Help me out with this.

[Mr. Wynand]

I've heard that the investment banks created debt by loaning at a 40 to 1 ratio. In other words, if you have 1$, you can loan out $40. How can this be explained? How would it be in the interest of the banks to amass this amount of debt? I'm assuming that the government is responsible, but I can't figure out how.

[Randroid]

The government is responsible by permitting this. Credit is money, and creating money in the form of credit (turning one dollar into forty) takes away value from the preexisting money. In other words, it's theft, which should be illegal across the board, but the government somehow makes an exception here.

Paul McKeever, who is also a member here, has an excellent series of videos on YouTube explaining this: Understanding Money and Banking

[gags]

I've heard that the investment banks created debt by loaning at a 40 to 1 ratio. In other words, if you have 1$, you can loan out $40. How can this be explained? How would it be in the interest of the banks to amass this amount of debt? I'm assuming that the government is responsible, but I can't figure out how.

They are talking about their leverage ratio. In other words, if an investment bank had $41 in assets and $40 in liabilities, then there is $1 in equity. The problem arises when the value of your assets declines by a relatively small amout (say 5% in this example), that causes about a $2 drop in asset value which entirely wipes out the shareholders' equity.

On the other hand, if the bank had generated a 5% return on its assets, that would have translated into a 200% return on equity! The problem is that leverage cuts both ways and when asset values are declining, too much leverage usually results in insolvency. However in this crisis, too much leverage results in government handouts.

[Reza]

The government is responsible by permitting this. Credit is money, and creating money in the form of credit (turning one dollar into forty) takes away value from the preexisting money. In other words, it's theft, which should be illegal across the board, but the government somehow makes an exception here.

Paul McKeever, who is also a member here, has an excellent series of videos on YouTube explaining this: Understanding Money and Banking

I am not an expert in this area. But credit seems to have done a lot of good for this country. People's skills are great assets, but they are hidden; they need capital to flourish. Historically, it used to be that you built your family fortune over many generations, with most of people's talents and ideas going to waste. I don't have any data on this, but it's my take on history. Nowadays (up until the recent capital freeze up) however, you can acquire capital, use your intelligence, ideas, and perseverance, to make a lot of money and build something for others to benefit from. From new construction to innovative services, the credit markets have given us so much opportunity. So I wouldn't call it theft at all. Stupid, perhaps, but only in some cases.

[adrock3215]

I've heard that the investment banks created debt by loaning at a 40 to 1 ratio. In other words, if you have 1$, you can loan out $40. How can this be explained? How would it be in the interest of the banks to amass this amount of debt? I'm assuming that the government is responsible, but I can't figure out how.

Gags has it right. At the start of this crisis, many investment banks had $1 in equity on their balance sheet, $39 in borrowed liabilities, and $40 in assets. Thus, with a mere $1, an investment bank was able to invest $40. A (say) 10% return on $40 equates to more than a 10% return on only $1.

Easy monetary policy by the Federal Reserve was the primary cause of this phenomenon. Remember that the capital structure of any company is constructed on the premises provided by monetary policy. If you look at the balance sheets of Fortune 500 companies in general over the last 50 years, you will see a decrease in funds sourced through equity sales and a corresponding increase in funds sourced through debt markets, notably, short-term borrowing. In an environment where the Federal Funds rate is negative in real terms (as it surely is now), one is essentially being paid to borrow money. Investment banks felt that it would be OK to borrow short-term and invest long-term, given that one can roll over the short term debt as it comes due ad infinitum.

[Randroid]

But credit seems to have done a lot of good for this country. People's skills are great assets, but they are hidden; they need capital to flourish. Historically, it used to be that you built your family fortune over many generations, with most of people's talents and ideas going to waste. I don't have any data on this, but it's my take on history. Nowadays (up until the recent capital freeze up) however, you can acquire capital, use your intelligence, ideas, and perseverance, to make a lot of money and build something for others to benefit from.

Credit itself is not the problem. There's nothing wrong with borrowing money. However, when a bank has one dollar in the vault and lends that one dollar to forty people, it inflates the money supply. It creates money that shouldn't exist and in fact doesn't exist, as the current economical crisis shows. Most importantly though, the inflation of the money supply with money that shouldn't exist devalues the money that was actually earned instead of what basically amounts to bills being xerox'd in the bank's basement.

[adrock3215]

Credit itself is not the problem. There's nothing wrong with borrowing money. However, when a bank has one dollar in the vault and lends that one dollar to forty people, it inflates the money supply. It creates money that shouldn't exist and in fact doesn't exist, as the current economical crisis shows. Most importantly though, the inflation of the money supply with money that shouldn't exist devalues the money that was actually earned instead of what basically amounts to bills being xerox'd in the bank's basement.

What you are posting is irrelevant information. The original poster asked about investment banks, not commercial banks, i.e. depository institutions. Investment banks do not expand the money supply.