Thursday, March 26, 2009 35 Comments

The Geithner plan, slightly demystified

Sometimes homeless guys come up to me on the street and ask: "what is this PPIP thing, anyway? One: does it have anything to do with PPP, IP, or PPTP? And two: will it work?"

One: no. But as one who once designed a C++ class called "PPTPPPPLink" - a choice from which my programming career has never quite recovered - I feel Secretary Geithner's pain. At least his latest acronyms no longer include words like "Troubled" or remind us of Star Wars villains.

And two: no. At least, not if by "work" you mean "convert our rapidly-disintegrating Rube Goldberg machine into a healthy, stable and productive financial system." Perhaps this comes as a surprise to you. But probably not.

But a more interesting question is: will the Geithner plan achieve its intended results?

Obviously, the PPIP is a bandaid, not a reboot. Its goal is not to create perfection. Its goal is to stop the hemorrhage. Will the artery finally clot, this time? If you know the answer, you can either make a lot of money, or at least avoid losing one. At least if you're the sort of fellow who can raise $500 million from your friends at the Palm Beach Country Club. I'm afraid the truth will not help the skells raise any quarters, though. Ah, change.

Unfortunately, my answer is: I don't know. I can guess, though, and I will.

Let's start by looking at one common misconception about the Geithner plan. Perhaps by clearing it up we can take our first step toward some small enlightenment.

The misconception I have is that the Geithner plan (and its predecessors in the department of liquidity-enhancing Star Wars villains, from MLEC to TALF) represents a subsidy to the hedge funds and other fat cats who may, or may not, participate in it. The essential Steve Waldman has battered this issue much, most recently here.

One can argue this point, if one is willing to finesse the word subsidy. But for me, a program is not a subsidy unless it can turn loss into profit. This the PPIP cannot do.

If the word subsidy attracts you solely on the basis of its negative connotations, fine. I am happy to admit that the PPIP is a black, reeking horror. And I wouldn't be surprised if its designers agree. Surely at least they consider it the least of many possible evils.

But, at its bottom, the PPIP is a government loan facility. By definition, no loan can render an insolvent balance sheet solvent. You cannot borrow your way to profitability.

So, as a fairly typical example of the misconception, the New Yorker's Surowiecki writes:
In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They’re non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested.
First, Surowiecki seems confused about the difference between a non-recourse loan and a loan guarantee. The FDIC's loan guarantee can be seen as a free option, but this option is a gift not to the bank, but to the "depositor." (I find "deposit," an English word which connotes the act of putting something somewhere and leaving it there, a dubious euphemism for a zero-term loan - hence the quotes.) The same is true for the PPIP loan guarantee.

A simpler way to model this transaction is that the "depositor" or PPIP bondholder lends to USG, whose credit rating is perfect thanks to its ability to print dollars, and USG then lends to the bank. If the bank fails, USG eats the loss and takes the assets - like any financial intermediary. This accounting interpretation produces exactly the same results. And it involves no funky instruments, just bog-standard vanilla loans.

Again: the PPIP is a loan from USG. Since USG can print infinite dollars, it can loan infinite dollars. But since a loan is neutral on the balance sheet, it is not a subsidy in my doxology.

So - second - consider Surowiecki's phrasing:
The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested.
I have seen this explanation a million times. The usual implication is that this represents a one-way bet - a typical case of Wall Street's practice of "socializing loss, privatizing profit." And perhaps it does, but not in the obvious sense.

In the obvious sense, the outcomes for the PPIP playa are exactly the same as in any leveraged investment. The most our playa can lose is everything he puts in. Duh. If you make an investment leveraged at 10 to 1, and that investment goes down by 10%, you lose all your money. If it goes up by 10%, you double your money.

This is not a subsidy. It is normal finance. It is true whoever is providing your leverage financing - Goldman Sachs, USG, or your Uncle Ernie. It is true whatever your asset is - Florida swampland, gold, or frozen-concentrated orange juice. The most you can lose is all your money. Again: duh. For what investment is this not true?

While I am not a fund manager, I am quite confident that there is no shortage of leverage for collateralized loans, whatever the asset, on Wall Street today. The cause of deleveraging is not a shortage of leverage, ie, of prime brokers willing to lend against collateral. While it's true that many of the "toxic assets" are one-off securities for which establishing a market price is not just a matter of a ticker query, this is why the big boys make the big bucks. Moreover, the spiral of deleveraging has affected quite a few assets which are continuously quoted.

The cause of deleveraging, and of course its result as well, is falling asset prices. More on this in a moment. But suffice it to say: no one at Treasury is stupid. They know this.

So what were the designers of the PPIP thinking? How is this machine intended to work? I was not, of course, in the room, but I am no dummy myself and I think I have it figured out. While my guess is that the PPIP, like its predecessors, will not operate correctly as designed, (a) I could be wrong; and (b) it could produce the desired result through unintended means.

First, let's review what makes a "toxic asset" toxic.

The prices of any asset X, whether stock, bond or Kewpie doll, is set by supply and demand. But in the Anglo-American financial system, which was invented by God and is so perfect that it has worked the same for over 300 years, banks practice a practice called maturity transformation. MT lets lenders who want to lend at a short or even zero term (such as bank "depositors") fund loans of a long term (such as mortgages). ("Fractional-reserve banking" is a special case of MT.) Thus, demand for X is magically transmuted into demand for Y.

Ie: MT creates demand for long-term loans. Ie: MT raises the price of long-term loans. Ie: MT lowers the interest rate on long-term loans. Ie: if MT breaks for any reason, the price of long-term loans falls sharply, and the interest rate rises. This is a "bank run," "liquidity crisis," etc, etc, etc.

In a world without MT - ie, one in which 30-year borrowers are funded by 30-year lenders - a cluster of bad loans (such as NINJA loans to impecunious strippers) would simply result in proportional haircuts to the original lenders.

