Nikkei vs S&P

I wanted someone to compare the Nikkei post the 1990 crash with the S&P since last year. Thank you Bloomberg!

Looking Back at the Bailouts

Megan and Tyler ask whether the financial bailouts were a good idea, and what should have been done differently. Here's my take:

1) Recapitalize banks by recapitalizing consumers

A "good loan" is a loan that will be paid back, and a "bad loan" is a loan that will not. It's a simple difference. The solvency part of the financial crises was caused by banks having too many "bad loans" on their books, and the Government's solution to this was to give the banks taxpayer money.

The "bad loans" were bad because people did not have the money to pay them off. Therefore, the Government could have simply given taxpayers the money directly, or at least, started taking away less of it through a payroll tax holiday. This money would either have gone to i) paying down debt (making bad loans good), ii) savings (giving banks cheap liabilities), and iii) spending (stimulating the economy, and supporting aggregate demand). In addition, businesses would have more money to retain employees, and maybe even hire a few more.

Over a year, this would cost around $1T-$2T dollars, which is about how much Obama's "stimulus" and bank bailouts cost. The difference is that this way, American households would be better off, instead of the situation now where banks and favored political constituencies are minting money, and the American household is in the unemployment line.

2) The Fed should lend to banks unsecured

The liquidity element of the crises was driven by credit risk entering the overnight bank lending market -- the lending market that the Fed uses (and intervenes in) to set short term interest rates. There were ample reserves in the system, but the banks would not lend to others because of counterparty risk. This meant that there was no single overnight bank lending rate -- it depended on which bank was trying to do the borrowing -- and thus there was no way traditional way that the Fed could set short term interest rates.

The Fed should simply have lent unsecured to banks that needed reserves to meet their regulatory requirements. This would have given them control of that policy instrument bank and dealt with the liquidity issue.

3) Let the FDIC do it's job

The FDIC is basically a branch of the Government that puts its capital in last loss position. It can operate the bank in any way it chooses once the bank has lost the rest of its capital and is now out-of-compliance with capital requirements. We had the farcical situation where one branch of Government (the Treasury) was putting its capital in front of another branch of Government (FDIC). Someone should tell these guys they are on the same team.

The FDIC may have decided to handle the banks that it took over in a different way from the traditional, small commercial banks that are safe to fail, but the perverse market incentives that the Treasuries actions have taken are breathtaking. Because of them the financial system is rightly viewed as corrupt, Government agents included.

4) FDIC insurance should be unlimited

The limits to FDIC insurance are nonsense. Whenever they are almost broached, the simply get upped. The Government should have embraced reality and simply made FDIC coverage unlimited. This would have solved the liquidity problems in the commercial paper market, as demonstrated by money market funds "breaking the buck".

5) Banks are pro-cyclical, focus on households

The major capture connecting all of these bad decisions, cognitive, regulatory etc., that has gripped Libertarians, Liberals, Conservatives, Regulators, Politicians, and Financiers, is that the economy depends on the health of banks. This is the Big Lie. Think about how capital requirements work -- leverage is easier when prices are rising, and harder when prices fall. This is exactly the mechanism that would create an industry that is pro-cyclical, that simply amplifies whatever is going on in the larger market. If the market does well, Banks do well. If the market does badly, Banks do badly.

So the idea that having "healthy banks" will somehow improve the health of the economy is nonsense. If a household has insufficient income to manage it's current debt load, or take on additional debt, does it matter how well capitalized Wells Fargo is? Banks (usually) lend to people who can pay them back. Stuffing them full of money will not make banks make loans to households who cannot pay the loans back. Creating households who can pay loans back will automatically help banks. The tail does not wag the dog.

Where are we now?

We have a situation where the banks are recapitalizing themselves through high net interest margins, thus transferring even more wealth from main street to themselves. Moral hazard is even worse than it was 2 years ago, if that can be imagined. Unemployment, through triggering the automatic stabilizers, is the only thing putting a floor under aggregate demand. The output gap is frankly massive, as high unemployment and underemployment has been the rule for the last year and a half, and probably the next 2-3 years (unless we slip into a Japan situation, where it can continue for over a generation). The US economy is massively demand constrained, with a financial system that's good at getting paid, but lousy at, you know, allocating money.

Mainstream economics has been thoroughly discredited, not that it seems to have noticed.

