Justin Fox has been asking how we might make the miscreants pay (and here). I have two ideas to throw out.

My first thought is an old doctrine. If we could get the people who supposedly represent the people to formally acknowledge the insolvency of the institutions we are bailing out, there is a wide-ranging doctrine known as “fraudulent conveyance” that might help. Payments by a bankrupt firm during the period preceding the bankruptcy are subject to challenge and reversal, under the theory that preferential transfers by insolvent firms to some parties rather than others are inequitable. I don’t know, from a legal perspective, how far back and how broadly the doctrine of fraudulent transfer could be applied to insolvent financials, but it’s possible that a formal insolvency (e.g. a nationalization or receivership) could put a lot of people who got paid by banks during the boom at risk.

Yves Smith pointed this out a while back. I think it’s worth taking a moment to wonder whether and how much the political resistance to formal nationalization is due to fears on the part of well-connected executives of being clawed-back via this doctrine. (Has fraudulent conveyance been aggressively pursued with respect to the Lehman bankruptcy? If not, why not?)

I hasten to add that I know very little about the legal details of fraudulent conveyance, whether it could in fact be applied to large, insolvent financials, what if any legislative action would be required to make the doctrine bite effectively, etc. I do know that even good-faith sellers of firms into leveraged buyouts are quite terrified of fraudulent conveyance, since even healthy firms become risky after the levering up and capital extraction that often followed these deals, and the former owners of previously viable firms can be made to take a serious hit. People who might know stuff about this (Buce?) are encouraged to weigh in. If we treated nationalizations as insolvency for the purpose of fraudulent conveyance, could we do some clawing back? Or is this a ridiculous idea?

Another way we could claw back is to simply enact a special tax on all recipients of income from firms receiving public support. Again, we are partially screwed by Hank Paulson’s cynical strategy of encouraging healthy firms to camouflage the rotten ones by accepting TARP funds. But we might set a deadline for the return of public capital, to encourage the healthy trend of banks returning unneeded public support. People who received income as an employee or contractor of banks requiring continued public support during 2004-2007 could be subject to a special, retroactive tax on that income. The IRS presumably has W-2s and 1099s by which they can identify those who would be liable.

This is obviously mean and unfair to many innocent bank employees, and cuts against the America tradition of eschewing collective justice. To diminish the meanness, the special tax could be progressive in the amount of income collected, so that janitors and tellers at Citibank wouldn’t be unduly hit. It could be spread over several years, to help people finance the unexpected charge. But, however imperfect, this sort of tax would be far better targeted than future taxes that penalize Americans broadly, or even forward looking tax levies on financials that (if we get our act together) might be very different from the dinosaurs and innocent of their sins. (Should prosper.com pay for the excesses of Citibank?) Administration of the tax should be straightforward and comprehensive, as even the sharkiest of sharks working for putrescent financials wouldn’t have seen this one coming a few years ago and contrived to hide the source of paychecks from Citi.

Of course, it would set a precedent going forward, so highly-paid agents of firms capable of forcing a bail-out might seek get paid via squirrelly networks of special-purpose vehicles in order to evade future clawbacks. But that is a feature, not a bug. One problem with our financial system is that it was easy for basically decent people to engineer rapacious and fraudulent practices while persuading themselves it was respectable work. Acting in a manner that yields private short-term profits in exchange for catastrophic risk to taxpayers and the economy is not respectable work. People who find they have to launder their paychecks like drug dealers are less likely to get confused about that (and less likely to be dealt with mildly if they push us to the edge again).

If we do this kind of thing, we should make it clear that its purpose is to cover actual rescue costs, not to arbitrarily discourage risk-taking. (I’d view it as similar to how people who get stuck on mountains are sometimes billed for the cost of their search-and-rescue.) Agents of firms that are clearly small enough to fail could rest assured that the taxman would have no claim against people caught in private tragedies. Fear of such a tax might discourage managers and executives from building up large or insidiously interlinked firms and then capitalizing on an implicit “too big to fail” guarantee. Firms may be too big to fail, but the people who make them that way needn’t be invulnerable.

Update: Reader Paul Morelli directs us to the excellent Adam Levitin at Credit Slips on the subject of fraudulent conveyance and bonuses. See also the comments, in which Tom Grey suggests a “windfall bonus tax”.

