Modify Purchasing Power Parity by adding in stocks and bonds
An optimal currency board price basket would contain both assets and goods.
In one sense, assets are future goods.? Assets throw off an uncertain stream of future benefits, which can be used to purchase goods at that time.? Based on the demographics of an economy, if marginal dollars tend to be saved versus spent, stimulus would affect the economy differently:
- Spent: we get goods/services price inflation.
- Saved/Invested: we get asset price inflation.
Asset price inflation is different.? It is difficult to transfer resources from the present to the future.? Even a zero coupon bond relies on the solvency of the issuer, and the realized goods/services inflation.? Hoarding gold/commodities relies on the idea that they will be more scarce in the future, which is unlikely as prices rise to encourage more supply.
Cash rarely earns more than the CPI.? Bonds have long cycles where they are alternatively “certificates of confiscation” or “beneficiaries of deflation.”
Asset prices rising is not always a good thing.? The rise in prices may reflect additional productivity or they may reflect a higher price for transferring goods to the future.
When I was a bond manager for an insurance company that had long-dated promises to pay, I bought a variety of fixed-rate bonds that that appreciated dramatically in value in a falling interest rate environment.? What did that do to my expected cash flow stream?? Nothing.? If anything, it meant we would earn less because we would reinvest excess cash flows at rates lower than the market yield of the bonds.
This is a reason why QE from the Fed is questionable.? Their asset purchases push up the price of assets, but the cash flows don’t change.? Maybe a few more entities decide to issue debt in the process, but that doesn’t mean the debt gets used for expansion.? It may well replace equity, given its cheapness.
Maybe the answer here is to look at inflation as a credit phenomenon, whether the credit is used to purchase assets or goods/services.? At present, assets are inflating more than goods/services, and that has been true for some time.? I suspect that relationship will reverse, but when that will come I can’t predict.
According to the St Louis FRED database, during Bernanke’s tenure at the Fed, 3 month T-bill rates have been at / above CPI levels only 11 months (and not 11 months in a row, a total of 11 months). Since QE tapering is not a done deal, obviously Fed funds / 3 month T-bills are not going to match or exceed CPI in the few remaining months of The Bernank’s failure.
That means 11 out of 145 months will have matched CPI — never mind actual cost of living. 134 months out of 145, 3 month T-bills were a loss. So much for the Fed’s written mandate to protect the value of the US dollar.
And for those readers who actually have to eat or use energy … this past month was particularly bad.
I am sure Bill Dudley will be on CNBC shortly to tell everyone to stop eating vegetables and start eating more iPads. And someone from JPM will argue that food and energy don’t count because they are volatile even though they constantly cost more.
Don’t see how the US economy can actually grow while we are all lying to ourselves.
As a response to Greg’s post of July 16, when i look at the FRED data over the past 145 periods, there are 51 months where the T-Bill rate (TB3MS) exceed the Y-O-Y CPI inflation (CPIAUCSL), or roughly 1/3 of the months. Maybe we are just comparing different CPI periods. There are often long periods where TB3MS exceeds CPIAUCSL, for example June 1993 – October 2001 and long periods where CPIAUCSL exceed TB3MS (primarily in the 1970s).
We are undergoing a period of financial repression where negative real interest rates are forced upon us (and asset inflation) but the alternative scenario would have been much worse (worldwide financial collapse in 2008). I was there, trying to fund a bank as treasurer while the world around us was collapsing. Bernanke had no choice.
@TreasuryGuy — my numbers are for Bernanke’s tenure as Chairman at the Fed. I wasn’t looking at June 93-Oct 01 when Greenspan was chair.
I have to disagree with your basic premise that “Bernanke had no choice”. Simply not true. The Fed is supposed to “lend freely and lend dearly” in the event of a financial crisis.
They are not supposed to provide subsidies to failed bankers and failed banks.
When Continental Illinois failed in the 1980s, the Fed provided plenty of money to keep the banking system going, but they did not provide unlimited funds at 0%. Check your facts.
When the Savings & Loan institutions (and the FSLIC) collapsed a little while later, the Fed once again provided plenty of funds (not at 0%) to protect the system. The Federal government put the bad assets into a separate entity, financed by REFCO bonds. The failed S&Ls were shut down.
