Are you hanging on for dear life because of debt?

The average person in my home town of Knysna cannot comprehend the money system. It has been so drummed into their consciousness that a good citizen saves money in a bank who in turn charges them interest for keeping it…even though the banks are using their money to make more money which is not fairly shared with them.

How can a bank loan your money it does not have?

How did so many pensions take a tumble even though the people holding the pensions made a profit?

Want a good credit rating? Well, borrow money because debt is the easiest way to ‘earn’ more debt.

These silly notions are being tested during our economic return to reality where property prices are dropping towards real value and food on the table is no longer the normality of the middle class. If anything, the middle class, which propped up the false money system with ignorant belief, is vanishing into the rising tide of lower class. In Knysna, a tourist-based economy, the effect has been startling and deeply disconcerting but can only achieve real value if its citizens pole-vault over the negative psychology that’s been passed on by generations before them.

By asking a simple questions such as, “Why are the stock markets currently at record highs whilst our lives are still slipping away?” would lead to answers protecting the next generation. The financial system may be a challenging topic to the uninitiated but watching the short comedy called Silly Money would make for a damn fine introduction…and a pleasant one.

(Are you still reading? Go back and watch Silly Money before proceeding)

A major challenge has been for activists to educate the masses. No matter how much information they deliver or respect they should have earned for predicting the economic crash, and the reasons for it (as opposed to the politicians and economists who lied whilst trying to make money til the last moment), they are generally treated as conspiracy theorists or become heated conversations in coffee shops by those whose opinions will never get past, “Milk and 2 sugars please.”

The fact is that banks have been loaning money they do not possess. South Africa’s laws provides protection for the consumer from such action but it has been a major challenge to enforce it as the banks simply bury protestors in legal bills. The struggles of New Era have been repeatedly mentioned in past blogs here.

But unemployment is rising, a swarm of dissatisfaction that cannot be denied and may one day sting all of us if we don’t address it. One benefit of it has been truth which has started to appear in the mainstream press. In South Africa, it has been sorely lacking even though some overseas have used such information to beat banks and hold onto their homes. So, it is with relief and welcome that SA Real Estate Investor Magazine (REIM) and writer Monique Terrazas have published the following as their May 2013 cover story:

MONEY GROWS ON TREES

“How can a loan agreement exist when nothing was loaned?

And how can the bank charge interest on a “loan” that is not legally valid? ”

The banking and financial system globally is under scrutiny as scandal after scandal rocks what we had always assumed was a trustworthy industry, solid as rock. But things have changed. There is little doubt that the irresponsible practice of securitisation and inter-bank lending brought about the global credit crunch. After setting in motion the subprime crisis that dumped the globa leconomy into the worst recession in living memory, banks were exposed for manipulating the Libor and Euribor interbank interest rates- providing false futres on key interest rates upon which mortgages and loans are priced, affecting millions of families and hundreds of thousands of companies, large and small, across the globe. As one commentator noted: “This dwarfs by orders of magnitude any financial scam in the history of the markets.”

In addition, the information age has brought to the man in the street the knowledge that“money” is no longer backed by gold reserves but fabricated through the fractional reserve banking system. Given how pervasive the financial system is affecting every aspect of our lives, it has become critical that we move out of our comfort zone where ignorance was bliss. We need to become far more proactive and involved, understanding thoroughly how the system works. This is the only way in which we can shift from being victims of a system we have helped to create through ignorance, complacency and greed, to becoming empowered consumers and users of these systems, understanding the rules so we can play the game or step outside the game for our own collective best interests, and the interests of generations to come.

Understanding the rules

We cannot play on an equal footing in the global financial system if we don’t understand the rules. While learning the rules requires time, effort and dedication, it is absolutely necessary if we are to become empowered players, instead of victims. It is not possible to explain the intricacies of the entire global financial system in one article, but there are a few concepts that, once understood, will help us to understand the basic tenets of the system, notably the fractional reserve banking system and securitisation.