But when 30-year borrowers are funded by zero-term lenders, falling loan prices force the maturity-transforming bank to sell more loans, receiving present cash with which to meet its zero-term commitments. This lowers the price of these loans, and so on - creating the feedback loop that is the basis of the bank run.

"Toxic assets" are toxic because they are at the business end of a bank run. In a "normal" market, the default risk of a loan can be calculated by comparing its yield to the yield of a risk-free security, such as a Treasury bond, of the same term. The spread between these yields can be assumed to represent the market's estimate of the probability that the loan will default.

In a bank run, this formula produces nonsense, because it is comparing apples to oranges. The market for toxic assets is simply a different market than the market for Treasuries. The latter contains new demand from maturity-transforming banks. The former does not.

Thus the yield on Treasuries is around 3%, whereas the yield on "toxic assets" excluding default risk (ie, the yield on an imaginary risk-free toxic asset) is probably something like 20%. The only buyers of toxic waste at the moment are the most patient "vulture" investors. The carcass-to-vulture ratio is quite high, and getting higher. Ergo: supply and demand, baby.

The goal of the various liquidity restoration plans, including PPIP, is to break down the partition between these markets, creating a flood of gigantic profits as sea levels equalize. We are now ready to look at how PPIP is supposed to work.

PPIP is essentially a bank-run-proof leverage facility. The key to PPIP is the difference between PPIP and an ordinary margin loan. As we've seen already, the risk-return profile of a PPIP investment is generally no different from that of an ordinary leveraged investment. There is a difference, though, and the difference is in the details.

An ordinary margin loan is a zero-term loan, like a bank "deposit." Unlike a bank "deposit," it is completely safe for the lender, even without an FDIC guarantee, because it is continuously marked to market. If you lever up at 10 to 1 to buy an asset on Tuesday, and that asset falls 10% on Wednesday, your broker will instantly and automatically sell the asset to repay the loan. The lender is left with all his money. You are left with squat. (If bank "deposits" worked this way, there would be no such thing as a zombie bank - Citi would be rotting peacefully in the grave.)

So, if you use an ordinary margin loan to lever up and buy toxic assets, and the asset price continues to dive, two things happen. One: you lose all your money, instantly. Two: the asset is sold, putting it back on the market and further depressing the price.

PPIP attacks this in two ways.

First, the PPIP loans are long-term. When you use a normal, zero-maturity margin loan to leverage collateral, say at 10 to 1, you are betting that the price of your asset will never drop by 10%. When you use a PPIP loan, say of 10-year maturity, to leverage collateral, you are betting that the price of the asset will not have dropped by 10% at the end of 10 years. Big difference!

The PPIP leverage can withstand short-term fluctuations; the standard margin loan cannot. Thus, it is not at all unreasonable for Treasury to hope that PPIP will attract buyers who are not, at present, ready to make leveraged bets on dodgy mortgage-backed securities.

Second, if the worst comes to worst and the toxic assets have not recovered even after 10 years, PPIP does not dump them back onto the market. It sells them to Uncle Sam, who buys them with his magic printing press. Thus, there is no feedback-loop spiral of asset dumping, as in the classic bank run.

(By the way, using the phrase "taxpayer dollars" to describe expansion of the Fed's balance sheet is a horrific abuse of both good English and good accounting. Sorry, Americans: USG does not need your dollars. It can print its own without any trouble at all. It taxes you simply because otherwise, everyone would be too rich, and prices would go up. In other words, the purpose of taxation under a fiat-currency regime is not to finance government expenditures, but to minimize monetary dilution, thus defending the currency as an effective medium of saving.)

So: do I think PPIP will work - as in, achieve its goal of taking the toxic assets off the bank balance sheets and restoring them to ruddy good health? Well, it is certainly not impossible. But no, I don't think it will work. There are three big problems.

One, PPIP has a long row to hoe in generating enough demand for the toxic waste for the banks to be willing to sell. Banks do not want to sell their toxic assets at the vulture-investor bid, because holding these assets at non-market prices allows them to pretend to be solvent. If the market price is 30 and PPIP demand can get that up to 50, a zombie bank that needs 85 for any kind of solvency will not sell.

Now, one way in which PPIP could work is if banks find a way to use it to buy assets from themselves. If they can bid 90 for their own assets held at 95, PPIP is simply a cover for the obvious solution, which is for the Fed to just buy all the toxic assets from the banks, at prices congenial to the latter. However, I don't expect this to happen, because this type of Enron scammery normally happens in the absence of public scrutiny. The PPIP could easily work by turning into a fraud, but USG winks at fraud only when no one is looking. Now and for the foreseeable future, the stadium lights are on. I'd be quite surprised if anyone major tries anything funny.

Two, remember our original point: leverage cannot turn losses into profits. If asset prices rise, PPIP investors will make money hand over fist. If they remain durably depressed, as in Japan, PPIP investors will lose their entire investment. If investors anticipate this result, they will not participate in PPIP. If investors do not participate in PPIP, asset prices will remain depressed - absent some more generous program.

Toxic assets tend to be collateralized loans themselves, and the collateral is generally real estate. Falling real-estate prices create defaulting loans. But since all real-estate is bought with loans, we see the vicious circle again. Asset-price deflation has its own momentum.

As the suction of deleveraging feeds through the economy, more and more assets enter the toxic category. Thus: expanding supply. Thus: falling price. PPIP must push uphill against this brutal, unrelenting gravitational suckage. Not an easy task.

Three, the vicious circle is not at all irrational. It is actually quite sensible.

Doug Noland, whose Credit Bubble Bulletin has been reporting on the impending disaster since Jesus was a little boy, calculates that the US economy needs about $2 trillion a year of new lending just to stay in the same place. This is obviously a seat-of-the-pants guess, but it sounds about right to me. Thus all the noise from the great and the good about "restarting the flow of credit," etc, etc, etc.

If we separate the economy into two consolidated balance sheets - A, the balance sheet of the government and the banking industry; B, the balance sheet of all other industries and households - we feel it is perfectly normal for B to borrow more and more money, every year, from A. But is it?

