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Comment by AC__ | Hacker News Reader

I wonder why this book doesn't explain the fractional reserve banking system. Oh wait, never mind, I know why.

Some of your money that is left in the bank is given to other people so long as they promise to give back even more money. Even though the bank doesn't have all the money that it has taken, so long as most people do not ask for their money at the same time the bank will always have enough for people that want their money back. The bank gives you some extra money for letting them do this. When a lot of people believe the bank can't give their money back, it may cause everyone to try and take their money out. This is called a bank run and can be very bad.

It checks out: http://xkcd.com/simplewriter/

That's the description of banking we were taught in school and though it's not wrong, in practice, banks don't really work that way.

Banks deposits are a tiny source of the money banks loan. In practice, they loan out a portion of the collateral that they get when issuing a loan.

Example: They give Bob a house loan for $100K and in return they get the deed to a house worth $110K and an IOU from Bob for $100K (plus some interest). The bank can now treat the house as a $100-110K asset on their own balance sheet and loan part of that asset ($90K) out to another borrower.

Or something like that. ;-)

Its weirder than you think. No banks have owned loans for a very long time. They're resold to various quasi government-ish organizations (think, like the IRS or the federal reserve, although not the IRS) in exchange for cash raised by selling mortgage backed security bonds. All kinds of random individual and orgs own those bonds. They pay off pretty well almost a sure thing when the first derivative of interest rates is negative, not so well at zero to positive.

Banks and mortgage brokers act as commissioned sales forces for the MBS bond market, basically.

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