And most recently, Berkshire Hathaway provided billions in emergency funding to GE and Goldman … at TEN percent, cumulative preferred. Warren Buffet doesn’t steal from his shareholders to subsidize failed bankers.
Protecting the overall economy and financial system is the Fed’s job. Subsidizing failure is simply not in the Fed’s mandate. Never was.
Bernanke had a choice. He (and Paulson/Geithner) could have followed long established historical precedent. This was not the first time a major money center bank failed.
It was the first time a clueless academic decided to experiment with unproven classroom models — and two ethically challenged Treasury secretaries took advantage to bail out their crony friends.
BTW — if you really do work at a bank as Treasurer (anyone can claim anything on internet), then you know your first loss is your best loss. Any competent trading manager would “tap out” (aka shut the trading book) of a trader who got him/herself over leveraged and faced massive losses.
Doubling down on an over-levered, bad trade is a rookie mistake.
If you really were a bank Treasurer, you should know that. if you don’t perhaps that explains why your bank had such problems in 2008.
You and Bernanke get no sympathy. It is your job to protect the bank’s balance sheet. It is the Fed’s job to protect the national banking system.
It is not anyone’s job to subsidize and bail out failure.
Bad banks have always been shut in the past. Depositors get made whole up to $100K FDIC protection. Everyone else, as they said in the book Liar’s Poker: NO TEARS.
You whiney bankers screwed up, and then have the nerve to demand a bailout. You act more like UAW union workers than capitalists.
And most importantly to Bernanke’s legacy of failure … 7 years (pretty much a full historical business cycle) of free money has not fixed Main Street’s economy. Not even close.
If you are a banker — aka a financial intermediary — who exactly do you figure you are intermediating? You can’t make money today because Main Street isn’t making money, and thus you have nothing to intermediate.
If Bernanke had two seconds of real world experience (not classroom daydreaming) — this would be obvious to him. Banks will never be stronger than the customers they are supposed to serve. DUH!!!!
Respectfully Greg,
Personal attacks really have no place here. I was a bank treasurer despite you accusing me that I wasn’t, the financial system really did come “that close” [index finger and thumb separated by 1/4 inch] to failing in the autumn of 2008, and Bernanke had no choice to provide liquidity. I made no comment about ZIRP post the financial crisis and the ongoing financial repression. My $1 Billion investment portfolio had ZERO writedowns during the crisis and thereafter as I knew all about risk management, fixed income portfolio management and liquidity. I was at BofA in the late 1980s when their fortress liquidity saved that bank. Don’t lecture me. You make some very good points but you can leave the anger out of it. Please.
@Treasury Guy — Bernanke ***DID*** have other choices. Actually, the established historical precedent was not to save bad banks, but to put them in wind-down and close them. As Keith pointed out, there were other options too.
Zero percent unlimited fed funds is nothing but a bailout — and no one outside the political class (which now includes money center bank CEOs) has been fooled.
Using this false premise to justify 0% funding to failed banks, while charging 4%+ to mortgagees (aka taxpayers that are bailing out the incompetent bankers) is both unethical and usury. Bankers deserve to feel ashamed.
Lastly, I think it needs to be mentioned that Bernanke is at least partially responsible for causing the 2008 crisis. He kept interest rates 2001-2005 way way way too low for too long. Did he not get the memo that Y2K had passed? Was he day dreaming of his days in a lecture hall, when students would not question his faux wisdom for fear he would arbitrarily lower their grade? These people in the real world have the nerve to question the almighty professor! How rude of them.
The Fed’s too loose policy in 2001 to 2007 is what allowed many banks to get over levered on dumb trades in the first place.
As a former treasurer and manager of a “$1 billion portfolio”, have you ever heard of someone selling a put on trillions of dollars of assets for free? What option model are you using to get that “free” price? Is it the same option model Bernanke used to value the proverbial “Bernanke Put”?
It was Bernanke’s job to take away the punch bowl in 2004 or 2005 — and he FAILED. Then he told us the subprime contagion was well contained.
Then he turned around and cowered before Hank Paulson and Tim Geithner — who used Bernanke’s earlier failures to justify bailing out their cronies.
Did you know Ken Lewis? Any reason you can think of why he accepted Paulson’s blackmail? Paulson was treasury secretary, not chairman of the BofA board of directors. he had no authority to fire Lewis, and no authority to treat BofA any better/worse than all the other banks.
