Finreg I: Bank capital and original sin

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I’m having a hard time expressing myself. So I’ll ask readers’ indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But “liquidity”, as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of “liquidity”, they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were “illiquid” because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a “too big to fail” option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

The US banking system was recapitalized by precisely three words: “no more Lehmans”. All the money we shelled out, the TARP, the Fed’s exploding balance sheet, the offered-but-untapped “Capital Assistance Program”, mattered only insofar as they made the three magic words credible. At this moment the Fed and the Treasury are crowing about how banks are now able to “raise private capital” and about “how TARP is being repaid” and “losses on TARP investments will be much less than anticipated”. That is all subterfuge and sleight-of-hand, flows of urine while the beast lumbers on. The US government has persuaded markets that it stands behind its large banks, that despite no legal right to such protection, all creditors will be made whole and equityholders will live to fluctuate another day. Banks have raised almost no private capital, in an economic sense. They have attracted liquidity on the understanding that the government continues to bear the downside risk.

It’s unfair to say that the government now supplies all large bank capital. Stockholders still suffer price volatility and there is some uncertainty that the government will remain politically capable of being so generous. But the vast majority of large-bank economic capital is now supplied by the state, regardless of the private identities and legal forms associated with bank funding arrangements. So long as the political consensus to support them is strong, American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite. But that is not a good thing.

No iron law of economics ensures that those who bear the risk of an enterprise enjoy the fruit of its successes. Governments have the power to absorb the downside of formally private enterprises (and the libertarian so principled as to refuse a bail-out is very rare indeed). But they have no automatic ability to collect profits or capture gains from organizations that they economically capitalize, but do not legally own. Bearing the downside risk of a project with no claim on the upside is the circumstance of the writer of an option. Private parties who write options, either explicitly or implicitly via credit arrangements, demand to be paid handsomely for accepting one-sided risk. Governments do not. Banks pay deposit insurance premia, but only on a fraction of the liabilities the government guarantees and in a manner that does not discriminate between the prudent and reckless (which creates a public subsidy to recklessness). When governments have lent to banks during the crisis, they have lent at well below the rates even untroubled, creditworthy nonfinancial borrowers could obtain on the market, so that the implicit option premia embedded in credit spreads were somewhere between negligible and negative. Governments paid banks for the privilege of insuring their risks, or to put it more accurately, they acknowledged that they had already insured bank risks and found ways of paying out claims via subsidies sufficiently hidden as to be politically palatable.

As we think about how to regulate banks going forward, we must first be clear about what we are doing. We are negotiating the terms of options that the government will offer to bank stakeholders. It is important to understand that, for both practical and philosophical reasons. As long as the state substantially bears the downside risks of the financial system, by virtue of explicit legal arrangements or de facto political realities, philosophical arguments for deregulation are incoherent. Deregulation is equivalent to a blank check from the state. If you are philosophically in favor of free market capitalism, you must be in favor of very radical changes in the structure of banking, towards a system under which the state would have no obligation to intervene, and would in fact not intervene, to support bank stakeholders even when their enterprise threaten to collapse. The “resolution regimes” currently proposed do not restore “free market” incentives, because those proposals codify rather than forbid state assumption of risk and losses in the event of a crisis. A free market resolution regime would allocate losses among private stakeholders only, and prevent any loss-shifting to the government. For the moment, such a regime, and the structural changes to the banking system that would be required to make it credible, are politically beyond the pale.

So, the options written by government to bank stakeholders will remain in place. All that remains, then, is to negotiate the terms of those options. Framing bank regulation in terms of option contracts underlines a reality that is tragic but true: options are zero-sum games. One party’s benefit is another party’s cost. Very deeply, there is no confluence of interest we can seek between our best and brightest financiers and the public good. Terms that are good for banks are bad for taxpayers. Negotiating the terms of an option with a wealth-seeking counterparty is an inherently adversarial affair. When President Obama is on the phone with Jamie Dimon, do you think he keeps that in mind? A fact of life that our President seems not to enjoy is that while sometimes there are miscommunications that can be resolved via open exchange, sometimes there are genuine conflicts of interest that must simply be fought out. Bank regulation, alas, is much more the latter.

There are indirect as well as direct effects of option contracts, so maybe I’ve framed things too harshly. After all, we allow and encourage formal derivatives exchanges because, even though the derivative contracts themselves are zero-sum, they permit businesses to insure against risks, and that insurance can enable real wealth creation that might not have otherwise occurred. We claim that derivatives markets make indirect positive contributions to the real economy, despite the fact that their direct effect is simply to shuffle money between participants. Banking also just shuffles money around, but we generally think that it enables important business activity. So one might argue that banks and the public have a common interest after all, and smart regulation to evolve could from a more consensual process. But, one would be wrong. We all have a stake in the existence of a payments system, and banks provide one, but managing that is a largely riskless activity, conceptually separable from the lending and investing function of banks. We would also like our economic capital to be allocated productively. But the effect of writing a more bank-friendly options contract is to reduce the penalties for poor capital allocation while enhancing the payoffs to big, long-shot risks. Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them. If we desire a better banking system, we must limit the degree to which private stakeholders can expect to be made whole by the state. With respect to regulation, what’s good for Goldman Sachs is quite opposed to what is good for America. The point of regulating is to align public and private interests by imposing costly limitations on how banks can behave. Indirect considerations of public welfare reinforce rather than reduce the degree to which bank regulation is zero-sum, a fight that pits the health of the real economy against the distributional interests of bank stakeholders.

