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Lehman v Argentina

by Brad Setser
September 16, 2008

I am guilty of instinctively comparing large defaults to the Argentina’s default. That is the largest default that I know well.

And Lehman qualifies as a large default.

John Jansen reports one of Lehman’s bonds now trades at 35 cents of on the dollar. That a bit above the levels that Argentina’s bonds traded at after Argentina’s default in late 2001. But Argentina’s bonds also eventually proved to be worth something like fifty cents on the dollar, at least to investors who participated in Argentina’s exchange and got the GDP warrant.*

Lehman’s bankruptcy filing indicates that Citi is a trustee for $138b of Lehman bonds, and the Bank of New York is a trustee for another $17b. The resulting $155b in outstanding bonds significantly exceeds Argentina’s outstanding stock of bonds at the time of its default.

And investors had far longer to adjust their portfolios in anticipation of Argentina’s default than in anticipation of Lehman’s default.

I continue to believe that the credit markets’ reaction to Lehman will ultimately matter more than the reaction of the equity markets. John Jansen reports that the spreads on Morgan Stanley and Goldman have widened significantly. Evans-Pritchard reports (hat tip naked capitalism):

The interest rate on Tier 1 debt for typical banks has jumped by 125 basis points since Friday. “This is a violent effect,” said Willem Sels, credit strategist at Dresdner Kleinwort.

Michael Lewis seems to be thinking along similar lines.

As important as it seems right now on Wall Street, this isn’t a day that most Americans will remember as all that big of a deal. When Lehman Brothers Holdings Inc. goes out of business, the reaction of the average citizen is either “Lehman who?” or, “I heard of them! What do they do?”

It is a big deal, however, but not because some bond traders are out of work, or that puff pieces in business sections about Dick Fuld’s survival skills turned out to be wrong. It’s a big deal because this is the day that American financiers, from the point of view of the Asians who sit on top of the world’s biggest pile of mobile capital, became a bad risk.

And yes, the Bank of China seems to have a bit of exposure to Lehman. It also presumably has additional exposure to other US financial institutions (The BoC has by far the largest external portfolio of the Chinese state banks)

Widening spreads though only really bite when debt actually has to be refinanced. AIG seems to be facing some rather more immediate pressure from its swap counterparties.

More in the morning …

UPDATE: John Jansen reports Morgan Stanley’s credit spread has widened significantly and LIBOR is way way up. LIBOR may now be the rate that banks don’t lend to each other at, but the banks do need funding.

UPDATE 2: AIG’s bonds are also trading at Argentina-in-default levels, 33 cents on the dollar.

UPDATE 3: The New York Times suggests that if AIG doesn’t get federal money, it will fail on Wednesday. That is a stark choice: a two day no bailout policy, or the second failure of a large financial institution in a week.

* I am doing this from memory; I have not checked the recent price for Argentina’s par bond and its GDP warrant recently. Do not hold me to an exact number. Argentina’s spread has widened recently, so I wouldn’t be surprised if Argentina’s par is now worth somewhat less than it was at some points in the past.

66 Comments

  • Posted by moldbug

    I never thought I’d say this, but Paul Krugman is right.

    As I said here something like a year ago: nationalize it. Nationalize it all. There is no other cure. If you just let the system try to liquidate itself, there is not a bank, a shadow bank, not any maturity-transforming entity or credit insurer, which is solvent. I admire Paulson’s courage, but he is cutting off his face to spite his face. Unfortunately, it’s our face too.

    Nationalization is just a recognition of reality. When first the conventional banking system, then the shadow banking system, was permitted to borrow short and lend long, it was nationalized. The Fed issued informal options which guaranteed holders of bank liabilities that they held risk-free securities. The spread of this informal protection – the Greenspan put – to all liabilities of major financial institutions was inevitable. And extremely profitable, while it lasted.

    Basically, the Fed needs to issue FRNs corresponding to the present market value of all the informal Greenspan puts it issued. If you held a liability from a bank or shadow bank, that liability was hedged by an informal Greenspan option.

    There is one simple way to close out these securities: buy the entire public financial industry, banking and shadow banking and double-secret super-shadow banking, at its present market cap. Ie, take it onto the Fed’s book. It should have been there all along. When Americans borrowed to buy a house, they were borrowing from Uncle Sam. When they lent to a bank, they were lending to Uncle Sam.

    For those who think that any such massive nationalization must be “inflationary,” consider: nationalization of any asset class at the current market price is portfolio-neutral. Everyone’s statement will show the same number it showed on September 16, or whatever day is chosen as the flag day. (It could even be a day in the past.) It is only the positions that will change: from non-cash to cash. Since this increases no one’s purchasing power, how can it cause any price increase? Who is bidding up what?

    Nationalizing the financial industry by printing new dollars would not really be a dilution of the dollar. It would be a recognition of the existence of a large number of informal dollar options that were issued, in the form of the Greenspan put, over the last n years. (Arguably, n = 314. But I digress.) It is those options that were the dilution. That horse is long out of the barn.

    The Greenspan options are now in the money. They are getting more in the money. The Fed can either dishonor them, leaving its partners in the scheme to hold the bag and causing massive societal suffering, or honor them, accepting its own ultimate responsibility for the excesses it promoted and protected for so many years. I wouldn’t bet on it being taken, but I think the righteous choice is clear.

    Paulson and Geithner’s Mellonian liquidation strategy, while obviously sincere and in fact incredibly brave, especially by the standards of Washington today, is more or less the equivalent of a drug lord getting off by turning state’s evidence against his distributors. True responsibility for the crisis starts at the center. Even more courage is needed.

    Of course, if nationalization signals an intention to repeat the process ad infinitum, and print the dollar into toilet paper, speculators will anticipate the degringolade. But if it signals a new era in which there will be *no* official protection of lenders, formal or informal, and the quantity of dollars outstanding is permanently fixed, gold will hit $100. And it will suck to be me, but who cares?

    Of course, if the present hyperdeflation is allowed to run its course, gold will hit $100 anyway. But it won’t. You simply can’t have 1000 bank failures. Congress will act, if no one else does.

    So what we’re looking at is more carnage, more bandaids, and an eternal future of lending in which the loan officer is Uncle Sam. Or possibly Barney Frank. Interest rates will fall, not rise as they would in a true liquidation. And what we’ll see is not hyperinflation or hyperdeflation, but hyperstagflation.

    Does anyone want this? If so, why do we seem to be going there?

  • Posted by JBW

    One thing that is noteworthy is the fact American institutions (Treasury, Fed, etc) are involved and the markets looking to them for cues. Perhaps the GSEs not withstanding, I was wondering if there is an opportunity for another central bank to act– and act not in concert with American regulators– in a global capital market. What would such a scenario look like and is it a genuine fear?

  • Posted by David Habakkuk

    According to the Michael Lewis story, one of the main fears of the Treasury and Federal Reserve was ‘the loss of the good opinion of the people who supply the U.S. with the capital it no longer generates itself.’

    What he is talking about, obviously, are Asian holdings in U.S. investment banks — about whose activities, in Lewis’s view, Asian financial firms have been ‘amazingly indulgent’ for twenty five years.

    But there is an obvious question as what impact of the Lehman bankruptcy and other current developments will have on Asian — and particularly Chinese — views of the desirability of holding U.S. assets in general.

