Are We There Yet?

With the US$ sinking and Gold setting new highs every few days those, like me, who have been waiting for the final collapse of the current $ based international financial system have one question on our minds- “are we there yet?”

“Not yet.  But we’re getting very close.”

This past week the US electorate, in a fit of justified pique over Democratic failure to fix the broken (at least from the perspective of the majority of US citizens) economy, put Republicans back in charge of the House of Representatives.  Big Finance must have viewed election results with glee.  Gridlock, as we Americans lovingly refer to government divided and thus incapable of passing radical legislation, means the Volcker Rules (or other meaningful financial reforms) have an even slimmer chance of becoming law. 

Coincidentally, the Federal Reserve announced plans to buy, during the next 9 months, $600B of long dated US Treasuries- a policy they refer to as “quantitative easing”.  I prefer “monetizing debt” to avoid confusion.   

While Big Finance in the US celebrated the return of Gridlock and the gift from the Fed, our foreign financiers most likely took a less sanguine view of the policy changes.  US banks will soon be free to take even bigger risks while the Fed actively drives the value of the US$- the ultimate “asset” our financiers are promised- ever lower. 

The wonderfully apt, in this case,  phrase, “thick face,” no doubt crossed many Chinese minds as they pondered US Treasury Secretary Geithner’s proposed current account targets to “accelerate global rebalancing” in the context of US debt monetization and ever more impotent regulation of the big banks who have led the world to the current impasse. 

To wit-  Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday, “We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”

    

It seems to me a sign of the times that Mr. Geithner didn’t respond to current concerns over the declining $ as Nixon’s Treasury Secretary, John Connally once did, i.e. the US$ “is our currency, but your problem.”  The swagger of US policy makers evident in decades past is now shrouded in sophisticated euphemism- but the effects will be similar.

“But, are we there yet?”

“Not yet.”

There is, in my view, one last road sign before we reach our destination.  When the US Bond Market begins to “fight the Fed”- a strategy normally as wise as spitting into the wind- we will begin the end stage of our journey to a new system of international finance.  When US Bond prices fall despite Fed intervention (better yet, when bond prices fall on news of increased intervention) the excrement will be about to hit the fan in international finance. 

We must, however, be getting close.  I noticed the Fed established the Office of Financial Stability and Research this past Thursday.  Talk about closing the barn door after the horses have all escaped.

GS Case Begs the Volcker Rules (and Blankfein a lesson in asymmetry)

The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility. Goldman Responds

Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry

As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."

There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.

Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.

To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.

Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.

That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun).  It also would be entirely legal, as we may find to be the case with GS.

Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.

The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.

All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair.  It would be assymmetric (if hockey players used such language).

Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?

When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real.  Nor should the rink be shut down because we made a mistake.

I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!

Goldman Goes For The Jugular With Derivatives' Control

"Given that much of the financial contagion was fueled by uncertainty about counterparties' balance sheets," Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, "we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions." Washington Examiner

I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.

When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.

I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.

Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.

Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.

Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn.  That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.

Death by regulation.

If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.

It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.

Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.

One coup de grace deserves another.

Disclosure: No positions in GS, JPM, BAC, or C

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)

Will the US sell Manhattan?

Those who face insolvency, Mr. Schlarmann, a senior member of Germany's Christian Democrats, said, must sell everything they have to pay their creditors. Thus, he said, Greece, given its debt problems, should consider selling some of its uninhabited islands to cut its debt.

The headline in the Bild newspaper took the argument a bit further, "Sell your islands, you bankrupt Greeks - and the Acropolis too!"

I guess we might call this the Andrew Mellon approach to sovereign debt crises- liquidate, liquidate, liquidate, on a national scale. It's a strategy which, if Niall Ferguson's argument-which contains the wonderful line, US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941- that the US, and other western nations, may soon follow Greece into crisis, proves prescient, might inspire calls for the US to sell some islands, like Manhattan.

Perhaps selling the island outright might be a bit much. Yet, while the Chinese Government isn't a fan of the Dalai Lama it might appreciate the Karmic touch of leasing Manhattan from the US for, say, 99 years. Imagine the road signs, "Now Entering New Hong Kong."

In a sense, assuming Wall St. and the NY Fed were included in the lease, it would be the ultimate "pump and dump"- temporarily stabilize the financial system, in large part with money from Asia, and then dump it, and the derivatives portfolios contained therein, on China. Why wait for the next financial crisis to go hat in hand to Asia. Let's sell Citibank at $4 instead of waiting for it to fall under a buck.