However, there is some light in the bleakness. Once we understand that we are negotiating option contracts, we can look to some guidance from the private sector. Option-like private contracts are negotiated all the time, and the issues that surround managing them are well understood. A compare-and-contrast of public sector bank regulation and private sector contracts will prove informative. That will be the subject of our next installment.

Acknowledgments: To be acknowledged by me is like being kissed by a putrescent semi-decapitated halitotic zombie creature. Nevertheless, I failed to weave many links into the above, and my thinking on these issues owes a lot to a bunch of people who are smarter and better smelling than me, so I feel duty bound to mention them. In particular, it was Winterspeak and Mencius Moldbug who fully disabused me of the notion that banks are intermediaries between private parties, which pushed me to think more deeply about the meaning of bank capital, and capital in general. Others who have the misfortune of having influenced my thinking on these issues include supercommenter JKH, Economics of Contempt, Wonkess, The Epicurean Dealmaker, James Kwak, Mike Konczal, and John Hempton. (I’m sure there are more I’ve missed: count yourselves lucky!) But the views expressed above are my own, and all of the people I’ve mentioned are far too sensible lend them any credence.


25 Responses to “Finreg I: Bank capital and original sin”

  1. This option theory of government bailouts — does it take into account revenue streams from future taxation?

  2. vlade writes:

    The post touches on something much much more fundamental in a lot of western societies – unwillingnes to carry risk. It presents itself differently in Europe (social state) and US (litigating state), but I think people in general are trying to offload too much risk on someone/something else. Worse yet, they assume that if the risk is offloaded, it vanishes into a thin air never to be seen again.
    The govt bailouts are only most visible expression of the above in the current environment.

  3. Steve Randy Waldman writes:

    Michael —

    There are lots of different ways to think about that question. My guess is that what you are asking is, taking into account the tax revenue streams from the financial sector, is it possible that the option provided by government is fairly priced?

    If we imagine, inaccurately but conventionally, that when thinking about valuing a macroeconomic option, we can use microeconomic market prices as inputs, the answer is clearly “no” — if you buy my contention that the “vast majority” of the risk of the banking system is ultimately borne by the state rather than its nominal private funders. Imagine for simplicity (and without losing too much realism, at least in the US) that the banking system holds only fixed income securities, and the entire portfolio offers an observable consolidated yield. Then the market price of the option that we are trying to price is the spread the banking system demands from borrowers to bear the risk but enjoy the variable upside of the real assets it is financing. In other words, the banking system prices the option for us, and the price it generates is the gross lending spread on the entire asset base of the banking system! Taxes, whether direct corporate taxes on banks, or perhaps you think we should include the income taxes of employees, obviously represent a small fraction of this.

    The price that the banking system generates is the price of an “at the money” option. If you think private funders do bear a very substantial portion of the risk of the banking system’s aggregate portfolio, then some share of the gross lending spread “ought to” go to the state, while some other portion “ought to” go to bank funders who actually bear risk.

    But, you do and should shout at me, all this is bullshit, right? Because the lending spread that the banking system earns, and strives to maximize, isn’t some efficient exchange-traded option on an exogenously varying price. Banks have to perform work to generate that portfolio, surely that compensation for that work needs to be reflected in the payouts. Banks perform services in crafting the portfolios whose risk they ultimately bear. But then I can shout back that, yeah, they perform work, so they get to structure it in ways that maximize yield and pile on tail-risk. So the state needs to be paid more than a normal price, because it is buying a portfolio predictably gamed to enhance the likelihood of large losses in ways that bankers do not price, ‘cuz they know ex ante they get to offload the risk!

    Really we have no reasonable means of determining what a “fair” premium would be for the option that the state writes. If it’s an at-the-money option, the state bears all the risk, so should get all the risk-based compensation, the full lending spread net of operating costs. But perhaps banks create portfolios better than states could otherwise craft. Or not. Nevertheless the order-of-magnitude we’re talking about is the gross lending spread on the full asset base. Corporate tax, a fraction of ROE is an order of magnitude too small. If we include income taxes, we might get to the right order of magnitude, but it’s still a fraction, and it’s double counting at least in part, as the people employed by banks would produce and earn income, although perhaps not as much, under alternative institutional arrangements.

    Fundamentally, it’s hard to believe a banking system could cough up reasonable compensation for a truly at-the-money option and still be profitable. Banks, even very old-fashioned banks, get paid primarily for assuming and bearing positions that are risky (or would be risky if taken on by less informed and skilled investors than bankers are supposed to be).

    However, a banking system with a state guarantee / option at its core could pay fair compensation and be profitable if the option is well out of the money, that is, if private funders bear much or most of the risk. Coherent theories of banking that acknowledge the state as an ultimate guarantor assume basically that private parties hold a sizable first-loss equity tranche, for which risk they can reasonably be compensated. What has been challenging about the present crisis and response is that formal “waterfalls” in bank capital structures have been mostly ignored, the state has put capital at risk with no losses allocated to any claimants except equity, and there only in a book value and fluctuating share price sense. I think that most of us thought the state-offered far-out-of-the-money guarantees, and though we could not price that option and may well have been underpaid for it, considered that okay. But now that we seem to have renegotiated that option up to a near at-the-money option, we gotta problem.