    For several years now, Brad Setser has portrayed the Chinese strategy of holding the renimbi down as economically irrational — as the immediate benefits in terms of export-led development will have eventually to be paid for with severe losses on its dollar investments.

    Given that one would have thought that the argument was obvious, many of us have been perplexed as to why it seems to cut no ice with Chinese policymakers — and have been racking our brains to find some plausible explanation, other than a bad case of Micawberite desperation and/or sheer obtuseness.

    The remarks by Victor Shih which Brad quoted not long ago — to the effect that officials at the People’s Bank of China blamed the United States and believed suggestions that the U.S. ‘deliberately lured China into buying its securities knowing they would later plunge in value’ suggests that obtuseness may have been at issue.

    Also interesting was the suggestion of a Chinese blogger, quoted by Keith Bradsher in the NYT, that it was ‘as if China has made a gift to the United States Navy of 200 brand new aircraft carriers.’

    The blogger is making a serious point. It is not obvious that it is in the long-term interests of China to facilitate military spending by a power which appears committed to unilateral military hegemony over the planet — a commitment which is highly liable to draw it into conflict with China.

    A situation where the U.S. pursues — or even appears to pursue — a highly militarised energy policy, substantially funded by borrowing from one of its energy competitors, does not seem stable. And again, one is left asking whether Chinese policy simply reflects obtuseness — and if it does, what is the likelihood that the Chinese will cease being obtuse, and would be the implications if they did.

  • Posted by Rien Huizer

    Only 10 years ago academic specialists were trying to figure out ways to make banks (not “investment banks”) “credibly uninsured” in order to avoid a chain of moral hazard running from large depositors, interbank creditors etc to bank managers and removing a very large and growing contingent liabilty from gvt balance sheets.

    Despite some good and practicable ideas, what was agreed was Basle II- not necessarily a bad system, but bureaucratic, difficult to implement, industry-driven, first and foremost something which is still a work in progress, which applies even more for parallel efforts for the insurance and securities industries. In a sense the current crisis is one of ineffective regulation. Part of that ineffectiveness is caused by poor design and poor adaptation of designs and regulatory principles to technological change (it would have been easy (howls of protest from an “innovative” industry of course) to simply restrict product powers of regulated financial institutions, using a system of officially approved valuation models and disallowing regulated firms to own, owe or facilitate anything outside that set. That would have resulted in a rather stifling bureaucracy for the few firms electing to be regulated and hence, have their creditors protected against regulatory error (for instance if regulators would prescribe bad models). Those firms might not be exciting equity investments, rather more like old style utilities, but there would surely be a market for their equity, because it would be an excellent hedge against inflation. Everything else would have to be largely unregulated and hence totally outside government responsibility and consumers should be warned against doing business with them. That unregulated entities not being banks can allocate credit is shown by the large and mainly profitable population of non-bank lenders in the US. To what extent that population would have been able to thrive without a population of regulated lenders in the same market is of course a question.

    No one knows to what the welfare effects are of different types of financial regulation. It is already difficult to distinguish between the economic effects of “bank-based” vs “market based” financial systems. What we know with certainty is that healthy financial systems need robust (i.e. virtually risk free) agents at the center, to act as deposit takers, central market makers and counterparties for transactions where credit analysis would be impracticable. We do not necessarily need them to market sercives to customers etc. Keeping these institutions healthy is a public interest, with a cost to be managed explicitly and publicly, for instance by the government disclosing best estimates of the contingent liability resulting from its responsibility as custodian of those core institutions. Nothing else would be “too big to fail” without markets perceiving that long before that stage would have been reached. That would make it unnecessary to have these occasional bouts of socialism for the rich in which the US seems to excel, even more than countries like France

  • Posted by Dave C.

    Just read that Obama is bringing Robert Rubin onto the team. Rubin knows all about bailing-out Wall Street cronies. Recall the Greenspan-Rubin bailout of the Long Term Capital Hedge Fund. A LTCM short position in Gold futures was absorbed by the Federal Reserve. Let’s see how much of the US bubble economy is left by the time Obama or Palin is sworn in. Rubin is another ex-Goldman Sachs guy, and buddy of Hank Paulson. We really must wean ourselves off these bankster bastards.

    On a separate note, a decade ago, my mother held an annuity from a New Jersey insurance company that went bankrupt and was taken over by the state. The 5-6% interest rate was slashed to 2% and annuity payments were suspended for 5 years. Eventually she did receive annuity payments but less than originally promised due to lower interest rate payments. A similar outcome probably awaits AIG annuity holders and pension funds.

    The Wall Street mantra is privatize the profits and socialize the costs to the taxpayer. There will be nothing left of the US Economy but the empty husk when the locusts and other assorted parasites have finished.

  • Posted by RealThink

    @Moldbug

    It’s really not serious to pretend that monetizing M3 (i.e. increasing M0 until it gets to current M3) would not be inflationary. It would be Zimbabwean and make the gold price skyrocket. And it would make the issue very well put by David Habakkuk all the more pressing.

    And even beyond that, it just does not make sense to preserve an extremely oversized financial industry. Just as it would not make sense to preserve an auto industry if it refused to adjust to an energy-constrained environment by producing much more efficient vehicles. (I do think the oil price will return to rising in 2010.) Will you in that case advocate the nationalization of GM, Ford and Chrysler?

  • Posted by Cedric Regula

    O my patron saint. Uncle Pedro. The US Treasury of Home Loans. The Home Bank of America. A new US Real every 10 years. Hyper whatever.

    A better way to regulate the derivatives market is needed. Model the above from the ground up so regulators can safely maintain high leverage against a more accurate but still fluid estimate of what assets may be worth, no matter what version of currency we have.

    Limit moral hazard, and be sure smart people with money will still invest in the system.

    I guess we might try it.

  • Posted by Dave C..

    “And investors had far longer to adjust their portfolios in anticipation of Argentina’s default than in anticipation of Lehman’s default.”

    Moody’s, Fitch, and the S&P ratings are absolutely worthless.

    http://globaleconomicanalysis.blogspot.com/2008/09/moodys-fitch-s-sec-are-useless.html

    Proving how completely useless it is, Fitch Downgrades Lehman Brothers Holdings Inc. to ‘D’ on Bankruptcy Filing.

    Fitch Ratings has downgraded the long- and short-term Issuer Default Ratings (IDRs) and outstanding debt ratings of Lehman Brothers Holdings Inc, (LBHI), parent of Lehman Brothers Inc and other subsidiaries as follows:

    –Long-term IDR to ‘D’ from ‘A+’;
    –Short-term IDR to ‘D’ from ‘F1′;
    –Senior debt to ‘CCC’ from ‘A+’;
    –Subordinated debt to ‘C’ from ‘A’;
    –Preferred stock to ‘C’ from ‘A’.

    If that is the best Fitch can do, then why bother? Moody’s and the S&P are equally useless.

  • Posted by RealThink

    The July TIC data just released provides essential context for evaluating the possibility of further Fed rate cuts (or outright US financial system nationalization).

    Net foreign purchases of long-term securities were $6.1 billion.

    Net foreign purchases of long-term U.S. securities were negative $25.6 billion. Of this, net purchases by private foreign investors were negative $20.7 billion, and net purchases by foreign official institutions were negative $4.9 billion.
    U.S. residents sold a net $31.7 billion of long-term foreign securities.