Update 2: Skeptical CPA has a great deal about bankruptcies and fraudulent transfers, for example here. He also points to this interesting summary of bankruptcy scams. To reiterate the connection between this stuff and current events, if the government bails out an insolvent bank by making creditors and counterparties whole, that is like a bankruptcy, except the government steps into the shoes of creditors and takes the hit they otherwise would take. Conduct that would harm private creditors in a bankruptcy harm the taxpayer in a bailout, and in theory should be litigated just as aggressively by the aggrieved party, which is all of us. However, by preventing any formal declaration of insolvency, bailouts enable scavengers to avoid the whole skein of case law surrounding bankruptcy, which tends to put people who extract benefits from a firm while it is foreseeably bust in jeopardy.

Update 3: Buce weighs in on fraudulent transfer (and distinguishes them usefully from preferential transfers) in the comments. His conclusion? “…maybe less here than meets the eye.” Thanks Buce! Not too many comments on the tax idea, which I thought the more incendiary of the two proposals…

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won’t speak for CR, but some of us would disagree with JH’s presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH’s plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers’ put option and its “vega” — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry’s quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It’s as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms’ reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we’d like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don’t think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking has ever been a successful industry for capital providers? A “healthy” banking system is arguably just a bubble, worth investing in only if you’re smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we’ve never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It’s long past time to try something else.

Call the President!

The indispensable John Jansen has hit upon a way of preventing the next teetering shoe in the financial crisis from going thunk. So far, we’ve heard surprisingly little from the long maturity financial intermediaries — insurance companies (excluding the counterfeiters at AIG FP) and pension funds. Apropos, JJJ notes

Metropolitan Life announced that in its holdings of corporate bonds they are sitting unceremoniously on $14 billion in losses. I suspect that they are now hoping that advances in medical science will render current actuarial assumptions void and vacuous and the time value of money will work in their favor.

Really, Mr. Obama, has there ever been a better time to fund a Manhattan Project to invent immortality! Kill two birds with one stone. It’s immediate stimulus, quick-start investment in a sector where the USA retains a comparative advantage, high-tech medicine. Plus it’s a nearly bottomless, um, well of employment opportunity for less skilled workers, who could comb the Lake Okeechobee environs in search of the Fountain of Youth. If successful — and of course it would be successful, this is America, can do, yes we can, shut up we can too — it would save the financial system from the slow tremors of unfunded baby boom retirements and unpayable life insurance obligations. No, Mr. Dole, building a better Viagra doesn’t cut it. However, an appeal to the patriotism of Dr. Carlisle Cullen might yield rapid progress.

I’ve just listened to NPR’s recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation.

As an aside, we’ve come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn’t that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it “more responsible” to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?

Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner’s repeated conflation of our “financial system” and our “institutions”. Mr. Geither’s unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are “strong”. But that’s not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become “too big/complex/interlinked to fail”, but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.

We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of “Mussolini-style Corporatism“. Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it’s pretty clear that quite a few familiar financials have failed the market test. What’s good for Citibank is not what’s good for America.

Did you catch this bit from Warren Buffett’s letter?

Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

“Lemon socialism” has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don’t see how preventing healthy good banks from harvesting the organs of our megabanks “strengthens our financial system”.

I think it’s time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn’t mean that we would shutter all of Citi’s branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling’s #2) while the government backstops some obligations and seeks buyers for the bank’s assets, operating as well as financial. In other words, it’s time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that’s more likely in a world where Citi’s logo goes all retro chic like Pan Am. Frankly, I think that’s all the (non-negative) “franchise value” that’s left in Citi, and several of its peers.

Word on the street today is that the Obama administration’s proposed budget includes a $250 “placeholder” for support of the financial system. (ht Economics of Contempt, Calculated Risk) President Obama made an admirable commitment “to restoring a sense of honesty and accountability to our budget”. However, his administration has failed to live up to that commitment with respect to financial system support. Unusually for government expenditures, the budgeted $250 billion dollars represents an estimated “net cost”. It presumes recovery of a substantial fraction of funds “invested” and actually enables cash payments that might amount to $750B. (See EoC, Marc Ambinder.). In plain English, buried in a $3.55 trillion dollar budget as a $250 billion dollar placeholder is a plan to more than double the controversial and unpopular TARP program, whose original enactment nearly tore the political system apart.