    A few more points: You might argue that it is not the tax from banks that serves as compensation for the option, but the tax on all the economic activity that banks enable. If, absent banks, we’d have a subsistence economy, than the direct costs of writing banks an option are far outweighed by the indirect benefits, in financial terms via taxation, but just in general.

    It’s almost certainly true that without formal institutions that facilitate and encourage capital formation, we’d have an economy we’d like less than the imperfect one we have now. But to compare status-quo banking with an uncompensated at-the-money guarantee with a stone-age void is to set up a straw man. The question is whether or not we can come up with arrangements that facilitate capital formation at least as adroitly (and hopefully with more discrimination) than existing institutions at lower cost (in terms of any implicity subsidy) to the rest of us. By highlighting the uncompensated option in status-quo banking, my goal isn’t to say that it’s bad, or that there should be no subsidy to capital formation and we must pay no more than some hypothetical “right price”. The point is that existing arrangements have arguably done a very poor job of their core role of making capital allocation decisions, and they extract transfers via sometimes nonobvious channels. If we want to optimize the cost/benefit, we have to address both sides of that. We might well choose to accept or even expand the subsidy, if we are confident that we’ve structured the institutions so that doing so will yield a better yield economy. But we might also conclude that eliminating an overgenerous and indiscrimate subsidy would yield more discriminating and sustainable aggregate investment (so that there’s a free lunch in bank regulation, we can get better outcomes for smaller transfers). I don’t think a reasonable person would conclude that what we have is pretty good, and should just be let be, but then definitions of reasonable vary.

  4. Steve Randy Waldman writes:

    vlade — broadly i agree.

    people always try to avoid risk, but ultimately it must be borne. i think a lot of our institutional forms arise from the fact that people (quite understandably) prefer to shirk risk if they can, so one can profit by constructing tools that hide and shift risk that do not disappear and must nevertheless be borne by someone.

    we’d be much better off devising systems whereunder people knowingly accept clear and comprehensible risks as trade-offs for benefits (or potential benefits). this would lead to better decisions, and legitimate allocations of risk. but just like it’s hard for broccoli to compete with Burger King, it’s hard for calculated risk (the idea, not the blog!) to compete with apparently costless but ultimately false security.

    i guess the best we can do is come up with mutations of broccoli that would be better tasting and yet nutritious, and call attention to just how unhealthy the greaseburger is despite its apparent good taste.

  5. constantine writes:

    The full context of our present predicament may make the uncompensated option seem more like a reasonable deal. Here’s some:

    i) A few days ago, the International Energy Agency finally put a date on peak oil (2020) after having dodged the topic for years. It all likelihood it’s sooner.

    ii) A frakked biosphere….

    iii) The Asian competitors we worried about decades ago are no longer measured in hundreds of millions but in billions.

    iv) We owe, we owe , owe… like we recently won some world wars (but haven’t).

    What do you do in such circumstances? Hunker or scan for solutions frantically (but usefully)?

    We’ve chosen the latter and that means orderly funding of a zillion dead ends as we look for an exit.

    We are a bit like a Renaissance city who has long handed over defense to very clever mercenaries so that that they could live with the illusion of no bodily risk. Think about the economics of that? With dust clouds on the horizon?

  6. Indy writes:

    Some thoughts:

    Always when people claim there is a dearth of “liquidity”, they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture.

    I’m not so sure about that “disagreement” part. Perhaps the supposed liquidity-starved “market failure” can derive not from any fundamental different in opinion between potential buyers and sellers as to the value or riskiness of a particular asset, but from the effects that such sales at the new “corrected” price would have on the seller. I’ll use a very simple example, which seems obvious, but I think leads to an important point.

    Let’s say I can borrow, in good times, with 4:1 leverage to speculate on asset-X. I put in $20 equity (all I own) and use $80 of secured debt at 5% interest to fund a purchase of $100. In a year, X goes to $124 (as I originally predicted it would based on simple extrapolation from recent trends) and I think I’m sitting pretty on unrealized gain – if I sell today, I can pay off the debt with interest and will have doubled my original investment.

    Then sometimes horrible happens in the world, and my new expected market price is 25% less than my original purchase price – $75. Now I am in real trouble – I am “underwater”. I have unrealized loss, and if I sell today I cannot even pay off the principle of my debt, let along the accrued interest. If you mark the assets on my balance sheet to market, you might even say I’m already technically insolvent.

    Let us say that there is a potential buyer that thinks just what I think, and knows everything I know about the asset. In other words: we are in complete agreement as to the appropriate non-panic-assessed value – $75 – and the distribution of likely future moves in the price – say, an equal chance of the asset declining another 10% or climbing another 20%.

    What happens if I sell, or am somehow forced to sell, today? I go bankrupt. My creditor gets the full $75, I am wiped out, and worse, should the lender have recourse and decide to pursue a remedy, I will remain on the hook for the $9 deficiency unless I am able to obtain a legal discharge.

    One the other hand, what happens if I wait and pray? Well, the price could still go down, which would hurt my lender but probably not me, because it doesn’t make any different to me if I go “more bankrupt”. However, there is also a slim but existing possibility that the asset will appreciate quickly and be sold for something greater than my aggregate debt – in which case I survive to fight another day.

    In other words, I have a choice: Die today with certainty, or probably die later but also possibly live. That’s not much of a choice at all.