    Net foreign acquisition of long-term securities, taking into account adjustments, is estimated to have been negative $8.2 billion.

    Monthly net TIC flows were negative $74.8 billion. Of this, net foreign private flows were negative $92.9 billion, and net foreign official flows were $18.2 billion.

  • Posted by bsetser

    real think — i just finished my morning engagement and am gonna sit down and work through the tic data; it seems like a release with a lot information content. the net foreign official flows are i think lower than the increase in the FRBNY’s holdings in july (I need to check this), so something isn’t adding up.

  • Posted by Cedric Regula

    The yen just went up 3% yesterday. Japan is the largest private holder of GSEs and Treasuries. Yesterday wouldn’t show up in the TIC data yet, but I think they are saying syanara.

    I think the Fed will cut just to prop up regional banks. Got maybe a thousand on the ropes and FDIC doesn’t have enough money for it all. They can use falling oil as an excuse to say inflation concerns are on the back burner.The Saudis may still pump lots of it even if a rate cut causes dollar weakness again.

    10 year Treasury yields are falling so that still means repatriating US money is staying ahead of foreign outflows.

  • Posted by Cedric Regula

    Fun chart to look at. Type in $UST1M to get 1 month treasury yield.

    Went from 1.6% almost down to zero yesterday.

    Now that’s liquidity !

    http://stockcharts.com/h-sc/ui

  • Posted by Matthew R. Tubin

    Brad,

    On the theme of Argentina — what contagion effects do you expect the burgeoning mess on Wall Street to have in the Emerging Markets? Spreads have widened, but should we expect worse?

  • Posted by tv

    Nationalize it all comment…..

    With what money?

    With how much money?

    With what surplus – ha

    What kind of supply must Tsy mkt absorb to do that?

    What happens to interest rates for the entire economy?

    What does this do to already massively restricted lending and credit

    What happens to .gov tax receipts to get the money to pay back our Tys debt…

  • Posted by moldbug

    tv, I hope it hasn’t escaped your attention that we’re not on the gold standard anymore!

    When financial pundits talk about “taxpayer money” they are in reality striving to prevent the US political system from realizing the awful, awful truth, which is that the dollar really, actually, is a fiat currency. Whee! Paper money! The Fed can issue as many dollars as it wants, at zero cost to the “taxpayer.” It might even feel good. Which is kind of the problem.

    Think of this this way: the dollar is nominally a Fed debt. But since it is not redeemable and has no yield (and even if it had yield, its yield would be in dollars), it looks a lot more like equity. Non-voting, non-dividend-paying equity, but isn’t there a lot of equity like that?

    So when the Fed issues new dollars, it is not taking on new debt that it will be unable to repay. It is merely diluting equity. How many new shares can Bank of America issue, in exchange for Merrill Lynch? As many as it wants. Exactly the same is true of the Fed and dollars.

    The basic problem with the present debt situation is that if you assume that all dollars are M0 dollars, our debts are not just unpayable but comically unpayable. In a world with 850 billion dollars outstanding (M0), how can the US have a $10T debt that is “risk-free?” Because it has the power to print as many dollars as it wants.

    At present the Fed is using that power very reluctantly in little dribs and drabs. This is because history teaches us that if you let a political system with a fiat currency know that it can spend and spend and never tax, hyperinflation Zimbabwe style is a certainty. The trickles turn into a hemorrhage.

    I am not suggesting this. What I’m suggesting is to blow the printing press out in one shot, cleaning up the unpayable debts, and then break it in a way that makes sure it can be never used again – a fixed dollar supply. As Mises showed almost 100 years ago, any supply of money is adequate.

    If the Fed is barred, perhaps even constitutionally, from issuing new dollars, it cannot serve as a lender of last resort. Thus it cannot create moral hazard. But if it is barred from issuing new dollars with the present dollar supply, we are looking at the nickel hamburger. Thus it needs to shoot its wad in one last orgy of monetization, converting itself into something like the RTC.

    A free market in loans can then emerge. If you’ve created enough money, interest rates in this market will be reasonable. There are plenty of historical examples of hard-money economies with 4% interest rates. Obviously, if you stick with the existing M0, triple-digit rates are pretty much a certainty.

  • Posted by Twofish

    To DC: If you shoot the bankers then who is left. The fact that Paulson is Treasury Secretary has been a good thing since I shudder to think about the mess that we’d be in if Snow was still in charge.

    Also need I continue to remind you that it’s not the US economy. It’s the global economy. If people cut the wrong wire or do the wrong thing there will be nothing left anywhere.

    Right now we the process of a series of controlled demolitions and trying to shut down a massive company that needs to be shut down is an extremely difficult thing to do.

  • Posted by moldbug

    Rien,

    Your description of the banking industry’s attempt to square the circle, creating a regulatory system in which there is no moral hazard but also no risk of bank runs, is perspicuous in every point except one:

    What we know with certainty is that healthy financial systems need robust (i.e. virtually risk free) agents at the center, to act as deposit takers, central market makers and counterparties for transactions where credit analysis would be impracticable.

    No. What we know with certainty – and this is a point on which, quite unusually, Austrian and neoclassical economists agree completely (for the latter, google Diamond-Dybvig) – is that maturity-transforming financial systems need risk-free agents at the center.

    The hidden assumption is that a maturity-transforming financial system is a healthy one. It isn’t. Maturity transformation is just bad accounting. You can’t teleport money from the future into the present. If Joe wants to borrow money for 30 years, he needs to be matched with Linda, who wants to lend money for 30 years.

    A financial system has an essential role in making these matches, and in diversifying and disintermediating default risk. Maturity-transformation risk – “liquidity” risk – is in an entirely different class. This is the realization at the core of Austrian economics.

  • Posted by moldbug

    RealThink,

    Prices are set by supply and demand, n’est ce pas? If you want to increase the exchange rate between dollars and anything, someone needs to have more dollars to spend. But if the nationalization is portfolio-neutral, they don’t.

    The intuitive equation between creating money and generalized price increases (inflation) is just that – intuitive. It is usually accurate, but logic beats intuition every time.

    As for gold, people buy gold because they expect future monetary dilution. If you fix the money supply, and fix it credibly, there is no expected future monetary dilution. Thus there is no reason to expect to profit by holding gold instead of dollars. Thus all the capital that has moved into gold moves back out, or should.

    And thus gold prices drop like a freakin’ stone. So if you think anything like this has any chance of happening, sell the ol’ yellow dog and sell him fast.

  • Posted by Twofish

    Huizer: Everything else would have to be largely unregulated and hence totally outside government responsibility and consumers should be warned against doing business with them. That unregulated entities not being banks can allocate credit is shown by the large and mainly profitable population of non-bank lenders in the US.

    The problem here is the Fannie Mae/Freddie Mac problem. If your unregulated industry grows large enough then if it blows up then it will have so bad consequences that saying “we are going to let you die” has no credibility.

    When times are good, the unregulated industries have enough money and power to prevent regulation, and ideologies that are opposed to regulation become extremely fashionable. Remember that in 2003, people were talking about how slow and inefficient governments were and how better off we would be in privatizing social security.

    Governments are indeed slow and inefficient, their job is to be slow and inefficient. Sometimes slow and inefficient is a good thing.

    People will learn a lot of lessons from this mess, which they will promptly forget in about ten years or so when the next bubble comes along. The good news is that we’ve all been through this before. The bad news is that sometimes it didn’t end well.

