Category: Banks

Too Many Par Claims versus Sub-Par Assets

Too Many Par Claims versus Sub-Par Assets

Posted on by David Merkel

The world is a maze of debt.? Debts layered on debts.

The Earth and its productivity is roughly the same or better than prior years.? What is the problem with the economy then?

The problem is this: there are entities that made bad loans in the past that expect to be paid back in full.? They assumed the future would be far better than it turned out to be.? There is no way that the loans will be paid back in full.? The solution is paying back at a discount, whether through compromise or insolvency.

Wait. Many of the lenders are leveraged as well, and can’t take significant losses.? Paying back at a discount will bankrupt a number of banks, which will in turn bollix the economy.

So, we have to go slow?? Does this bring us back to the problem of how one eats an elephant?? “One bite at a time.”? That is the method of Japan, leaving an over-indebted government, and reasonably indebted private sector.? But it took two decades.

Whether it is in the Euro-zone, China, or America, it would be better to let entities fail, and deal with the mess.? Yes, GDP will drop a lot, but it will rocket out of the troubles 2-3 years out, the way that Eastern Europe did post-Warsaw Pact.

Ending? the economic malaise means ending the debt overhang.? Where is the government, or set of governments willing to attack this and reduce debts economy-wide?? I know it is a tough prescription, but economies don’t work well when they are overindebted.

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

The Rules, Part XXVII, and, Seeming Cheapness vs Margin of Safety

Posted on by David Merkel

The market takes action against firms that carry positions bigger than their funding base can handle.? Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.? After that happens, valuation-motivated sellers appear to offer more at those prices.? The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.? As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”? The short-term proclivities of investors usually have no effect on the long run value of companies.? Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.? One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.? And often, they invested in financials that looked cheap, but took too much credit risk.? Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.? Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.? Every time I read something by him or see a video with him, I think, “Bright guy.”? But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.? Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.? From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.? And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.? Are the assets and liabilities properly stated?? Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

  • Company size (the ability of management to make sure values are accurate or conservative declines with size)
  • Rapidity of the company’s growth
  • Length of the asset or liability
  • Uncertainty over when the asset will pay out, or when the liability will require cash
  • Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”? It is also a question of whether the company will have adequate financing to hold those assets in all environments.? For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”? All financial asset values are relative to the financing environment that they are in.? Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.? Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.? Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.? (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.? Do they try to grow rapidly?? That’s a danger sign.? There is always the tradeoff between quality, quantity, and price.? In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.? Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?? How much do they explain away one-time events?? Are they raising leverage to boost ROE, or are they trying to improve operations?? Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?? Even with good financial companies there are disappointments.? With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.? They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.? What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.? Even the others of his top 10 have not done well, and the fund as? a whole has suffered.? Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.? And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

  • A 9.9% return from inception to 5/31/2011 is hot stuff, and,
  • A 6.0% dollar-weighted return is very good as well.? Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”? Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

  • It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
  • Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
  • When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.? The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.? It can be a negative self-reinforcing cycle for some time.? My one bit of advice would be: focus on margin of safety.? If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

Risk-Based Liquidity

Risk-Based Liquidity

Posted on by David Merkel

When there is financial failure, it comes as a result of illiquidity.? Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due.? Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times.? Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture.? They spend time on liquidity and other issues.? With liquidity, it is uncertain how they will view repo markets.? To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts.? Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic.? All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different.? In that, premium reserves are invested in high quality short-term debt.? Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over.? The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders.? The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently.? They should invest like P&C or life insurers.? Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known).? After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios.? Illiquid investments (e.g. private equity)? should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away.? And that is what I propose.? Note that if that happens, average people will have to pay some fee each year to have a checking account.? Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry.? Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only.? You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.

What could be better?

Musing Over Glass-Stegall

Musing Over Glass-Stegall

Posted on by David Merkel

This is one area where I would like feedback from my readers.? My view is that the repeal of Glass-Stegall had little impact on the crisis.? Most of the crisis occurred as a result of ordinary failures in investment banking, and commercial banking, with little change from combining them.

I would argue that the overall model for investment banking failed.? No major investment bank survived the crisis intact.? Goldman Sachs and Morgan Stanley had to seek banking charters to survive and receive help from the Treasury/Fed (one entity, but like Janus, two faces).? Everyone else needed help from the Feds, or failed, or merged.

I would also argue that the overall model for commercial banking failed, with many making loans that were horrendously underwritten.

So, what aspects of the crisis stemmed from the repeal of Glass-Stegall? Remember, the Fed was chipping away at it for some time.? Feel free to comment below, but if you don’t want to do that, email me.? Thanks.