In fact, when this "flow of credit" ceases, the result is described as a "recession." And it is certainly quite painful. And when the flow reverses - that's real pain.

Now: imagine you were considering investment in a business, and that business had borrowed two trillion dollars last year. Or two billion dollars. Or two million dollars.

There are two possibilities. One, the business is in an expansion stage, and is creating equity with negative cashflow. It has a "burn rate." But it is using this money to make productive long-term investments which will, in time, reverse this and produce a profit.

Two: the business is a dog. It is losing money. It needs to be liquidated or at least restructured. Woof! Sorry, Old Yeller. The time has come to say hello to Mr. Smith and Mr. Wesson.

Which is it? There is no way to know. However, if we discover that the same business has been borrowing money every year, in the same way, for the past decade, we probably have our answer. If it has been bleeding for the past quarter-century... behold: Exhibit A.

In this interpretation, the United States, as a whole, is a money-losing operation. The fact that the dollar is a fiat currency has allowed us to disguise this, because fiat currency is essentially equity, and equity can always be diluted. So our losses are funneled into a hemorrhage of new shares, in the classic equity death spiral of the dying corporation. But since USG, unlike most dying corporations, is sovereign, the game can continue indefinitely.

The difference between capitalism and socialism is the difference between profit and loss. It's not just that money-losing businesses lose money. They also produce crappy goods and services. Once disconnected from the need to make a profit, they lose the tension that makes them perform. There is only one way for a string to be taut, but all kinds of crazy ways for it to be slack.

Nor is the US unique. If there is an economy in the world that does not run a trade deficit with the future, so to speak, I do not know of it. The fact that we think of continuously increasing debt levels as normal is a measure of the 20th-century detachment from reality. Reality just called - it wants its money back.

This structure is especially interesting when juxtaposed with the fact that there are less than 2 trillion actual dollars in the world (M0). How can a company be capitalized at $50 trillion, when its customers have less than $2 trillion to spend? Because the Fed can create new dollars, both explicitly by expanding its balance sheet, and implicitly by issuing formal or informal loan guarantees.

And it does. At least in normal times. But these are not normal times. Owen Glendower could call spirits from the vasty deep. Did they come, when he called? Not as I recall.

The Fed can create new dollars, by the quadrillion. It could buy every slice of pizza on the planet for a hundred dollars each, and abolish the IRS in the bargain. But will it? As we see above, the Fed's mission is to lend, not buy. And it seems to be having a bit of trouble in doing that. If PPIP fails, does it have the political power to take the next step and straight-out buy toxic waste? With "taxpayer dollars?" I am not sure - not sure at all.

USG can also emit dollars via deficit spending. At present, via the wonders of "quantitative easing," it is selling bonds for dollars to fund its deficit, then buying those bonds with printed dollars. Net effect: spending printed money. But how much money is USG really capable of injecting into the economy, via all its lightbulb-changers, roof-caulkers and Iowa piglet museums? It'll take a lot of lightbulbs, even the most sophisticated and environmentally pure, to replace all those home-equity cashouts from 2006.

USG is simply an senescent state. It is so vast, ancient and sclerotic that it has great difficulty in accomplishing the most basic function of government: wasting money. If it cannot continue to produce dollars and spread them around broadly, the spiral of deleveraging continues. Asset valuations that look reasonable in the light of M0 are the only possible backstop.

And if USG can muster the energy to hemorrhage money, it diverts more and more of its productive resources toward the point of the bleeding, and gradually turns into the Brezhnev-era Soviet Union. In case you have difficulty translating "Brezhnev" into English, the word you are looking for is "Dilbert." Non-profitable businesses become process-oriented, ineffective, and generally insufferable for employees and customers alike. To say nothing of shareholders!

If both these outcomes seem unattractive, perhaps it's time to consider Plan M. (M - for Moldbug.) I feel it's essential to accompany all such destructive criticism with a positive proposal, even just a summary. It's always nice to end on an up note.

The goal of Plan M is to shut down our present financial system and replace it with one that is healthy and stable, preserving relative valuations in a way that is fair to everyone and doesn't interfere with anyone's life or work.

A healthy, stable financial system has two main characteristics.

One, it uses a hard currency - one with a fixed or naturally restricted supply. An example of the latter: gold. An example of the former: the numbers from 0 to (2^64 - 1).

Two, it exhibits balanced lending - maturity-matched banking. For every private-sector borrower of $X at term T, there is a private-sector lender of $X dollars at term T. I believe this is what is known as a "free market." Financial intermediaries diversify risk by aggregating loans, but do not systematically violate this constraint. Interest rates at every term are set by this equilibrium, producing a stable yield curve which shifts only with real supply and demand.

The catch is that to convert our present 300-year-old Anglo-American Frankenstein into a healthy, stable financial system, a complete shutdown and reset is required. USG is no more capable of this procedure than I am of jumping to the moon, but we can still talk about it, I hope.

To reset: consolidate all financial securities and their collateral, including real estate, onto the Fed's balance sheet, at the present market price. The Fed buys all stocks, all bonds, all houses, all commercial real-estate, etc. Automated appraisal tools, a la Zillow, can be used for unique assets. If you own a home, your mortgage becomes rent and your equity becomes cash.

The result is a 14- or 15-figure M0 that includes all former financial assets. Corporate debt disappears, because it becomes debt from the Fed to itself. Same with mortgage debt. If it is necessary to buy votes, unsecured personal loans can be forgiven. Otherwise, they are debts to the government - tax liabilities, essentially.

And all the toxic assets cancel, because they were held by banks whose stock is acquired, and owed by homeowners whose home has been acquired. Again, the Fed owes itself nothing.

Outcome: the citizens of America are sitting on a giant buttload of cash. The Fed is sitting on a giant buttload of real assets. A giant auction is held. Eternal Bolshevism is averted, and life returns to normal. Only better, I suspect.