    So I’ll assure my lender that his collateral is fine, these low “offers” are only panic, fire-sale prices, and, not to worry, things will recover soon, and I’ll put X on the market for something above $84. And when no offers are forthcoming, I’ll loudly defend the prudence of my sales price, and deflect blame to the universe while I complain about a “lack of liquidity” or a “credit crisis” or some other such lamentations concerning the mysterious forces spinning the stars in the heavens into such an inauspicious alignment.

    But there is no such thing. There is no liquidity crisis, for there is no disagreement in the economic conclusions of the buyer and seller. There is no credit crisis – for another lender is perfectly willing to lend to the trustworthy buyer on favorable terms provided he obtains the good price of $75. What there is, actually, is a seller who is holding out at an unreasonably high price crossing his fingers and hoping for a quick bounce to higher values because the alternative is a certain and immediate wipe-out.

    There is a party who is acting recklessly because he has little or nothing to lose from trying. If, in addition to the possibility of rising prices, there is also a decent chance that my rich Aunt Samantha will hear my pleas and agree, as a gift, to guarantee my debts (and therefore, indirectly, to also give the gift of a guarantee of full payment to my creditor) but that she hasn’t yet made up her mind and if I sell today I get nothing, then that only reinforces my decision to string things out as long as I possibly can. It even gives my risk-averse lender the same incentive – he may even get off my back about selling the collateral ASAP in case it might continue to decline in value, and instead agree to share my targeting of this long-shot, and even cooperate in lobbying my Aunt for assistance.

    The market can therefore “seize” and “fail”, creating potential external harms, only because of this entirely rational but stubborn refusal to deal.. Delay, and pursuing risky strategies relying on highly unlikely scenarios, is still preferable to immediate liquidation.

    Ordinarily the lender would, understanding my perverse incentives and the grave risk my plan places on their debt, and if he is legally permitted to do so, repossess the collateral and either hold it or take his lumps and collect the proceeds from a sale – rapidly reliquefying the market. After all, a sophisticated and experienced secured lender was supposed to understand that the legal regime under which he functioned did not actually absolve him of all risk. He was supposed to be conscious of the implicit partnership that is an unavoidable aspect of the creditor-debtor relationship, and also cautious and prudent in both his initial extension of credit and also in his continuing supervision of the debtor to a level commensurate with his low appetite for risk.

    But in this case, because of the possibility of an intervention from Aunt Samantha, the lender may very well rationally decide to forebear, allow the debtor to retain control and pursue his crazy scheme, and therefore passively conspire to keep the market frozen. With this new factor, Aunt Samantha’s potential for generosity turned an ordinary correction of a speculative bubble into a full-blown “liquidity crisis”, and the potential for a “liquidity crisis” only makes her intervention more likely. Of course, if the lender himself was also highly leveraged, and even small losses could render him insolvent, then that will only exacerbate this vicious phenomenon.

    I’m not sure how well the above scenario describes the conditions of the real-world crisis, but I think it’s not an unreasonable guess at some of what occurred in the CDO market. The bottom line is that whatever we do to reform the regulation of banking must, in my opinion, address this problem as it applies to large financial institutions, and I’m not sure it ever really can if any form of the implicit guarantee survives and continues to hang in the background. That only leaves a few options.

    1. Explicit guarantees, funded somehow, most likely through “premiums” on the insured parties – that’s the problem Mr. Waldman describes above.

    2. No guarantees – a firm commitment to “Everybody Lehman!” and allowing institutions (even many of them simultaneously) to fail, go bankrupt, and either liquidate or go into reorganization either through nationalization, resolution, receivership, conservator-ship, “spin-off reprivatization”, “second public offering”, or whatever name or system you want to choose. Simply put – one way or another, it leaves lenders with well-established, legally determined recoveries, without the possibility of further government action, regardless of the scale of a crisis. The credibility of our government exhibiting such political discipline in an emergency is, to put it bluntly, in doubt.

    3. No need for guarantees – producing a system of finance that somehow avoids the longshot-holdout “liquidity crisis” scenario I’ve described, preferably (I think) through some kind of self-regulating mechanism. Consistently robust reserve capital requirement and strict and rigorous (and vigilantly monitored and enforced) lending standards just might constitute such a system, but, it would seem, the credibility of our government exhibiting such political discipline even in the good times is also, unfortunately, in doubt.

  7. SW:
    You write, “No economic risk is borne by insured bank depositors”. I disagree. No accounting risk is borne. But they are at risk of the Fed suppressing interest rates to benefit bank stockholders and bear purchasing power risk. Did you see Paul Krugman’s recent NYT piece asking Zimbabwe Ben to buy another $2 trillion of assets? Yves Smith has a nice piece about the banks “repaying” TARP funds. What a joke. You admit banks borrowed from Uncle Sam at subsidized rates. I favor “radical changes in the structure of banking”. I do not believe “derivatives markets make indirect positive contributions to the real economy”. They only encourage more risky behavior looking for federal bailouts when the bets go bad. I favor “small banking”, i.e., separating payments from lending and investing. I see no benefit to looking to options. The contracts will always be evaded. My answer: prohibit any financial institution from being a corporation. It must be a general partnership. But that would end publicly-held bank holding companies. So?

  8. vlade writes:

    Slightly OT again:
    have you read Soros’ lecture on open society and capitalism? I think you might find some interesting ideas there. Say this:, but there are few others.

    I was fascinated few times in recent three months how people are unable to see the agency problem in democracy (and thus primary assumption is that laws are given and almost always right, and if not right, they can be easily changed to be right) – even people who can see the agancy problem with managed companies.
    Sorry for OT, but I think it might be interesting to you in the wider sense of this.