The incompetence and ineptitude of the Obama administration in dealing with the financial industry may also be hobbling its attempt at healthcare reform. Unfortunately, that is the smallest cost of this debacle.

Why financial innovation is bad

Is it just me, or does this NPR Planet Money podcast completely miss the point. Felix Salmon makes two excellent arguments:

1. We need to control leverage (ie. impose capital controls)
2. Most financial "innovation" has been about escaping capital controls and taking on hidden leverage.

Tyler Cowen, who takes the other side (maybe just for the attention) makes the usual glibertarian pro-market arguments.

First, Tyler does not seem to understand the difference between equity financing (which restructures balance sheets, but does not expand them) and debt financing (which expands balance sheets). The former is pretty innocuous, the latter is potentially cataclysmic. Felix does not press this point, maybe he doesn't understand quite how important it is. Tyler bringing up venture capital is egregious.

Second, neither of them seem to understand that the liability side of bank balance sheets is no place for market discipline. We have both empirical (last 75 years) and theoretic evidence for this (DD equilibrium).

Third, debt financing in particular should be focused on credit analysis, so innovation should take the form of better credit analysis. It isn't hard to get the incentives right for this -- just mandate that the loan be kept on the lender's books.

Fourth, the empirics behind the benefits of securitization are awful. Take the original MBS with passthrough -- it began in 1970. Did the US exhibit ANY inability to make enough houses to shelter it's population pre-1970? Since it did not, what real, practical purpose did MBS serve?

Why FDIC is a fraud

FDIC claims to be an "insurance" policy. Banks pay "premiums" to the Government, who puts them in a "fund", and when a bank has the bad luck to go bankrupt, the Government makes depositors whole (up to some limit) out of that same fund. Just like insurance.

Unfortunately, this whole system is a fraud, leading to nonsense articles like this one: is the FDIC bankrupt?

The FDIC is not, and cannot, go bankrupt, because it is part of the US Government and the US Government cannot go bankrupt because it is a currency issuer. All currency issuers, in a fiat, non-convertible world, have the ability to extinguish any obligation in their own scrip by changing a cell on an excel table. They may choose not to change that cell, but they always always have the option to change it, and thus, not default. There is no "fund" because it can be topped up at any time.

So, what are FDIC premiums then, if they are not premiums? Answer: they are a tax, like any other.

Why is the US Government taxing banks on one hand while it doles out money with the other? Answer: Good question. And not just for banks.

Banks are part of the private sector, although an unusual part, and taxes draw down their ability to net save just as it does to any other part of the private sector. What's even more important to banks is capital requirements, and the Government is acting counter-productively here as well. First, from Mish:

A comment concerning the FDIC - As of June 30 the rates being charged banks have increased substantially. Risk 1 category went to 12 basis points from 5, risk 2, 17 basis points, risk 3, 35 basis points, and risk 5, 50 basis points. Additionally, a 5 basis point special assessment is being charged on September 30 on total assets less tier 1 capital. It is probable that a second assessment will also be charged in December.

The cost of FDIC insurance for a two hundred million dollar, 1 risk rated bank last year would have been around $8,300 per month or $100,000 per year. It would have been much less in previous years.

For a 5 risk rated bank, which many banks have been moved into, the cost will be $1,100,000 including the 5 basis point assessment being levied in September. While warranted, this will exacerbate the problems and ultimately hasten the death or forced sale of a lot of banks.

This will certainly mark the end of the banking model using wholesale funding and aggressive deposits to fund commercial real estate projects. In other words this is going to come down hard on the FIRE economy.

The end of rapid real estate appreciation and current overhang of CRE stock marked the end of banks using "wholesale funding and aggressive deposits to fund commercial real estate projects", higher FDIC requirements are just higher taxes, and a drain on savings.

And now, from Mosler:

If these securities become ‘impaired,’ as defined by regulation, they are marked to market and capital adjusted for that loss.

But recently an additional measure was taken by the regulators.

If they are downgraded to below ‘investment grade’ they are not only marked to market for net capital calculations, but also treated as a ‘charge off’ for capital ratio purposes.

For example, if we have $1 million security that is downgraded below investment grade and has a current market value of $500,000, we reduce our stated capital by $500,000, as had previously been the case.

But now, even that $500,000 remaining value, is, for all practical purposes, counted as 0 for purposes of determining our capital ratios.

The capital ratio is the important calculation as it determines how many assets a bank can carry for a given level of capital.