Peak Credit

Peak Credit

Posted on by David Merkel

What I write here will not be rigorous.? We’ve heard about “peak oil.”? We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence.? Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off.? The EU is? overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls.? We’ll pay the government debt off later.? Don’t worry. 😉

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem.? How do does one solve a liquidity problem?? Get a loan.? If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze.? But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem?? Will a loan help cure that? No.? You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems.? As an example, most corporate bonds don’t default on principal payments, but on interest payments.? For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear.? Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable?? One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth?? The former, of course.? Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation.? Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.”? It would depend on the structure of the liabilities in question.? But once the fuzzy limits get exceeded:

  • Growth can slow.? (Think of the book, “It’s Different This Time.”)
  • Debt deflation may arrive. (Extend, Compromise, Default)
  • Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.
  • And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts.? Short-term rates skyrocket, and the prices on long debt discount expected recovery levels.? For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

  • Dividends would be deductible, and not interest.
  • This would apply to all personal and corporate interest, including mortgages.
  • We would eliminate the GSEs, and all government lending programs.
  • We would run balanced budgets as a nation, and live with the modest volatility that induces.? We would not engage in fiscal stimulus.
  • We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%.? We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.
  • Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.
  • We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles.? Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world.? Better we should have had a smaller financial sector, and avoided the financialization of the economy.? As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts.? I suspect the former, but I can’t ignore the latter.

Redacted Version of the December 2011 FOMC Statement

Redacted Version of the December 2011 FOMC Statement

Posted on by David Merkel
November 2011 December 2011 Comments
Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.

 

 Getting more optimistic about growth.? I think they are going to get surprised on the downside again.
Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. The unemployment rate is down, but jobs aren?t being created, as people drop out of the labor force.? This is improvement?
Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Shades down their view on business investment.? Shades up their view on consumer spending.
Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable. Gets more definite about inflation moderating, except that it hasn?t moderated.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. No change.
The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. No change.
Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. Strains in global financial markets continue to pose significant downside risks to the economic outlook. Focuses the risks on the financial sector, particularly as the risks in Europe & China could affect the US.? ?Not our fault!?
The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee?s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. Drops language on commodity prices.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. No change.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. No change.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability. No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. No change.? Won?t miss the hawks that weren?t.
Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time. No change.? Won?t miss Evans.

?

Comments

  • The more I read the Fed statements, the more I think that they are paid to be Pollyannas.? The rose-colored glasses are glued to their faces.? There is never any criticism of their actions; blame always goes elsewhere.? They are similar to modern teenagers that lack talent, but have incredible self-esteem.
  • GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.? Inflation has not moderated significantly, either.
  • They point to the risks coming from global financial markets.? The Fed is the lead regulator in the US of banks and SIFIs; if trouble abroad leads to trouble here, they have no one to blame but themselves.
  • In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
  • Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
  • The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

  • Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
  • Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
  • Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
  • Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
  • Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
  • Could we end up with another debt bubble from keeping short rates so low?
  • If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
  • Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
At the Cato Institute?s 29th Annual Monetary Conference (Epilogue)

At the Cato Institute?s 29th Annual Monetary Conference (Epilogue)

Posted on by David Merkel

I wrote about the thoughts of others Wednesday as I took notes on their talks.? I don’t type that fast, so my notes gives synopses of the talks given.

Now for my own thoughts.? I have a sympathy for anyone that wants to take monetary policy out of the hands of the government, because they don’t do it well.? Some sort of hard money standard is necessary, whether gold, silver, or a commodity basket.

Ideals

I have one major ideal here, and I don’t care as much how it is accomplished: get the government out of the monetary policy business.? My secondary ideal is regulating banks properly.

A gold standard could do the job, but I am not wedded to the idea.? Gold standards can be inflationary or deflationary.? It depends on the price at which you link the currency to gold.? Post-WWI, Britain pegged it too high, and got deflation.? France pegged it too low and got inflation. Getting the right level would be important.? Fortunately, we know where it trades now relative to the dollar, and that would be pretty close to the right level, if the stated gold levels of the Fed and the Treasury are accurate.

Practical

A full audit of the Fed is a minimum, as is an audit of the gold at Fort Knox.? Do it once, so that all doubts can be dispelled.

I think that bank regulation for leverage and asset-liability management is more critical than monetary policy itself. Banking crises stem from inadequate asset-liability management.? As James Grant pointed out from the historical example that he gave, deposits should back only self-liquidating assets.? Longer term assets must be backed by matching funding, or equity.