  • Posted by jkiss

    David Habakkuk Says:
    “A situation where the U.S. pursues — or even appears to pursue — a highly militarised energy policy, substantially funded by borrowing from one of its energy competitors, does not seem stable. And again, one is left asking whether Chinese policy simply reflects obtuseness — and if it does, what is the likelihood that the Chinese will cease being obtuse, and would be the implications if they did.”

    China and its rulers are more concerned with stability than the depreciating value of their holdings, and even more than the US borrowing to spend on military; they are not ready to cut off their exports to us, and they therefore are forced to use the dollars earned to purchase our paper. Our purchases of chinese goods is anyway winding down as we go into deep recession and our trade deficit goes to surplus, and this means we will perforce buy our own bonds, nobody else will have dollars. And, gov consumption of all US private capital will in turn will force us to slash gov spending – both on military and domestic – just as we go deeper into recession… hard to imagine a more perfect storm.

  • Posted by Dave C..

    “The fact that Paulson is Treasury Secretary has been a good thing since I shudder to think about the mess that we’d be in if Snow was still in charge.” – Twofish

    With the duly noted exception of permitting the Lehman bankruptcy, Hank Paulson’s financial strategy has essentially been to foist private sector capital misallocation to the federal government balance sheet. As the former CEO of Goldman Sachs, Hank Paulson’s overtime services over the past several weekends are extremely expensive to the US taxpayer wallet: over $5 trillion in GSE debt added to the US government balance sheet. $5 trillion or $10 trillion federal debt, we are bankrupt the same!!!!!

    So far we have bailed-out Bear Sterns, Fannie Mae and Freddie Mac at US taxpayer expense. AIG and Washington Mutual are pending taxpayer bailouts under the “too big to fail doctrine”. Ford, Chrysler and GM are also demanding a $50 billion taxpayer loan bailout under the false flag of national economic security. What is the worst that can happen if Americans drive US-built vehicles from Toyota and Honda? The US Airline industry is wreck and will also need a bailout.

    Hank Paulson’s economic agenda is no longer “free market capitalism”, but in the words of Economist Nouriel Roubini, “socialism for the rich and politically connected”, otherwise known as “fascism”. Welcome to the United States Socialist Republic of America (USSRA).

  • Posted by Jian Feng

    When US government does not rescue, more and more financial institutions will bankrupt – AIG, Wachovia, WaMu, etc. If US government were to rescue again, the losers will simply dump all their debts to Uncle Sam, until nobody is willing to buy US treasury bonds. Even Roubini does not think this would happen and believes that somewhere down the road, the blooding may stop. But do we have solid data to support this scenario. Has anyone made any estimate on how much more debt US can run? What did 1932 look like? Any foreigners holding lots of US treasurys back then? How do we know that 2008 will be less than 1932 but more than 1987? The market seems to be doggedly determined to be free of government interventions and may destroy any government that attempts to defy economic gravity.

  • Posted by bsetser

    back in the 30s, the US was a creditor in the global system, so i am not the question about how much us debt foreigners held is as relevant as how much German debt Americans held. The end of US inflows to germany contributed to the depth of Germany’s crisis.

    there is, tho, no evidence that the market is saturated with us treasury paper.

    and i also see no evidence that the market is determined to be free of government intervention

  • Posted by Dave C..

    Jian Feng,

    There are just too many Wall Street banksters wanting moral hazard government sponsored bailouts that put US taxpayers at risk.

    One of the reasons we have increasing numbers of these federal taxpayer bailouts is because the Federal Reserve approved past bailouts causing more and more reckless behavior over time.

  • Posted by Twofish

    DC: As the former CEO of Goldman Sachs, Hank Paulson’s overtime services over the past several weekends are extremely expensive to the US taxpayer wallet: over $5 trillion in GSE debt added to the US government balance sheet.

    The $5 trillion only happens if everyone stops paying their mortgages. The numbers of how much it is actually going to cost are in the $200 billion range.

    DC: Welcome to the United States Socialist Republic of America (USSRA).

    I thought you were a supporter of China’s socialist system?

    JF: When US government does not rescue, more and more financial institutions will bankrupt – AIG, Wachovia, WaMu, etc.

    The US government is pretty much out of cash right now, and the game now is to arrange for institutions to go broke in an orderly way that doesn’t cause a spiral of bankruptcies. One thing about the Lehman bankruptcy is that the markets I think reacted very well to it, and there isn’t a sense of panic on the street right now.

    AIG is much larger so if it fails (and we should know within a day), it will be far more challenging to keep the dominoes from falling, but at this point you need to depend on people’s skills and judgment.

    If by the end of the next week, the dominoes have stopped falling then we can take a deep breath and look at more systemic issues.

  • Posted by Twofish

    bsetser: and i also see no evidence that the market is determined to be free of government intervention

    The basic problem is that people got this silly idea that markets and government regulation were somehow in opposition. You can’t have free markets without massive government intervention.

  • Posted by moldbug

    I see no evidence that any market has ever been determined to be free of government intervention.

    Closing out the interventions is the government’s job. Similarly, if the government creates perverse incentives and the market follows them over a cliff, it is the government’s job to at least clean up the cliff base.

    2fish: “You can’t have free markets without massive government intervention.”

    Can you have free markets _with_ massive government intervention? I mean, both of these terms are pretty vague. But given this, isn’t “a free market with massive government intervention” pretty much a contradiction in terms? If you were setting up a new society in space, and someone asked you how the financial system would work, would you say, “I recommend a free market, with massive government intervention?”

    So perhaps you can’t have a free market at all, with or without massive government intervention. But I don’t think this is what you mean. And if by “government intervention” you mean “contracts are enforced,” you are trivially right, but this seems a little trivial.

  • Posted by JKH


    Moldbug,

    Even if you believe (and even if it’s true) that maturity matching is a necessary condition for a healthy financial system, it’s not a sufficient one. In that sense, it’s not even the core risk of banking. Solvency is. Although the two are functionally interactive in a profound way, solvency and liquidity are distinct. Bear and Lehman were in different cells of this interactive matrix. Short funding a bad asset may or may not accelerate perception by the market or recognition by the bank that it is bad. Conversely, matched funding may or may not delay same. But with respect to the asset, the truth is the truth, regardless of the funding. I have some difficulty visualizing mismatched funding as the teleporting of money through time, and see no problem with it conceptually, other than it is a risk that interacts in a potentially dangerous way with solvency risk. In relating this to Lehman, Argentina, and the US, I see similar general relationships between solvency and liquidity. But in the case of the US, I see potential macro funding problems being related entirely to liquidity rather than solvency. The net international funding mismatch (notionally, apart from term structure) is simply too small, and the corresponding size of household wealth (even with worst case real estate deflation) is simply too large for it to be otherwise. And the liquidity issue itself should not be overstated. Catastrophic problems would manifest themselves not in the failure of external funding liquidity per se, since this is a captive quantity created by the export of dollar ownership through the cumulative current account deficit, but in the violent churning of its external composition and the accompanying effects on the dollar.