The world might even benefit from such an arrangement. Yesterday, Paul Volcker told the House Financial Services Committee that regulators, like the NY Fed, are unlikely to rein in excessive Wall St. speculation. If the Chinese get the NY Fed, and thus oversight of financial markets, their no-nonsense approach to dealing with corruption, which includes the death penalty, might help finance get back on the "straight and narrow." I'd love to see Lloyd Blankfein testify to the Chinese Communist Party.

A man can dream, can't he? And who knows what the future will bring. I doubt the Ottoman, Mughal and Manchu Empires could have imagined that the West would take over administration of their territories.

Fortunately, at least for Wall Streeters wary of Chinese justice, the German proposal fell on deaf ears. Yet, the seemingly intractable problem of many western governments' unsustainable debt levels remains.

Niall Ferguson argues that the problem is the welfare state- perhaps he should take on Keynes with a new book, The Economic Consequences of the Welfare State. I suspect, however, improper- to the extent such policies are seen as wise means of avoiding social unrest- welfare state funding is but a symptom of an apparently widely held view by many in both public and private sector positions of power that, in the words of Dick Cheney, deficits don't matter. 

War finance and Wall St. bail-outs played at least as large a part as welfare spending in US Federal Debt doubling since 2001.   Those bail-outs, in turn, were made necessary by Wall St.'s take on Cheney's wisdom, which they express as, too big to fail.

Contra Mr. Cheney, deficits, which add up to debt over time, do matter.  Contra Wall St., no insitution is too big to fail.  Both views are, in my view, effects of a broader issue.  There is no agreed upon method, barring adoption of island sales, for sovereign debt resolution. In decades past when nations retained currency sovereignty devaluation was always an option, and fear of devaluation kept investors on their toes. The more recent desire for supra-national currencies turns countries like Greece into states like California with very limited options.

If current trends continue, nations like Greece and states like California might simply be absorbed into larger bodies. Greece could become a special administrative region of the EU and California could become a district of the US Federal Government. Yet this would simply buy time, making the ultimate sovereign debt problem that much harder to resolve.

If the world is ever to reform global finance it will need, first and foremost, to agree upon a method of debt resolution applicable to all large institutions, public and private.   So long as those running large institutions feel there are no consequences to deficits, debt problems will continue to mount.  If we are going to use money to drive the world, we need to take it seriously.

It's Not The Size Of The Banks, Comrade Bernanke, It's...

Mr. Bernanke, speaking at a Federal Reserve Bank of Boston meeting Friday on Cape Cod, said [in response to question about "too big to fail"] he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms." WSJ

The players are laying their cards on the table at the Big Casino debates over regulation. On one side of the table we have Paul Volcker, and Alan Greenspan, Mervyn King et alios, who think that banks should be broken up (although with some difference between them on how that might be done). On the other side of the table we have current Fed Chairman (who obviously knows whom he speaks for ) Ben Bernanke who thinks that Bigger is still Better when it comes to banking.

To wit, in that Friday speech, Mr. Bernanke argued: First, recent experience confirms the value of supervision of financial holding companies--especially the largest, most complex, and systemically critical institutions--on a consolidated basis, supplementing the supervision that takes place at the level of the holding company's subsidiaries.

Leaving aside the rather obvious (to anyone but Big Bank CEOs and Ben Bernanke, it seems) point that recent experience only proves that that the value of supervision of financial holding companies was roughly nil, let's examine his argument more fully.

He continues: Second, our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. The extraordinary pressure on financial firms last fall underscored how profoundly interconnected firms and markets are in our complex, global financial system. Thus, any effort to address systemic risks will require a more systemwide, or macroprudential, approach to the supervision of systemically critical firms. More generally, supervisors must go beyond their traditional focus on individual firms and markets to try to identify possible channels of financial contagion and other risks to the system as a whole.

A ha. In other words, Big Banks mean Big Regulations. According to Comrade Bernanke, it's the job of the Fed (or another even Bigger Brother) to to promote financial stability, whatever that might mean.

The thin edge of the wedge has pretty much split the log of Capitalism here. The Fed's job, at least before Humphrey Hawkins slid into obscurity, is to maintain price stability and foster as full an employment situation as is consistent with the first directive. Financial stability, under that head, is only important to the extent it impairs one of those directives.

If "Financial Stability" of Comrade Bernanke refers to the casino-derivative markets never being short of liquidity, that is a fool's dream- Big Finance will keep leveraging until they ex(im)plode. It also strikes me as anti-Capitalist. Bankruptcies, liquidity shortages, defaults and currency crises are part of the game- a self-correcting game if failure is allowed to extract its price.