    [SRW: fixed an unclosed link in the original post. no other edits.]

  9. vlade writes:

    Oops, apologies. [SRW: no problem, the link has been fixed.]

    IA: I think that any deposit taking institution should be unlimited-liability. Only investment institutions that are extremely clear about the risk (you can win, but you can lose) should be limited liability. Payments and basic deposit holding should be an utility like structure, where no risk is taken. Any savings accounts and similar should be “investments” and at risk. I also strongly favour limiting the size of (any) non-utility corporation.

  10. Blankfiend writes:

    Steve – another outstanding, brilliant analysis! The idea that the codification of the existing implicit taxpayer guarantee of large financial institution risk-taking should come with a reasonable, market-based option premium is a laudible one.

    However, a couple of points bear further exploration.

    Firstly, your statement “American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite.” Is this really true? Does the federal government really have the capacity to cover infinite USD-denominated losses? Does there come a point where the creditors of the US either no longer accept the devaluation of their USD investments, or demand such an exorbitant premium for them that the US is no longer able to monetize debt? Does there not come a point where the price paid for essential imports, like oil, would be so high as to strangle the real economy and possibly lead to political revolt among the populace?

    Secondly, the entire thesis of economic growth so entirely dependent on the extension of credit bears re-examination. As you so nicely explained several posts ago, the Fed has set up an economy in the US in which credit is the core of the economic reactor. When credit freezes, the reactor shuts down. The creditors are protected at all costs, while debtors are shuffled off to the tit of the unemployment roles to default in pacified silence. Is this the economy we want? Is the price of such an economy not going to be a repetitive series of boom-bust cycles that progressively drain the resources of the nation into the coffers of the credit providers?

  11. Blankfiend writes:

    Indy, your post is outstanding as well. The idea that the very possibility of a bailout would cause a freeze in markets is, IMO, spot-on. After all, a market is made of willing buyers and sellers at an agreed-upon price. When both sides recognize the potential for government intervention, naturally no transactions will take place at a penalty to either party until the nature and extent of that government intervention is established and understood.

    Knowing this, I think the critical step is to credibly inform the market as to which transactions may carry the possibility of government intervention, and which will most certainly not. From my incomplete reading of the House bill H.R. 4173, it seems that few, if any, transactions are exempted in the contemplation of the resolution of a failing institution. I believe this is wrong. I am much more inclined to side with the thoughts of Paul Volcker, who calls for a sharp dilineation or “traditional” banking activities and proprietary trading as carried out by firms like GS or, for that matter, the trading desk at JPM.

  12. […] Finreg I: Bank capital and original sin – Via Interfluidity – Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence. […]

  13. Steve Randy Waldman writes:

    constantine — “The full context of our present predicament may make the uncompensated option seem more like a reasonable deal.” in the sense that we’re screwed in so many ways, what’s another?

    Indy — a lot of good points, with which i mostly agree. i should have qualified the word disagreement as “claimed disagreement”. i agree that a lot of actors complaining about “illiquidity” did not in fact believe that the prices at which they claimed securities should be liquid were justifiable prices. but by using the word illiquidity, that is what they were implying. by calling securities that were overpriced and therefore unsalable illiquid, they were cynically (mis)representing that those securities were really worth much than other actors thought. i agree that they needn’t have actually believed those (mis)representations.

    the point that potential “liquidity support” by the state creates an incentive to misrepresent a value problem as a liquidity problem in hopes of an overpriced bailout by the liquidity provider of last resort is excellent and subtle.

    IA — I think we’re disagreeing less than you think.

    You’re right that bank funders bear the purchasing power risk of the dollar, so in that sense they bear economic risk. I should have qualified by saying that they bear none of the economic risk of the asset portfolio of the particular bank they are funding. That is, they are not meaningfully providing capital to the borrowers or security-sellers funded by the bank.

    Anyone who holds capital in a fixed-income dollar-denominated instrument of any kind is bearing dollar purchasing power risk. In that sense, in addition to possibly providing capital to a particular enterprise (e.g. the holder of an uninsured corporate bond), all holders of such securities are providing capital to the US government & central bank, bearing some portion of the risk those agencies will fail to live up to their commitment to maintain the purchasing power of a dollar. Like you, I am of the opinion that this is a very large and insufficiently compensated risk, and (like you, I think), I’ve largely withdrawn my capital from the US govt / central bank by going short US fixed income and long precious metals.

    I also agree with you on bank structure — I’d like to see ‘em small and stripped of limited liability.

    I think we’d disagree only on derivatives markets. I do think that some derivatives exchanges serve very usefully as vehicles to spread and manage risk, and as vehicles for speculation (which I am not at all opposed to, as long as the speculators — like me! — bear the downside as well as the upside of their positions). I’m finicky: I mostly think that the trade in credit derivatives, for example, ought simply to be eliminated. But I think exchange-traded futures and options can in fact contribute to real economic activity and so are worth keeping.

  14. Steve Randy Waldman writes:

    Blankfiend — re “infinitely well-capitalized”, good point. in fact, though the US government is operationally capable of bearing unlimited USD risk, in doing so they run into serious political, social, and economic constraints. in fact i think the likelihood of outright default rather than high/hyper-inflation as a means of discharging USG’s ever burgeoning set of obligations is understated.

    i am also with you that the model whereunder credit expansion is taken to be the driver of economic growth is deeply misguided, a terrible theory with awful consequences that is taken as though it were nature by much of the mainstream. i think we need to eliminate credit expansion as a driver of growth. credit as a fraction of GDP was relatively stable when the United States originally industrialized, and obviously enjoyed very high growth. we need to stabilize credit expansion, and simultaneously increase matched consumption and production to drive growth going forward.

    btw, i’ve written a bit about this here:

  15. Blankfiend writes:

    Thanks for the reply. Paul Volcker would seem to agree.