We do have a bit more transparency this time about how the “Capital Assistance Program” will be managed. Taxpayers will purchase securities at prices which, as Michael Shedlock points out, appear to have been back-dated in order to give taxpayers a raw deal. In an astonishing abuse of the customary language of finance, the “convertible preferred” shares the government intends to purchase, in addition to mandatory conversion after seven years, are convertible to common stock at the option of the the banks, rather than at the option of the taxpayers holding the securities. James Kwak unearthed this bit of chicanery in the must read piece of the day. In addition, existing bank shareholders would be protected upon any conversion by “customary anti-dilution adjustments”. God forbid that shareholders in bankrupt institutions who would otherwise be wiped out entirely get diluted. The poor dears. (To be fair, it is inaccurate to characterize all institutions that will receive “capital assistance” as bankrupt. The new Treasury Secretary will almost certainly continue the old Treasury Secretary’s strategy of “encouraging” healthy institutions to take government money, so that angry taxpayers cannot use acceptance of funds as evidence that a bank is in trouble. Under the new program, any publicly listed US bank can apply for a capital infusion of up to 2% of risk-weighted assets as a matter of course.)

President Obama’s obvious intellect, idealism, and diplomacy are a breath of fresh air for a nation whose economic and political institutions have suffered a near catastrophic collapse. But the President cannot put his imprimatur on continued financial obscurantism and expect to retain a reputation for honesty and transparent government. It is wonderful that the President intends to come clean and account for the wars in Iraq and Afghanistan on-budget. But Mr. President, past and proposed expenditures to support the financial system dwarf the total financial costs of both those wars combined. This is not a small thing. You can’t hide the terms of these transfers in fine-print befitting a credit-card agreement and expect to retain your reputation with the American people for forthrightness.

Here is my advice to the U.S. Congress: Put $750B in the budget, right up front, for financial system stabilization. But don’t contribute another dime to Secretary Geithner and Neal Kashkari‘s little slush fund. Allocate funds to the sole use of the FDIC, for resolution of troubled banks as foreseen by Congress under the FDICIA (text). See this excellent piece by former bank regulator William Black. The government has been flouting the terms of a binding legal regime designed precisely to resolve insolvent and near insolvent banks transparently, at least cost to the taxpayer, in a manner that minimizes both moral hazard and systemic risk. Former Secretary Paulson’s ad hoc let’s-pretend approach has been tried, and has failed. Why not try following our own laws?

We have a new administration in Washington that claims to be committed to the rule of law and good governance. Congress should help the President achieve these goals by funding an accountable FDIC rather than by putting more discretionary funds into the hands of a compromised Treasury secretary.

Update: The always excellent Nemo also noticed the odd reverse-optionality of CAP “convertible preferreds”. He finds the coincidence of widely publicized insider purchases during CAP’s price-determining 20-day window to be intriguing as well. Purchasing shares with the intention of increasing their effective price to taxpayers under a foreseen government relief program would certainly constitute a crime. What did Ken Lewis know, and when did he know it?

(It’s worth mentioning that the allegation of backdating and that of insider price manipulation are mutually inconsistent — if insiders knew that the window would be 20 days preceding Feb 9 in late January, that implies the price-determining date was appropriately set in the future. You can either suggest that the date was chosen retrospectively, or that it was chosen in advance and shares were bought and talked up, but you’ve got to pick one conspiracy and stick with it. I guess if you’re really cynical, you might suggest that Feb 9 was tentatively chosen in advance, but only finalized when it was clear in retrospect that prices were advantageous, relatively speaking…)

We don’t know exactly what Timothy Geithner has in mind for the “Public-Private Investment Fund”. But we do have a few hints. First, we know that among its purposes is that it

allows private sector buyers to determine the price for current troubled and previously illiquid assets.

And we also know, that on the very day Mr. Geithner offered his outline of a financial stability plan, the Federal Reserve announced its intention to expand its Term Asset-Backed Securities Lending Facility, or “TALF” to up to a trillion dollars, coincidentally the round number that Geithner suggested the “PPIF” might expand to. Hmmm. What is the TALF again?

Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral… As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets… The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

Does your head spin, acronym upon acronym, non-recourse, warranties, and covenants? Well, unspin it. The New York Fed is telling us, in plain and simple legalese, that it is planning to make a very generous gift to investors that participate in this program (and indirectly to the banks that sell assets to them). A non-recourse loan bundles an ordinary loan with an option to “put” the collateral back to the lender instead of paying off the loan. Sometimes this is not much of a gift: When a pawnbroker lends you half of what your Fender Stratocaster is worth, and the fact that you can surrender the guitar rather than pay off the loan is cold comfort. But if someone fronts you substantially all of what an asset is worth, and the value of that asset is uncertain and volatile, then the put option bundled into the “loan” becomes extraordinarily valuable. If the asset appreciates, you take the profits and “ka-ching!”. If the asset falls in value, the lender takes the trash and eats the loss.

A near-the-money option is itself a valuable asset. Offering non-recourse loans to participants in the PPIF would directly contradict the program’s goal of “allow[ing] private sector buyers to determine the price for… troubled… assets.” Private sector buyers would not be pricing the assets themselves: they would be pricing a portfolio containing a troubled asset and a free, three-year put option, courtesy of the Fed. Depending on how much of the transaction the government is willing to finance, the value of the put option could represent a substantial fraction of the value of the asset being priced. This is a subsidy, that would be incorporated in the sales price of the asset and split by banks and private investors. It amounts to the government bribing investors to certify banks as more solvent than they are, by overvaluing bank assets in subsidized purchases.

John Hempton wrote a very brilliant essay on what it means for a bank to be solvent. If you haven’t read it, go do. Hempton’s definitions 2 and 3 of bank solvency — current accounting value (which implies mark-to-market valuation for many assets) and economic value as an ongoing enterprise — diverge because the cost of funding for investors in risky bank assets is unusually high. Under these condition, Hempton reasonably suggests, private fund managers will be unable bid assets up to their best estimates of “hold-to-maturity value”, less a “normal” risk premium, because investors are desperately unwilling to hold anything other than government guaranteed securities. Definition 3 is a very generous view of what it means for a bank to be solvent, because it implies that the actual market risk premium is wrong, that an estimate of hold-to-maturity asset values by a reasonable analyst, even accounting for risk, would put those values above current market bids. But in evaluating bank solvency we should be generous: Since an insolvent bank must be nationalized (reorganized, received, conserved, preprivatized, whatever), we should try to avoid declaring as insolvent banks that do have positive economic value, since that would amount to a capricious expropriation of private property.

But generosity in evaluation is distinct from a generous cash gifts from taxpayers to banks and investment funds. What is required to get a generous but still accurate evaluation of bank solvency is inexpensive funding, so that analysts willing to bet on what a “toxic asset” is worth can borrow the funds they need to back their spreadsheets with shekels without giving away all the upside to nervous lenders. What is not needed, what is in fact positively counterproductive, is to give investors a special bonus in the form of a free option if they buy the asset. This guarantees that assets will not be accurately priced (they will be overpriced), and reduces analyst incentives to value assets carefully and generate reliable market prices.

I actually think having the government offer cheap, full-recourse loans on a maturity-matched basis to investors willing to bear the risk of holding currently disfavored assets is a clever idea. (“Maturity-matched” means investors don’t have to worry about margin calls: as long as they get the long-term values right, they can ride out any tempests in mark-to-maket prices.) We do need a market in these assets, and if it is true that funds availability for people willing and able to bear the risk of ownership is preventing such a market from arising, then by all means, that’s a “market failure” the government can correct. But the key point is that a market price is the price at which private parties are willing to bear that risk. If funds are provided non-recourse, much or all of the risk of ownership is absorbed by the lender. Any prices that result from “private” purchases by investors funded at high-leverage on a non-recourse basis are not market prices at all. Such prices would be sham prices, smoke-and-mirror prices, sneaky off-balance sheet public subsidy prices.

We are all tired of the lies, Mr. Geithner. By all means, let nationalization be a last resort, and do all you can to offer liquidity to private parties willing to take both the upside and downside of speculating in questionable paper. But if you keep nationalizing the downside and privatizing the upside, it will not be very long at all before the public concludes that stress tests and market prices are just a sleight-of-hand for Davos man while he picks our pockets, again. Act fairly, and you may end up nationalizing the worst few of the larger banks. Keep up the games, and we will insist that you nationalize them all. It is getting hard to believe that there is a banker in the land who has not already robbed us. Eventually we will tire of drawing fine distinctions.

