The Lost Secrets of the Federal Reserve

I have a very esoteric mind....if I could just remember where I put it. A. Burns

The problem with esoteric institutions, from the Priests of Ancient Egypt to today's Federal Reserve is the difficulty in retaining the well-hidden secrets these institutions are built upon.  The more successfully esoteric the institution, the greater the risk "essential"- a claim deserving of vigorous debate, in my view- secrets will be lost.

The priests of Ancient Egypt, whose understanding of Nile flood cycles, inter alia, made them one of the first economic policy makers in the historical record, hid their knowledge of seasonality behind a dense a screen of esoteric theology.  The science, or exoteric understanding of the effects of the earth/sun relationship was left to younger cultures, uninhibited by Egyptian taboos on such studies, to "discover."

The Egyptians worshiped the Sun and made sacrifices and offerings thereto (thus enriching the priests).  The Greeks openly theorized about the sun and many other things and thus developed a more accurate world view.

In more modern times, the US Federal Reserve, the Creature from Jekyll Island, as some have called it, was formed in secret, around secrets.

I'd like the share some of those secrets (assuming I've actually divined them- an assumption the reader must determine for himself):

1) Industrial Capitalism is (and can continue to be in the future) so efficient that an ever increasing percentage of an ever increasing number of people can do nothing and yet receive the necessities of survival.

2) The social utility of money- i.e. the elastic variety of modern Central Banks- is (and has been for decades) decreasing as  an allocator of capital resources and increasing as an allocator of (ever increasing) labor resources.

In other words, the problems of economics once a nation industrializes (and more so when nations trade freely) are not on the production side (the already sufficient pie, if you will, can yet grow) but on the distribution side (how shall the pie be sliced). 

Consider, as an example, US agricultural production:

• 1900:  41 percent of workforce employed in agriculture
• 1930: 21.5 percent of workforce employed in agriculture;
• Agricultural GDP as a share of total GDP, 7.7 percent
• 1945: 16 percent of the total labor force employed in agriculture;
• Agricultural GDP as a share of total GDP, 6.8 percent
• 1970: 4 percent of employed labor force worked in agriculture;
• Agricultural GDP as a share of total GDP, 2.3 percent
• 2000/02: 1.9 percent of employed labor force worked in agriculture (2000); Agricultural GDP as a share of total GDP (2002),
• 0.7 percent

Source: Compiled by Economic Research Service, USDA. Share of workforce employed in agriculture, for 1900-1970, Historical Statistics of the United States; for 2000, calculated using data from Census of Population; agricultural GDP as part of total GDP, calculated using data from the Bureau of Economic Analysis.

We, in the US, can not only feed ourselves, we can generate an exportable surplus using less than 2% of labor resources.  Food is easy, which explains, in part, the obesity problems of the modern world.

Food, houses, clothes, transportation (most likely not of the automobile variety), education and health care, to name a few key "necessities" of life can be produced in excess of demand.  The problem, in my view, lies in how to distribute the goods. 

One solution, chosen by men steeped in the tradition of the Protestant work ethic, was the use of elastic money to keep idle hands from "the devil's work."  Rather than a massive expansion of welfare, which, I believe, would be more intellectually honest and restrict money's social utility to capital resource allocation- i.e. the hard money advocated by Ron Paul, inter alios- money would be (and still is, with decreasing efficiency) used to soak up excess labor resources and "explain" the vagaries of goods distribution within a society to modern sensibilities.

Paradoxically, Rep. Paul favors not only hard money, but also further decreases in transfer payments, i.e. welfare and "make work."  Hard money, in my view, generates increased efficiency- more goods for less labor- which, in turn, generates unneeded labor resources.  Hard money "end the Fed" advocates need to ponder the unnecessary, but existent population problem.  Swift's modest proposal of eating Irish babies, which we can expand, in the modern world, to eating unemployed people (Soylent Green!) strikes me as most unsavory.  (I couldn't resist)

State enforced population restriction, like China's "one child" policy could be used, at risk of imposing human for "natural" selection on humanity.  How would we know which humans are worth bringing to life?

The esoteric solution of the Federal Reserve, aided by the views of JM Keynes, worked, in my view, tolerably well so long as the secret of excess labor was understood by its leaders and national capital infrastructure wasn't in need of retooling.  Greenspan's statistical fumblings with productivity coupled with his anti-welfare/anti-inflation views suggest to me that the secret was not well transmitted as does the lack of import placed on previously believed key elements of the Fed's role in fomenting social stability embodied in Humphrey Hawkins legislation.  The financial sector, taking its cue from the confused Fed thinks its function is to make money rather than allocate capital resource.

The secret has been lost.

Thus, it seems to me, the current problem of long term unemployment.  The policies of the idle wealthy, or leisure class, desirous of maintaining and bequeathing to their progeny their position at the head of the pie cutting table via reductions in transfer payments implemented by the financial sector risk increased social tensions, and increasingly widespread populist uprisings, such as we are witnessing in Egypt and other nations. 

Solving this problem, in the context of the need to recapitalize our transportation system away from the automobile (and goods trucking) towards more efficient means, will be most difficult unless we are willing to slay a few sacred cows. The protestant work ethic inspired elastic monetary system insulates the real (production) sector from necessary conforming to new reality (decline in US and world oil production) pressures until a crisis is reached.  Hard money would make the necessary transportation (and other sector) changes easier, but would increase the social tensions noted above.  Increased transfer payments in the proposed hard money system should alleviate these tensions. 

Sadly, as noted, the hard money advocates are not fond of such transfer payments.  Perhaps they will be fonder of such socially calming methods when the turmoil in the Middle East rears its head closer to home.

Bernanke and the Depression of Damocles

It's showtime for Ben Bernanke, Fed Chairman. The moment of truth, so skillfully postponed by months of swapping good money for toxic debt, is once again at hand.

He will either be the hero or a punch line in some future Fed Chairman's speech.

To wit, in Bernanke's own words:

The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. After the stock market crash of 1929, many thought a financial and economic crisis was necessary--even desirable--to wring out speculative excesses that had built up in the 1920s. Remarkably, despite the fact that the Federal Reserve had been founded to mitigate financial panics, the central bank made essentially no effort to prevent the wave of bank failures that paralyzed the financial system at the start of 1930s. Indeed, the Treasury Secretary at the time, Andrew Mellon, believed in the tonic effects of weeding out weak banks and famously advised President Herbert Hoover, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … It will purge the rottenness out of the system."

