What's A Dollar - Exactly?
A US dollar is evidence of a debt that is allowed to pose as "money" by United States legal tender laws.
It is far more (and far less) than just the paper bill you carry in your wallet. Dollars are created electronically whenever a bank makes a loan.
You keep hearing that the dollar is "backed by the full faith and credit of the United States government." That, if it is true at all, is true only in an allegorical sense. It is backed by the US government's power to tax you and I so that it can make payments of principal and interest on the money it borrows from the Fed.
In other words, the federal government does not live off our tax dollars, it lives on money it borrows from the Fed, and it taxes us so it can pay the Fed back - with interest.
Primarily therefore, at least as far as the dollar's domestic value is concerned, it is backed by every borrower's promise to repay - whether that borrower is an individual, a business, or the United States government.
The vast majority of US dollars are created via a bookkeeping entry by the Federal Reserve Bank when Congress borrows money from the Fed. A Fed employee creates a "credit" on the US Treasury's account. The Treasury then issues bonds and notes that are essentially promises to repay the money borrowed from the Fed.
When individuals go to a private bank to apply for a loan, essentially the same thing happens. Instead of issuing bonds, etc. the borrower signs a legal document entitled a "note" of promissory note, which is a contractual promise to repay the loan over time, at interest. In return for his promise, the borrower gets a "credit" on his account. That credit is nothing ore than a bookkeeping entry. The banks gives up nothing it actually owns when it makes a loan.
That promise to repay is then carried on the bank's books as an "asset". It is quite literally what backs the loan amount.
That loan amount is then counted as part of the "money supply." "M1", the most liquid form of money, consists mainly of physical cash and "demand deposits." Demand deposits are bank checking and saving deposits.
Every dollar you have ever earned, saved, spent, or gambled away in a casino (or the stock market) was created in the same way.
Easy Come - Easy Go
The dangerous part of this arrangement is that, theoretically, the entire money supply of the United States could be destroyed if every borrower defaulted on his promise to repay at the same time. The US economy would simply cease to exist if that ever happened.
Now, that is very unlikely to ever happen, but it explains quite beautifully how the current credit crisis came about.
The Financial System's Clay Feet
Mortgages are loans. "Subprime" mortgages are those made to people with poor credit ratings who didn't really qualify for a "prime" loan and who tyherefore agreed to pay a higher interest rate, for example. Many of these subprime loans were "adjustable rate mortgages" or ARMs.
ARMs share one thing in common: They have a low initial"teaser rate" that subsequently resets at higher levels. Subprime borrowers bought on the assumption that they could afford the initial teaser rate and would later refinance before the ARM reset.
But that was before the housing market collapsed. As home prices dropped, refinancing became more and more difficult because lenders just wouldn't agree to extend new terms with less collateral to back up the loans.
Consequently, many sub[rime borrowers began to default on their mortgages, but their mortgages had been sold by the originating lender to investors to get them off their balance sheets and book the proceeds as pure assets without liabilities attached.
These sold-off mortgages were often used to "back" debt instruments issued by big corporations to finance their daily cash needs. These debt instruments are called "commercial paper."
All of this started to unravel when borrowers began to default. It is a perfect example of the riskiness of debt-based finance. Debt can be defaulted upon, and in tougher economic times often IS being defaulted on.
The financial system's "solution" to all of this: Make more loans to those who are in trouble.
But that means that more debt is created. Therein lies the problem.