Afterthought: There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ’em a ticker symbol, and put ’em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

…for Yves Smith.

If you aren’t shrill, you aren’t paying attention. Weren’t we supposed to be done with shrill now?

So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that’s a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.

1. Never, ever feed the zombies!

   Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at “hold to maturity” values. Just say no! A healthy financial system cannot be run by zombies. “Rescuing” insolvent banks makes about as much sense as tying string to the arms of a loved one’s corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it’s sure to smell really bad, and it’s gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.

2. Help private individuals save good banks.

   A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:

   The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed… to produce fair accounts for Gotham. Ten weeks should do it… The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank’s viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can’t or won’t fund the bank in full knowledge of its position then it is nationalised.

   The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank’s shares until the loan was fully paid.

   In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks’ viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is “illiquid but not insolvent”, since the government has offered liquidity on generous terms to help get the deal done.

   (For the record, I view this procedure as too generous. As far as I’m concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people’s heebeegeebies about the government owning what it pays for, I’d put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)

3. Nationalize, reorganize, privatize spin-off to taxpayers.

   Insolvent banks become wards of the state. They are nationalized. The “N-word”, as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn’t change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about “nationalizing”, say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.

   Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too “systemically important” to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.

   Henry Blodget suggests we

   refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn’t appropriate for people to get paid.

   But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO “pop” goes to flippers, not to the firm or its original shareholders. There’s a deep literature on the phenomenon of “IPO underpricing”.)

   Here’s an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they’d quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value “toxic” assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.

   This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild “stimulus” — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it’s far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.

Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. “Compare and contrast” is a fruitful exercise. The spin-off idea owes something to this perspective.

So, I like to go on about how we don’t have a financial system, how the system we have is inadequate and structurally broken, how we need to invent new institutions. I think we need to experiment, in a startup-y, techy kind of way, with more flexible, fine-grained, and transparent exchanges that could augment and perhaps replace traditional capital markets. Really, that’s what I want to do someday.

Unfortunately, I’m slow and lazy. But occasional commenter Thomas Barker is not. He writes to say he’s helping to organize an informal meeting in London of people interested in pursuing just these kinds of projects. I desperately want to go, though I’m afraid the odds are slim. The event will take place on February 14th. (Yes, how romantic.) For more information, try here.

I’ve been flabbergasted by just how good Winterspeak has been lately. I don’t agree with all of his conclusions, but the perspective he’s developing is quite beautiful, and very useful. I’m going to highlight a few of the bits I really like, and add a bit of spin.

I want to start with a related insight from the excellent Mencius Moldbug. Apologies to Mencius if this isn’t the best reference, but the point is very clearly stated, in a comment at Brad Setser’s:

Money is the bubble that doesn’t need to pop. As long as there is demand for indirect exchange, at least one asset will be stockpiled by hoarders, hence experience demand that is not a consequence of any direct utility, hence be overvalued. As long as the storage cost for this asset is zero and the supply in existence is fixed, you have a perfect Nash equilibrium – using any other asset as a medium of indirect exchange provides no advantage, and runs the risk of buying into a bubble which will subsequently pop as punters revert back to the stable standard.

This idea stands in stark contrast to the view recently offered by John Cochrane:

The value of government debt, including money, is equal to the present value of the primary surpluses that the government will run in order to pay off the debt. Nominal debt is stock in the government, a claim to its taxing power.

I think Mencius’ view is more accurate. [1]

The next insight I will attribute jointly to Mencius and Winterspeak (while quoting neither): When a government implicitly or explicitly guarantees deposits and other bank debt, it is useful and in some ways more accurate to describe the arrangement as loans by individuals to the government and then separate loans by the government to banks. If bank loans sour, it is the government who is out the money. Bank creditors do not discipline banks, or select banks based on their investing acumen. The connection between the deposit base of a bank and that institution’s ability to lend is formal and vestigal, and is disappearing as reserve requirements become an ever less binding constraint on bank lending. (I’m pretty sure I’ve read both Winterspeak and Mencius make this point, but I can’t find great quotes. Here’s an example from Winterspeak.)