The Depression of Damocles hangs over his head while he deliberates long run strategies for managing the Fed's balance sheet- a hot topic at the Fed's meeting late last month.

The staff next gave a presentation on potential longer-run strategies for managing the SOMA. At previous meetings, Committee participants had expressed support for steps to reduce the size of the Federal Reserve's balance sheet over time and return the composition of the SOMA to only Treasury securities. The staff discussed the potential portfolio paths and macroeconomic consequences of a number of different strategies for accomplishing these objectives. To date, the Desk had been reinvesting the proceeds of all maturing Treasury securities in newly issued Treasury securities, but it had not been reinvesting principal and interest payments on maturing agency debt and agency MBS, nor had it been selling securities. One strategy considered in the staff presentation was a continuation of the current practice, which would normalize the balance sheet very gradually. In addition, the staff presented information on a number of other strategies that included sales of SOMA holdings of agency debt and MBS and under which the proceeds of maturing Treasury securities would not be reinvested; these strategies differed by the date and circumstances under which sales would be initiated, by the average pace of sales, and by the degree to which the timing and pace of such sales would be adjusted in response to financial and economic developments.

Ironically, the Fed is not debating whether to "liquidate" à la Andrew Mellon, toxic debt purchased from the banking sector, but rather the pace of liquidation.

The modern Fed, if it tries to drain liquidity by liquidating toxic assets, may well, like its counterpart in the early 1930s bury the economy under a mountain of unpayable debt in order to maintain a "strong dollar", which, as an aside, has risen roughly 20% so far this year in Forex markets.

Let's return to Ben's jab at Andrew Mellon, The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. Whether this first lesson is currently well understood at the Fed remains to be seen.

While there are many aspects of financial stability, one key feature is sufficient income to service liabilities, a task which gets most difficult the higher the ratio of liabilities to income.

The graph below depicts total US financial liabilities (source Fed's Flow of Funds data) divided by US national income (source BEA).

As you can see, current trends do not engender a sense of US financial stability. Income needs to rise to avoid a Mellon-esque liquidation. Financial stability, in my view, does not flow from support to financial institutions, which but buys time, but from a financially stable real sector. Right now, the last thing the US real sector needs is less liquidity and a strong dollar.

The question, in my mind, is why the Fed tolerates a "strong dollar". Will the words of men like Bob Rubin- "a strong dollar is in the US national interest"- become Mr. Bernanke's ironic epithet?

In time, economic historians may realize the only interests served by a strong dollar in recent times are those of the TBTF banks, who get a "free ride" on the exorbitant privilege of the US$'s role as main global reserve. Bernanke, to avoid being the goat, needs to solve Triffin's Paradox as Alexander the Great solved the Gordian Knot, by cutting it in half- and choosing to support the domestic (real) economy.

The real economy in the US needs a weak dollar and inflation or it will not be able to service its debt. How one can think finance needed the Fed's shock and awe in 2008-09 but the real sector doesn't, and can instead service its debt with a long and gradual decline in unemployment, escapes me.  The US needs some inflationary shock and awe.

"But," you might be thinking," hasn't the US been inflating?"

Yes and no. While the monetary base has tripled over the past decade, growing even faster than in the 70s, when it doubled, broader money stock measures are not responding in kind- M2 has roughly doubled during the past decade while it more than tripled during the 70s. Credit, more and more over the years, is flowing to the financial markets, (and overseas- some $300B of US currency is in foreign hands source: BEA) bypassing the US real sector.

Debates over the pace of Fed credit draining via toxic debt liquidation is ample proof. US monetary policy has been hijacked by international financial concerns who don't want the value of their dollar holdings inflated away (but don't seem to realize current income without inflation only invites default). 

Bernanke needs to make a choice. Supporting the TBTF banks and the "strong dollar" as basis of global reserves got us into this mess. More of the same won't get us out of it.

Derivatives of Mass Destruction: From "Fat Man" to "Fat Finger"

I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones. Albert Einstein

Deputy National Security Adviser John Brennan said Sunday that the White House does not believe Thursday's Wall Street nosedive was the result of a cyberattack. The Hill

Had Mr. Einstein lived long enough he would not have been ignorant of WWIII's weapons- they are financial in nature, and, instead of "Fat Man" and "Little Boy", modern WMDs are called Credit Default Swaps (CDS) and are ignited by a "Fat Finger".

The need to hedge derivative portfolio "delta" (sometimes in amounts far exceeding the underlying security's total value and often "computer driven") makes financial markets very vulnerable to "Fat Finger" problems (or any multi-standard deviation price changes). It's a WMD (not confined to CDS, hedging is common to all derivatives) waiting for a trigger.

We need to dismantle these WMD, instead of focusing all effort on stamping out the next lit fuse. 

Unconvinced?  Think I'm (falsely) "shouting fire in a crowded theater"?

Read on.

In theory, CDS provide securities' owners a means to cheaply insure against their default. By paying a (or series of) small premium(s) (usually far smaller than the security's yield) the risk of default is swapped to the CDS seller.

In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer's stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs.

In practice, (as I learned, painfully) trying to maintain hedges in fast markets (and I traded foreign exchange- a pretty liquid arena) can be impossible. Worse, as price deviation from last hedged position grows, the amounts to hedge grow as well. A .5% move in the underlying might call for a 10% hedge, while a 2% move might call for 35% and so on.

Adding insult to injury, all those hedges may have to be unwound if prices come back to "normal". Among traders, market chasing as described above is called hedging "bad gamma" (which is about as fun as having "bad karma").

In practice, CDS are not primarily used as insurance. They are, more often, purchased "naked", not to hedge against a default, but to bet on it, and perhaps, as you'll see, to actually accelerate it, particularly if one could, through naked purchases in greater amounts than existing underlying securities, force hedgers into selling over-drive.

I suspect events like last week's panic in equity markets will become far more frequent so long as CDS (in particular) use, and thus necessity of hedging thereof, continues to grow.

Warren Buffett, before a Galileo-like recantation and rebaptism in the church of TBTF finance, was a pioneer in recognizing derivatives as financial weapons of mass destruction. Like the nuclear weapons of WWII, modern WMD are examples of tremendous leverage- tiny amounts of fissile material or premium, respectively, explode with enormous yield, wrecking horrific damage.

Unlike atomic weapons, whose direct effects are limited to a blast and radiation radius, modern WMD, like CDS use high speed connectivity and computer driven hedging as transmission mechanisms. The "Fat Finger" ignites a "critical price deviation" forcing hedgers of naked CDS to (try to) sell what might be many multiples of available securities.

