A currency printing press in your wallet: Fractional Reserve banking

Bank regulations require banks to keep enough money "in reserve" to meet customers' withdrawal needs and generally remain in business. Fractional reserve banking allows a bank to keep only a fraction of its deposits in reserve. That fraction varies, but howstuffworks reports that it is currently 3% to 10%. Wikipedia does a nice job of illustrating how a $100 deposit, through loans that are then deposited at other banks, can become $457 in currency. (Note that they are using a 20% reserve requirement in their scenario - actual reserve requirements are much lower.)

If I sell my house for a $100,000 profit and then deposit that money with my bank, the bank only has to keep a portion of the cash in reserve, say, $10,000. They can then lend my neighbor $90,000. If he uses it to buy an RV from the lady down the street, and she deposits the money in the bank, then the bank credits $90,000 to her account, puts $9,000 in reserve, and looks for someone to borrow the remaining $81,000. From that original $100k, we have my $100,000 checking balance and the RV seller's $90k in the bank. We just printed money, without bothering the government's mint. The "created" money expands exponentially.

So, if you wondered where all that money was coming from to fund home purchases at double 2001 prices, now you know. The banks, essentially, printed it out of thin air. Yippee, we're all rich, everyone can afford a Mercedes and a Humvee and a pair of jet skis. My Visa card is a pocket-sized mint.

So what happens if somebody defaults after borrowing money the bank never had? Hopefully, the bank can make up the difference out of profits. If a lot of people default on their loans, the bank can still hope to make the money back by the time I withdraw my $100k. But with stock income gone, prices climbing, and job losses mounting, more people are withdrawing from their savings.

Leverage=risk. So banks prefer to make their money originating loans, and then sell the loan to investors who can afford the risk. But investors left a clause in there that the banks have to buy back certain types of bad loans - early default, fraudulent loans, etc. Banks didn't plan to have to buy those loans back. Banks planned to keep making money.

A $10,000 cash loss is a $100,000 loss in lending ability. If Ocrenter kept a tally of losses, just on the houses he features, how much would you guesstimate that would be? A couple hundred million in losses? A couple hundred million in losses is a couple hundred billion in loans the bank can't afford to make anymore. Fractional reserve requirements create exponential growth in money supply - but when the pendulum swings the other way, it's an exponential contraction in money supply.

Ruh-roh.