Bailing out Merril Lynch was about bailing out Jon Thain — another Paulson protogee. Lots of banks would have been happy to take on the brokerage business, and leave Merrill’s trading floor to a bankruptcy court and/or wind down.
That is what needed to happen to help the greater economy — which is both the Fed’s job and the US Treasury’s job. Protecting Jon Thain’s reputation from reality is not any government entity’s mandate.
Protecting Franklin Raines (and Barney Frank) from their failures at FNMA — also not in any written mandate.
Protecting Jon Corzine from his own performance — not in anyone’s mandate. Protecting Dick Fuld from his decision to use off balance sheet financing at Lehman — not in anyone’s mandate. Actually, the Fed did have a mandate to audit, detect, and prevent that behavior — and under Bernanke’s leadership, the Fed failed year after year after year. Protecting AIG Financial from their bad bet making ( it sure as heck wasn’t investing nor insurance) was never in the Fed’s mandate.
I could go on and on about all the stupid (and often extra-legal) things Bernanke did leading up to the actual 2008 crisis. If he had been doing his job instead of telling us how smart he thinks he is — the banks would not have been able to get so over-levered.
Bernanke subsidized failure 2002-2008, by not enforcing existing written laws and regulations and by lending at below fair value rates (which generally went to banker and FNMA bonuses, not to mortgagees).
Then, instead of taking responsibility for his earlier failures, Bernanke made a whopper of a lie that he had no choice but to steal from savers (including the elderly) in order to conceal his earlier screw ups. That Paulson and Geithner wanted to bail out their cronies only helped sooth Bernanke’s ego.
2008 was a massive regulatory failure, pure and simple. The regulators had all the authority they needed — in existing written laws and existing regulation.
“Free market” pressure is nonsense. There is no central economic committee (aka the Fed) in a free market. There is no SEC or CFTC or FASB in a free market.
Bernanke had lots and lots of choices to prevent the 2008 crisis from ever happening — and he had many options of how to handle it once it did happen. He was too busy peacocking.
And just for the record: 2008-9 is over. We are not in a crisis anymore.
Even if you want to believe the dim-witted professor “had no choice” then, there is no way to justify a crisis lending rate long after the crisis is over.
TG — I went back to FRED data and looked at the 3 month (secondary market rate) minus CPIAUSL (CPI all consumers, SA).
The are only two occasions since 1950 (post WW2 distortions) in which short term rates were below CPI for extended periods (more than year).
The first event was the latter half of the 1970s — when pretty much every Fed observer agrees the Fed was in total screw up mode. Blue collar workers knew the Fed was a disaster, even if they didn’t have the college degree to articulate why/how.
The other time? The Bernanke era. Blue collar workers had to educate William Dudley (ex Goldman guy, now NY Fed president) on how the common man could not feed an iPad to their children. Nor could the iPad be used to heat their homes in the winter.
Food, energy, child education costs, healthcare and taxes are all going up by annual percentages greater than 5yr treasury yields.
Don’t you dare further humiliate the financial profession and suggest that those items don’t count.
TG,
I would comment on a couple of elements of your post.
You said that BB had no choice, but I don’t think that is so. Greg brings up one possible alternative, and I don’t think that is the only other possibility. I do recognize that there was a crisis, and that it can be difficult to make good decisions in those situations. Therefore I can forgive any errors made during the crisis. However, I can’t forgive that the Fed still doesn’t have the intellectual integrity to discuss the situation in hindsight. It is either arrogance or a limited imagination.
My other comment would be that I believe that you are confusing the financial crisis with the economic recession. I can understand some extreme measures during the crisis, but that was 5 years ago. The current economic situation is not so terribly unusual that it clearly justifies the continuing use of such extreme measures.
@keith — I think we are saying much the same thing. We may have a different view on what price the Fed should have been lending freely at. The Fed might not get the same deal as Berkshire (BRK is profit oriented, the Fed is system stability oriented). But the “correct” price for the money should have been at or above market price (otherwise it is just a subsidy). And sure as heck the correct price was never 0%. Bernanke wasn’t protecting the system, he was exhibiting cowardice in the presence of Hank Paulson who all to obviously wanted to protect his cronies.
The Fed should have provided emergency lending during the crisis, but not at zero percent. That is a subsidy. As the Fed subsidizes failure, it just gets more of it. Simple incentives at work here.