Thursday's market action might in the future be seen as the Trinity test of the financial Manhattan Project, broadcast live to anyone in the world with an internet connection.

Fortunately, just as atomic weapons require radioactive cores, so too do our CDS WMD. In the latter case, the underlying core (financial entity) must be highly leveraged. Instability, either at an atomic or financial level, is key to explosive yield. Trying to force default in an unleveraged, highly solvent financial entity would be about as fun as using carbon-12 instead of uranium-235 in an atomic bomb.

In other words, while real world WMD deterrence might require a missile shield, financial WMD deterrence might require a solvency shield. The more solvent, and less leveraged a company becomes, the less it needs to respond to the whims of the markets.  It can just go about its business.

Highly leveraged financial companies like Lehman and Bear Stearns were prime "fissile" material- so unstable they needed daily financial stabilization. Unfortunately, there seems to me to be far more financially unstable material laying around than fissile isotopes- Wall Street finance being far more effective than, say, Iranian centrifuges.

On the bright side, fears of "Fat Fingers" igniting naked CDS into financial WMD might someday be seen in the same light as plans for mutually assured destruction (MAD)- as signs of the need to dismantle armaments. Perhaps Homeland Security should audit the Fed, and dismantle the highly leveraged and unstable financial cores we've strategically placed around the nation.

Either that or people of the future might visit New York as they now visit Hiroshima and Nagasaki- looking at a plaque commemorating the destruction caused by a "Fat Finger" instead of a "Fat Man" or a "Little Boy".

Who knows, maybe in addition to Arms Control, Capital Control will be a national security matter.

Finding the Right Safe Haven For This Crisis

"Is it safe?"

That question still brings shivers up my spine as I recall the 1976 movie, Marathon Man, starring Dustin Hoffman, Roy Scheider, and Laurence Olivier. If you haven't seen the film, here's the scene in question on YouTube.

Terrifying.

That question, no doubt, is running through the mind of many an investor at the moment as they search for a safe haven. Like Dustin Hoffman's character in the movie, many financial advisors may well be telling clients this or that investment is "very safe, so safe you wouldn't believe it." Also like Hoffman's character, they may not know what they're talking about because, I suspect, experience isn't much of a guide these days.

You don't know if I do either, so I'll just lay out my arguments and you can decide if they make sense.

I believe the world is in the final stages of what has been the longest unanchored credit expansion (by which I mean a period of undefined monetary units) in modern history. Previous credit expansions ended, after a manic phase, with prices quickly finding some equilibrium in relation to the monetary anchor's price. In modern history that anchor has been gold and/or silver.

"Oh no," you might be thinking, "it's another lecture from a gold bug."

Yes and no.

I think the past 39 years has demonstrated the potential for an unanchored monetary system. In "The Fed Vs. Gold" I charted the US$/Gold price for each of the post 70s crisis Fed Chairmen, and prior to Mr. Bernanke's tenure (and the end of Greenspan's), even though the US$ was not convertible to gold at a fixed rate, the price behaved, more or less, as if it was.

The point being, convertibility isn't the key, rather, however one measures monetary stability, Central Bankers need to shoot at a target and the market needs to have some sense of what that target is.  No commodity or inflation target, no bond vigilantes.

The target now, apparently, is to ensure that the world's big banks don't go bust, ergo the size and direction (to the banks and not the people, infrastructure projects, etc.) of "rescue" flows each time the increasingly frequent crises erupts. 

The effect of this policy was readily apparent today, as it was during the last few months of 2008- nobody knows what anything is really worth. Traders, on their own or, more often, guided by computer models, act on "asset" price cues and sling around huge volume orders in markets suddenly thinned of price makers. 

I sometimes wonder if, in part, the substantial increase in computer driven trading has kept this game going far longer than it otherwise would.  After a while, you'd think, humans would begin to wonder what things are actually worth, instead of simply reacting to price cues.  Of course, the answers to those questions might not be favorable to the big banks, or governments.

It's not safe.

Over the past few years the number of safe havens have been shrinking, and, in one key respect shifting. For the first time in many years, gold rose as traders looked to shed risk. This, to me, is a most interesting development. Historically, gold has been the premier safe haven, the ultimate store of value in times of financial confusion. I expect this to continue.

As I noted a few days ago (the timing was more fortuitous than a result of expertise), credit conditions are tightening and should continue to tighten. The authorities, most likely, will try to inflate their way out of the tightness.  The Fed, as the supplier of global reserve currency liquidity will have to act as lender of last resort at a time when Fed Funds are already near zero.

They key, in my view, the last peg to the US$ standard, is the US bond market. Had bond prices fallen sharply today I would have qualified today as the terminal stage of the credit expansion, but prices rose.  Prior to the 1987 crash, a substantial equity market decline would have, as today, led to thoughts of more liquidity and, unlike today, higher inflation.

If the argument laid out above is correct, at some point in the not too distant future, US bond prices will fall sharply along with equity markets, major currencies will slide against key industrial commodities, and gold will rally sharply. 

When people don't know what money is worth, and have no faith in its stability, how can they know what anything else is worth in terms thereof?

At times when nobody knows what anything is really worth there is one answer historically to the question, "is it safe?"

It's safe, if it's gold.

An interesting observation:  I spent the day playing golf and none of the televisions in the club house were tuned in to CNBC.  That would not have been the case in 2000.

Full Disclosure: Long lots of Gold (thank you, Morgan Stanley, for those 1998 Golden Eagles at $275)

Collapse of Occult Economics and US$ Based World

I see bad libor rising
I see trouble on the way
I see market crashes and (near) defaults
I see bad times today

Don't go 'round tonight
For it's bound to take your cash
There's a bad libor on the rise

Ex-Fed Chairman Greenspan has been accused of occulting (hiding from people's view) dissent from the Fed's panglossian housing market forecasts in 2004. While I'd love for that to be true, I'm with Felix Salmon, who, after reading the whole transcript (always a good idea before jumping to an opinion) discerned the offensive quote (see below) referred to debate over Fed transparency and not the housing market.

We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.  Fed Transcript

To my mind, a more interesting quote can be found in Ms. Minehan's discussion of US economic growth at the same meeting: And like everybody else, I don’t know why the pace of hiring has been as slow as it has been or whether it will get slower or speed up more quickly than we expect.

There's an admission worth noting, she, like everyone else at the table didn't know why the pace of hiring had been as slow as it had been (perhaps because Fed liquidity had gone more to overseas markets than at home would be my guess). In other words, the only occulting that occurred at Fed meetings was the far less sinister, but much more ominous blind leading the blind.