  • Posted by gillies

    a free market would consist entirely of entities ‘small enough to fail.’

    one elephant may haul around a mass equal to several million bees – but the consequences of death are quite different among the more fragmented and dispersed population.

    this would be a good time to open a local bank for local business, in some frontier town -

    - like wasilla in alaska ? ?

    the time is near for president palin to consider putting air force one on e bay, and getting back to basics. it is wall street that has been living several thousand miles from reality. and the pentagon – don’t forget them.

    it’s game over.

    new rules are not going to resurrect the old game.

  • Posted by Rien Huizer

    Moldbug,

    Despite my insufficient knowledge of Austrian econmics (but familiar with most of the Austrian classics), I fail to understand why only a maturity transformation system needs healthy agents. I did not specifically refer to maturity transformation as a core function.

    Quite simply, one needs a secure payments system and that requires safe deposit taking institutions, and there may be other transactions that needs robust agents. My universe of agents would, for instance include clearing houses. I fully agree that maturity transformation is not a function that should have a high public interest priority, but -unfortunately for you- we need institutions that are acceptable to a democratic public. No Kraft durch Freude here, mein Freund, just hard work. Or did I look at the wrong kind of Austrianness?

    Jokes aside (even bad ones) you have the beginning of a point: it is difficult to mix state activity and market activity (in finance) in such a way that welfare is high, transaction costs are low, rents are low and markets incur only very little friction. I believe Austrians would prefer governments to do very little for the simple reason that the cannot know what to do and are likely to make things worse. That is not the political reality of democracies. Voters rarely produce coalitions around policy platforms that maximize welfare. And dominant democracies can make other countries foot the bill. Too bad.

  • Posted by Dave C..

    “I thought you were a supporter of China’s socialist system” – Twofish

    The United States is no longer a meritocracy, but a kleptocracy of K-Street lobbyists. “Socialism for the rich and politically connected” is the antithesis of “socialism with Chinese characteristics”.

    There are just too many Wall Street banksters wanting moral hazard government sponsored bailouts that put US taxpayers at risk.

    One of the reasons we have increasing numbers of these federal taxpayer bailouts is because the Federal Reserve approved past bailouts causing more and more reckless behavior over time.

  • Posted by gillies

    did the russian stock market plunge 17% today – and if so why so little about it ? is the financial news being censored to maintain calm ? ?

  • Posted by Dave C..

    Expect US Taxpayers to be raped $90 to $200 billion from the pending AIG bailout

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aModqMIEqaGY

    The Federal Reserve is considering extending a “loan package” to American International Group Inc., the insurer facing a cash shortage, according to a person familiar with the negotiations.

    The stance by federal regulators is a reversal from a position they held as late as last night, and people with knowledge of the talks are “cautiously optimistic,” said the person, who declined to be identified because negotiations are confidential.

    The person gave no timetable for reaching an agreement or estimate on how much money New York-based AIG would need.

  • Posted by pseudorandom

    Twofish: People will learn a lot of lessons from this mess, which they will promptly forget in about ten years or so when the next bubble comes along.

    This fatalism about the inevitability of bubbles because it is somehow part of human nature is completely unwarranted. There have been long periods in modern capitalist history with very few bubbles and bank runs. Gary Gorton points this out in his paper at Jackson Hole:
    http://www.kc.frb.org/publicat/sympos/2008/Gorton.08.25.08.pdf

    Twofish: Governments are indeed slow and inefficient, their job is to be slow and inefficient. Sometimes slow and inefficient is a good thing.

    Yes indeed.

  • Posted by Cedric Regula

    Twofish: Governments are indeed slow and inefficient, their job is to be slow and inefficient. Sometimes slow and inefficient is a good thing.

    I guess we are getting our wish there, sort of. We are going on the “real estate standard”. People used to say the gold standard was intractable because a mine strike could cause a recession. Now falling real estate prices can do it.

    And what if France demands settling of its debt in real estate? Or the Arabs and Asians?

  • Posted by bsetser

    gillies — i am sure russia’s fall is big news in russia, but it is secondary to AIG in the us. and russia has the resources to address its own problems there days. no intentional desire to steer clear of it on my part, only limited time and resources

  • Posted by Twofish

    moldbug: But given this, isn’t “a free market with massive government intervention” pretty much a contradiction in terms?

    No it isn’t and the fact that people thought that it was is what got us into this mess. Football games are hard to have without referees and rules.

    pseudorandom: This fatalism about the inevitability of bubbles because it is somehow part of human nature is completely unwarranted. There have been long periods in modern capitalist history with very few bubbles and bank runs.

    I did some tracking down of the references and that quotations are rather out of context. Europe had boom bust cycles throughout the 19th century but was able to avoid American style bank runs and collapse largely by doing what the Fed is now.

    Also the quote from Andrews is wrong since the panic of 1890 was doing to the insolvency of Barings which was prevented by a Bank of England bailout.

  • Posted by Twofish

    moldbug: But I don’t think this is what you mean. And if by “government intervention” you mean “contracts are enforced,” you are trivially right, but this seems a little trivial.

    No it’s not. Putting together an infrastructure of courts and laws is *NOT* trivial. These things just don’t happen, they require lots and lots of effort.

    You run into a lot of “who watches the watchmen” problems in finance.

    gilles: a free market would consist entirely of entities ’small enough to fail.’

    For that to work you need massive government intervention in order to keep entities from gobbling up either other. Absent that, the big entities will use their capital to eat out the little entities. Also if you have lots or small entities you can end up with lots of herd behavior, which can cause you equally as much trouble.

    The AIG thing is this massive game of financial chicken to see who is going to blink first. It will be interesting to see who does blink first or if nobody blinks.

    Right now AIG is telling the Fed that if they don’t get money that the devil will arise from hell and destroy the world. Obviously they have a strong self-interest in saying that but the trouble is that being self-interested doesn’t make you wrong.

    Also China has its equivalents of K-Street lobbyists and industries wanting bailouts and often getting it. After all, China did a $250 billion bailout of its banks, not to say that it was a bad thing, but it was a bailout.

  • Posted by moldbug

    jkh,

    You are 100% dead right that the important question is the relationship between liquidity risk and solvency risk.

    I think this relationship is actually a pretty simple piece of game theory. Unfortunately, the theory – at least in my analysis – says you can’t separate the two. Thus, a CB cannot insure the liquidity of a financial system without also insuring its solvency. And this means the CB has it on the balance sheet, whether it likes it or not.

    Consider the relationship between a lender of last resort or CB, X, and a classical mortgage-deposit bank, Y.

    You can think of Y’s deposits as epsilon-term liabilities, which are automatically rolled over every epsilon unless the customer shows up at the ATM that epsilon. And Y’s mortgages are structures of long-term future payments. Ego the bank is a maturity transformer.

    When X looks at Y’s balance sheet, it sees that Y is solvent. Ie: the sum of its liabilities, in present dollars, exceeds by some regulatory percentage the sum of the prices, *in present dollars*, of its assets.

    However, Y is illiquid, because in terms of cash-flow accounting it cannot meet the demands of all the people it contractually owes money to at the same time.

    In the absence of X, the result will be a classic bank run: rational depositors will instantly refuse to roll over their deposits. Ie, they will go to the ATM.

    Y will attempt to meet this run by selling its assets, the mortgages. Since the sum of the prices of Y’s mortgages exceeds the sum of its present liabilities – as we stipulated, Y is solvent – you’d think that the depositors would be safe. Therefore, they need not go to the ATM, and therefore there is no run. This is the “benign” attractor of the Diamond-Dybvig multiple equilibrium.