Like you, I cannot accept Bernanke’s two faced lies about the present circumstances. Some people say the economy is growing slowly — supposedly this is Bernanke’s view. Some people are saying the economy is barely at stall speed. Some are saying it is still in a common recession.
Absolutely no one on Wall Street or Washington DC or the FOMC is claiming that the US economy is in a crisis. No one is even suggesting that.
The FOMC is saying out of one end of its mouth that the US economy is growing very slowly, but their actions (0% emergency crisis funding) says the economy is near death. Which version of the FOMC’s story are we supposed to believe?
Either Bernanke needs to admit he is lying about the economy, or he needs to admit his 0% Fed Funds rate is simply wrong. Bernanke is disagreeing with Bernanke.
Making two faced policy statements while stealing from everyone with savings (aka depleting the capital stock the country needs to invest) — is simply dumb policy.
And bankers screaming about the sky falling and thus they require endless subsidies is just embarrassing to the banking profession. Lets get rid of the failed bankers, and replace them with some actual capitalists.
Bankers and traders want a meritocracy. UAW and government union “workers” want never ending subsidies instead of restructuring.
Keith,
I agree with several points in your post. My original post was not meant to be an unqualified, 100% endorsement of everything Bernanke has done since he was named Fed Chairman. However, providing liquidity during a crisis is one of the jobs of the Fed. I was fully funded during the crisis and I wouldn’t lend Fed Funds to ANY bank, even if I thought they were fully solvent (like a Wells Fargo). Since you weren’t 100% sure, you just sat on the funds and didn’t try to earn interest. The system was frozen and only the Fed could provide liquidity.
My original post questioned the premise that only 11 months of the last 145 months had the t-bill rate exceeding CPI. I think it’s closer to 1/3 (but I admit I don’t know the calculus that Greg used to measure CPI) but I also tried to point out that there are long stretches in history **before Bernanke** where CPI exceeds 3-month bills and VICE VERSA.
Personally, I would like to see positive real interest rates as financial repression distorts asset prices and causes unintended (adverse) consequences. Like Nixon’s wage/price controls in the early 1970s, distorting the ability to price assets (though Nixon’s mechanism was different) causes long run problems.
Whether you like Mike Shedlock or not, he defines inflation pretty much as you discuss in your last paragraph–changes in credit demand, nothing really to do with prices. This has allowed him to do battle correctly with the hyperinflationists–though he has gotten many other things wrong.
It’s impossible to properly calculate CPI as the government tries, and they do more harm than good if you ask me. For the last 10 years they tell you inflation is 2% almost every year, when you and I both know it was 3 times higher in the mid 2000’s and likely deflation in 2009.
TG,
I have read your response, and I thank you for clarifying your position. I am not familiar with some of the mechanics of the crisis process, so please forgive me if I ask some silly questions. I am struggling to understand issues of solvency versus liquidity. Some people make a big deal of the distinction, but I tend to think that its simply a difference in price. I would like to explore this with you.
You appear to indicate that you had available funds but you would not lend them. Clearly you did not want the risk. In this situation, you would consider it the Fed’s job to provide a loan (“liquidity”) to a struggling firm? Is it true that you would not lend the funds at all, or was the price simply too low to compensate for the risk?
Keith,
I hope the following helps:
The easiest way to think of the difference between solvency and liquidity is this way. Think of insolvency as an accounting statement: Your liabilities exceed assets. However, you can be totally insolvent but still open the doors every morning if you have sufficient liquidity (effectively, cash on hand). Balance sheets have to balance. For banks, the place where that balancing typically happens on the margin is at the Federal Reserve. Banks move money around for customers, everything from receiving folks’ paychecks or deposits for CDs or sending money out from people’s checks clearing or wiring funds for home purchases. So each day there is a net inflow or net outflow. You balance the balance sheet each day via the Fed. In a fully functioning market, you might sell your excess funds at the Fed to another bank via the Fed Funds market. If you are short, you buy funds via the Fed Funds market. (There are many other ways, but this is most illustrative.)