I think the same phenomenon lies behind TPM's discovery of occult practices at the US Treasury in their dealings with Congress (Ms. Pelosi has recently reported the meeting to first request funds came at her, not the Treasury's, request) prior to the request for TARP funds. It isn't sinister, it's just a case of enforced ignorance, as in, let's try whistling past the graveyard, it might work.

Neither Greenspan, nor Rubin, nor Summers (whose financial prescience was shown to be flawed at Harvard) nor Blankfein nor any other of the financial big wigs knows what's going to happen in the financial world because they believe this time is different. (If they did know they would have run for the hills long ago) They have thrown away the only tool that allows economic forecasting, the assumption that the rules of economics always operate (qualifying the proper conditions as they relate to the past being the tricky part of the game, whether I've done so accurately this time remains to be seen).

The collapse of occult economics to which I refer is the apocalypse (Greek for unveiling) of the US$ based system as operating under the same rules of finance that have always operated, specifically the fact that true provision of global liquidity can only come (in a US$ based trading system) through increased US$ supply, a.k.a. Triffin's Dilemma.

As I've previously discussed, Robert Triffin noted the dilemma at the heart of the US$ based global trading system- in order for the world to get the liquidity it wants US$ balances overseas will have to grow, thus eventually weakening the US$ such that it could no longer serve as global reserve currency.

Two events are conspiring to unveil Triffin's Dilemma to the world, the coming economic slowdown in China as a result of previous credit over-extension and current tightening and the current emerging crisis in the Euro periphery- the "G"-less PIGS (Portugal, Italy, Greece (who've gotten their bail-out), and Spain). The "G"-less PIGS must have felt a bit left out of the liquidity party for Greece this past weekend and are now clamoring for their own rescue package.

As an aside, I'm only partially facetious when I suggest a most profitable Hedge Fund theme, find liquidity deprived countries to invest in a fund that will blow out your spreads (CDS and swaps) and create the need for a bail-out. As an added bonus, the rescue deal will likely include a fully funded financial rescue package.

As always there are options available to policy makers. They could allow defaults to occur but that is the "it" (being deflation) Bernanke promised wouldn't happen here (in the US, and by extension, the world), and that option too would likely lead to the end of the US$ based trading system. The other option, the option that has become the rule is more liquidity, and in this case, barring a significant decline in the Euro and RMB vs. the US$, the Fed will have to supply that liquidity at a time when they would prefer to begin unloading some of the toxic securities they bought from the TBTF banks.

Unlike the 2008, 2000-2001 and 1997-1998 crises, however, Fed Funds are already near zero. Quantitative easing, in the form of continued declines in acceptable collateral for Central Bank discounting will be the tool- monetization of poor credit, in large amounts.

At that point, I suspect, Gold will begin to soar against all currencies, and the search for a new global international reserve will being in earnest.

The signs of impending crisis are already manifesting: 1) global stock markets are rolling over 2) credit default swap prices for the "G"-less PIGS are rising rapidly 3) the pace of decline in US$ swap rates has eased.

In the not too distant future, if stock markets continue to weaken, US$ swaps rates will rise. US$ liquidity will, once again, be in short supply and the Fed will be called on to rescue the world.

Let the unveiling commence.

p.s. the primary rule of economics that, in my view, has been occulted from view, because it is so distasteful (to some) is the no free lunch rule...just my, rapidly depreciating, two cents

p.p.s yes, I'm way out on a limb on this one, but what the heck, I'm just a pajama-wearing blogger

Full Disclosure: Long lots of Gold

"Banging the Close" and Other Urban Truths

The CFTC said Moore's fund portfolio manager tried to manipulate platinum and palladium futures from at least November 2007 through May 2008 by entering trades in the last 10 seconds of trading in a manner designed to exert upward pressure on the settlement prices. The practice is known as "banging the close." Reuters

"The timing of the SEC's filing of a civil securities fraud action against Goldman Sachs has created serious questions about the commission's independence and impartiality," said Darrell Issa, the top Republican on the House Oversight Committee, in a letter to the SEC on Tuesday.  Reuters

I couldn't believe my eyes as I read the stories above. A Hedge Fund (and former employer), Moore Capital, caught manipulating closing prices and the SEC caught timing the release of GS fraud charges to further their agenda.

What's next? Will the experts soon assert, with somber gravitas, that life, in fact, exists....on Earth?

That is, the incredulous implication of the above articles (and many others these days) is to me, incredulous. Do we all really believe we take up no space? politicians and bureaucrats don't play politics? fund managers don't "window dress", "paint the tape" or "bang the close"?

Mr. Bacon of Moore Capital, for whom I have great respect as a trader, and from whom I learned a great deal during my short time there, is no fool. I'm sure he authorized the obligatory statement: Neither Moore Capital's principals nor its current management were involved in any improper trading, and none have been accused of any wrongdoing.

I'm just as sure he senses the absurdity therein.

Every big player in every market I've traded effects the price when they trade. Central Banks count on this effect when they "intervene"- a word that implies some deus ex machina instead of another institution with an ax to grind. Why should anyone care if a firm decides to make liberal use of the "Texas Hedge"- increasing exposure to push the price in their favor?

Ultimately, "Texas Hedging" requires a greater fool to relieve you of your position at the "manipulated" price, or the practice will generate losses. A Hedge Fund manager willing to give up 2% in the long run to get an extra 1% (and consequent (but temporary) increase in performance fee) at quarter's end is just making his job that much harder.

If "banging the close" is illegal how should we qualify the Fed and Treasury's decisions to buy hundreds of billions of dollars of non-performing mortgage debt and ring-fence other "toxic" assets from a dreaded mark-to-market?  Both aim to effect the market, and the state has a nasty habit of leaving the general public "holding the bag" on unwound Texas Hedges.

I'll take the former over the latter any day.

Where's the harm in the former? except to modern institutional myth belief. The myth to which I refer is the view that modern institutions both public and private are impartial and altruistic, peopled by angels, and not humans.

I've little doubt both the CFTC's and SEC's cases are "timed" for effect. The state is trying to dispel the mythic quality of finance- to change public perception thereof (the fines are mainly beside the point). After all, that is the game they play. Explicitly, politicians and bureaucrats through policy and media access aim to effect popular opinion. Are we next going to chastise judges who aim to "make an example" of someone? Isn't deterrence an aim of public policy?

