The Banker's Dilemma and the Golden Solution

If you were in the lending business and you knew double digit inflation was coming, would that affect your willingness to make loans?

Let's create a hypothetical loan situation.For sake of the example, let's say 10% inflation will be here in one year.Currently, we run 1.1%, if you exclude everything that is inflating.(sarcasm added)

Sam here wants to buy a house and take advantage of historically low rates.He has enough money for a down payment and qualifies for a $90,000 mortgage on a $100,000 home.Now to continue with the example, let's say the loan was approved at 4% and Sam got his house.

As soon as the sale was complete, inflation started ticking up.Stimulus money is filtering its way through the economy, some new jobs are being created and Sam is happy.He thinks he bought at the bottom of the housing market.Now his house is going up in value.Good thing he locked in when he did, cause he's noticing the cost of goods and services has started to rise as well.

Groceries are more expensive, so is gas for the car and energy costs to heat the new house.Not to worry though.Sam got a bit of a raise and thank goodness the house payment is fixed. That will never change till the house is paid for.

By the time a year goes by, inflation is running at 10% and still rising.The economy is heating up, even more jobs are coming back online and yes, the cost of everything is still rising.Still not to worry though, Sam got another raise and even though things he has to buy are going up in price, Sam is now able to save some money because his mortgage payment is still fixed at the same payment he started with.

Meanwhile - Back at the Bank!Concern is mounting.Sam's loan is going bad along with thousands of others.But how can that be?The economy is heating up, jobs are being created, Sam is making more money and he's still making his payments.What's the worry?

At the origination of Sam's loan, inflation was a mere 1% and the interest rate at which Sam got his loan was 4%.Since inflation is really a measure of the rate at which a currency loses value or purchasing power, the bank, at the outset was making 4% per year in interest while anticipating being paid back in currency that was only losing 1% per year in value.

In short, 1% inflation turns each dollar the bank receives in payment against principal into 99 cents for a 1 cent loss per dollar.The interest, however, at 4% annually, earns the bank 4 cents for every dollar still owed on the house.Even as inflation has robbed the bank of 1% of the value of the money it receives in payment, the interest Sam pays still earns the bank a 3 cent profit per dollar on the principal balance.

Of course other factors play a role in determining the profitability of any loan the bank makes, not the least of which is the rate of interest the bank paid to borrow the money it loaned to Sam.Yes, believe it or not, the banks have to pay for money they lend.But, for purposes of this example, let's say the bank had no cost of borrowing.We are only analyzing the loan considering inflation.

Now 2 years has gone by since Sam bought his house.The first year inflation ran at 1% but in the second year has averaged 10% and appears to be heading even higher.Yes, food and energy costs are inflating but stimulus money is still filtering through the economy.More jobs are being created, Sam is making even more money and despite the rising costs of living, Sam's mortgage payment has not changed.Now Sam is actually saving more money.

At the bank, concern has turned to panic.Every dollar it received in payment against Sam's loan in year 2 was only worth about 90 cents.Inflation took 1 cent in year one and another 9 cents in year 2 and inflation is still rising.In fact the rate anticipated for year 3 is now 15%.Simple math tells the bank that every dollar paid against principal in year 3 is going to be worth about 12 cents less than last year's dollars or, by now, 78 cents.Obviously, the 4% interest does not make up for the lost purchasing power.

Indeed the situation at the bank is getting critical.Just as stimulus has boosted economic activity and grown Sam's salary enough to offset higher costs, the bank has to pay higher salaries and higher operating costs.These costs are what drives down the value of the dollars received in payments.

Sam's situation is just the opposite.Inflation has grown his income and even though some of his costs to live have risen, his largest expense has remained constant.That would be his mortgage expense.The dollar is being destroyed but so is the debt as Sam continues to make his payment with dollars that have increasingly less value.

If only the bank knew what was ahead it may have hesitated to make the loan, especially one at a fixed rate.Without the opportunity to raise the interest rate on the mortgage note, the value of the debt is gradually destroyed.

Currently, it has been well noted that banks are hesitating to make loans.Qualifying is more difficult than ever.Now one sees why.With the Fed promising billions perhaps trillions more in Quantitative Easing, the banks know inflation is sure to rise, destroying the value of any debt issued.

As time goes on, Sam realizes the shrewdness of his decision to borrow.In hind sight, he wishes he borrowed more and extended himself a bit as rising inflation makes it easier and easier to pay off the debt.

Now, when we apply this example to this country's current financial condition we arrive at a sudden realization.In our example Sam is Uncle Sam.The difference is Uncle Sam is borrowing like crazy.I submit it's because government knows inflation is coming and any debt it incurs now will be more easily paid back as inflation begins to soar.As the biggest debtor nation in the world a plan to pay off debt begins to emerge.

The implications are endless and questions arising are countless.Domestically, our banks have an intuitive hesitancy to lend.Foreign banks, however, may be caught in the trap Sam's bank, in our example, found itself in just 2 years into a long-term fixed-rate loan and there may be only one escape.GOLD!

The only way out of the debt destruction dilemma, foreign banks now find themselves in, is to own an asset that outperforms inflation.Without the outperforming of one investment to offset the loss from another, foreign banks will literally be left holding our empty bag of promises to pay.Now do you know why gold demand is soaring and why there may be no limit to the rise in gold prices?

This now just leaves one question left to answer.

In our example, Sam is able to service his debt and have something left over because inflation has increased his income.

If the example holds, how does Uncle Sam propose to do the same?

Stay tuned.

Meanwhile, if you think it's time to own some gold of your own, visit LearCapital.com for real time gold prices, free special economic reports and low online pricing for gold and other precious metals.