    Unfortunately, the benign equilibrium is very unstable. Reason: in accounting there is many a slip twixt cup and lip. Depositors of Y have no reason to have 100% confidence that Y is, as it says, solvent, and that the assets it has marked to market can actually be sold for that price. As soon as this confidence dips below 100% – say it goes to 99.99% – there is an incentive to withdraw. This incentive is autocatalytic. Thus the benign equilibrium is a pencil balanced on its point.

    Thus the need for X – a visible hand to stabilize the pencil on its point. X has the legal authority and the mental brainpower to assure that Y really, genuinely is solvent. Moreover, it has the financial resources – in this case, an infinite printing press – to stop any bank run, because it can convert 99.99% back to 100%.

    Problemo solvato. This is your classic lender-of-last-resort model, the Anglo-American banking system, beautifully described in Bagehot’s _Lombard Street_, in use for 314 years and counting. And, as Austrians would tell you, causing boom-bust cycles for 314 years and counting.

    There are two objections to this: a theoretical objection and a practical objection.

    The theoretical objection is that any accounting system which permits maturity transformation and has a maturity insurer, X in this case, is equivalent to one which does *not* permit maturity transformation, but in which X uses its printing press to either issue (a) loans or (b) options, to private parties, at sub-market cost.

    I think we all agree that for the government to print money and lend it to private parties, or give away options, or whatever, is a pernicious abuse of the printing press. Ie, it is fundamentally corrupt, and nobody wants to be corrupt. Or at least, nobody wants to look corrupt.

    There are two ways to construct this equivalence. In one, Y balances its maturities by borrowing from X, using its mortgages as collateral. Does this ring a bell for anyone? In the other, X covertly issues free loan guarantees to the depositor of Y, essentially printing free options that pay off if Y fails. Every depositor is also a CDS holder. If the depositor’s faith supplies 99% of his account’s value, the CDS issuer supplies the other 1%. Either of these dodgy structures will

    Essentially – if we focus on the first, simplest, case – maturity transformation is covert or informal lending. CBs love informal transactions of this sort, because they leave all the power in the CB’s hands: it is X who decides whether the “shadow banking” system is to be insured or repudiated, whether the Greenspan puts are real or not. Ambiguity and accounting are not two tastes that taste great together.

    This is a mere ethical nicety, of course. The real problem is practical.

    The practical problem is a Misesian calculation problem. Seeing it requires us to assume that there is not just one X and one Y, but one X and many Ys – Y1, Y2, Y3, etc. Of course this is the actual situation.

    X’s problem is to assess the solvency of all these Ys without itself, personally, assessing the quality of the loans. If X does not assess solvency, it is effectively guaranteeing a system of arbitrarily dodgy loans. If X assesses loan quality, it itself is the true lender, the Ys are no more than agents, and we have the situation everyone wants to avoid: when you want to do some remodeling, you apply to the Eccles Building for a loan.

    This is the circle we are trying to square. As we’ll see, it is thoroughly and fundamentally unsquareable.

    To assess the solvency of the Ys without using its own opinion, X must rely on the market for loans. It requires the Ys to “mark to market.” Market price of all mortgages exceeds sum of all deposits – Y is solvent. Otherwise, not.

    Problem: a market is a market. It is not magic. It does not and cannot measure the “true value” of an asset – this ethereal, almost phlogistonic quality, so reminiscent of the good old medieval “just price.” Rather, the number produced by marking to market is a mere temporal price, which tells us no more than the price at which there are just as many buyers as sellers.

    As an asset, a loan is a promise of future payment. Its price (a) can be rigorously determined if you know (b) the correct interest rate, and (c) the risk of default. If you know any two of these variables, you know the third.

    Unfortunately, if you know only one of (a), (b) or (c), you are basically SOL. Typically we observe (a). But observing (a) is not an observation of *either* (b) or (c).

    Ergo: suppose some class of mortgages becomes suspect. Mortgages to people with last names starting with S, let’s say. Perhaps it’s just a rumor – next year, the S’s will all get together and declare a mortgage holiday, the government will bow to this large, powerful interest group, and refuse to foreclose.

    We do not know if this rumor is true. Or, to put it differently – for X to determine if the rumor is true, X has to actually analyze the S-housing market. Ie, it has to analyze the actual quality of the actual loans. This is the condition we are hoping to avoid.

    What X sees, in its quarterly reports, is that banks are selling S-loans, and the price is going down. There are two ways to interpret this, and either could be wrong.

    What we’re seeing here is basically a run on the Bank of S. Since all Ys make S-loans, this run is spread over the whole system, not concentrated. The bank-run game theory, however, is the same. When in doubt, sell. Nobody wants to become insolvent.

    In one interpretation of this event, the S-loans are good. There is no secret S-conspiracy to default. The panic is a liquidity panic. And what’s happening is that the *yield on S-loans* – the interest rate that the free market would charge for a new mortgage to an S-borrower – is soaring. The price of S-loans has fallen because the maturity transformers, who turn demand for ATM deposits into demand for mortgages, have dropped out.

    There are always vultures around, with plenty of cash and minimal liabilities. Vultures can assess loan quality. Or at least so one would hope. But vultures (a) have no incentive to buy until the S-market hits bottom, and (b) are not supercharged by maturity transformation – so they simply cannot replace the demand of the conventional market.

    Thus, this completely unfounded rumor produces a stable and highly damaging anomaly in the mortgage market, not to mention a gross injustice to people with S names. It is entirely productive for the lender of last resort to support the banking system, insuring liquidity.

    On the other hand, the S-loans could really just be bad. The change in S-loan price could reflect a genuine change in default risk, not just a panic that breaks down maturity transformation and creates an anomaly in S-loan yield. The presence of panic is certainly not an indication of the absence of a genuine default risk!

    But to know the difference, the LLR – X – has to actually try to estimate the default rate on S-loans. Which, again, makes it the true lender – and so on.

    In a bank accounting system that does not allow maturity transformation, this problem simply could not exist. MT is blatantly essential to the multiple-equilibrium phenomenon of bank runs, shadow or otherwise.

    You can argue that bank regulation would still be a social good for other reasons, but this one is surely the most glaring. And when you argue that MT is necessary for social purposes, eg lowering interest rates for farmers, widows and orphans, you are just making an argument for the government to print money and lend it. This argument may be valid, but it is certainly not in fashion.

  • Posted by moldbug

    Please read: “each of these dodgy structures will effectively prevent a bank run.”

  • Posted by Joe Rotger

    Aggh! I didn’t pass the math???

    Let’s try again, hope this second time around, it will improve.

    I wholeheartedly agree with Twofish.

    I think we’re missing a couple of fundamental issues:

    Life, or its advacement is all about taking risks, so, every now and then, we will fail, or suffer the low probability of risk taking.

    Central banks were created to aid us through these times, if not, we would repeat the 30′s depresion mistake all over again.

    So, falling, and lending a hand, is part of a natural and unavoidable process. It is interesting to note, that by increasing or spreading the money supply, we all participate in helping to rescue the ones that have erred and tripped along the way.

    Finally, let’s not forget that if exports were booming out of the USA, none of this would be happening.

    Let’s not lose sight of the chinese labor price arbitrage, which IMHO is the overbearing shadow which explains the downward stumbling spiral of the US economy, with inflationary money-supply bursts, and bouts of depressionary jobless liquidity tightenings.