Of course, the state takes a risk in their myth dispelling goal. Once myth-busting becomes a habit, who knows which myths are next to face apocalypse? If finance is revealed to be just a bunch of guys with axes to grind, so too, the public may soon learn, are politics.

The public might even learn the money in their pocket has no intrinsic value- Insha'Allah.

I hope this myth-busting leads, as it often does, to renewal. I'm aware, however, that the path of social myth-busting is often chaotic. Dashed dreams make for unhappy people. On the bright side, dashed dreams improve one's sense of reality, if one is strong enough to get over the disappointment.

In Hindu theology, Shiva, The Destroyer (of myths) leads Brahma, The Beginner. It is said nobody worships the Brahma phase of the Hindu Trinity, perhaps because worship requires the sense of awe destroyed by Shiva. After Brahma comes Vishnu, renewed worship and a period of institutional status quo. Old myths acquire new faces.

The cycle repeats.

TBTF Requires a Controlled Demolition

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control.

Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail

As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.

While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.

Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.

Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.

Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.

Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.

Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.

Why should senior bank employees with the least "skin in the game" reap the largest benefits?

A controlled demolition of TBTF might proceed something like this:

1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).

2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.

3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.

4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).

Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control. 

It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow.  Concentration of money occurs when investment is passive.  Move Your Money!

One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

A Fascinating Exchange on Pre-Fed Banking Regulation

Almost 100 years ago, the US Congress was investigating the Money Trust, as the concentration of money and power on Wall Street was then called.  The St. Louis Fed has documentation of the hearings of the House of Representatives Subcommittee on Banking and Currency into the matter, better known as the Pujo hearings, which make for fascinating reading.

Then, as now, people were concerned with the power of Wall Street, and the deceit (stock and commodity price manipulation, inter alia, has been around for a long time).  Unlike the current situation, however, big finance was largely self-regulated  (then, as now, there were laws, but then, it seems, big finance thought the government too lax, and slow to act), and the idea of a government bail-out would have been absurd to men like J.P. Morgan. 

Also unlike today, the then captains of finance were all in favor of closing down insolvent banks, and even temporarily solvent banks who might well be frauds, even before the government got involved, as this exchange between Samuel Untermyer, Esq.,  counsel for the committee and J.P. Morgan demonstrates.

Mr. Untermyer: Do you not think there ought to be some authority, in the State or Government somewhere, to give to a solvent bank the right of clearance through the association?

Mr. Morgan: Yes; but it depends upon in whose hands the bank is.

Mr. Untermyer: Oh, you think the competitors of a bank ought to determine into whose hands it should go?

Mr. Morgan: For instance, suppose I were the clearing house- I would not be in favor of allowing a man to be associated with me that I thought was a fraud, simply because he owned a bank which at that particular moment was solvent.

That's a powerful argument in favor of private owners policing their own industry, which, as an aside would not work today as the banks are all publically owned.  Perhaps the current regulatory problems are unintended consequences of breaking up the large privately held conglomerates. Nothing like fear of personal loss to keep one on the straight and narrow.  Would Goldman have taken a different path over the past decade if they had remained private?

The view above might also be a defense against claims that certain banks had "shaken down" others in the Panic of 1907.  It's hard to tell without all the accounts available.  It does make me wonder if JP were alive today, (and as good as his word) would he have instigated a panic before things got so out of hand, and wound down the offending banks (and gotten grief about it for having too much power).  As best I can discern he seemed to take the issue seriously. 

The exchange continued:

Mr. Untermyer:   The question I ask you is as to whether competitors should have the fate of another competitor entirely in their hands. to close it up or let it go on, without any review anywhere.


Mr. Morgan: If they are insolvent, I think they should be shut up at once.


Mr. Untermyer: But do you think the competitors should have the right to pass upon that without any review.


Mr. Morgan: There is no other review possible that I know of.


Mr. Untermyer: Do you not think a review on the part of the banking authority would be possible?


Mr. Morgan: Not unless there is time. The question of time comes in.


Mr. Untermyer: It does not take long to telephone, does it?


Mr. Morgan: It does sometimes.


Mr. Untermyer: It takes too long to give the bank a chance, Anyway?


Mr. Morgan: Yes. Sometimes some people have to step in and take the bank’s balance in order to get them cleaned, at that.


Mr. Untermyer: Have you known of other banks doing that and getting well paid for it?


Mr. Morgan: I have known of some people doing it without being paid at all.

For Mr. Morgan, the key question in banking was character.  The idea of keeping a failure in business, even with financial backing, made no sense.  To wit:

Mr. Untermyer: If that is the rule of business, Mr. Morgan, why do the banks demand, the first thing they ask, a statement of what the man has got, before they extend him credit?


Mr. Morgan: That is what they go into; but the first thing they say is, "We want to see your record."


Mr. Untermyer: Yes; and if his record is a blank, the next thing is how much has he got?


Mr. Morgan: People do not care, then.


Mr. Untermyer: For instance, if he has got Government bond or railroad bonds, and goes in to get credit, he gets it, and on the security of those bonds, does he not?


Mr. Morgan: Yes.


Mr. Untermyer:. He does not get it on his face or his character, does he?


Mr. Morgan: Yes; he gets it on his character.


Mr. Untermyer: I see; then he might as well take the bonds home, had he not?


Mr. Morgan: Because a man I do not trust could not get money from me on all the bonds in Christendom.

I'm still working on an examination of Fed goals that transcend their stated directives of maximum non-inflation growth and thought this might make interesting reading in the meantime.

GoldiSachs and the TBTF Banks

GoldiSachs and her friend MorganStanley were tired (of worrying about insolvency) so they went upstairs in the Banks' home and found a bed labeled TBTF that was just right. In contrast to the children's story, GoldiSachs and MorganStanley were welcomed into the club.

In March of 2008, years of poor investment decisions finally caught up to Bear Stearns, forcing the firm to accept a $2 per share bid (later revised to $10) from JPMorgan (financed by loans from the NY Fed). A once mighty financial firm which had survived the Great Depression was no more. Adding insult to injury, its final 5 year stock price chart, which depicted a dive from over $150 to the single digits could easily have been mistaken for that of a dead Tech firm which never generated a dime in profits.

Coincidentally, the Federal Reserve announced the creation of the Primary Dealer Credit Facility (PDCF) which allowed any Primary Dealer not already authorized to borrow at the Fed's Discount Window, to, in effect, enjoy the privilege of discounting their securities if they were cash poor.

Despite the new access to Fed liquidity, however, stock prices of Primary Dealers, who, inter alia, sell US government debt, were under assault within 6 months. Lehman Brothers did not survive the assault, declaring bankruptcy on September 15.