Back in the early 1980s there were many S&Ls who were technically insolvent but they could open the doors each day because they could pledge their good loans as collateral or sell their remaining good assets in order to keep the outflow of funds (depositors leaving, or all those loans no longer paying interest) less than the cash they are getting for their good remaining assets. Eventually, they run out stuff to sell/pledge. Then the doors close and they go out of business. Banks go out of business due to lack of liquidity, not due to accounting insolvency.(Many financial institutions are seized before that point when it clear to the FDIC that the day of reckoning is coming and there is no capital infusion coming from investors. I went on some due diligence trips to kick the tires of failed S&Ls and basically it’s like looking in a deserted home cupboard — lots of cockroaches, abandoned or rotten items left on the shelves and a complete mess.)
What happens in a crisis is folks don’t REALLY know who has sufficient **liquidity.** So a bank doesn’t trade its excess reserves. It’s like the quote attributed to Will Rogers: “I’m not as concerned about the return **on** my money as I am the return **of** my money.”
The reverse of the S&L can happen in a crisis. You can have totally 100% great assets (all paying loans, no problem with interest income) but run into trouble if you don’t have sufficient liquidity. Think of the farmer who has a very valuable corn crop in the fields (analagous to a bank’s loans to customers) but no cash to pay his electric bill (a/k/a “cash poor”). During the summer of 2008, I made sure I didn’t have to rely on daily cash borrowing (caused by the regular ebbs and flows of banking). I borrowed long term funds from the FHLB of San Francisco, using part of our residential loan portfolio (the FHLB at that time gave you about 75-80% LTV). I got in a net postitive cash position so when the crisis hit in September 2008, I had plenty of excess funds EVERYDAY. At that point, we were so close to the precipice that I wasn’t going to lend that money TO **ANYONE** including our own bankers for loans. At that point, you don’t know who is good for the “return of your money,” even overnight. All of my informal borrowing lines to all the banks were effectively canceled by them (in reality, if I called Wells or BofA or whomever, they would just say that they were “square” for the day and they didn’t want to lend funds). And I wouldn’t lend to them if they asked, either! Fed Funds are an unsecured loan. That’s when the Fed steps in as the lender of last resort. Note that Fed in normal times does not make unsecured loans. I had all of our commercial business (“C&I”) loans were pledged at the Fed discount window. Luckily, things didn’t get so bad that I had to tap that source. However, it came pretty darn close. We came within days of a full fledged bank run like in the Depression (or like scenes in “It’s a Wonderful Life”). IF the depositors demanded their cash at the branches, then I would have had to raise funds (more FHLB borrowings IF they would/could or discount window borrowings). If even more depositors demanded their cash in Depression Era run, then eventually my good collateral would run out even though I was totally solvent. And we truly came very close to that scenario.
Hope the above makes some sense.
TG,
That is quite clear and makes a great deal of sense. Thank you for the education in an area where my knowledge is weak.
Your story indicates that you were thoughtful and prepared for the crisis. It appears that your firm also walked away from some profitable opportunities so that you could maintain your cash position. (“we were so close to the precipice that I wasn?t going to lend that money TO **ANYONE** including our own bankers for loans”) I think that these are the behaviors that most of us hoped that bankers would exhibit. Unfortunately I suspect that you were an outlier.
So let’s imagine two firms. The first firm (Bank A) is almost as sensible as your firm, but not quite. It is clearly solvent on a long term basis but it finds itself short some cash because they did not guard it quite as well as you did. When the crisis comes it finds itself short of cash.
The second firm, Bank B, is more daring. It funds itself with hot money and always invests as much as possible. It frequently borrows overnight. It is constantly on the look out for high-yielding opportunities to invest even if they are a bit dangerous. This philosophy is quite successful in good times, which roll on for years. Then the real estate market gets shaky, and their leveraged investments begin to sour. But that is a long term problem, and in the short term they are short cash.
Both of these firms have liquidity problems. Are they both deserving of help from the Fed?
Keith,
The biggest problem with your postulation is that you really don’t know for sure ex-ante which is Bank A and which is Bank B. Ex-post, you know the difference when troubles erupt, typically at the Bank Bs. Nobody intends to make bad loans except…. There were tremendous abuses by mortgage originators (banks or otherwise) on loans that they intended to sell to others (to FNMA, FHLMC, private label MBS). Even good banks got caught by lending to home builders who may have been great customers for many years and always paid on time. Many experienced homebuilders got caught up in the bubble and went bust, defaulting on their construction loans. Not only was their was a housing bubble but also a total failure in credit analysis, prudent risk management and regulatory oversight. Too much greed, not enough rationality. It was a gravy train… over a cliff.