    “I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.

    I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse.”

  16. […] Steve Randy Waldman, “Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them.”  (Interfluidity) […]

  17. You might argue that it is not the tax from banks that serves as compensation for the option, but the tax on all the economic activity that banks enable.

    Yes, this was my point. That’s what makes this crisis different than (say) the dot com crash. The banking system provides the currency needed for commerce throughout the economy. A closer historical analogy for October 2008 would be England prior to 1694.

    The point is that existing arrangements have arguably done a very poor job of their core role of making capital allocation decisions, and they extract transfers via sometimes nonobvious channels.

    There’s nothing to argue with here. You write very persuasively, and have thought about these issues more than I. But at the end of the day, the problem seems to come down to a very human one. The people in government who sell these puts are not often the same ones who have to honor them if and when they are exercised.

    Let’s get less abstract. What do you think of Goldman Sachs? Did Goldman come out smelling like a rose because its people were smarter and wiser, or because Paulson was ex-Goldman? Did Buffett put his money into Goldman rather than Lehman or others because he thought it was safer there, or because Paulson was ex-Goldman? (Most likely, both!)

    Anyway, I like the way you think. My general sense, however, is that pricing such options more accurately means putting order books into the hands of a central regulator, who can then see the interconnections that might lead to cascading failures. And that’s a lot of info for a small group of people to have confidential. Is there a big difference in practice between that kind of regulation and the public control of production envisaged by Mao? Worrisome questions.

  18. Indy writes:

    the point that potential “liquidity support” by the state creates an incentive to misrepresent a value problem as a liquidity problem in hopes of an overpriced bailout by the liquidity provider of last resort is excellent and subtle.

    Thank you for the compliment. I wish more people understood the possibility of that misrepresentation, and the related possibility that the conventional narrative of the financial crisis as being one of a unique “market failure” or “liquidity trap” or “credit crunch”, may be little more than a convenient fiction promulgated by certain institutions and public officials.

    It provides a kind of political cover for what would otherwise be understood as a commonplace boom-bust cycle of an easy-and-expanding-credit-fueled environment of increasingly risky speculative investments. One where simple-trend-extrapolation, irrational exuberance, and unfounded optimism caused particular asset valuations to become progressively more detached from the “fundamentals” (the aggregate underlying cash-flow capacity to service the debts long term) – in other words – a typical bubble correction. Surprising and sudden and severe to extents that overwhelmed institutional investors’ capacities to adapt, perhaps, but that’s still completely typical.

    A lack of willingness to lend to those recently discovered to be insolvent through poor investing is not a panic, but instead perfectly rational and legitimate and it therefore does *not* constitute a “liquidity crisis”

    Would we be in a different place today if the public and policy-makers had believed from the start that ever-easier-credit (to the point of the very disappearance of meaningful underwriting) and self-reinforcing feed-backs had aligned a significant fraction of the activity of our entire economy, either directly or through indirect dependence, into a fevered frenzy of (what turned out to be little more than) bad bets?

    It’s impossible to know, but I guess we would indeed be in a different place. Whether it would have been the prudent course of action to prevent a systemic collapse or not – I don’t think our society’s sense of justice would have been capable of mustering the sufficient sympathy necessary to bail out the big banks if the reason given was, in essence, “Gambling losses”. Something expert-jargon-esque and of purported other-worldly complexity, like a “liquidity crisis” that was really “the whole system’s fault”, and not anyone’s in particular, and that threatened somehow to ruin us all, makes for a much sweeter sell. Of course, a spoonful of sugar is equally good at making the medicine go down, as it is for making the poison go down.

    But even if it was true that we needed that story to save the system then, that’s no good reason to sustain the narrative today. On the contrary, we simply will not get the reforms we require unless and until an accurate understanding of the facts of past crisis, and the proper lessons to draw from those facts, become widespread.

    There is a common-sense expression in residential real estate that, “There’s nothing that price won’t fix.” Of course, as anyone who has ever tried to buy a sell a house well knows, the expression is true and translates financially into “There’s really no such thing as a liquidity crisis as to the sale of assets between sophisticated parties (or their agents) with symmetric access to information concerning the asset”.

    The only case where you do plausibly get these market valuation problems is under conditions of asymmetric information, for example, in the famous “Market for Lemons” analysis, or in the “adverse selection” problems with insurance provision. The problem arises when one party can only use averages while the other understands the particulars – a discrepancy in granularity.

    Consumers worry about buying used cars without warranties – even at fair prices – because they know there is a chance that the used car dealer, who knows more about the car than the potential buyer, will exploit the gap in knowledge and sell them a lemon. Insurance companies worry about selling plans that “pool risk” at average prices (average because they can’t learn enough about their customers to achieve perfect actuariality) while healthy/prudent/safe customers won’t buy – rationally concluding they’re getting a bad deal with the average price – and unhealthy/reckless/endangered customers will pile in – rationally concluding they’re beating the system.