This idea foreshadows the new Winterspeakian synthesis that has me suddenly awestruck. Winterspeak presents a view of the monetary/finacial system in which the government is ultimately the hub. As above, when we “save” without explicitly investing, we don’t lend to banks which then lend to businesses. We lend to the state — we hold instruments that are ultimately claims against the state — while the government organizes the distribution of loans, implicitly via how it structures bank lending or explicitly by various forms of directed credit. But the government’s role is deeper than that. Here’s Winterspeak’s counterintuitive, but obvious-once-you-think-about-it view of taxation:

Everyone agrees, more or less, that the Federal Government has the power to print money. That’s what fiat money means by definition. Since the Federal Government can print it’s own money, in whatever quantity it chooses, have you ever wondered why it taxes at all? In fact, if you chose to mail in your 2009 taxes in crisp Federal Reserve Notes, the Government would take that paper money and shred it.

The Federal Government does not need taxes in order to spend. At the Federal level, because the Fed is a currency issuer, the sole purpose of taxes is to extinguish money, reduce aggregate supply, and therefore limit inflation to a tolerable level.

But if the government destroys money, it also creates it:

The Government creates money and transfers it to the private sector by spending. The private sector transfers the money amongst itself (spending, investment) and puts the rest in the bank. If the private sector wants to put more money in the bank, that money can either come at the expense of transactions, or it can come from the Government simply running a larger deficit, and thus creating additional money for the private sector. So long as the private sector uses this money to save, it’s creation is not inflationary and will not show up in the CPI. Inflation is caused by too many dollars chasing too few goods, and dollars under the mattress are not chasing anything.

There’s an elegance to this perspective that comes with what is of course oversimplification. Winterspeak invites us to consider the government, the central bank, and the private banking system as a consolidated entity. Money taxed, lent to the government or deposited in a bank is money destroyed (at least temporarily). Money spent by the government, or borrowed from a bank is money created. Questions of control are not addressed — we don’t know whether it is Congress, the Fed chair, or private bankers who most influence this public-private hybrid at the core of the monetary system. But thinking about money this way cuts through a lot of confusion.

Let’s combine all this with the Moldbugian insight that money is the bubble that needn’t break, that its value is due to the stability of a Nash equilibrium — as long as everyone wants it, it is rational for everyone to want it. The government/banking system, then, has the incredible power of creating what everyone wants or destroying it, as it sees fit via spending and taxation, but also via lending and borrowing. However, there may be constraints on its ability to use that power, for institutional and political reasons, but most profoundly because of the dynamics and potential fragility of Nash equilibria. We’ll come back to this.

Both John Cochrane and Paul Krugman would agree that the current crisis, at least in part, is a phenomenon related to an unusual increase in people’s desire to hold money. Moldbug’s Nash equilibrium is on overdrive somehow: all everyone wants is what everyone wants, claims against the government that the government can create or destroy at will. To understand the implications of this phenomenon, we have to add a bit more substance to the meaning of “savings” and “investment”. We’ll follow Winterspeak’s treatment first, which is remarkably insightful, although I don’t entirely agree. (I hope W— will for give me for lifting such a large chunk of his post, but I’d not do it justice in paraphrase.) Winterspeak:

The Issue

Essentially, Cochrane and Fama both assert that savings = investment (+ capital account), and so say that any Government stimulus will crowd out private investment. Here’s the derivation (by identity) to get you S = I

Y = C + I + G

National savings can be thought of as the amount of remaining money that is not consumed, or spent by government. In a simple model of a closed economy, anything that is not spent is assumed to be invested:

NationalSavings = Y – C – G = I

If you think that banks make (investment) loans based on their deposits, then it’s reasonable to assume that all money not spent (ie. saved) is invested. But banks do not take deposits and loan them out. In fact, banks make loans first and then those loans become deposits. Remember — loans create deposits, deposits do not “enable” loans.

Loans create deposits

Banks, by way of their Federal charter, can expand both sides of their balance sheet at will, subject to capital requirements. This money is created ex-nihilo, but always nets out to zero in the private sector, as each (private) asset that a bank creates must be matched by a (private) liability. Government can create money outside of the system, but banks always need to net out and balance the balance sheet.

People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.