Federal banks are regulated by the Office of the Comptroller of the Currency (OCC) whereas their parents, the bank holding companies, are regulated by the Fed. State chartered banks are regulated by the applicable state’s financial institutions agency. Prudent management and regulation is supposed to have more Bank As and less Bank Bs. It obviously doesn’t always work.
In normal times, all borrowings at the Fed are collateralized by whole loans of the institution. These loans are have a signficant haircut (like 60% LTV) and they have to be performing, etc. So when Bank A runs into a liquidity issue, you can go to the Fed and get some funds. If Bank B runs into liqudity issues, they can also go to the Fed and borrow against their good collateral. However, if their loans continue to go bad, their pledgable assets decline over time (as only fully performing loans can be pledged) and the haircut can get even steeper if they get classified as a troubled bank. So Bank B can run out of liquidity and gets seized by the FDIC. (Bank B would also do other things like sell investment securities, sell whole loans to other banks, etc., but eventually they get stuck in the 1980 S&L death spiral where they exhaust all their performing assets by either selling them or pledging them and then they are kaput.)
The Fed will lend against good collateral to Bank A or Bank B. But you can see how Bank B isn’t as good as Bank A from a credit perspective.
TreasuryGuy
The movie “Its a wonderful Life” predates the repeal of regulation Q (1978). It predates the widespread use of money market accounts. It predates all mortgage securitization (whether residential or commercial).
If your bank is lending money funded by savings deposits, statisticians can (and did) estimate the average life of a dollar’s deposit. Individual accounts might be withdrawn at any time, but in aggregate, a bank’s total deposit base was (and still is) fairly stable. There are seasonal oscillations longer term demographic shifts (jobs leaving the area = deposits moving to some other bank, etc) … but the deposit base was fairly stable. Funding long term loans (like mortgages) with long term deposits **WAS** an effective business model — at least back in the 1950s.
Today, deposits can easily be shifted anywhere in the country. Even back in the 1980s (ie 20 years before the 2008 fiasco), most savvy depositors would move their savings around in search of the best CD rates and the best money market rates. The average life of a deposit dollar shrunk from several years to weeks if not days.
Many bankers were intellectually lazy and did not adapt their business model to a changing market and changing customer preferences — something every single retail establishment is expected to do. Funding long term lending with short term funding is not the same business as funding long term lending with long term deposits. Dinosaurs didn’t adapt either.
In 2008, most money center banks were funding long term loans with overnight repo (and/or 6 month renewable loans from FHLB). Whether you understood your risk at the time or not, you were making two highly correlated trades… You had the credit risk of the loan itself, plus you are making a huge yield curve bet on the side. On top of your loan risk, you are betting with at least 80% leverage that the 1month – 10yr spread is going to remain stable or steepen. A flattening yield curve (whatever the reason for short term rates rising) blows up your trade.
That is what destroyed the S&L industry. They had a massive asset liability mismatch between a deposit base and a loan base.
The exact same thing blew up General Electric (via their GE Capital arm). As Bill Gross pointed out publicly on numerous occassions, GE Capital was funding C&I loans, long term multi-year leases, etc — with money market debt.
I have no idea what department you worked in at BofA — but even if your department was operating prudently, the bank as a whole was making highly correlated yield curve bets on top of almost every loan they made. The same can be said of all the money center banks; even Wells Fargo and JPM.
When BofA acquired Countrywide (which had both a bad yield curve trade AND bad credit problems), BofA essentially became insolvent. Adding Merril to the mix just made the situation worse — especially at the price that Trsy Sec Paulson imposed.
Regulators nearly finished off Citi trying to add Wachovia to their existing messes — Citi had bad yield curve bets (asset / liability mismatches), plus they relied on off balance sheet financing (the SIVs where Citi stashed subordinate tranches they could not sell).
The money center banks did have short term liquidity issues — because as you say no one would lend to anyone in 2008 even if they were solvent. But that was merely a symptom of the underlying disease: more than half the banks were (and still are) insolvent.
Losses stemming from bad credit spread bets, losses stemming from bad yield curve bets, and sizable losses from both subprime and 95% LTV loans wiped out all shareholder equity.