This means, for example, that if a bank had securities that were below investment grade with a market value equal to all its capital it could not carry any other assets or deposits.

So, a $1M security which marks to market at $500K gets downgraded to ZERO when it is re-rated as "non-investment grade". Not downgraded to $500K, but downgraded to ZERO. This dramatically worsens banks capital ratios, and inhibits their ability to lend, or at least be in regulatory compliance (those two used to go hand-in-hand, but now no longer).

So, the Obama administration cuts rates to zero, depriving the private sector of interest income, while letting banks re-capitalize through high NIMs in this tight credit environment. With the other hand, it raises taxes on banks directly through FDIC, and de-capitalizes them through... the ratings agencies. Abysmal.

Working just as it should

The new MacBook Pro's headphone jack combines audio-out with line-in. So, plug in your iPhone combo headphones/mike and you can Skype right away. Perfect.

Why unemployment, and not the stimulus, is helping the economy

In this NYTimes piece, the Obama administration makes its case that its stimulus is what's keeping the economy from shrinking further. This is why economics is not, and should not pretend to be a science. So much has happened in the past 18 months, how can you really separate correlation from causation? It's easy to dismiss some patent drivel though:

The signs of the stimulus are there,” said Allen L. Sinai, chief economist at Decision Economics, a forecasting firm in New York. “Government — federal, state and local — is helping take the economy from recession to recovery. I think it’s the primary contributor.”

Federal Govt has helped some, but State and Local have not. Certainly, California's budget cuts in no way can be considered "stimulative", and the rest of the nation is just California writ small. Let's look at the other Government efforts that may or may not be having an effect (positive or negative):

For one thing, Mr. Obama’s stimulus program was only one component of a broader effort to combat the financial crisis. The Federal Reserve printed vast amounts of additional money, creating a raft of borrowing programs for financial institutions and businesses. It is in the process of buying up $1.25 trillion worth of mortgage-backed securities, a move that has pushed down mortgage costs for homeowners and new homebuyers. Meanwhile, the Federal Deposit Insurance Corporation has further subsidized lower borrowing costs for Wall Street firms and banks by offering federal guarantees on the bonds they issue.

Certainly the backstops have helped enrich the financial industry--NIMs have risen dramatically--but how does a better capitalized financial industry help the broader economy if not through cheaper credit (which we do not have)? And isn't credit rationed by ability to repay? It certainly isn't reserve requirements.

If you look at the actual numbers, it's clear that the biggest, most dramatic changes are 1) the expansion of the Federal balance sheet, and change in its composition, and 2) the increase in Federal debt. The former was driven by positive action taken by the Fed and Treasury to add more Govt money in a first loss position ahead of FDIC. Warren Mosler first made this point, and I think he is quite right: having a second branch of Government put Government money in front of another branch of Government already having Government money does not seem like the stuff that recoveries are made of. That leads us to the increase in Federal debt, or paid in equity, as unemployment (automatic stabilizers) lowers tax revenue and increases Government spending thanks to welfare benefits. This directly puts a floor under private sector credit collapse by funding the paid-in equity that all private sector balance sheets rest on.

So, a "stimulus" program that has yet to start, a rearrangement of financial assets, or an increase in private sector saving driven by unemployment, and set up by a Government 80 years ago, now running on autopilot? What do you think stopped the fall?

Bye-bye Brad, and thanks for all the fish

Brad Setser is leaving the CFR and will no longer track international capital flows. Part of me is sad, Brad was an island of civility and data in a blogosphere woefully short of both. That said, I had stopped reading him as I increasingly realized how fundamentally useless his information was. It can be summed up here:

Fundamentally this blog was about an issue – the United States’ trade deficit, the offsetting trade surpluses in other parts of the world and the capital flows that made this sustained “imbalance” possible. Most of my early blog posts argued, in one way or another, that taking on external debt to finance a housing and consumption boom wasn’t the best of ideas. Even if (or especially if) the deficit was financed by governments rather than private markets.

The US housing bubble was driven by bad credit risk, as the US financial system was (and remains) poorly motivated to accurately assess credit risk. The rest of the world did not finance anything in the US, the US funded the rest of the world's desire for $ savings. This is trivial if you simply think what "asset" is being stored, who can produce that asset, and how much it costs them to do so (answer key: dollars, the US Govt, and 0).

No one is, or needs to, "finance" the US Fed deficit. Tracking it is tracking the demand for US Savings, but how interesting or important is that, really?