Paul Volcker's "middle of the road" approach, echoed by Mervyn King, to "financial stability" is to separate the casino (he, being more genteel used, speculative) elements of finance from the utility elements. In other words, instead of "financial stability" we should aim for "commercial stability" and retain the "survival of the fittest" aspect of capitalism in the big stakes arena.

In that way, Comrade Bernanke might even get his way, although I suspect the virtues of economies of scale to which he refers are offset by the vices of complacency that flow from lack of competition. As olive branch perhaps we can separate the commercial banking departments of the Big 5 from the speculative elements and roll them into one or two big firms with some Banking Czar, like Comrade Bernanke, in charge. Not that I'll be banking there, I'm going to stick with my local bank.  Then we can see if the proprietary traders at the big banks are really worth the bucks without risking the commerical financial system in the process.

The problem, to which I alluded in the title, is not the size of the banks. It's Big Finance's use of key commercial banking aspects to shield them from speculative losses that would have sent any other not protected firm into bankruptcy. Even LTCM got wound down.  Trading is supposed to be about managing risk (at least if the intent is to allocate capital wisely), and if you can't go bust, there isn't much of that.

Of course, mine is but a lone opinion from the woods of Upstate NY. I'm eager to see how the battle progresses, assuming the debate doesn't become moot due to another crisis.

The Fed vs. Gold

In August, 1971, the US began a unique experiment in modern finance- with, I must add, after a very bumpy start, astonishing success, until recently. This was an experiment in "fiat money." The trick was to make the US$, without any fixed exchange rate to Gold, a store of value that wouldn't drive people back into the yellow metal.

I've put together a few graphs, the first of which depicts the relative value of an investment in Gold and in Fed Funds (I also ran a few simulations with Bonds and found that the 10 year has an even better relative return, thanks to the timely reset in 1981, although even there Gold is beginning to outperform) assuming that the Gold was purchased when Nixon closed the Gold window and held for the duration of the simulation while the coincident Fed Funds investment was reinvested daily (I used average monthly rates, which should be close enough).

As you can see, despite the very bumpy start, US$s invested in Fed Funds became as "good as (the) Gold" purchased at the beginning of the experiment by 1998 or so.

The second graph examines the Volcker Fed era, with a much higher starting Gold price.

His policy of very high rates early and stubborn (according to Greider's Secret's of the Temple) refusal to ease, made the US$s earning Fed Funds a better investment than Gold.

The third graph examines the Greenspan era.

Surprisingly, to me at least, the Greenspan era also was a better time to own US$s earning Fed Funds than Gold (although how this was done is a matter of some debate (see GATA)). Certainly by 2000, Gold once again began to shine as the relative return this century is 2.16.

The final graph examines the Bernanke Fed era.

Under Chairman Bernanke, Gold has been a much better investment than US$s, invested anywhere in the curve. While the relative performance during his Chairmanship is not yet as poor as that under Arthur Burns, Nixon's man at the Fed, with US yields so low he just might catch up (or down as the case may be).

Ultimately, as Ben Graham taught; in the short run, the market is like a voting machine--tallying up which securities are popular and unpopular. But in the long run, the market is like a weighing machine.

Since 2000, the scale is tipping, increasingly, towards Gold.

It's a Bad Time for Bad Money

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

Come January in upstate NY, when the snow flies and temperatures drop below 0F, it's a bad time to drive without a shovel. Likewise, when the financial system of an economy misprices assets and liabilities, it's a bad time for bad money.

To the extent one believes, as I do, that men, from time to time, as Charles Mackay wrote, think and go mad in herds, especially with regard to money, it seems a wise idea to have some sort of monetary standard to attenuate the degree of inevitable error. The more out of whack the mispricing the more difficult the path of recovery will prove to be, and the more likely will the anti-money crowd find open ears. A few more years like the last one here in the US and the Marxists will start coming out of the woodwork. The greater the disconnect between the real and financial sectors of the economy, the louder will the anti-money/anti-finance crowd scream- with even those usually in favor of Capitalism crying foul.

To wit; Naked Capitalism recently ran a piece entitled, Does Banking Contribute to the Good of Society, which opens with:

Quelle horreur, some smart people are starting to question whether banking serves a redeeming social function.

Of course, in the abstract, it does. Banking (or more accurately, extending credit) is essential for commerce. But any essential support function, if it overpriced in relationship to its true value, becomes a drag on the productive economy. And our modern system is extracting a very large toll relative to its actual worth.