If a bank is levered 20-1, it can only withstand 5% losses before it becomes insolvent. Money center banks were levered at least 25x — once you count all the off balance sheet shenanigans. More than a few were leverered 30+ times; Lehman was levered at least 45x — meaning a mere 2% trading loss wiped them out.
These are all insolvency problems. It is deceitful for you to ignore the massive trading losses on over-leveraged trades. I am saying “deceitful” because I assume a treasurer should know the difference between an overnight funding problem and hundreds of billions in losses stemming from bad loan bets.
Many home mortgages are still underwater even today, 7 years later. The borrowers are underemployed and/or unemployed now, and many of them could never have paid the loans at all without massive bubble-like home price appreciation.
These are real losses, not liquidity problems, even if political concerns delay the day of foreclosure.
The yield curve bets gone wrong are all real losses– and Bernanke letting (and encouraging) them to double down on a bad bet is just foolish. We all heard in 1978 that insolvent S&L’s were going to borrow more and then grow their way out of the problem — and we all know the final cost to taxpayers was more than four times the original cost of closing the bad S&Ls.
In trader’s lingo, your first loss is your best loss. When the trade goes against you, cut your losses. Borrowing money from a loan shark (even a foolish loan shark like Bernanke) in the vain hope that the roullette wheel will be nicer to you next year is just amateur hour.
Yeah, I know. JP Morgan has a battleship balance sheet and their poop doesn’t stink. They also had a $6 billion (and counting) loss from a silly Excel spreadsheet error — which should make investors wonder about the supposedly precise risk management system they use.
This time will not be different from the S&L mess. The final cost of closing bad banks in a few more years will be much higher than it would have been in 2009.
So in that sense: Bernanke’s failure is also not unprecedented. False claims that politically connected bankers are merely having liqiudity issues is also not unprecedented. Yester-year’s S&L Keating 5 are today’s Jamie Dimon, Lloyd Blankfein, Jon Corzine, or Bernie Madoff. Madoff was untouchable for years because of his NASD (now FINRA) connections. Dimon has slept in the White House more often than many heads of state. Blankfein certainly had a supervisory duty to prevent Fabulous Fabrice not to (allegedly) rip his clients faces off — read the series 24 requirements.
And lets not forget all the interference that Barney Frank ran for FNMA and FHLMC. Lets not forget all the interference Chris Dodd ran for AIG and Countrywide.
The 2008 crisis may have had a small liquidity issue component to it — but mostly it was (and still is) an insolvency problem.
Lending more billions at zero percent to bad bankers who don’t understand the curve risks they are taking has not, and never will, fix the economy nor reduce unemployment nor protect the financial system.
The Fed needed to normalize interest rates no later than 2010, and arguably 2009. Instead, Bernanke made a political decision to steal from savers and subsidize bad bankers at insolvent banks.
Insolvency is not a liquidity issue; it can’t be solved with cheap Fed Funds.
TG,
That makes sense.
Greg,
I agree with many your views.
Unfortunately, the crisis was made so much worse due the lax regulatory environment that immediately proceeded it. Surely some insolvent firms were treated as if they only had liquidity issues. As TG points out, however, when a crisis hits its difficult to sort out the solvent versus insolvent firms. Hence, everyone gets the benefits of the enhanced “liquidity” programs.
I have far different feelings about ZIRP. During the crisis there were likely many financial firms that were insolvent, but held up through liquidity programs. As the crisis receded, these firms should have been allowed to fail. Instead they were allowed to recapitalize through ZIRP. BB has claimed that he is interested in supporting Main Street, when he has actually managed an enormous bailout of the banking sector at the expense of savers.
Many people have pointed out the hazard of protecting those that should have gone bankrupt. A great many people should have lost their jobs and experienced the pain associated with their errors. While I agree with this position, I think that there is another area of damage that is less appreciated. At any one time there are value investors (“bottom-feeders, vultures”) that are holding cash with the expectation that asset prices will get cheap. They buy when things get bad, and their behaviors represent a safety net for the system. (An example is Buffet and his investment in GS.) If we don’t allow prices to fall, however, there is no reason for bottom feeders to keep cash these balances. The system loses “buyers of last resort”, and becomes more dependent on the “lender of last resort.”
Thank you both for the conversation.
Regards,
Keith