If you have a finance background, you may call this obvious and call me naive for realizing so late. But maybe you also did not know before. There are a couple of naive assumptions I had about money, and bringing them all together formed quite an abyss to look into. There are three parts to it.
First part: I assumed that all money would be backed by the central bank. So a local bank could not invent money. They would have to have people bring in their hard-earned cash and put it into a (say 10 year) fixed-term deposit. Then other people would request a mortgage and the bank would take a portion of the savings money and lend it to these other people. This scheme only works because the fixed-term deposit cannot be accessed in that time. The lender pays a large interest, the bank pays a small interest to the saver and keep the difference itself. From this difference they would pay the salaries of employees and take the risk of default (people not paying).
The reality is that local banks just invent their own book money and only like 10 % of the money needs to exist for real (as central bank backed money). So the amount of credit that a bank can give to customers is not limited by the amount of money that people have in their fixed-term saving accounts, but it is a large multiple of all money, even including checking accounts. This means that the bank would break if only a fraction of the people would cash out. Additionally there is money from investors into the bank, so the saving accounts may be only a small fraction of the real money that the bank holds. For investment banks there might even be no saving accounts at all.
Second part: Construction companies develop condo complexes. I assumed that they just had a bunch of capital and bought land, built the complex and then rented it out to people. Then some 40 years later they would have gained the construction costs from the rent. At this point they could build the next condo complex. Of course they would have a bunch of these projects in parallel such that they could build continuously.
Then I realized that lately they sell the condos do individual people. So they each go to their bank, request a mortgage and buy a condo. The construction company gets its money pretty much directly after finishing construction. Actually they are sold before they are even finished. So when they hand over the keys to the new owners, they already have made all their money and can directly start with the next condo complex.
Third part: People want to save money for their retirement. They want to have some interest or profit while doing so, therefore they may choose to invest into funds. I have assumed that these funds would invest in projects like the early railway in the USA; projects which are too ambitious for a single company to pay for in advance. Long-term value generation would make the shares more valuable over time. People would eventually sell their shares and retire on that money. The money they have effectively lent to companies has been used for investment, to develop new branches of business; things that create long-term value.
This was all somewhat independent until I watched the TV show “Bad Banks”. The major point I did not realize is how investment banks sell their credits. There was a city development project which needed four billion EUR in money. I just assumed that the bank could give them the money, after all they were a bank! What they actually did is give them the money, but then sold the credits to other banks and investors. The main job of the investment bankers was to sell those loans. After this “closing” the bank is directly done with everything and has the money back from its investors. They can turn around and sell the next batch of loans and then sell them.
But who buys these loans? These are investors who have money sitting around that they need to put somewhere. The banks basically create things that they can invest into. And the money that needs to be invested (partly) comes from people wanting to save for their pension.
And this where we go full circle: A construction companies starts a new condo complex. Before they are even finished building, they start selling the units to people. These people go to their banks and request a mortgage and buy the condo. The bank turns around and sells the mortgages in bundled form to investors coming from large financial institutions like retirement funds. The retirement funds have their money from the very same people who bought the condo. Effectively the mortgage interest the people living in the condo pay partially end up as returns in their pension fund. The other parts are profit for the construction company, bank and the retirement fund.
This also lead to the situation where loans are a product in itself that get bundled and sold to the next investor. The housing bubble was constructed like this, and there seems to be sub-prime car loan bubble. Since the bank has sold the loans to investors who manage pensions, defaults will effectively lead to losses in pensions. If the loan market crashes, so will the pensions. Banks are encouraged to pump out credits and create a bond marked stuffed with potentially risky loans.
It all seems like a really fragile system, and the more I realized about it, the more frightened I got.