Wednesday, March 11, 2009

To Counterfeit is Death

The words “To Counterfeit is Death” appear on the reverse side of the paper money issues of several of the British American colonies. Massachusetts was the first to issue government paper money in the Western world, followed by the other 12 original colonies. Paper currency augmented a scarce supply of gold and silver coin.

Two forms of colonial paper money were issued. One was backed by taxes dedicated to the redemption of a specific note issue, usually with the colonial Treasurer burning the redeemed notes before the colonial legislature. The second was a loan office, or land bank, issue described below. When necessary, sheriffs were ordered to foreclose on delinquent mortgagees.

Colonial governments were keen to preserve the value of their paper money against currency notes of other colonies and British sterling. To discourage counterfeiting, several colonial legislatures enacted the death penalty on convicted counterfeiters.

The concept of counterfeit money is an apt metaphor for the multiple credit instruments that contributed to the currency global financial crisis.

Begin with property. In general, mortgages of a specified duration and interest rate are issued for the purpose of purchasing residential or commercial property, which are collateralized by the property for which they are issued. In the colonial era, a borrower had to pledge twice the value of a loan in land or three times in real property to secure a loan. Modern practice traditionally required a down payment of 10-20 percent to insure that a lender could reclaim the full amount of its mortgage in the event the borrower failed to repay.

Contemporary money consists of banknotes and coins, bank reserves held at a central bank, and deposits held in commercial banks. Banks grant loans on the basis of some reasonable multiple of deposits on the assumption that depositors will not rush to withdraw all their deposits at the same time. Banks profit from the difference in deposit and loan rates.

In recent years, financial innovations changed the treatment of loans. Financial institutions began to bundle up mortgages (credit card balances, auto loan balances, etc,) and sell them as securities to third party investors. These securities are known as asset backed securities (ABSs), specifically mortgage backed securities (MBSs) for property. MBSs, which included substandard, sub-prime mortgages, were diced, sliced, and combined into new securities known as collateralized debt obligations (CDOs). Financial institutions wrote credit default swaps (CDSs) to insure against losses on these various products.

One way to think about this alphabet soup of derivative securities is that they represent counterfeit forms of money. Once that discovery occurred (due to falling home values), banks, non-bank financial institutions, and other firms quit trading these securities among each other, demanding payment in non-counterfeit money. As in the case of counterfeit money, the derivative securities based on defaulted mortgage loans became worthless.

We no longer put counterfeiters to death. Nor has the Congress enacted legislation stipulating which derivative forms of money are counterfeit. To reduce the likelihood of future financial crises, it may be worthwhile to try to define the status of new financial instruments more precisely (without stifling productive innovation) and toughen penalties against counterfeiting.

1 comment :

eyepatchman said...

Hi all,

Here's an interesting one for you.

An analysis of the current economic crisis we are all unfortunately facing but looked at from a slightly different perspective.

This analysis looks at past banking crises and how they have effected various aspects of the economy.

It is titled The Banking Crisis - Where are we now? (follow the link should you be interested) and has particularly interesting points about how the previous banking crises has effected assets including property prices.

Hope you enjoy.