That article was sourced from one similarly titled in UK's Telegraph. It argues:

The whole of economic life is a mixture of creative and distributive activities. Some of what we "earn" derives from what is created out of nothing and adds to the total available for all to enjoy; but some of it merely takes what would otherwise be available to others and therefore comes at their expense.......

Much of what goes on in financial markets belongs right at the purely distributive end. The gains to one party reflect the losses to another, and the vast fees and charges racked up in the process end up being paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through the costs and charges that he pays for goods and services.

Even what the great investors do belongs at the distributive end of the spectrum.

On the same theme I found How the Servant Became a Predator: Finance’s Five Fatal Flaws, which begins:

The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

While I agree, in part, with many of the underlying views behind the articles, and, from time to time, have used radical rhetoric myself, it's during crisis phases that proper articulation is key. Radical anarchic/revolutionary rhetoric in the late 19th Century inflamed populations sufficiently to inspire a rash of assassinations, including William McKinley here in the US. I've personally witnessed successful and attempted revolutions in Indonesia and Jamaica respectively, and they're no picnic.  During crisis phases, the risk of throwing the baby out with the bathwater rises sharply.

Back to the articles. Finance doesn't have a socially redeeming function in the abstract, it puts savings to real use, when well functioning the investments provide wonderful benefits for many. That there are more people living on the planet than, according to my understanding of history and anthropology, at any other time, speaks to these benefits.

Finance, in my view, is not necessarily a "distributive" activity. George Westinghouse's investment in Tesla's alternating current generation powers the computer on which you read this essay, and the pump that brings water in to your house, and allows sewage removal- a key point now that winter sets in as outhouses are quite cold places.

Yet, these financial polemics have a point. Big Finance, currently, is a large drag on the public sector, and by extension, the public, due to, I believe, a conflation.

Sadly, it was the titans of finance who fomented the current confusion over the virtues of finance when restrictions separating investment from commercial banking were dropped. As I recently argued, echoing Paul Volcker: Instead of designating certain financial institutions as "too big to fail" the US, he [Volcker] argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading. finance (intentional small "f"), i.e. commercial banking is key. Finance, i.e. investment banking, has its benefits as well, but only, I believe, when it is willing to accept the rules of Capitalism full bore- survival of the fittest.

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

I wonder if the currently in production sequel to Wall Street will have Gordon Gekko almost losing it all in derivatives and then getting bailed out by the Feds to retire in comfort.

But where, you might be wondering, do the monetary standards you noted come into play?

Thanks for the reboot, I sometimes go off on a rant.

I opened with the idea that monetary standards act sometimes as a policy tool itself but minimally as a measuring tool of sorts. If a specie standard is chosen the drain (or excessive gain) thereof sends a sign that policy needs to change. If some monetarist standard is chosen there will be limits on the amount of liquidity prudently considered available to "buy time." There are other standards one can use but all act as a limiting factor- an anchor to some sense of reality, or measure of the divergence between the real and imaginary.

French Philosopher Baudrillard (about whose views I've opined here) reflected on the NYC Billboard depicting the growth of the public debt: The disappearance of the referential universe is a brand new phenomenon. When one looks at the billboard on Broadway, with its flying figures, one has the impression that the debt takes off to reach the stratosphere.

In other words, by bad money I mean unreal money, anchorless money. There is, apparently, no accepted measure by which one might judge a currency as failed- Baudrillard's hyperreallity. In plain language our money has been so bad for so long many assume it to be normal.

Consider. The British Pound was the currency of choice for a good portion of international trade in the latter half of the 19th and early 20th Centuries. It cost a bit more than 4 Pounds to buy an ounce of Gold. Over time it lost its utility as both a medium of international trade and standard of value from WWI through the eventual loss of most of its colonies in the 60s. During this time the value of the Pound declined from that 4+ Pounds per oz. of Gold to 14.5 Pounds per oz.- roughly 72 pence off each pound.

Few in the 40s, 50s, and 60s would have argued that such a devaluation was not a disaster. The US$ has lost a similar amount vs. Gold in the past nine years and yet there is heated debate to the effect that the demise of the US$ is exaggerated.

Some, like the FT's Martin Wolf, in rather stark contrast to his usual astute views, argues that Gold's price is a dubious indicator of inflation risks: its previous peak [just north of $800] was in January 1980, just before inflation was crushed.

This argument strikes me as silly. Yes, Gold did fall from $800, settling during the almost 2 decades of relatively stable commodity prices from 1980 to 1999 at $350. But that $350 was a 10-fold increase from the Gold Standard rate of $35. In my view, Gold was a wonderful inflation barometer during the 70s, and, barring the overshoot inspired by the Iranian Revolution and Russian invasion of Afghanistan, inter alia, remained a good barometer during the 2 decades of price stability- and obviously since (or perhaps not so obviously).