Unseasoned asset classes (i.e., asset classes for which we have no real loss statistics because they have never had failure as a group) should be disallowed as investments for banks except against surplus.? After that, risk based capital should be based off of strict actuarial studies, with a significant provision against adverse deviation, and no credit for diversification.? And, don’t allow banks to score their own riskiness, a la Basel.? That is ridiculous; the fox guards the henhouse.? If a bank has superior risk control, they will earn the results over time; they should not as a result lever up more.

Now, I really don’t care if it makes banks unprofitable, or earn less than their cost of capital.? In that case, we will get fewer banks, the margins of the remainder will rise, and you end up with a genuinely stable system with occasional bank failures that don’t threaten the system as a whole.

There was one idea that I thought could be put into practice immediately, Treasury Trust Bonds optionally backed by gold.? If nothing else, like TIPS, it would give the Fed another indicator on how credible their monetary policy is.

Conference Zeitgeist

The Taylor Rule got some respect.? Many suggested that if it had been followed, we would not have gotten into this crisis.? I’m a little less optimistic there, because bank regulation was co-opted allowing for too much risk to be taken relative to liquidity and capital.

 

Most felt that the Fed was the major player in causing the crisis, with the GSEs playing a lesser role.? The overpromotion of home ownership, and the constant provision of liquidity to the markets led borrowers to become reckless amid asset price inflation.

Incentives also played a role. Managerial and shareholder liability at banks would help prevent reckless behavior.? Wall Street worked better when it was a bunch of partnerships, rather than limited liability corporations.

Most thought that things are worse now than the ’70s.? The debt levels are higher, which makes demand punk, and businessman more skittish to expand and hire.? Government policy is less predictable as well.

The speakers largely expect more inflation; more debt monetization is the path of least resistance.? Politicians get what they want without a vote being taken.? On the question of where to invest, everyone was an inflationist.? Gold, silver, TBT, were trotted out.? Personally, I’ll stick with my stock investing.

People

Jeffrey Lacker showed courage in coming to the conference.? He made a really good point that the Fed should focus on its liability policies, and limit itself to investing in Treasuries.? The Fed gets bad press and popular dislike when it uses its assets for special lending programs and bailouts, leading to charges of favoritism.

Zoellick was a reasonable guy regarding the problems in the Eurozone.? Germany has to figure out what it wants.? To me, it boils down to this:

  1. You can have a suboptimal euro that is not a good store of value, and bail less well-disciplined governments out via the ECB sucking in their debts, or,
  2. You can have a smaller Eurozone en route to no Eurozone, or,
  3. You can have a Federal Europe, and dissolve Germany into Europe as a state of the whole, as the 13 colonies did after the Articles of Confederation.

Personally, I would choose #2, because people in Europe identify themselves with their nations, not as Europeans.? Political and economic systems must derive from cultural systems or they will not work in the long haul.

It was fun seeing my old professor, Dr. Steven Hanke.? I reminded him of nine years earlier, when he gave a talk to the (then called) Baltimore Security Analysts Society, and we discussed why we thought the Euro would have a tough time surviving.? Most of that discussion is now taking place.

Ron Paul was Ron Paul.? He doesn’t change much — that’s one of his apolitical virtues.

John A. Allison was entertaining; he argued that capital levels are too low, and regulation too high.? He thinks that you can’t expect much, and don’t get much from regulation.? Especially interesting were the discrimination in lending allegations by the regulators that BB&T fought and won twice.

Conferences like this attract cranks.? Lots of people with odd political agendas hoping to get noticed, others with odd business propositions.

Other

As a final note, the concept of free banking and/or competitive currency issuance, I think invites more problems than it solves.? Think of it this way: people aren’t very good at evaluating financial promises.? The fewer the better, and the lower level of complexity, the better as well.? There has to be some monitoring of financial promises, some intelligent regulation of banks, or things can go badly wrong.? US history backs such an idea up, regardless of whether we have a gold-, silver-, or commodity-backed currency, or a fiat currency as we do now.

Update — thanks to Eddy Elfenbein for catching a typo/thoughtless mistake in paragraph 4.? For France, it was inflation, not deflation.

At the Cato Institute?s 29th Annual Monetary Conference (VII)

At the Cato Institute?s 29th Annual Monetary Conference (VII)

Posted on by David Merkel

CLOSING ADDRESS

John A. Allison
Former Chairman and CEO, BB&T, and Distinguished Professor of Practice, Wake Forest University

Problems primarily caused by government policy, loose Fed policy, GSE policies.

Fed jobs: payment systems, bank regulator and monetary policy

Payment system monopoly benefits inefficient small banks.