This dollar pool can either be fixed, producing an ultra-hard fiat currency, or mapped to the nation's gold reserve. While the former is economically optimal, the latter has numerous political advantages.

Mapping 10^15 dollars to Fort Knox will produce a much higher gold price than the current value. This is a feature, not a bug. It has the usual effect of currency devaluation, ie, stimulating economic activity. But the stimulus does not become addictive, because the currency is now hard and will stay that way. There is also a Keynesian effect in which gold mining absorbs a large number of now-unemployed workers. While the production of currency does not create goods and services, from a political perspective it never hurts to get disgruntled people off the street. Gold holders also win big, but they win big in the right way: by being right.

And, of course, a hard gold standard is self-enforcing, whereas a fixed money supply is not that hard to un-fix. Given the 20th-century experience with virtual money, I suspect that it may be another century or two before the snake can tempt Eve again. As Mark Twain said, a cat who sits on a hot stove will never sit on a hot stove again - or a cold stove, either.

While Plan M (which I've been proposing for, oh, about the last year and a half) is politically inconceivable, it is an economic no-brainer. At least to me. If you agree, perhaps you should consider what can be done about the political obstacles. America certainly has no shortage of lampposts.

35 Comments:

Anonymous Anonymous said...

Lampposts? Mencius, you seem to be getting revolutionary in your old age.

March 26, 2009 at 5:33 AM  
Blogger G. M. Palmer said...

Mencius,

I would suggest figuring out a way to tie Plan M and the Gold Standard to evangelical athiesm, gay rights, global warming, and vegetarianism.

Or perhaps get Lil' Wayne to write the soundtrack for a Sean Penn movie about Plan M. Maybe start a supergroup of Lil' Wayne, Kanye West, the cast of American Idol, and produced by Rick Rubin -- and they can call themseleves Plan M & the Gold Standard.

It wouldn't hurt to buy Clear Channel or maybe the NY Times. . .

Or find some other way of selling the idea to voters with a 10th-grade education and a 5th-grade reading level.

P'raps -- hey, do you want a free house and no more credit card debt?

Vote for Plan M!

March 26, 2009 at 5:54 AM  
Blogger Daniel A. Nagy said...

Want to have your argument displayed right between the relevant lines of MM's post? Annotate it at Thiblo.com. Have fun!

March 26, 2009 at 5:54 AM  
Anonymous Anonymous said...

Would anyone be willing to recommend a reputable bullion dealer here in the comments? I would prefer to hold actual gold in my own safe.

March 26, 2009 at 6:09 AM  
Anonymous josh said...

I wrote the above comment. I know there is someone here who actually uses the handle anonymous.

March 26, 2009 at 6:10 AM  
Anonymous m said...

Mencius = Winterspeak

Or Winterspeak is his father, or something.

March 26, 2009 at 7:07 AM  
Anonymous Geronimo said...

"In other words, the purpose of taxation under a fiat-currency regime is not to finance government expenditures, but to minimize monetary dilution, thus defending the currency as an effective medium of saving."

Is this a roundabout endorsement of Chartalism? Chartalism (the State Theory of Money) argues basically the same thing, but says that taxation is necessary not because of money dilution, but to create a demand for the fiat currency. Without taxation, that is requiring taxes be paid in the fiat currency, there's no guarantee that the fiat currency will be accepted by ordinary citizens.

March 26, 2009 at 8:52 AM  
Blogger GW said...

With respect to the "Reset" scenario, wouldn't it be simpler and more feasible (politically and financially) from a "Formalist" standpoint to deal with the real estate leverage problem as follows:

Mortgagee: You now own your real estate free and clear. All loans secured by your real estate assets are forgiven. Go on your way and be well.

Mortgager: Here are X number of brand new Hard Currency Dollars(TM) in the amount equal to the outstanding principal on loans you have issued to forgiven Mortgagees. Go on your way AND DON'T DO THAT AGAIN.

This yields essentially the same result, while being more direct about the most fundamental aspect of any formalist plan: possession is nine points of the law. You are in possession of your house and the mortgage issuer is in possession of a piece of paper saying you owe him some ludicrously large number of dollars. By formalizing this fact in the resolution of the difficulty, everyone comes out clean and whole, and you don't wind up with most US homeowners paying rent to the Federal Government (any more than usual, I mean).

March 26, 2009 at 9:43 AM  
Blogger Reginald said...

The gold standard cannot work long-term. A gold standard implies an entity fixing the amount of paper currency to an amount of gold. No government, or person, can resist the temptation to print paper money and cancel all convertibility into gold. Afterwords, full debasement begins anew. The sole solution is a massive upheaval as everyone converts fiat to private money, and producers price their goods/services in the same money. The private money is usually a precious metal, but will never be fiat money unless violence is used.

March 26, 2009 at 9:52 AM  
Anonymous Anonymous Goldbug said...

Where I live, you can buy gold at the banks. (Of course, I'm in Asia, and Chinese and Indians are rather more fond of gold than Americans have traditionally been.) In the States, most coin shops will probably have some available at near-spot prices, and almost all will have "junk silver"--pre-1964 dimes, quarters, and half-dollars (and occasionally dollars) in such bad shape as to be worthless numismatically, but eminently salable for their 90% silver content. On my last trip home, I picked up $75 face value (about $900 in actual silver content) in quarters and half dollars, just to add a little diversity to the pound of gold I've already got.

There's plenty of perfectly reliable places online to get the usual forms of gold (American Eagles, Canadian Maple Leaves, Krugerrands, etc.)--your biggest problem is probably going to be the three-month-long line you'll have to wait in.

March 26, 2009 at 9:59 AM  
Anonymous Anonymous said...

Junk silver is going like hotcakes around here (also guns and ammo). It's actually pretty hard to find.

March 26, 2009 at 1:08 PM  
Anonymous Michael S. said...

