Where's the Collateral?   (May 1, 2012)

A sound system of credit is built on collateral. A doomed system of debt sits precariously on phantom collateral.

The global "recovery" is based not on reducing debt but on increasing it. Nice, but where's the collateral? The basic idea of debt is that credit is extended based on collateral, i.e. something of enduring, tradable value, or an income stream that isn't reduced to zero by non-discretionary spending and taxes.

A funny thing happened to collateral like housing equity and financial assets in the past four years--it shrank by trillions of dollars. According to the latest Z1 "Balance Sheet of Households and Non-Profits" from the Federal Reserve, real estate fell by $4.9 trillion since the bubble top in 2007 and owners' equity lost $4.2 trillion.

Despite the stock market doubling since 2009 and a healthy run-up in the value of bonds, financial assets shrank by $2 trillion as well.

These are non-trivial sums when we consider that collateral is generally leveraged. If a home buyer puts down 20% cash, then that cash collateral is leveraged 4-to-1 in an 80% mortgage. If the buyer puts down 3% (as in an FHA loan), then the leverage is over 30-to-1.

Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its "assets" column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank's "assets" are based on phantom collateral.

Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt.

Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt.

How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%'s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.

Interestingly, The Wedge between Productivity and Wages by economist Mark Thoma reports that the enormous advances in productivity over the past few decades did not translate into higher wages for the bottom 90%.

I have often addressed income disparity and the evaporation of collateral, for example, Two Americas: The Gap Between the Top 5% and the Bottom 95% Widens (August 18, 2010) and The Housing Bubble Broke the Middle Class (April 27, 2011).

Regardless of the various causal factors, the fact remains that 90% of American households have limited collateral or discretionary income to leverage into more debt. That leaves around 10 million households (the top 10%) with the means to take on more debt--if they want to. Can 10% of the households prop up the entire economy with more debt and consumption? What if the wealthy decline the opportunity to leverage more debt?

We can also ask "where's the collateral?" of the banking sector. As frequent contributor Harun I. observed about the European banking sector's phantom collateral:

European banks do not have enough money for deposit redemptions (people withdrawing their cash from the banks) and the only way to get it is to have the European Central Bank (ECB) print money out of thin air thereby devaluing every euro, thereby destroying purchasing power (you get your money but it buys less).

And what collateral are the banks providing for these loans? The sovereign debt of countries that are insolvent. Why not sell the bonds to raise the capital that is rightfully owed to depositors so that they could receive their money at par? Why then bond prices would tumble and governments would be forced to borrow at much higher interest rates. But borrow from whom? Insolvent banks that must have money printed to give depositors their money back at a fraction of its worth from when they deposited it. Not due to market forces which indicate their labor is worth less but because everybody just wants what's rightfully theirs.

So to summarize this, the ECB prints money to buy the bonds of insolvent banks which are backed by the bonds of insolvent nations. The result of which is insolvent nations or in reality the people thereof are not only poorer, they are now responsible for paying back money that was their property to begin with... at interest.

Put these two factors together and you get a global economy dependent on debt borrowed against phantom collateral and an American economy in which only the top 10% have credible collateral and income to leverage into more debt. In a sane system, when the collateral vanishes, so too does the debt (writedowns, write-offs, bankruptcy, take your pick). In an insane system, then phantom collateral supports ever greater mountains of debt.

How long do you reckon the insane system we have now will last? The collateral is phantom, but the interest payments are very, very real.

New video presentation: Gordon T. Long and I discuss "Generational Cycles" (27 minute video with charts)

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We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.

We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.

The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution, and it combines cultural, technological, financial and political elements in a dynamic flux.

History is not fixed; it is in our hands. We cannot await a remote future transition to transform our lives. Revolution begins with our internal understanding and reaches fruition in our coherently directed daily actions in the lived-in world.

If this recession strikes you as different from previous downturns, you might be interested in my book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc. Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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