Facts on the ground

If a description of how banks actually work doesn’t shatter your belief that savings = investment, consider Reality. From about 2000-2006, American savings went negative, yet banks loaned out huge amounts of money (made huge investments). In fact, they came up with all kinds of clever ways to skirt capital requirements so they could make even more investments. If savings = investments, and savings fall, how can investments rise? By the same token, from 2006 to now, the private sector has actually delevered, saved, but banks aren’t making any loans (investments). What’s up with that?

More Facts on the ground

Anyone who thought they were saving by putting money in the S&P500 has had a rude wakeup call. They were not saving, they were investing, and now 40% of that money is gone. I don’t think they will confuse saving with investing in the near future.

So, what is savings?

A better way to think of savings is to think of it as what’s left after taxes, consumption, and investment.

Y = C + I + G

Net Private Savings = Y – C – I – T = G – T

Austrians will howl that it is unreasonable to define savings as a residual, there should be a term S for active savings, but people have to save in currency, and in a fiat, floating fx, non-convertible world, currency is not a store of value. Fiat currency trades bankruptcy risk for inflation risk, and fiat currency is all that’s sitting in bank accounts. So the Austrians are right, there should be some way to actively save, but they are wrong, because fiat currency in a bank is not it.

You split out savings from investment and you get Net Private Savings = Government spending – Taxes, also known as the deficit. So, the Government runs a deficit (spends more than it taxes) in order for the private sector to have the extra money it needs, after consumption, investment, and paying those taxes, to net save. This idea totally blew my mind when I first encountered it, but it actually makes total sense.

So, if you acknowledge that savings does not equal investment, then you see that Government deficit enables private savings. This is the OPPOSITE of all the Chicago guys who argue that the Government deficit REDUCES national savings. Government is a currency issuer, why does it need to save? Does a bowling alley need to hoard the points it awards for strikes and spares? Everyone acknowledges that the Fed can print money, but few people actually think about what that means.

There is so much meat in this. First, a quibble. Winterspeak is disingenuous when he suggests that the disconnect between the miniscule savings rate and the maxicule investment rate argues against the traditional closed-economy identity S = I. The US very much was not a closed economy. The US was importing capital at a breathtaking rate to fund its investment boom, and globally the traditional S = I identity always held. In Bernanke-speak, a Chinese and Middle Eastern savings glut funded an American investment boom. That Americans saved less than they invested hardly mattered, as long as foreigners were willing to lend.

Winterspeak has not really disproved anything here. He has just derived a different definition of savings. The reason this is important is because we talk about savings, economists and real Americans alike slip between the two definitions unconsciously, which badly muddles things. On the one hand, we talk about the savings rate, which most certainly includes investment: If you were contributing to your 401-K or buying farm machinery, you were doing your part to keep the US savings rate above zero. But on the other hand, when we say that during this crisis, Americans’ shift to savings is proving disruptive of aggregate demand, what we are talking about sudden desire to hold claims on money rather than to invest in real capital. Let’s disentagle these two phenomena. Keeping with a closed economy, we’ll define:

Investment = Y – G – C (Traditional savings)
ΔClaimsOnGovt = Y – C – I – T = G – T (Gov’t deficit = Winterspeakian savings)

Actually, this is my party, and I hate how private expenditures are conventionally disaggregated into investment and consumption, while government expenditures are just “G”. So, let PC be private consumption, PI be private investment, GC be government consumption, and GI be government investment. Then:

Investment = Y – GC – PC = GI + PI (Traditional savings)
ΔClaimsOnGovt = Y – PC – PI – T = GC + GI – T (Gov’t deficit = Winterspeakian savings)

So here’s a bit of insight: We can increase Winterspeakian savings in three ways: by increasing government consumption, increasing government investment, or reducing taxes. But note that an increase in Winterspeakian savings only results in traditional savings (current new investment) if the government purchases investment goods. I don’t wish to take a side on the stimulus debate now, but I do want to point out that when people use the normatively charged word “savings” to imply investment, a tax reduction that enables purchases of bonds doesn’t cut it. A tax reduction increases claims against the government without increasing aggregate investment. Individuals imagine they have saved, but collectively, we have only reorganized claims surrounding the consumption and investing we were already doing. (Arguably a tax reduction could saturate the demand for government claims and lead to more real private investment. But that’s a dynamic scoring kind of story.)

