Wednesday, March 14, 2012

Answer to Poll Question: Of these four things, Lender, Borrower, Loan or Collateral, which is considered the "Asset?"

Correct Answer: LOAN
In the modern banking system (Fractional Reserve Lending), the Loan exists only when all three of the others (lender, borrower and collateral) come together. All three create the entity we know of as the Loan. It is considered an asset for 2 main reasons:

1) Of the four things, the Loan is the ONLY thing banks will buy and sell and trade with other banks.

2) Origination of Loans causes the total supply of money in circulation to expand. The total debt within an economy is exactly the amount of money in circulation within it.

If you are interested in reading more a further explanation is attached below.

Thank you for participating in our informal poll on Facebook. We're working on collaboration with local businesses and government to include a greater amount of financial literacy into classrooms - primarily within the subject of US history in elementary and high school. As a part of an ongoing project, this poll served to illustrate the common misconception that "collateral" is considered the asset in our Modern Monetary System.

So, why isn’t collateral considered an asset anymore?

By definition, collateral is encumbered and therefore of no “exchange” value to the borrower. Similarly, collateral is not an asset to the bank because they are deriving no “use value” from it (the house, car or boat is not in their direct possession and they are not using it, living in it or driving it on a regular basis).

The truth is, that those of you who answered, "collateral" would have been correct if the year was 1912 or earlier. School textbooks used to have a course in monetary theory that reflected the financial system in place in the U.S. At that time, a bank’s charter prevented it from selling loans to other banks – as such an act was deemed to be a breach in the original lender-borrower contract. That all changed in 1914 with the passing of the Federal Reserve Act in 1913, during the administration of President Woodrow Wilson. Once this law was enacted, the restriction was lifted and debt became the primary method of money creation, making the Loan the asset. Textbooks were not updated to reflect this change.

Simply put, in 1913, the creation of money transferred from government to central banks, and the process of increasing or decreasing the total supply of money in circulation was accomplished by creating debt. The debt or total of all the Loans in force = the total supply of money in circulation. Without the loans, there would be no money in the economy.

For example: You cut down a tree in your backyard and carved out a chair out of the wood. You then took the chair to the bank and mortgaged it for $100 cash. Your hand-made chair is appraised by the bank, and is determined to be worth about $100 to the highest bidder. The bank draws up a piece of paper, commonly referred to as a "note." On it, the bank spells out the terms of the loan. The moment you sign the bottom line, $100 is added to the total money supply in circulation in the economy. The bank hands you $100 cash at 10% interest. At the end of the loan, you would have paid a total of $110.
During the life of your loan, also known as the “term,” the bank may also charge you a periodic interest rate, which you have to pay on a monthly or yearly basis. If you fail to make a payment, the bank will go to your house, take your chair and sell it at auction to get the $100 back. If you faithfully make all the payments, at the end of 10 years, the bank will have received a total of $110 plus the periodic payments you made for the life of the loan. If your loan term was for 10 years at 10% per anum, you will have paid the bank a total of $210.*

The bank makes money in 3 ways from the creation of a Loan.

1) Interest payments: During that 10 years, the bank has taken your interest payments (made in cash by you) and re-loaned that cash to other borrowers using the same method.

2) Selling the Loan: At any point during the term of your loan, the bank can sell your promise to pay $10 a year for 10 years to another bank for a lump sum of money. For example. Your loan with bank A is sold to bank B for $90. Bank A now doesn’t have to wait 9 years for the $90 and can immediately re-lend to other borrowers. In the meantime, bank B can brag to shareholders that it made a $120 profit on the purchase of your promise to pay, because bank B will now receive your principal and interest payments every year for 10 years.

3) Credit Default Swaps: the bank makes money from the sale of its stocks and bonds. The most controversial of the profit methods because CDS’s are done “off the books.” No formal documentation is made that can be reviewed by shareholders or the SEC. Bank A and bank B agree to back each other up in case of defaults of their respective borrowers. This arrangement allows rating agencies to rate a bank’s financial performance within an exchange (bonds) or value based on performance (stock price).

Only the Loan allows banks to profit in this way, making it the most important “Asset” in modern banking. Again, as soon as the chair becomes collateral for an agreement between a lender and a borrower, the chair transfers any exchange value it once had as an unencumbered piece of property to the newly created Loan, which is exchanged over and over again reaping profits all the way. When all four things are present, Lender, Borrower, Loan and Collateral, the only one of the four that has exchange value is the Loan, making IT the Asset. As the new saying goes, “Debt makes the world go ‘round!”
So, while the answer, “collateral” was the most prevalent, it is also almost 100 years out of date. However, don’t despair, because once you have paid your loan back to the bank at the end of 10 years, the loan document is destroyed and your chair is “free and clear.” At this point it does indeed become YOUR asset. But remember, if you ever put your chair up for collateral again, it is no longer an asset.

Thanks again for participating. I welcome any questions or feedback.

* For those of you who noticed...
How can a total of $210 be paid to the bank if only $100 was put into circulation by the creation of the Loan in the first place? Where does the other $110 come from?

Warning: The answer is what economist refer to as "The Red Pill."
"You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes. " - Morpheus from The Matrix

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