FDIC insurance is not a direct government guarantee. It is, in fact, an experience-based actuarial system in which the participant banks pay premiums based upon a percentage of their insured liabilities (deposits). Premiums are based not only on system-wide loss history but on assessment of both general and particular future risk, under which more conservative and better-rated banks are charged a base rate, and riskier, less well-rated ones are charged a higher amount, much as suburban matrons are charged less for automobile insurance than their adolescent sons.

The funds to pay these premiums are, naturally, budgeted costs of a bank's operation, and as such increase rates of interest charged to borrowers, while decreasing rates paid to depositors, wages paid to employees, and shareholders' return on investment.

I believe MM again overstresses the maturity-transformation issue. Soundly run banks DO engage in balanced lending; analysis of loan terms vis-à-vis time deposit terms and amounts held in demand deposits (which are really the only 'zero-term' liabilities of a bank) is part of standard funds management practice. As I've noted here before, at least at my bank, we never make any loan for longer terms than our longest time deposit terms. A residential mortgage may be on a 30-year amortization schedule, but it renews every 5 years, permitting the rate to be adjusted. The longest CDs we offer are 6 years.

The area where maturity transformation happens is in the investment portfolio of a bank. There, indeed, banks hold fixed-income securities having long terms, such as 30-year bonds. Their liquidity is assumed on the basis that a ready market exists for them - they are, after all, "marketable securities." The salient characteristic of the present panic/collapse is that the assumption of marketability has proved unfounded for many such securities. Accordingly, many of the commercial banks that are in trouble are because of their investments rather than their direct loans.

Just as an example, consider OneUnited Bank of Boston, Mass., for which the off-the-wall left-wing Rep. Maxine Waters, together with House Financial Services Committee Chairman Rep. Barney Frank, recently procured federal bail-out money. It had its capital nearly burnt up because of investment losses in Freddie Mac and Fannie Mae securities. These were, of course, sold as gilt-edged investments with the implicit backing of Uncle Sam. It helped that Ms. Waters's husband was a stockholder and former director of the bank. One wonders how many other purchasers of Fan's & Fred's preferred stock will get such favored treatment. It is, also, a point to note that as the crackup was a-brewing, Rep. Frank's catamite du jour was Herb Moses, a prominent Fannie Mae executive. Obviously, it wasn't just Herb's fannie that got buggered. Still, these are questions for another time.

Discussion of 'banking' could really be improved in quality if a better understanding could be brought to bear of the respective roles of loans, investments, deposits, and capital on a bank's balance sheet. It would also help if the various activities lumped under the heading of banking were differentiated. An obvious distinction is the one between investment banking and commercial banking. More subtle, but perhaps even more essential, is an examination of the business activities of the country's ten largest banks that, willy-nilly, have come to hold about 60% of domestic deposits, since interstate bank branching was first permitted in 1994. I suspect many of their operating losses result from operations other than ordinary commercial lending.

There are about 8300 commercial banks in the United States, and the great majority of them are community or regional institutions that are soundly managed and not at risk. It is the magnitude of the risk at a few very large institutions deemed 'too big to fail' that is the source of the present concern. The FDIC insurance fund now has about $19 billion in it, and FDIC says that needs to be about $60 billion, to be raised in the next two years. FDIC insurance premiums have doubled from last year to this, and there will apparently be a surcharge in addition to this of either 10 or 20 cents per $100 of insured deposits, the amount being unsettled at my last information.

This is, of course, still not adequate to contemplate a takeover of, say, Citi or Bank of America by FDIC. The lesson to be learnt is that any bank that is "too big to fail" is just plain too big.

March 26, 2009 at 1:14 PM  
Blogger Studd Beefpile said...

Maturity matching would not have prevented the current situation. I would go to a bank and deposit a bunch of money as a 30 year CD. The bank then loans the money to someone to buy a house. The housing market goes bust and the 30 year loans stop paying. The bank was relying on the income from those loans to pay off loans made 30 years ago, so they are now insolvent. There is a rush to sell off all the CDs, and the result is identical to a classic bank run.

And the problem with the hard gold standard is the same as it was 100 years ago, in an industrial world the amount of stuff to buy rises much faster than the quantity of gold, which means persistent deflation. You are right that theoretically this doesn't matter but in reality it does. People HATE deflation and moderate inflation has always been politically popular.

March 26, 2009 at 1:33 PM  
Anonymous Anonymous said...

I can't help but think that "Plan M" is a little cranky. How can one buy the entire financial system, liquidate the debt, and sell it back without massively distorting the underlying "real" structure of the economy? Are you implying that the only problem with the financial system is a few bad debts, and that the government will simply getting rid of the bad debts and magically make the economy well again? Doesn't the problem of over-leveraging of debt signify serious problems with the way capital is allocated?

-Victor

March 26, 2009 at 7:35 PM  
Blogger Leonard said...

Beefpile, you've got a mistaken impression of what a maturity matching bank would do. It would match maturity on loans with "deposits". First off, it would have full backing for any demand deposit; but obviously it could not pay interest, and these would not be popular. (In any case, with hard money, you don't need to go to a bank to save; you just hold money, and it increases in value automatically.)

A maturity matched bank would serve a function similar to that of our current banks, as a middleman between savings and borrowers. It would serve as an aggregator, pooling cash by selling normal corporate bonds, then lending directly at the same (or lower) time frames. I.e., borrowed 30 year money can be lent at any time scale of 29.99 years or less. But it would borrow via bonds, not via dipping into demand deposits. Those bonds are no different than any other corporate bond. If there is a broad housing decline, then the bank may end up being insolvent. Sure, it happens. Normal bankrupcy procedures can be applied. But what does not happen is the multiplied effect that fractional reserve banks get, the systemic crash, and the resulting feedback loop of doom.

As for what people think about "deflation", by which you mean, their money increasing in value: how do you feel about computers and technology? Do you HATE the fact that you can buy a better computer next year, for a bit less money? It is true that inflation is popular politically, but so what? You cannot do it on a gold standard, at least, not sustainably.

March 26, 2009 at 9:04 PM  
Blogger Leonard said...

at least at my bank, we never make any loan for longer terms than our longest time deposit terms.

