Great Depression Online Archive Issue:

FDIC Disaster in the Making

Great Depression Online
Long Beach, CA
September 08, 2009

Inside This Issue You Will Discover…

*** Doing Natures Work
*** The Origins of a Bad Idea
*** FDIC Disaster in the Making
*** And More

“Banking establishments are more dangerous than standing armies.” – Thomas Jefferson

Doing Natures Work

Over the weekend five more banks vanished from the face of the earth.

“Lenders in Illinois, Iowa, Missouri and Arizona collapsed, pushing the number of bank failures to 89 this year amid continuing fallout from the worst economic slump since the Great Depression,” reported Bloomberg.

The obvious culprit, of course, was bad real estate loans.  But the real culprit was the lenders themselves.  Just what was it they were doing that left them with billions of fire ants swarming inside their oversized financial pantaloons?

Certainly not lending. 

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The term lending itself, in this occasion, is merely fraud and flattery.  For it suggests some consideration or prudence was involved when the real estate loans were made…that risks were considered, most importantly, a person’s ability to repay the loan.

But that’s not what happened at all.  More accurately the lenders were doing natures work…they were helping people ruin themselves by giving them money they couldn’t repay to buy houses they couldn’t afford.

And now that the whole fraudulent edifice has come a crumbling down an even larger and more fraudulent edifice wobbles and sways in the winds of a financial twister bearing down on a Great Plains farm house.

Just how did we get here?  That is the yoke of today’s dispatch.

The Origins of a Bad Idea

Nearly all banks operate under a fractional reserve system.  This means your bank only has a fraction of the money you’ve deposited in reserve.  The rest of it has been lent out to others. 

Yet, even though the bank does not have your money in reserve, they maintain the obligation to redeem all your deposits upon demand.  This system, though inherently flawed, is legitimized by law in most countries.

Fractional reserve banking originated back when people deposited gold and silver coins at the goldsmith.  In return for their deposit, they’d receive a promissory note.  Over time, rather than going to the goldsmith to withdraw the coins to make a purchase, the notes became a trusted medium of exchange.

Goldsmiths soon discovered depositors would never redeem all their notes at the same time and they began profiting off the interest they could charge for loaning these deposits out to others.  Goldsmiths went from guardians of gold and silver coins, which charged fees for safe storage, to bankers that made interest-paying loans…and fractional reserve banking was born.

The problem with this practice has been proven over and over again…more loans are issued than the reserves available for redemption.  Subsequently asset prices swell well beyond what the economy can support.  A panic follows.  Banks can’t meet their obligations and they go bust. 

Over and over this sequence has repeated itself…always leaving financial ruin and regret in its wake.

FDIC Disaster in the Making

Fractional reserve banking works great as long as bank depositors don’t all show up and demand their money at the same time.  Yet, during a period of financial panic, this is precisely what happens.  It is known as a bank run.  Such episodes were commonplace during the Great Depression, and resulted in the complete loss of lifesavings for many individuals and families. 

You don’t hear much of bank runs today because of the Federal Deposit Insurance Corporation (FDIC), which was established in 1933 by President Franklin Roosevelt.  The FDIC provides deposit insurance, which guarantees checking and savings deposits in member banks.

A dangerous consequence of FDIC is that rather than correcting the inherent instability of fractional reserve banking, it provides a false sense of safety, while enlarging the ultimate hazard.

“It does not take much to realize that bank management will make different decisions, pursue riskier ventures, and accept financially-qualified clients if they know the FDIC has their back, wrote David Kretzmann last Friday, in a story titled The FDIC and the Follies of Modern Banking: Part 2.  “The moral hazard that comes with the FDIC is undeniable.

“The slightly hilarious part,” he continues, “is that in the event of a true banking meltdown, the FDIC wouldn’t have near the amount of necessary funds to ensure depositors got their money back.  According to the FDIC’s own website, they manage an ‘insurance fund’ of more than ‘$52.8 billion,’ yet the agency ‘insures more than $4.3 trillion of deposits in 8,494 U.S. banks and thrifts.’ Let’s see… $52.8 billion of funds to cover $4.3 trillion of deposits.  Yes, the FDIC carries enough cash to cover a whopping 1.23% of the total deposits that it claims to insure.”

But it may be much worse.  From the Bloomberg story we began with we learn…

“The FDIC insures deposits at 8,195 institutions with roughly $13.5 trillion in assets and reimburses customers for deposits of up to $250,000 per account when a bank fails.  The surge in failures has depleted the Washington-based regulator’s deposit insurance fund, which fell to $10.4 billion at the end of June from $13 billion in the previous quarter, the agency said.”

By this account, the FDIC can only cover 0.08% of the total deposits they insure.

It’s a disaster in the making.

Sincerely,

M.N. Gordon
Great Depression Online

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