    So, in this particular kind of circumstance the honest used-car seller rightfully complains “I can’t sell this genuine gem for what it’s really worth because people are worried it might be a lemon” and the healthy insured rightfully complains “I deserve but can’t buy a properly cheaper policy because the insurance company is worried that I might be secretly sickly!”

    That’s an actual liquidity problem. But they are not necessarily intractable. They are handled everyday! How do illiquid sellers deal with such problems? They exchange money for more information – some equivalent of providing more and more disclosure until the gap is narrowed and symmetry is restored. Here’s how it works:

    For existing housing – leveraged sales are almost universally accompanied by thorough and independent inspections because buyers pay more for inspected houses than ones sold “as is”. Used car dealers encourage you to take test drives for the same reason. Both sales sometimes include the extension of a warranty which would be a money-loser for lemon-dealers and the real purpose of a warranty is not actually insurance but as a credible communication of information concerning quality. An insurance company will indeed (if they are allowed to) offer you a cheaper rate on the condition that you submit to a more thorough medical evaluation.

    In all these cases – buyers will pay more and sellers will charge less in exchange for more information, and so long as the information gap exists and can be cheaply overcome – the potentially illiquid market automatically and continuously re-liquefies through this process of information arbitrage.

    So long as buyers as sellers do not somehow form mutually-exclusive groups that consistently interpret identical information differently – then the only true “liquidity crisis”, or “market failure”, is one where effective communication is too costly and the information gap cannot be cheaply overcome.

    In the insurance case, this is a perfectly realistic scenario, and part of the reason why health insurance is not a normal market and there is a big national political debate ongoing on which you may have heard a thing or two. Buyers and sellers are indeed in mutually exclusive groups of disparate sophistication, they interpret the same personal health data differently, and medical tests are costly, inconvenient, uncomfortable, time-consuming, invasive, and still of limited reliability and predictive capability.

    But can this ever possibly be the case for financial instruments as between expert investment institutions, in an era of lengthy disclosures and instantaneous electronic communication and standardized computational analysis? I venture the answer is “No”. And even if it were possible, information arbitrage could still be accomplished by potential sellers through extending the financial equivalent of a air-tight “money back guarantee warranty” – a fully-secured (on solid collateral) sales-price put-option that comes with purchase of the asset.

    The complaint from the financier would be, “I think this CDO is worth $100, but I can’t find anyone to buy the thing for more than $80 because they are overestimating the risk. It’s a liquidity crisis I tell you!” What he is really saying is that the market price for a $100 put option is erroneously $20 too high. But a “liquidity crisis” implies that he’s somehow helpless and he’s not! When options traders see prices being paid that are “too high”, they see an opportunity to make money by selling at a lower price – and in this case that can be performed by the seller of the asset himself.

    He could say to a buyer, “Look, I’m so certain that this CDO is worth $100, that if you buy it from me at that price today, you can, at any time in the next year, demand that I buy it back from you (minus some options market-based premium). That kind of “warranty” in the open market would cost you $30, but I’ll throw it in for only $10! What’s more, I’ll even take $100 of proceeds from your $110 purchase and just bank it for the year as cash collateral, so you know for sure, no matter what happens, you’ll be able to get your money back. For only $110, you have a package of assets that is guaranteed to be worth at least $100 and could be worth much, much more, and I’m offering it to you because that is my sincere opinion of the risks in this environment. As a matter of fact, if you were as confident as I am about the nature of that asset, you would sell that option to the market the moment after sale for $30, and it would make you come out ahead even should the asset decline another 20%! Now isn’t that a great deal?!”

    This is information arbitrage in action – and since it is so easily, cheaply, and readily achievable in today’s advanced marketplace, it should make claims of a “liquidity crisis” altogether implausible. Financial companies, combined with analysis from ratings agencies, are in the business of being able to translate their honest beliefs about risk into creating the very instruments which will automatically and unavoidably restore liquidity, no matter what market conditions prevail. When people realize that, the whole notion of a “liquidity crisis” should be considered deeply suspicious.

    How were the financial companies able to get away with such claims while refusing to write these options? Properly understood, they were trying to sell what they now thought to be lemons at high prices and complained they couldn’t find a buyer while simultaneously remaining unwilling to extend warranties! We wouldn’t cut a used-car dealer any slack for such a state of affairs. Unless, that is, the used-car dealer told us that he was holding out *because* all he really had were lemons he bought with debt, and that writing warranties would bankrupt him almost immediately, and that there was some chance that, purportedly to improve some other aspect of the public good that could not be achieved without the dealors’ cooperation, the government would come along and buy all his clunkers at a steep premium.

    The financial companies, because they and their creditors (and their creditors’ creditors) were all so heavily leveraged and incestuously interconnected that trading at corrected prices would cascade through the system drive them all into certain and immediate insolvency, had the nearly universal incentive to refuse to deal or admit true valuation because they had no other choice if they were to stay afloat. And so, even without a purposeful attempt, and even without any conscious conspiracy, the ubiquitous nature of the problem yielded simultaneous coincidental actions that were effectively the equivalent of concerted activity.

    In there markets, there was not so much a liquidity crisis as there was a spontaneous, cartel-like, withholding of supply. This did two things. 1. It raised transactions prices above equilibrium for assets that would trade, and 2. It froze markets in assets that wouldn’t trade at insolvency-preventing prices and therefore took away the healthy functioning of those markets from society as a hostage for which the ransom was a massive bailout. I like to think that Hayek himself would be both amused and disgusted at the unconscious emergence of this spontaneous order without even an awareness on the part of the participants of the kind of collective action they were accomplishing.