I think that your bank is exceptional. I have never banked at a bank that did not offer 30 year fixed mortgages.

March 26, 2009 at 9:09 PM  
Anonymous Anonymous said...

Are you implying that the only problem with the financial system is a few bad debts, and that the government will simply getting rid of the bad debts and magically make the economy well again?

And if that were true, why not just write off the bad debts and not restructure the whole system? Maybe increase oversight to prevent it happening again, but no more. (Speaking of which, I haven't heard anything about the government actually solving any of the underlying problems, e.g. regulating derivatives or prohibiting sub-prime loans. Has that happened and I missed it?)

March 26, 2009 at 9:18 PM  
Blogger Johnny Abacus said...

Michael S:

Are you claiming that the FDIC could actually pay out to everyone with a claim in the event of a financial meltdown... without assistance from the Fed/Treasury? Just looking at the ratio between M2 and M0... this seems a bit questionable.

As far as:

The salient characteristic of the present panic/collapse is that the assumption of marketability has proved unfounded for many such securities.

There is always a market clearing price (assuming the value of assets sufficiently exceeds transaction costs); banks don't want to sell their assets at market price because then they would obviously be insolvent.

Studd Beefpile:

First off, when a bank is created, there is an initial amount of money that investors contribute to the bank in exchange for equity. Secondly, banks would charge a spread - they would pay less interest on deposits than they would charge for loans - enough of a spread that they would be profitable in the face of defaults.

These two force combined should be enough to stabilize most banks through most crises. Moreover, since the level of leverage in a full reserve banking system is so low (duh!), it would be possible for a private company to provide deposit insurance.

As for deflation - we deal with deflation all the time. Know anyone who buys computers, medical services or automobiles? People learn to live with deflation and act accordingly. Modest deflation (~3% annually) does not strike me as particularly difficult to deal with, compared to the roughly 50% annual deflation the computer industry goes through.

Leonard:

While I'm sure that banks would continue to offer what amounts to safety deposit box services, there is really no reason why they would not offer CDs as well.

You hit the nail on the head here:

A maturity matched bank would serve a function similar to that of our current banks, as a middleman between savings and borrowers

A slightly different way to think about banks is that they provide essentially two services:

1. They aggregate or disaggregate loans so that depositors and debtors don't have to be precisely matched up.

2. They provide loan insurance for a percentage of the loan value.

March 27, 2009 at 1:06 AM  
Anonymous The Undiscovered Jew said...

Is there good reason to believe a gold standard would have prevented and/or much mitigated the current economic crisis?

I don't see how a gold standard would have stopped exotic debt vehicles from being formed.

March 27, 2009 at 11:55 AM  
Blogger Isegoria said...

How can a company be capitalized at $50 trillion, when its customers have less than $2 trillion to spend?

The dollar serves as both a unit of account and as a unit of exchange.

Just because a company is worth $50 trillion does not mean that $50 trillion dollar bills must exist to pay for it.

After all, we can quote the value of any asset in dollars, euros, ounces of gold, ounces of silver, bushels of grain, or any other unit of account — or combination of units — we want.

As a unit of exchange, money has a velocity. We only need enough dollars to handle the transactions in process at any moment.

March 27, 2009 at 12:05 PM  
Anonymous Leonard said...

Undiscovered, it depends on how hard of a gold standard you are talking about. It is easy to have a "gold standard" where the backing of a fiat currency is still kinda, sorta, a little bit gold.

But of course that sort of thing is not what goldbugs want. What goldbugs want is a gold standard of sufficient hardness as to preclude currency manipulation by any actor, be it individual bank, cabal of banks (i.e. central bank), or the state itself. In this case, then yes, gold would have prevented the current crisis.

You are mistaken in planting the blame on exotic debt. These are a problem, but nothing a sound economy could not handle. They are not the root of the problem. The root of the problem is maturity tranformation, which is fundamental in our banking system. As MM said in his analysis of the bank crisis:

there is another way to save a Bagehotian banking system [our system]: find a new lender who can print infinite amounts of money. (Or, in a metallic standard, compel the acceptance of paper as equivalent to metal.) This friendly fellow is generally known as "the government," or more formally as a "lender of last resort."

The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable, and it drives down long-term interest rates - just as if the government itself had been making the loans itself. ... And with wishy-washy, informal, wink-and-a-nod protection ... these toxic qualities are combined.


A functioning gold standard makes a lender of last resort impossible, because nobody can print money. One thing or the other must give: gold backing, or maturity transformation.

Of course, historically the result was that the banking elites cartelized via the state, and displaced gold with fiat. However, this time around things will be different. It was pretty hard in 1933 to move all your money to Switzerland to prevent its confiscation. If gold ever gets remonetized, it will be very hard for governments to get back on top, because the money market is global now.

March 27, 2009 at 1:19 PM  
Anonymous Michael S. said...

Johnny Abacus, re-read the last paragraph of my previous post. After describing all that the FDIC has so far done to increase its operating fund, I wrote:

"This is, of course, still not adequate to contemplate a takeover of, say, Citi or Bank of America by FDIC."

How much plainer could I be?

Leonard, the commercial banks that you have seen offering 30-year fixed rate mortgages almost certainly do not make them to hold in their own portfolios. They deal them off on the secondary market to the GSEs or to outfits like Countrywide. They do or did this in order to compete with the store-front mortgage brokers. Often commercial banks will continue to service such loans for fees of, say, 25 basis points, but they don't hold them. I suppose I should have been more precise about the distinction between merely originating loans and "making" them, i.e., to hold.

Of course some of these originating lenders may effectively have bought some of these loans back in the form of Fannie Mae or Freddie Mac preferred stock or mortgage-backed debt securities. The bad penny returns... however, not to the loan portfolio, but to investments.

You can learn a lot about how the mortgage market operates by looking at the foreclosure notices in your local paper. These customarily list both the originator and the current holder of the mortgage in question. You'll find very few of them are held by your community bank or others like it.