The Fractional Reserve System

In previous articles in REIM, we revealed that banks do not actually lend out money they already possess, but rather “create” the money loaned to borrowers, using the “promise to pay” signed by the borrower. In other words, “money” is created through debt. This is called a ‘fractional reserve’ banking system, and it is used by governments, central banks and financial institutions across the globe.

On a national scale, central banks print money that has no intrinsic value, based on a “promise to pay” issued by a government. Because this new “money” has no intrinsic value, it derives its value by literally taking value from the money already in circulation, and this is what is called “inflation”. The money already in circulation is worth ever less to give value to new money that is printed.

This practice was taken to extreme in Zimbabwe not so long ago, when the government practice of simply printing more money at a rate well in excess of economic growth, sent inflation to levels above 1 000%, rendering the money already in circulation worthless.

Of course, today, they do not really actually “print” more money, but simply “create” the money through a “deposit entry”, even though no deposit was made by anyone! The same happens when a borrower approaches a bank for a loan. The bank does not actually have the money it “loans” to the borrower. They simply “create” money, through similar electronic “deposit entries” or “book entries”, simply based on a borrower’s “promise to pay”, with no actual deposit being made by anyone, anywhere.

This raises a number of issues, including the legal validity of a “loan” and the legality and the morality of charging interest on such a “loan”. It has been contested in a number of court cases that a “loan” agreement cannot exist legally under these circumstances, because the bank did not “lend” something they had prior title, ownership and rights to. The “money” lent to the borrower did not exist before the borrower signed the all-important “promise to pay”, but was “created” based on the borrower’s “promise to pay”. How can a loan agreement exist when nothing was loaned?

This, furthermore, raises issues around the charging of interest. How can the bank charge interest on a “loan” that is not legally valid? If the “money” loaned is “created” out of nothing more than a “promise to pay” – which belongs to the borrower – and the bank does not loan its own money to the borrower, why is interest charged by the bank? “A management fee payable to the bank for managing the system seems more appropriate,” comments Robert Vivian, Professor of Finance and Insurance at the School of Economic and Business Sciences at the University of the Witwatersrand.

Securitisation

Securitization – screwing the small guy!

Another hot topic over the last few years is the practice of securitisation.

Banks securitise loans by bundling them together, using a special purpose vehicle (SPV), and selling them to third party investors, who trade them on the capital markets. For example, in the home loan market, the borrowers’ promissory notes are backed by collateral through the mortgage contraction of the property. As such, these become “mortgage-backed securities”.

The bank approaches another institution that buys and sells mortgage-backed securities. It “sells” the buyer’s mortgage-backed security to this institution for the full amount – the principal and interest – payable by the buyer over the period of the mortgage loan. This is up to three times the amount of the principal debt.

Since the bank is paid in advance, it makes a tidy profit without using or risking its own money. However, legally, once a bank securitises a loan, it loses all rights to it i.e. the bank is no longer the owner of the debt.

Should the borrowers default on their loans, the debt to the SPV and its investors are covered by insurance policies, called “credit default swaps” in the US and other countries. While the use of this insurance has not been confirmed in South Africa, it stands to reason, according to legal experts, that an SPV trading on a stock exchange would be required to have this insurance in place. The South African Securitisation Forum has confirmed that the implication of this is that the bank cannot, for example, repossess the property if the borrower defaults on repayments, because the bank no longer hasany rights to the property that is the collateral for a “loan” which has been securitised and now belongs to another entity.

Quite simply, there can be no legal case against the defaulting borrower, because all parties have been settled. The bank was settled when the mortgage-backed security was sold, and the investors were settled through an insurance policy. Several recent court rulings in a number of states in the US have, essentially, declared the practise of securitising home loans illegal, and, as a result, numerous banks have stopped foreclosure procedures on homeowners who have defaulted on their mortgage repayments. The implications are staggering: Four million people in the US have had their homes repossessed illegally and the banks have been forced to pay out $8.5 billion in settlements.

Read Part 2 to discover the situation in South Africa (article appears at 7.30am today)

[Money Grows on Tree
first appeared in SA Real Estate Investor Magazine (REIM)
and was written by Monique Terrazas – kudos to them!]