Perhaps due to the thinning ranks of Primary Dealers (in the previous 2 years, 5 Banks, ABN AMRO, CIBC, Nomura Securities, Lehman Brothers and the aforementioned Bear Stearns, had left the club or died) or some other reason (more on that in my next post) the Fed and Treasury made the hitherto unsaid policy of Too Big To Fail (TBTF), explicit, and welcomed GS and MS into the club (which, according to Simon Johnson and James Kwak, numbers 13), declaring the new entrants Bank Holding Companies (BHCs), for emphasis.

A recent check of the Fed's NIC (a wonderful resource on BHC data) demonstrates that GS and MS fit into the BHC club about as well as I fit into the crowd on my first visit to Beijing many years ago. Their source and use of funds are quite different as are their arenas of profit.  They are investment firms, more closely related to Hedge Funds than banks.  I'm all in favor of investment firms, however, I don't agree that, if TBTF is wise policy (which, at this stage, I doubt) they should be included in the protected group.

I still, on the topic of sticking out from the crowd, remember being asked to join a picture of a Chinese family during a visit to the Great Wall, because, I suspect, this rural family rarely saw white people and wanted to show the folks at home their great adventure.

Banks, as I recently argued, always and everywhere earn their money lending. As the table below demonstrates, however, the meaning of the term "bank" is being diluted at roughly the same pace as the US$.  Admittedly, the banks themselves, in their desire to be more like Hedge Funds, are helping the dilution of meaning.  This makes me wonder if the next GS to join the club will be George Soros. Perhaps if he becomes a primary dealer....

                   click for larger version

As you can see, GS and MS needed no help in provisioning against bad loans (one argument, with some merit, in favor of TBTF is that the banks provided more mortgage credit than they otherwise would have if the government wasn't promoting home ownership).  These investment houses earn money from, inter alia, Investment Banking, Brokerage and Proprietary Trading. 

Proprietary Trading is the arena one tends to find "rogue traders" like John Rusnak, Brian Hunter of Amaranth fame and this fellow from France.  A policy of TBTF might well bail out a "rogue bank"or the banks' creditors, perhaps it already has.  This isn't to suggest I'm against prop trading (it's one way I earn my keep) I just don't see the positives (if any) outweighing the negatives. 


A thoughtful reader at Seeking Alpha wanted a more explicit statement of TBTF effects which inspired the use of "scam" in my last post.

TBTF direct effects include, as he noted, creditors avoiding "haircuts" (reduction or total loss of investment), and, as I added, employees and owners equally avoiding "haircuts" (reduction in compensation and loss of investment).

I used the term "scam" in reference to the latter two effects.  Reductions in compensation and dividend outflow would go right to the bottom line, mitigating the need for equity and liquidity support.

TBTF rewards failure, which creates its own ill effects, and it will impose financial costs on families across the US as the effects of the changes in the Fed's System Open Market Account (latest data seen below) and growth in US Federal Debt manifest.  Further, supporting firms which failed to see the collapse coming, or minimally to adjust their exposure accordingly, removes from the list of positives the one social virtue of trading I needed to know to become licensed as a securities' dealer- price discovery.

While I agree with the reader that US financial authorities had trade-offs in mind (I didn't use "total" in my original title) when TBTF became explicit (some going beyond finance, as I'll discuss in my next post) some are taking advantage or "scamming" the public in the lax environment.

Take a good look at aggregated employee compensation in the first table.

The ultimate question of TBTF is not "if" it will end.  It will.  Such arrangements always end.  The Medici were known as God's Bankers, under the protection of the Vatican- the best shield going at the time- and they went under. Money, like water, eventually finds a way to flow around (or through) constraints. 

The question is, will we end TBTF or will it end us, in our current form?

TBTF isn't just Bad Policy, it's a Scam

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal contraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income (NOI) for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

The streams here in the Northeast US today, following a solid 2 day rain, are akin to those of income enjoyed by US Banks- spilling over at record setting levels.

As promised yesterday when I detailed the obscene compensation of bank industry employees, today's musings will focus in more detail on US Banking sector incomes, expenses and the future of Too Big To Fail.

Banks always and everywhere make the bulk of their income from lending and the US sub-species is no exception to this rule. Bankus Americanus is, however, unique in a few regards. It is the only animal on the Endangered Species list whose dwindling numbers are a result of cannibalism. To wit, in just the past 15 years numbers have dropped from 12,604 to 8,012 but those that remain are fatter than ever. Additionally, (and somewhat more seriously) unlike most banks in history, in recent times non-interest income has risen to more than 50% of interest income, helped in part, by the termination of Glass Steagall restrictions.  Data: FDIC- all covered institutions, aggregated

Given the substantial compensation American Bankers receive one might expect the increased non-interest income to come via trading, investment banking or the recently allowed insurance and brokerage activities, but this is not the case. Service charges on deposit accounts earn US Banks more than trading, investment banking, insurance, or brokerage in every year for which I have data. The lowly paid back office workers, in other words, generate much more income than the highly paid traders.

Admittedly, as I learned at Chase, there are indirect benefits to having a trading desk (and other financial services). Trading, for example, requires a cash deposit which will not only generate its own set of fees but also increase lending by whatever multiple the bank deems prudent.

Regardless, in the aggregate, US bank trading profits (exclusive of employee expense) have never exceeded 10% of net interest income. And the banks haven't even begun to unwind their derivatives portfolios, an event which may well push the absolute value of trading income above that of interest income for a year or two. I suspect in the not too distant future the wisdom of bank trading will be seen as pure folly. The NIMBY (Not In My Back Yard) movement which drove, e.g. chemical processing, off to foreign lands will soon, I believe, drive trading from Banks.

Moving on to larger streams, the biggest line item in the FDIC's breakdown of non-interest income is obscurely titled "additional non-interest income." The FDIC defines this as:

 All non interest income of the bank not required to be reported elsewhere, including (but exclusive to): 

1. Income and fees from the rental of safe deposit boxes;
2. Income and fees from the sale of checks, money orders, cashiers' checks, and travelers' checks;
3. Income and fees from the use of the bank's ATMs;
4. Income from performing data processing services for others;
5. Earnings on or other increases in the value of the cash surrender value of bank-owned life insurance policies;
6. Rent and other income from Real Estate Owned.

Chalk up another win for the back office, and, better still, the electronic office. An inquiry with the FDIC informed me that ATMs (and related services) were some of the biggest earners at US Banks. How clever of Bankus Americanus. The advent of the computer and internet age led to price reductions in most industries, inspiring the then Banker in Chief Greenspan to proclaim a productivity miracle. Bankers, by contrast, increased their income.