Loans made and held by commercial banks are called "risk-based assets" and are typically the subject of close scrutiny by examiners. Securities held in their investment portfolios, on the other hand, don't get the same treatment because they are assumed to have been well underwritten by the investment banks that floated them, well rated by rating agencies like S&P or Moody's, and in some cases guaranteed by insurers (like AIG!). I suspect that regulators will start to look more carefully at banks' investments now that it is too late to do much good. They always, as the old saw goes, close the stable door after the horses have escaped. What is called "mark-to-market" (when there isn't a market) brings to mind another cliché, this one about bayonetting the wounded.

March 27, 2009 at 1:23 PM  
Anonymous Anonymous said...

Josh:

I have been generally pleased by Affordable Jewelry and Precious Metals, at ajpm.com. I started buying from them before the Y2K foofraw and they are still around now.

I do not work for them, do not have any association with them, and in fact have liquidated my PM for personal reasons, but so far as I know, they are still run by the same people and should be reasonable to deal with.

March 27, 2009 at 1:40 PM  
Anonymous The Undiscovered Jew said...

But of course that sort of thing is not what goldbugs want. What goldbugs want is a gold standard of sufficient hardness as to preclude currency manipulation by any actor, be it individual bank, cabal of banks (i.e. central bank), or the state itself.

No government run by human beings will ever, ever, ever agree to restrict their power over the currency to the extent Austrian goldbugs want. Fractional Reserve Banking gives too much power to the elites to manipulate the economy. Nothing short of nuclear war would cause them to give it up.

Furthermore, even if an Austrian gold standard were somehow established, politicians would look for - and find - loopholes to undermine the constraints a true gold standard would place around government action.

This must be why the Lew Rockwellites want to effectively abolish government in favor of total economic anarcho-libertarianism. The paleolibertarians know that it is inconceivable any government on earth would allow a true Austrian gold standard. So, all forms of government must be abolished.

The goldbugs are therefore charging at windmills. They are dreaming of establishing an economic system that human nature is far too imperfect to sustain for any long period of time - which, ironically, makes them Utopians, inspite of paleolibertarian pretensions of representing the Old Right.

This is not to say that Fractional Reserve Banking as good or bad, just that we are stuck with FRB, or something similar to it, forever.

March 27, 2009 at 1:49 PM  
Anonymous josh said...

thanks.

March 27, 2009 at 2:04 PM  
Blogger Studd Beefpile said...

Beefpile, you've got a mistaken impression of what a maturity matching bank would do. It would match maturity on loans with "deposits". First off, it would have full backing for any demand deposit; but obviously it could not pay interest, and these would not be popular. (In any case, with hard money, you don't need to go to a bank to save; you just hold money, and it increases in value automatically.)

A maturity matched bank would serve a function similar to that of our current banks, as a middleman between savings and borrowers. It would serve as an aggregator, pooling cash by selling normal corporate bonds, then lending directly at the same (or lower) time frames. I.e., borrowed 30 year money can be lent at any time scale of 29.99 years or less. But it would borrow via bonds, not via dipping into demand deposits. Those bonds are no different than any other corporate bond. If there is a broad housing decline, then the bank may end up being insolvent. Sure, it happens. Normal bankruptcy procedures can be applied. But what does not happen is the multiplied effect that fractional reserve banks get, the systemic crash, and the resulting feedback loop of doom.


I wasn't implying that demand deposits would cause an MM bank run, but a large enough decline in asset values could. An MM bank that took a a lot of 30 year money and used it to buy subprime mortgage debt (or make subprime loans directly) would be just as insolvent today as a normal bank.

Of course, you could have a MM bank that directly matched lenders and borrowers, but it would be an almost useless institution. The whole point of a bank is to evaluate risks for me so I don't have to, and to absorb some of that risk should they bet wrong. In exchange they get their spread. Now, they could recommend and insure individual loans, but then we're just back at the beginning. The bank is still insolvent if too many loans fail at once.


First off, when a bank is created, there is an initial amount of money that investors contribute to the bank in exchange for equity. Secondly, banks would charge a spread - they would pay less interest on deposits than they would charge for loans - enough of a spread that they would be profitable in the face of defaults.

These two force combined should be enough to stabilize most banks through most crises. Moreover, since the level of leverage in a full reserve banking system is so low (duh!), it would be possible for a private company to provide deposit insurance.


Except this is exactly what isn't happening right now. Past spread has been pocketed by shareholders and current spread plus reserves isn't enough to cover all the losses on sub prime debt. Eliminating fractional reserve wouldn't have prevented much. There would have been somewhat less lending because there was less money to go around, but people would just have shifted their savings from banks(which would charge interest instead of paying it) to institutions selling long term debt. Those institutions would have invested in sub prime mortgages and would now be just as insolvent as the banks are. All you would have done is change is the names of the institutions involved.

As for what people think about "deflation", by which you mean, their money increasing in value: how do you feel about computers and technology? Do you HATE the fact that you can buy a better computer next year, for a bit less money? It is true that inflation is popular politically, but so what? You cannot do it on a gold standard, at least, not sustainably.

As for deflation - we deal with deflation all the time. Know anyone who buys computers, medical services or automobiles? People learn to live with deflation and act accordingly. Modest deflation (~3% annually) does not strike me as particularly difficult to deal with, compared to the roughly 50% annual deflation the computer industry goes through.


People don't mind falling prices, but they hate falling wages. The people that supported men like William Jennings Bryan mostly had a rising standard of living, but felt poorer (or feared poverty) because the prices they were getting for their crops were falling every year. More generally, deflation makes paying back debt look harder. It isn't rational, but people seem to mind paying interest with inflating dollars much less than paying no interest with deflating dollars. Now, it is quite possible that, with time, people would grow to get used to deflation, but democratic political systems rarely sacrifice popularity now for general future benefits.

March 27, 2009 at 2:40 PM  
Blogger Johnny Abacus said...