Regulation: FDIC insurance destroys market discipline.? Financing using FDIC-insured deposits to make real estate loans.

Fed failed to oversee other regulators.

Private deposit insurance a la Bert Ely was possible. (?!)

Now-discredited study Boston Fed on discrimination in lending.? Loosened loan standards as a result.

BB&T fought it and was found not to discriminate.? Still fought it, until Republicans were elected and the investigations was dropped.? Same under Obama administration, until Republicans were elected and the investigations was dropped.

CRA eliminate redlining — banks don’t do well with low-quality lending.? Worked so long as home prices were rising, but gave the rating agencies the wrong loss factors that blew up when the bust happened.

Grossly misregulated during Bush, Jr. Administration — Privacy, Patriot Act, etc.? Only Spitzer caught.? Wasted a lot of management time which lead to less true risk control.

Would eliminate regulations before taxes. (DM: of course, taxes are easier to fuddle)

Regulators don’t catch things proactively.? No surprise, because regulators don’t act during the boom phase because everything is going well.? Describes a junky bank that BB&T passed on, until it went bankrupt.

In the bad times, regulators irrationally tighten.? BB&T no longer will make good loans that they used to.? FDIC was worse now than the early 80s & 90s.? Affects small banks most.

Price controls: no one at Fed believes in it, yet the FOMC triues to regulate interest rates.

Greenspan most regularly ran policy with negative real interest rates, helping to create a bubble, until he finally began his last tightening.? Bernanke inverted the yield curve, banks took more credit risk to compensate, worst loans were made then.

Fed held prices up in the ’20s by holding prices up when they should have been falling.? Hidden asset bubble.? Prices should have been falling in the 2000s with the addition of new labor to the capitalist system from China and India.? The process of inflating incented jobs overseas, aside from home construction jobs.

Fed policy today is destructive and lowering productivity.? Private equity guys he talked to are not changing their hurdle rates.

Current policy robs savers for borrowers.? Humiliating many older savers (DM: makes them take too much risk also).

If Congress can print money via the Fed, they will do so.

Who do enslave via regulation?

Short-term versus the long-term, we pick the short run… leading to inflation away of debts, and loss of responsibility.

Life, liberty and the pursuit of happiness… takes a dig indirectly at the gift and estate taxes… free to give it away.? (DM: perhaps it should have been pursuit of virtue, or serving Christ, but that wouldn’t have fit the Founders)

Self-esteem mainly comes from work? (?!)? An encouragement to do your best.? Welfare lowers self-worth.

Q&A

Why should intervention not have occurred in the credit markets?

After making so many mistakes creating too much credit and a pseudo-boom, it was required after that. After that, the bailouts were not predictable.? The losses were not going to be so big.

Makes a mistake saying the insurance industry would not have been affected by the failure of AIG.

Disses Paulson (investment bank unsystematic), Bernanke (Academic) and Geithner.

Should bank executives have personal liability?

No. Thinks capital ratios should be 25%.

Why did they bail out Bear Stearns?

No good reason, thought it would be one-time.

Big rise in the monetary base?

Inflation, Stagflation coming.? No unemployment in a truly free economy. (?!)

 

At the Cato Institute?s 29th Annual Monetary Conference (VI)

At the Cato Institute?s 29th Annual Monetary Conference (VI)

Posted on by David Merkel

PANEL 4: A PROGRAM FOR MONETARY FREEDOM

Moderator: Alan Reynolds
Senior Fellow, Cato Institute

Stimulus: money away from productive uses and toward the goverment and other unproductive bits of malinvestment like autos and homes.

James Grant

Editor, Grant’s Interest Rate Observer

The cumulative effect of history

Problem in banking not a shortage of capital, but a shortage of capitalism.? Must allow banks to fail.? In old days, unlimited liability made banks more cautious.

Deutsche Bank vs JP Morgan Chase

  1. 15% capital-to-risk-weighted assets
  2. Leverage — also identical
  3. But DB 42x vs JPM 13x assets/equity
  4. 60x vs 17x — tangible assets /tangible equity
  5. JPM has less callable liabilities

1842 New Orleans — divide bank balance sheet in two; movement: self-liquidating loans and gold against deposits.? Deadweight: surplus — could invest anywhere.? Worked for a generation.

Clarity, simplicity and elegance

Kevin Dowd

Visiting Professor, Cass School of Business

Bailouts just another profit center for banks.

Liquidation would have been better than the bailouts — mentions Mellon

Low interest rates just create another bubble. DM: Hair of the dog

Confidence only comes from strong balance sheets.