Pause for a moment. Can you imagine the outrage if ATMs were outlawed and tipping a teller a few dollars each time one made a withdrawal became mandatory? Can you imagine how many people would suddenly get the urge to be a bank teller? Banks would then have no problem staying open 24 hours a day, just like the ATMs- and we might all enjoy a human voice saying, "Thank you for banking with us."

There's a lesson to be learned here. The aggregate data strongly suggests that bankers aren't smarter than they were 30 years ago, they are just more protected. Protection of the sector allowed a relatively small group of people to pay themselves huge salaries (and huger bonuses) while the bulk of bank income was derived not from their efforts but from normal bank services spared the ravages of tech sector cost cutting. The high priced guys are the one's who have generated the problems.

Returning to cash flows, income isn't generated for free. The network of ATMs required development (but shouldn't the patent protection for this have expired like those for pharmaceuticals?), installation, and continued service. Profits accrue only when incomes exceed expenses. Banks must borrow funds more cheaply then they lend them.

As interest income is the bulk of bank income, you would expect that interest expense (i.e. cost of funds) is the bulk of bank expense. Up until the past few years, this was true. In 1994, interest expense was $145B (interest income was $321B) while employee compensation was $70B. In 2009, interest expense was $145B (interest income was $541B) while employee compensation was $163B. Amazingly, less than 2 million bankers (actually the problem is caused by the top 10%) paid themselves more than they paid the 100s of millions of depositors for the use of their funds. They even paid themselves more than they paid the bank owners.

If this (taking new equity capital to pay off previous investors and line their pockets) sounds like a Ponzi scheme that dwarfs that of Mr. Madoff, then I've made my point.

This brings us to the bottom line. If the Banks are truly TBTF and Bank employees truly indispensible, Capitalism is well and truly dead and Banking no longer a job, but a religion. In Capitalism, shareholders, not employees are the ultimate arbiters of business. Once net income goes to zero or below, the business, in its current form, is on borrowed time.

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal constraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

Yesterday Paul Volcker said TBTF was "moral hazard writ large". He was wrong. It's a hazard before it happens. This has been going on for 3 years.

As with the Tech Boom, something has to give. The real sector in the US isn't recovering, in part because credit is just circling round in the financial markets, as was the case in the early 90s, but on a much larger scale today. Real sector borrowing rates (adjusted for tighter credit conditions) are still too high. Thus the residential mortgage problem is not going away, and likely to worsen now that the Fed is out of the game (for the moment at least) and a commercial mortgage problem is looming.  Unlike the early 90s, there is no RTC set up to recover money for the banks, and there's that problem of who really owns the mortgages to be solved.

At current price levels it will be years before the banks are back to whatever constitutes normal these days, and I don't think we'll have that much time. Unlike the 90s, we have a government debt roll-over problem. If Banking sector NOI is roughly zero again this year, will shareholders be willing to accept zero dividends? I doubt it. Absent a sudden recovery in the real sector, US Banks, like the Irish Banks, will soon find they need more money.

Barring an unlikely substantial reduction in employee compensation (a solution I highly recommend, rolling salaries back to 1999 levels would free up roughly $70B A YEAR for loan loss provisions), the banks could dilute their own shares (but only for so long) or try to raise more overseas equity, but the amounts would be limited, in the case of foreign investment, to less than a controlling stake. I can't imagine the US population or government allowing China to hold a controlling interest in Citibank or any other big BHC.

A $ devaluation policy would alleviate the mortgage problem but the subsequent rise in interest rates would likely ignite another, much larger problem in the 200+ Trillion dollar derivatives portfolios, and our foreign creditors would be none too pleased. Sadly for them, the Germen option of forced liquidation is that least desired by the powers that be. Devaluation, I suspect, is the only option- it just has to appear to be an accident.

Regardless, we'll likely soon discover that TBTF isn't just bad policy, it's a scam- the Tech Boom on steroids.

A note on aggregation: Sometimes this process makes it easy to miss the trees for the forest-some banks might have profitable trading desks but they get lost. Goldman Sachs comes to mind. Yet, during the crisis of 2008, GS would have gone the way of LTCM (for the same reason) but for their transformation into a BHC and the bail-out of other institutions (notably AIG) which kept payments flowing.  GS isn't much of a bank in the usual sense but an investment house.  They should not, in my view, have gotten the protection of commercial banks. 

A note on trading: This essay might leave readers with the notion that I'm against trading. I'm not. I trade.  I simply believe that for trading to provide the promised price discovery benefits, they must stand on their own as private sector businesses.

It's Good to be a US Banker (for now)

I remember the first time I saw a fellow trader get fired from Chase Manhattan. Sitting down at my desk in front of the green screens (this was before the invasion of computer terminals) I had my coffee in one hand and a phone in the other when a buddy sitting behind me whispered, "check out the security guards."

I looked around and saw two guys in uniform standing at attention near the elevators. I hadn't noticed them when I arrived, as I was reading the newspaper. "What's up with that?," I asked.

"Someone's getting fired," he responded.

The 35th floor of Chase was very quiet, I suddenly noticed.

A few minutes later another trader walked in, nose buried in his newspaper, on the way to his desk. The guards, one of whom carried a cardboard box, followed him and just before he reached his desk told him to pack his things in the box and come with them. He reached for a phone but the guard was quicker. "No calls," he said, "pack your stuff and let's go."

It was a scary scene, but on reflection, as I still had a job (I was later to be on the other side of this issue), it made me feel as if banking (at least on the trading side) was a place where Capitalism reigned. Perform and you get very well paid. Screw up, and you're fired.

Or so I thought.

I've spent much of the past 2 days downloading data from the FDIC (more on those details in my next post) and was amazed to discover the best uptrend in the financial markets is banking salaries and employee benefits. One look at the graph below and I realized Lloyd Blankfein must be right. Bankers are doing God's work (or at least being compensated as if).

the data is skewed somewhat higher from the late 90s on by the repeal of Glass Steagall

You might think, if Bank employees are doing well, the owners must be doing even better. If these banks were more privately owned I would agree, but they aren't. It's apparently much better to work for a big bank (smaller banks don't pay even their top guys that well, as I found drilling down in the data) than to own it, just ask the gang at Goldman. The graph of cash dividends isn't nearly as pretty (but you can't argue with any dividend for 2008 or 2009, given the recent crisis, if you're an owner).