Michael S.:

Fair enough. There is a difference between refunding depositors and buying distressed banks, but it is trivial enough not to quibble about.

What I don't understand is this:
FDIC insurance is not a direct government guarantee.

If FDIC is an insurance-like program that can't pay out... how is it anything but a direct guarantee (de facto, not de jure)?

Studd Beefpile:

Fair enough in regards to deflation, particular with the democratic caveat.

March 28, 2009 at 7:53 AM  
Blogger Leonard said...

the commercial banks that you have seen offering 30-year fixed rate mortgages almost certainly do not make them to hold in their own portfolios

Fair enough. I have no idea what banks do with such loans. I do know that the three mortgages I've had have not stayed with their originating bank. All have ended up with GMAC or Wells Fargo.

March 28, 2009 at 8:35 AM  
Anonymous Michael S. said...

Johnny Abacus - the point I was trying to make is that FDIC is an insurance program. Its operating funds come from premiums paid by insured commercial banks, not from the U.S. Treasury. The premiums, as I wrote earlier, are based both on previous loss history and on both general and particular assessment of future risk. The principle is exactly comparable to that on which fire and casualty insurance operates.

The FDIC does not "buy" distressed banks. It takes over failed banks. It did this 25 times in 2008. There is no capital left in these cases, therefore no ownership interest to buy. The stockholders lose everything. The FDIC typically comes in - effectively nationalizing the failed bank - and very quickly sorts out its good loans from its bad. The FDIC sells the good loans to, and places the deposits at, a sound bank, and keeps the bad loans - the ones it cannot sell. While it tries to work out the bad loans, obviously some of them cannot be recovered even in part, while in others the repossession and subsequent sale of the collateral results in a partial loss. These losses reduce the balance in the operating fund. That, rather than paying off depositors directly, is the usual way in which the FDIC experiences loss.

The FDIC system was designed for risk that was more widely distributed than what commercial banking now presents. Until 1994 there was no interstate branch banking. What this meant was that most banks were smaller in their total footings, and they were more numerous. When a large banking operation wished to do business in several states, it had to be set up as a bank holding company and to charter separate banks in each state where it operated - regardless of whether they had state or national charters. Each had to be separately capitalized, and have its own distinct corporate identity, board, management, etc. This requirement markedly discouraged large retail banking operations, broadly distributing the risk of failure over many small individual locations.

The present circumstance, which has come into existence within the past fifteen years, is one in which (as I noted earlier) the 10 largest banks in the U.S. hold more than half of all bank deposits. They are 'too big to fail,' in part because the FDIC, with its fund of deposit-insurance premiums, lacks the resources to deal with the consequences.

Absent political action, the FDIC is not a direct guarantee. If it should not be adequate, the options are to do nothing, or to make some sort of expenditure of taxpayer dollars. The first is not a politically viable option; just how the second will work is what's being ventilated in Washington, on Wall Street, and in the press right now.

The other source of concern is that the changes in the way that the American financial system works have placed many assets that, in the past, would have been held as savings in commercial banks, outside their purview. Similarly, the big businesses that were once the large customers of money-center commercial banks bypassed them to raise working capital directly from the public.

The FDIC does not insure stock brokerage accounts, mutual funds, commercial paper, money-market funds, etc. Yet somehow the vendors of these vehicles are lumped in with 'banks' - the press treats, and people seem to regard, investment houses as banks. Indeed, as a response to the collapse, some investment houses (e.g. Merrill Lynch) have been bought by commercial banks, in sales arranged by the Federal government. This has relieved their problems at the expense of deepening those of the commercial banks that bought them.

Leonard, your personal experience with mortgages demonstrates my earlier point. The 30-year loans are bought on the secondary market and are not held by their originators against their own deposits. There is thus not a maturity transformation issue in their loan portfolios. They've dealt it off to others, and the sold loans are typically 'securitized' and held as investments. This, as I've previously tried to explain, is (to quote W.C. Fields), the real "Senegambian in the fuel supply."

March 28, 2009 at 3:01 PM  
Anonymous Zdeno said...

Mencius, and several commenters, seem to know quite a bit more than me on this topic. That's kind of unfortunate, since I am a graduate student of economics, but the field is more econometric and dynamic programming dick-measuring contests than real, practical study of human behavior.

Anyways I'm toying with the idea of writing a paper on an alternative history of the great depression (perhaps soon to be known as "The first great depression") and I was wondering if some of the more learned out there would recommend some additions:

General Theory... - Keynes

America's Great depression - Rothbard

Monetary history of the US - Friedman

Causes of the current economic crisis - Mises

What am I leaving out?


Cheers

Zdeno

March 28, 2009 at 4:39 PM  
Blogger Aaron Davies said...

@zdeno: actually that's a double-retcon: the real first great depression was in the 1870s; see kenshi's Economic Version Control for more info

March 28, 2009 at 10:57 PM  
Anonymous minute said...

Zdeno,

Check out Robert Higgs. He has already written all the history you'd want to write.

March 30, 2009 at 7:43 PM  
Blogger dm said...

no subsidy!?

If the govt offers to guarantee the performance of an asset for no charge, how is there no subsidy?

Note that this plan doesn't subsidize the buyers of the toxic assets, it subsidizes the sellers to the extent that the feds undercharge for the guarantee (because buyers bid competitively).

March 31, 2009 at 7:39 AM  
Blogger Aaron Davies said...

Mapping 10^15 dollars to Fort Knox will produce a much higher gold price than the current value.

4 to 7 million dollars an ounce, if my math is right, and depending on what exactly the gold reserves are. (one wikipedia page says ~4000 tonnes, another ~8000.) while, as a minor gold holder myself, i would strong approve, one wonders about the general feasibility.

btw, how exactly would one go about estimating future prices under such a regime? i assume one of my maple leaves would not actually be sufficient to buy me three or four bugati veyrons, but it would presumably buy me more transportation than the fair-to-middling mountain bike it's currently good for.

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April 8, 2009 at 11:30 AM  

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