Quotes Jackson regarding the Second Bank of the United States

Solution is to eliminate the Fed

Endgames: Monetize the debt, or watch interest rates rise.

Solutions? Gold standard, End Fed, personal liability for bankers.? Constitutional settlement because governments and money don’t mix.? Prohibit bailouts, and intergenerational transfer schemes.

Kurt Schuler
Senior Fellow, Center for Financial Stability

Competitive vs Monopoly issue of currency — why the shift?

Easy way for the Government to make money through seniorage.

Four places today where parallel issuance of notes goes on today: Scotland, Northern Ireland, Hong Kong, and Macau.? 100% segregation of assets in reserves at the central banks, generally.

Where might issuance of competitive notes be legal?? Mostly teensy places, with the exception of the US & Japan (they aren’t sure) and the 4 mentioned above.

Q&A

Raising interest rates to improve matters?? Where to invest?

Gold, silver, TBT

Currency transfer schemes talk, no question

DM: There are lots of these schemes around

At the Cato Institute?s 29th Annual Monetary Conference (V)

At the Cato Institute?s 29th Annual Monetary Conference (V)

Posted on by David Merkel

 

PANEL 3: TRANSITION TO A NEW MONETARY REGIME

Moderator: Steve H. Hanke
Professor of Economics, Johns Hopkins University

DM: Steve Hanke was a professor of mine when I went to Hopkins.

Targeting NGDP — Cato Institute — 2003 — Nominal Gross Domestic purchases or final sales


Richard H. Timberlake
Emeritus Professor of Economics, University of Georgia

Why did we go off the gold standard?

Dual Mandate is the main problem at the Fed.

Fed very different animal than at its inception.

Legal tender laws — goes back to the Civil war, 2.5x inflation afterward.? Debts paid off with depreciated greenbacks.? Tested by Supreme Court — Salmon Chase, Lincoln’s Treasury Secretary in 1864, was the Chief Justice at the time in 1869, and he changed his mind, on the ability to pay off pre-1862 debts with the greenbacks.

Rankled Grant administration — appointed 2 new justices, and a new case reversed the ruling. 1871

1884 — Congress can issue any currency it likes because it has sovereignty.

1913 — System needed a lender of last resort, thus Fed creation.

1922-1929 — Stabilized the price level, amid a gold standard…

Benjamin Strong dies, and power shifts from the NY Fed to the Board.? New leader opposes speculation; banks needing liquidity could not get it if they had been lending to the stock market. 1929-1933 huge contractions and bank failures.

FDR abandons the gold standard; devalues; collects gold; eliminates gold clauses.

Supreme Court relies on legal tender laws saying that Congress could define money as it chose.? He thinks the precedents should have been re-argued.

Judy Shelton
Author, Money Meltdown

Ruble collapse — Why back to gold standard?

Thinks all candidates should be talking about monetary reforms.

Money should be a stable unit of account and should be liquid.? It should allow us measure value well.? Convey the price signals of the market accurately.

Jefferson wanted a hard currency defined in terms of precious metals.

Offer Treasury Trust Bonds with a an optional conversion feature to gold.? Would receive par back or an ounce of gold.? Priced initially with par of an ounce of gold, no interest paid.

Argues for a balanced budget amendment.

Thinks other nations would mimic the ideas if a US Government gold bond would be issued.

Greenspan proposed this idea 40 years ago.

Lawrence H. White
Professor of Economics, George Mason University

How to go back to the gold standard?

A lot is calculating the proper initial parity with gold.

Treasury owns enough gold to re-establish a gold standard at $1600/ounce.

“At least I assume it is there, Fort Knox hasn’t been audited in a while.”

1) Eliminate excess reserve by eliminating interest paid on reserves.

2) Redeem reserves at Fed with gold.

Back M1 100% with gold — $8000/oz, Inflationary, reduction in wealth, etc.? Warehouse notes w/storage fees.

Central bank?? No monetary policy needed.? People would buy and sell gold daily.

Single mandate has not worked well for the ECB.? Inflation there running at 4% or so.

Competing private banks worked better than with central banks.

Or, the Fed could become a currency board in the short run.

Q&A

Taxation of Tsy Trust Bonds?

Shelton: Would confuse some of the issues.? Just get this out there so it can be tried.

Will the gov’t take action?? Guesses as to when?

Shelton, White: No idea.

Would would trust the Treasury w/Treasury Trust bonds?

Shelton: They would be collateralized.

Why is monetary reform important?

Hanke: because the Fed ran a reckless monetary policy, and did not regulate leverage of banks well.

 

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