    So, finally, the big question remains? How can we prevent this from ever happening again. The answer, in my judgment, has to start with preventing the faulty “liquidity crisis” argument from ever achieving potency in the first place. The only way to do it that I can see is to somehow prohibit this collective holding out by requiring sellers to deal, either with the assets themselves or through these put options or other similar instruments. How to best accomplish that, however, I’ll have to think more about.

  19. SW:
    We are not far apart. I favor banning credit default swaps sales and have for about 24 months. While I would permit commodity futures sales, I think any benefits from their sale minimal. The price risk never goes away; it just gets “shuffled around”. You are correct about my investment position. My “blog mantra” has been, “Got gold? Get more. Got bonds? Why?”. Much recent “financial engineering” aimed to obscure risk and “end run” accounting rules so banks true leverage positions cannot be seen. Many years ago Franz Pick called bonds “a graveyard for capital”. I think 30-year US Treasuries at 4.49% are among the worst investments one could make today.
    Merry Christmas!

  20. Blankfiend writes:

    INDY – another outstanding comment. How do you think the concept of the holders of these assets being able to “insure” themselves against loss with CDS’ interplayed in your scenario?

  21. This sentence of yours probably describes most accurately the heart of all economic crises: “it’s hard for calculated risk to compete with apparently costless but ultimately false security”. Absolutely great article! If only our leaders were smart enough to understand 5% of this.

  22. scwizard writes:

    Truly suburb comment Indy!

  23. Nick Gogerty writes:

    great post, in terms of content, metaphor and thought. the options and zero sum game really hit home. I also like the emphasis on who ultimately bears risk and a societies attitude towards it.

  24. strainer writes:

    Very interesting article. I think that the free lunch can only last for so long, eventually we’ll have to pay the piper for the reckless decisions of our government. And I think that until the govt addresses the basic structural problems in our financial system of too much debt, we will not have a sustainable recovery. So while the stock market can stay irrational in the shorter term, in the long run I believe it will go back to reflecting the fundamentals of our boom and bust economy. And that’s why I continue to feel that for long term investors a better portfolio allocation is in cash and gold. I think the gold price will continue to rise due to a lack of faith in central banks’ policies and in fiat currencies. I recently read a good article on this topic called Gold Price Wobbles Under $1,130 But U.S. Dollar Future Bleak, which discusses the relationship between the dollar, the gold price, and gold mining companies as a result of the Federal Reserve’s monetary policies. I thought it was especially helpful for investors to read to get a better sense of the relationship between gold and the dollar given all the uncertainty in the economy.

  25. najdorf writes:

    Great post with lots of great comments!

    A further reinforcement to Indy’s liquidity point: the people claiming that the securities are illiquid continue to have jobs as long as their company doesn’t go bankrupt. As long as the accounting doesn’t show massive losses, they continue to get huge bonuses. As long as they continue to lend to fellow insolvent financial institutions, nobody fails and everybody looks ok. If anyone admits that their institution is insolvent, they probably never work again in their chosen field or for remotely similar compensation. I wonder why it has taken several years from the peak of the housing bubble in 2006 to realize the fraction of the total losses realized so far? The fact that MBIA is still operational is a joke.

    At the same time, note that equity-holders of any financial co. outside the top tier (GS/JPM/WFC and local banks that actually remained solvent through the last few years) have been obliterated. People have taken real losses. The government is on line for the really big pain, but plenty of fortunes have been cut down. Unfortunately the government has chosen to maintain the fiction that debt isn’t risky. Eventually you can’t pretend any more and you realize that huge swaths of dollar-denominated paper can’t be turned into much of anything real.

    I share the almost unlimited skepticism regarding political will to fix our debt problem and banking problem in America. One thing I’d add is that the endgame here doesn’t have to be US government default/dollar hyper-inflation. The US can do what declining empires have done for as long they’ve existed – sell assets and gradually devalue currency as citizens adjust to a declining standard of living relative to those outside the empire. We’ve made a great beginning on this mission already!

    Even someone as negative as me on the national debt still figures that America has a hugely positive net worth. We’ve got all this great land, tons of natural gas, some really cool cities with tall buildings, shockingly excellent universities, factories that could produce cars for Asia, etc. We can sell this stuff to our less screwy neighbors for hundreds of years before we fall to parity with the third world. I think the future involves much larger ownership of U.S. real assets by non-U.S. citizens and much lesser ownership of non-U.S. assets by U.S. citizens.

    Also remember that these populations aren’t stable – at some point the smartest Asians will stay in Asia and make their countries better rather than coming here and making the U.S. better. At some point the smartest Americans will start emigrating to countries with more favorable tax codes or better opportunities for entrepreneurship. What matters isn’t the paper value of the housing or the companies – it’s the human capital.

    So I’m pretty negative on the future of the U.S. empire, but I have a lot of faith in the ability of our political class to maintain the slow-motion nature of the train wreck. For one, due to our position of world leadership we have a lot of power to drag others down with us – look how eager they are to invest in our banks and government debt! If I were in any kind of position of power I would spend the next few years trying to sell as much paper as possible and buy as many solid claims on real assets as possible. For instance, we should buy Canada’s natural resources now before they get too expensive. I wouldn’t bother with gold because it doesn’t feed us or heat our houses – stay focused on useful real assets and companies that can demonstrate skill in providing necessary services.