Fundamentally, Winterspeakian savings is about restructuring our collective balance sheet in a way that leaves individuals with more claims on government. If the private sector reduces investment and the government increases investment to take up the slack, the ultimate result is the government controlling more real capital, and individuals holding claims on the government. In other words, what the private sector is doing right now is using financial markets to demand more socialism. Individuals no longer want to hold direct claims on private enterprise. They wish to hold claims on government, which implies the government must own and direct the productive activity that will enable it to make good on all those claims.

Regular readers may have noticed that I love telling ironic capitalists-are-socialists kind of stories. But I don’t think a shift towards public ownership of the means of production is a good thing. A consumption-centered stimulus or tax cut would keep the government out of the business of investing while enabling people to hold more money, but that would lead to reduced future production despite an increase in “risk free” claims against government. Today’s “savings” would be a losing investment, in real terms. That is, if we satisy the public’s demand for an increase in government claims, but do not invest the proceeds well, we should expect a great inflation. Hopefully, we are capable of identifying sufficiently productive infrastructure and public goods investments that the government can earn a real return without interfering in the traditional private sphere. But in the intermediate term, there will be no substitute for increasing PI. We need to persuade individuals to undertake investments whose risk they hold and bear if we want to have a capitalist economy. We need a private financial system.

But did we ever have one? If you buy the Moldbug/Winterspeakian view of banking, we did not to the extent that individuals used the banking system to intermediate investment. Instead, the government effectively created incentives for bankers to invest in good projects by letting them keep the proceeds when they chose well, while punishing them a bit but then eating their losses if they chose poorly. We could reproduce that system more directly by having the government invest in private equity funds. Is that what we want?

We really need to think clearly about what we used to have, what was good and what was broken about it, and what we want going forward. How much should investment risk be socialized, to encourage entrepreneurship, vs how much should be borne privately, to encourage discrimination? Would it be possible to build the right mix transparently, rather than to rely on hidden guarantees and subsidies as we have until now? (It may be that subterfuge is prerequisite to an effective financial system in a political world. But I don’t like to believe that.) To the degree that the investors will actually bear investment risk, can we define instruments that they can productively invest in? As index investors have learned, bearing risk without discriminating between good and bad is a prescription for disaster, eventually.

This has gotten terribly long, and terribly rambling, but I do want to come back to one idea. Early on, I described a Winterspeak/Moldbug synthesis in which the government comes off as incredibly powerful. Government money is what everybody wants because everybody wants it. The government destroys money through taxation and borrowing, and creates it by spending and lending, and can do so at will. A very large fraction of “private” lending is in the influence of government, by how it organizes the pseudoprivate banking system as well as via direct market interventions. With so much power, what are the government’s constraints? Why can’t it get an outcome that it wants, presumably a good economy with a bit of corruption on the side? Let’s put aside the institutional stuff. (For example, governments usually have to pretend private banks are private; their ability to direct the loans they guarantee is limited; in fact, a bankers-control-government-expenditure story is historically more compelling than government-controls-bank-expenditure). Right now, the government can pretty much do what it wants with the banking system, can expand the quantity of risk-free claims to meet demand at will, can lend to whomever it pleases. Why can’t it fix the country?

Cassandra had a brilliant post not long ago called “an idea crunch“. Read it if you haven’t. Ultimately, a financial system has to find productive projects for the private parties to invest in. The government can invest directly, can delegate investment to the best and the brightest, can saturate the public’s demand for money until private parties try to find other means of storing wealth. But it’s what real human beings do with real resources that ultimately matters. Our financial system didn’t fail because it was overlevered. It failed because it was uncreative: It could not conjure up worthwhile things to do with the capital it was asked to invest, and instead of owning up to that, it pretended that poor projects were good. Financial markets are ultimately information systems. The only way out of this is to discover worthwhile things to do, or more importantly, to develop better means of generating a diverse menu of worthwhile things to do going forward. Right now, the government is being asked to do what the semi-private financial system could not: generate a positive real return on trillions of dollars of undifferentiated future claims. The stakes are very high — that Moldbugian monetary Nash equilibrium can be a bitch. Money is the bubble that need not pop, but that’s no guarantee that it won’t. Anything that’s desirable only because everybody desires it is just a single major failure away from being yesterday’s darling. If unthinkable banking system failures can occur, so can unthinkable failures of the monetary system.