If you aren't a bank share owner but simply a taxpayer hoping the Fed won't let the currency in which you're remunerated shrink in value, you can argue plenty.

Recent news headlines proclaiming the wondrous profit (of $7B, not enough to pay salaries and bonuses of the top men at the big 5 US Bank holding companies) ready to be realized by the government with the sale of Citibank (brokered by these same bankers) miss the point. The Fed's balance sheet exploded to ensure that the Bankers who approved the loans which fomented the crisis could provision (inadequately, I suspect, as I'll discuss next time) against the losses and get paid handsomely for their shoddy work.

We'll all pay the price for that down the road and it may not be that far ahead.  Irish banks have gone back to their government for yet another infusion of capital.  Back here in the US, Elizabeth Warren of the TARP Congressional Oversight Panel is warning of an impending commercial real estate loan crisis.

When the next crisis hits, (not too long now, I suspect) the Bankers won't need a TARP, they'll need some flak jackets.

As Paul Volcker said today, the banks must face a credible threat of closure.  Ultimately the failing firm should be liquidated or merged. In all... it is a death sentence, not a rescue at the hospital.

Capitalism is Dead: Keynesianism, Marxism and Communism are too!

The Obama administration is making final preparations to sell its stake in the New York bank (Citibank), according to industry and federal sources. At today's prices, the sale would net more than $8 billion, by far the largest profit returned from any firm that accepted bailout funds, and the transaction would be the second-largest stock sale in history.  WSJ

John Kenneth Galbraith was once asked what he thought Nixon meant when he said, "We're all Keynesians now." Galbraith responded, in part, "He probably didn't know himself."  This might have been a joke.

I'm no expert on his views, but here's my attempt to succinctly present Keynesianism: 1) Capital (the means of production) is not the ultimate driver of economic growth, Demand is. 2) Demand can be manipulated by changes in government taxing and spending. 3) Economic growth can (and should) be maintained, if necessary, by such manipulations.

This interpretation of Keynesianism contrasts with that of Capitalism, which, I believe, in an ideologically pure sense holds that privately owned Capital, regulated solely by adherence to hard money rules of profit, loss and bankruptcy, is the driver of economic growth. Within that perspective, "Supply Side-ism" (if you will, a "child" of Capitalism) adopts the latter two elements of Keynesianism- capital can and should be manipulated by government intervention.

Using those definitions, with which, I'm sure, many will disagree, Capitalism is a rarely seen model. Supply Side-ism seems the most prevalent model in the west historically, and, recently throughout the world. US so-called Capitalists at the turn of the last century are, due to protective tariffs, better termed, Industrialists.

Within the past 30 or so years, however, the long time model of Supply Side-ism (sometimes leavened with Keynesianism, more often not) has fallen into disfavor and a new model has become preeminent in the US-Speculationism.

I'll borrow from Friedrich Nietzsche to continue: Have you not heard of that madman who lit a lantern in the bright morning hours, ran to the market-place, and cried incessantly: "I am looking for Capitalism! I am looking for Capitalism!"


As many of those who did not believe in Capitalism were standing together there, he excited considerable laughter. Have you lost it, then? said one. Did it lose its way like a child? said another. Or is it hiding? Is it afraid of us? Has it gone on a voyage? or emigrated? Thus they shouted and laughed. The madman sprang into their midst and pierced them with his glances.


"Where has Capitalism gone?" he cried. "I shall tell you. We have killed it - you and I. We are its murderers. But how have we done this? How were we able to drink up the sea? Is there any up or down left? Are we not straying as through an infinite nothing? Do we not feel the breath of empty space? Has it not become colder? Is it not more and more night coming on all the time? Do we not smell anything yet of Capitalism's decomposition? Capitalisms too decompose. Capitalism is dead. Capitalism remains dead. And we have killed it. How shall we, murderers of all murderers, console ourselves? That which was the holiest and mightiest of all that the world has yet possessed has bled to death under our knives. Is not the greatness of this deed too great for us? There has never been a greater deed; and whosoever shall be born after us - for the sake of this deed he shall be part of a higher history than all history hitherto." (with slight modifications)

Nietzsche's madman ranted about God, but I think his form is useful in the current regard. For Nietzsche, God died because man stopped understanding the word (a pun for theologists) and believing in its intended sense. Those who followed after God's death would need some new more powerful (Nietzsche hoped to find something more fundamental, or was he just mocking the attempt, it's hard to tell sometimes) controlling idea or chaos would ensue.

While I feel Nietzsche's argument form seems quite apt for the purpose of this essay, I don't share his faith (if such was the case) that we will find any more powerful, fundamental, controlling idea....and thus chaos ensues.

Consider the opening news item. The government bought a corporation not with the idea of controlling it- i.e., contra right wing talk radio, Obama is no Marxist- but with the idea of profiting from the speculative purchase.

To paraphrase Nixon, "we're all Hedge Fund managers now."

Capitalism is dead. Long live Speculationism.

Speculationism is the belief that economic growth is a function of money flows- not the hard money of decades past but money of indeterminate value which allows its quantity to be increased almost endlessly. Like Keynesianism and Supply Side-ism, note the implicit coordination of the state's power to create money and the providers of economic growth, finance.

The above, as an aside, is but an observation, not a critique. I do, however, find it funny that in the same way US Industrialists, protected behind tariff walls, fancied themselves "capitalists" decades ago, so too do today's Speculationists, protected by the Fed's ability to create money. Who are they kidding?

To wit, the US seems increasingly comfortable allowing its capital to move where it will (and it seems to want to move away) so long as Speculators can profit, not by running the company- i.e. controlling the means of production- but by betting on changes in its "market set" value. In Speculationism the term widget can, in the new textbooks, apply equally well to the things produced and the means of producing them.  The term capital itself has morphed and is no longer a reference to the means of production but rather to the money (sometimes previously referred to as financial capital, but this became repetitious) which, presumably drives it. 

Economic growth in the US is less and less a function of what we make (and how efficiently we make it) and increasingly a function of speculative profit. Thus, argue the Speculationists, the foolishness of Volcker's idea of separating speculative activities from commercial banking: Industry is dying, commerce is a small thing. The business of America is Speculation.

And they are right. Whether this will prove wise in the future remains to be seen, but things don't look good from where I sit.  I think we will miss Capitalism, and the capital (in its old sense) which has moved away.

p.s. Yes I waxed hyperbolic and didn't do justice with my definitions. This is but an essay, a word which means, to try (in this case to throw some ideas into the internet ether)