If you prefer a monetarist perspective; the Greenspan Fed's decision, followed more vigorously by Bernanke's Fed, to allow the monetary base to expand by leaps and bounds every time investment banking got in trouble seems ominous, the warning signs are clear.

Pick a standard and the message is the same, the US$ as international medium of exchange and on the margin choice of international store of value, is not just dying, it is dead. But as John McCain once quipped about Greenspan, the authorities are simply doing a Weekend at Bernie's- propping up the corpse of the US$ and declaring everything fine.

If we had some monetary standard I believe the monetary authorities would long ago have decided that investment banking needs to be cut loose to sink or swim on its merits, which are not small, if the manager is competent (I don't see George Soros begging for hand-outs) instead of dragging the US medium of exchange into the toilet and risking social discord on a scale not seen in many decades.  Instead the disconnect between the real and financial economies will simply be allowed to widen further.

Imagine how angry the common man will be if the DJIA hits 15K with gas at $5 and unemployment at 20% (as so accurately measured by the BLS).  It seems to me time to choose between letting the big investment banks go bust or (if you happen to have some assets left) living in walled off communities, hoping a revolutionary spark won't ignite.  I wonder if some have forgotten that there are other reasons besides gaining wealth that economists began tracking economic growth, income equality and other such statistics- societies are not inherently stable, reason and wisdom do not always prevail. 

Do you know where the tipping point is?   

Russia and China are just now recovering from a few decades of the effects of throwing the baby out with the bathwater.  These things happen.

Yes, it's a bad time to have bad money.

Full Disclosure: I'm long Gold and Silver

From Black Scholes to Black Holes (part 4- Finance)

Were a modern-day financial Rip Van Winkle to awake today having slumbered for the past 20 years, he would observe a capital market vastly different from the one he knew. Introduction: From Black Scholes to Black Holes

It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.


I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.

The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.

Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.

In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)

I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.

Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.

50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).

Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.



The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.

Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.

The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.

In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.

Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.

In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.

Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?

From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.

What Volcker Said

Commercial banks, taken collectively, are certainly systemically important. Their basic role is to provide vital basic services to customers – payment services, a safe depository for liquid funds, credit for individuals and businesses and financial advice.

As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.

Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Paul Volcker

Speaking to the House Financial Services Committee, former Fed Chairman, Paul Volcker took dead aim at "too big to fail" and hit that nail on its head. Instead of designating certain financial institutions as "too big to fail" the US, he argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading.

In other words he is calling for the Banking Act of 1933 (a.k.a. the Second Glass Steagall Act), which separated commercial and investment banks, to be resurrected. With the benefit of hindsight, other things equal (which is never the case), had the Financial Services Modernization Act of 1999, which allowed consolidation of financial firms, not been enacted, the taxpayer cost to maintain a functioning commercial financial system would have been much less.

In econo-jargon, the benefits of economies of scale in consolidation are outweighed by additional costs associated with maintaining a functioning commercial financial system after the inevitable failures. This argument is predicated on the validity of Minsky's theory- capitalist finance, while a marvelous organizational tool, inevitably, over a period of generations, tends to systemic failure. If such is true, cost effective procedures for keeping vital financial functions operational, thus avoiding, inter alia, economic distress sufficient to expose a nation to invasion or substantial domestic poverty and discord (which lends itself to radical political solutions inconsistent with currently desired forms of representative government).

None of the above is an argument against more speculative financial practices. If you want to be a highly paid hedge fund manager who trades with high leverage and you don't want the Fed complaining about your risk management techniques- go ahead. If you succeed, great. If you fail, don't expect to be bailed out.

It seems worth noting that Goldman Sachs may well have failed had it not gotten the NY Fed to designate it a bank holding company (a sordid affair I opined on a few months back) and thus eligible for bail-out funds. This would not have happened if the old Banking Act was still in force. In other words, we could have exorcised the Goldman demon.

This seems to me a wise compromise. It doesn't prohibit investment, indeed, it might even lead to easier regulations on that sector. Yet, it considers commercial banking a vital part of America life, much as utility providers are, and thus government protected, and regulated. We don't want to lose the commercial flow of funds any more than we want to lose the flows of electricity or water. The phrase mature industry comes to mind, in particular the risk averse sense contained therein.

I was asked earlier today what I thought of Volcker's testimony. My reply, with my head nodding yes, "what he said."

Now we just need to wait for another financial collapse to get it passed.