) who would cut them up and sell them to other banks (still greater fools) who would sell them to mutual funds, pension funds, town in Norway (just one example) and anyone who wanted to gamble (greatest fools all).  A deliberate side effect of the scheme was that property values inflated, making it look like everyone was getting rich and masking the fact that no value was being created.  

Since about year 2000, this Ponzi scheme has been the engine--the essence--of the US national economy.  Now it is folding up, and sure! there are dark times ahead!  

It is just the cream of the jest that when the music stopped, some big banks were still holding a lot of that paper that they had not yet thought to get rid of.  They thought the game was still going--that they still had time!  

The Fates are kind.