    Let’s see how I do with the sums now.
    Again? wth?

  • Posted by Cedric Regula

    2fish
    …but was able to avoid American style bank runs and collapse largely by doing what the Fed is now.

    Looks like Ben is at somewhat confident in his new approach to CBing of opening up the discount window to anyone and everyone, and taking illiquid collateral in return.

    I thought the Fed would cut rates to give the banking system more margin and “earn” themselves out of their problems.

    They did issue the landmark statement “We are concerned about both downside risks to growth and upside risks to inflation.”

    So for now, Ben thinks he can have it both ways and just target lending to the needy in crisis, while anchoring inflation expectations.

    I guess we will have to see how long the money lasts. AIG is coming !

  • Posted by moldbug

    “Quite simply, one needs a secure payments system and that requires safe deposit taking institutions, and there may be other transactions that needs robust agents.”

    Robust agents can be privately bonded and secured. It’s pretty easy to have 100% trust in a 100%-reserve warehouse or “giro” bank, like the old Bank of Amsterdam. Trust requires a government in 2fish’s sense – a contract enforcer, but not a liquidity insurer.

    Of course nothing in any country can be more secure than its government, which is always the last watchman in the chain. But this is a very different thing from a lender of last resort.

    Also, on Austrians: the core Austrian School theory of banking, found in Rothbard and de Soto, can be slightly misleading on this point. Rothbard thinks of “fractional reserve” as a moral problem rather than a game-theoretic one, and he is not always clear on the importance of matching the maturity of time deposits, as opposed to just having the time not be zero. But he reaches pretty much the right result, if not always for the right reasons.

  • Posted by Joe Rotger

    One more thing I left out.

    According to what I just said, Greenspan or not, the put has to be in place.

  • Posted by Joe Rotger

    Oh! And, I also forgot.

    We will always find a way to get the cheese, no matter how much they improve the mouse trap.

    Better believe it!

  • Posted by pseudorandom

    Twofish: I did some tracking down of the references and that quotations are rather out of context. Europe had boom bust cycles throughout the 19th century but was able to avoid American style bank runs and collapse largely by doing what the Fed is now.

    If you define bubble loosely enough, then yeah you can say they occur all the time. But the fact remains that the quality of governmental oversight has a huge impact on the size, severity and frequency of asset bubbles.

    19′th century Europe managed to avoid US style booms and busts be doing what the Fed was supposed to be doing now but failed miserably to.

    Twofish: Also the quote from Andrews is wrong since the panic of 1890 was doing to the insolvency of Barings which was prevented by a Bank of England bailout.

    You are proving my point for me. One major bank failure in a century sounds like a very successful regulatory regime to me.

  • Posted by Twofish

    pseudorandom: But the fact remains that the quality of governmental oversight has a huge impact on the size, severity and frequency of asset bubbles.

    True enough, which is the cause of my statement that lassez-faire capitalism doesn’t work and you need massive government intervention to make a modern economy work. Without such intervention, bubbles get out of hand, and blow markets apart.

    People who work on Wall Street actually tend to favor regulation since once you see how the sausage gets made, you really can’t imagine how a market can work without massive government involvement. Even to enforce contracts and allow for bankruptcies requires huge governmental involvement.

    pseudorandom: You are proving my point for me. One major bank failure in a century sounds like a very successful regulatory regime to me.

    It’s not one near-major bank failure. It’s one of several. It actually goes to prove my point that people very quickly forget history. The quote that England had no bank failures since the Napoleonic Wars was written in 1908 by which time they had forgotten about 1890.

    It’s very hard to tell actually what did happen since no one alive lived in 1850, and memories for even more recent events change over time.

  • Posted by pseudorandom

    Twofish: People who work on Wall Street actually tend to favor regulation since once you see how the sausage gets made, you really can’t imagine how a market can work without massive government involvement. Even to enforce contracts and allow for bankruptcies requires huge governmental involvement.

    Well Wall St wants *selective* government involvement. They want to be given a free hand in boom times and they want bailouts in bust times. It is hypocritical but hey who cares, right?

    Until the subprime bubble burst guess who were lobbying hard against predatory lending regulations?
    http://online.wsj.com/article/SB119906606162358773.html?mod=hpp_us_whats_news

  • Posted by Cedric Regula

    Lots of variable rate mortgages and HEW tied to the LIBOR rate.

  • Posted by JKH


    Moldbug,

    An interesting model with some descriptive dynamics, most of which I would agree with. But also some disagreement:

    (With apologies to Brad Setser for swaying temporarily from topic):

    Conceptual preamble:

    Bank Y as a going concern attempts to self-insure its own capital and liquidity risk. The adequacy of the first is essential but not sufficient for the adequacy of the second. The full package includes appropriate return on capital and reasonable risk management, and other things.

    The Fed is primarily a direct liquidity reinsurer for Y and indirectly for its customers. The FDIC is primarily a solvency reinsurer for the customers of Y. The payment of a solvency insurance claim also happens to be a liquidity event for the customers of Y.

    The point I’m attempting to make is inherent in your words:

    “On the other hand, the S-loans could really just be bad. The change in S-loan price could reflect a genuine change in default risk, not just a panic that breaks down maturity transformation and creates an anomaly in S-loan yield. The presence of panic is certainly not an indication of the absence of a genuine default risk!

    … In a bank accounting system that does not allow maturity transformation, this problem simply could not exist. MT is blatantly essential to the multiple-equilibrium phenomenon of bank runs, shadow or otherwise.”

    The problem you’ve identified as not existing with matched maturities is the question of differentiating actual from perceived solvency risk. But my point is that the case of actual solvency risk is binding with or without maturity transformation. The same perception will materialize by maturity at the latest. Maturity transformation tends to increase liquidity risk because the proof of solvency is delayed, and the risk of perception increases. I’m not disputing the potential for maturity transformation to wreak havoc with liquidity and solvency risk. I just don’t think it’s the most central pivot point for comprehensive banking risk that I sense you portray it to be. I think solvency risk, actual or perceived, immediate or delayed, drives liquidity risk when liquidity risk materializes. And matched maturities will not prevent insolvency.

  • Posted by Spencer Bradley Hall

    Eventually the banking system will be nationalized because economists are trained in the Keynesian dogma. Bernanke is very smart, but even he does not understand money & central banking.

    And as any monetarist knows, it is impossible to control properly the money supply, through the manipulation of interest rates – including the federal funds rate.

    This crisis would never have reached it’s deminsion, if the rate of inflation had been controlled. The higher the rates of inflation, the more risks that are taken.
    Rampant speculation is always characteristic of an excessively easy money policy.

    This bubble was extremely obvious from the get go. In fact, it is impossible to miss an economic bubble. All payments clear through bank debits. Don’t open your mouth before you crunch the numbers.

    To the Keynesian economists on the FEDs research staff, transactions velocity is a statistical “stepchild”, it is income velocity that matters (see Milton Friedman WSJ Sept 1 1983), see also (http://www.nowandfutures.com/fed_watch.html)

    The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units. The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity.

    Actually the equation is a truism – to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc. See also: “Does Money Matter” Sept/Oct 2001, pg 10, Laurence Meyer, Federal Reserve Bank of St. Louis,

    The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt.

    Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M) (as opposed to Milton Friedman WSJ, Sept. 1, 1983). The product of MVi is obviously nominal GDP. So where does that leave us?… In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process.

    To the Keynesians, aggregate demand is nominal GDP, the demand for serves (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

    Admittedly the data for Vt are flowed. So are nearly all economic statistics, but that does not preclude us from using them. An educated estimate is better than no estimate at all. For example, we know that the international balance of payments balances – debits equal credits, payments equal receipts, etc. The Department of Commerce statistics do not prove this, so in order to make their statistics balance, they put in an “errors and omission “balance figure…The triumph of good theory over inadequate facts.

    The Fed first calculated deposit turnover in 1918. It reported weekly until 1942. The figure “other banks’’ was used until 1996. After the revision in 1977, Vt included all banks located in 232 SMSA’s excluding N.Y. City. This was the best that could be done to eliminate the influence on prices of purely financial and speculative transactions. Obviously funds used for short selling do not contribute to a rise in prices.

    The Fed calculates these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits. Like M3, the series was also discontinued, in Oct. 1996.

    In calculating the flow of funds (MVt), I am assuming that the Vt figure calculated by the Fed is not only representative all commercial banks in the United States, but that the velocity of currency is the same as for demand deposits. Is this valid? Nobody knows.

    But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds.

    Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these money flows.

    As a reminder:

    Some people prefer the devil theory of inflation: “It’s peak oil’s fault.” This approach ignores the fact that the evidence of inflation is represented by “actual” prices in the marketplace.

    The “administered” prices of the world’s oil producing countries, would not be the “actual” market prices, were they not “validated” by (MVt), i.e., “validated” by the world’s central banks.

  • Posted by Twofish

    pseudo: Well Wall St wants *selective* government involvement. They want to be given a free hand in boom times and they want bailouts in bust times. It is hypocritical but hey who cares, right?

    I don’t think this is true at all. If you are an honest businessman, you just can’t compete against dishonest businessmen in a low regulation and no regulation environment. There is no way that someone who is honest can offer a better deal than someone that is dishonest.

    Also the company that you referred to in the article isn’t a “Wall Street firm.” It’s based in California.

  • Posted by Twofish

    Actually, I don’t see how you can practically ban maturity transformation even if you wanted to do it. It’s such as useful and profitable thing to do that if you pass laws against it to make it impossible for regulated banks to do it, you will end up with unregulated banks, which gets you back in the mess that you have in the first place.

    One reason I like Austrian Economics is that a lot of it focuses on the limits of what a government can do even if it wanted to.

  • Posted by pseudorandom

    Twofish: I don’t think this is true at all. If you are an honest businessman, you just can’t compete against dishonest businessmen in a low regulation and no regulation environment.

    Not sure what you are getting at. Are you trying to excuse dishonest/unethical behavior by financial firms because their competitors were dishonest?

    Twofish: Also the company that you referred to in the article isn’t a “Wall Street firm.” It’s based in California.

    Was based in Calif. It no longer exists. It was mostly bought out by Citi in 2007.

    In any case this is just hair-splitting. Wall St firms bought, packaged and serviced the mortgages originated by Ameriquest and other subprime cos. They are part of the same ecosystem.

    Or are you suggesting that Wall St firms actually supported the Georgia and NJ predatory lending legislations?

  • Posted by Twofish

    pseudo: Are you trying to excuse dishonest/unethical behavior by financial firms because their competitors were dishonest?

    No, I’m saying that lax financial regulation doesn’t work because if you have lax regulation, the industry is going to be dominated by people that lie the most. If you don’t have regulation, then pretty soon no one around is going to be honest, since all of the honest people are going either be driven out of the business or leave in disgust.

    pseudo: Or are you suggesting that Wall St firms actually supported the Georgia and NJ predatory lending legislations?

    I’m saying that firms are made of people and if you did a survey of people who work in the financial industry in NYC, you’ll find a surprisingly large number of people that personally support legislation like that, and a surprisingly low number of people that believe that laissez-faire capitalism works.

    Not that it necessarily matters since corporations are not democracies, and the people who make the decisions about what to lobby for or against really don’t care much about what people in the firm think.

    But it is one artifact of seeing how the sausage gets made. Capitalism and markets are great things, but I don’t see how you can work in one and think that there isn’t a big role for government.

  • Posted by pseudorandom

    Twofish: No, I’m saying that lax financial regulation doesn’t work because if you have lax regulation, the industry is going to be dominated by people that lie the most. If you don’t have regulation, then pretty soon no one around is going to be honest, since all of the honest people are going either be driven out of the business or leave in disgust.

    You are right. Deregulation didn’t work and everyone became either corrupt or naive and it is happening exactly as you described above.

    However lets not forget that in the meantime, while the boom was still going, hypocritical executives and traders made enormous fortunes. The taxpayer is now left to pay for the losses.

  • Posted by moldbug

    jkh:

    “But my point is that the case of actual solvency risk is binding with or without maturity transformation. The same perception will materialize by maturity at the latest. Maturity transformation tends to increase liquidity risk because the proof of solvency is delayed, and the risk of perception increases.”

    I think you’re still missing the feedback loop at the heart of the problem. You’re not by any chance an electrical engineer? If so, think of it as a flipflop. Feedback creates memory. The circuit has multiple equilibrium states.

    The price of our questionable security – the S-MBS – is set, like all things, by supply and demand. The supply of S-MBS doesn’t change much. But the demand, because of the Diamond-Dybvig dual equilibrium, has two stable states: MT-on and MT-off.

    When MT flips off, it reduces the S-MBS as an asset class to a price level which, compared to its relatives the R-MBS and T-MBS, indicates a preposterous default risk. In fact, it is just a preposterous interest rate – corresponding roughly to whatever the price of any MBS would be in a world without MT.

    MT supplies a very, very large percentage of the world’s demand for high-maturity assets. This is why, if you eliminated MT across the entire financial system, but preserved the existing formal money supply (ie, M0), you would see preposterous interest rates for long-term money. Or to it another way, the price of *even risk-free* 2038 dollars in 2008 would be preposterously low.

    When MT shuts down even in one asset class, basically what you see is that the demand for 30-year loans has to be fulfilled by 30-year lenders. How many people want to buy a 30-year CD? Does this product even exist?

    The key to the problem is that it’s mathematically impossible to distinguish a low price of S-MBS as caused by astronomical default risk, from a low price of S-MBS as caused by the astronomical interest rates of the MT-off state (which, in our example, applies only in the case of the market for S-mortgages).

    Thus, for our real-world bad mortgages, the present market price does not indicate the default risk of the security. It simply indicates the extent to which holders of these mortgages have accepted the MT-off price. Which, obviously, sucks. (The situation is exacerbated, of course, by the feedback loop between new mortgage availability and real-estate prices – but let’s not go there.)

    If MT is off to begin with, and 30-year interest rates are actually set by the interaction of supply and demand for 30-year money – a loan requires a 30-year lender and a 30-year borrower – none of this can happen. There is no phase change that can descend suddenly and unpredictably without warning.

    Of course, momentum can drive any asset price up and/or down. You can have a default-risk panic, or any other class of panic, in any asset. But the market tends to converge on a single equilibrium price. There are no multiple equilibria. Diamond and Dybvig are not in the building.

    Another way to see the essential instability of MT is to see the way a maturity-transforming bank depends on the rollover behavior of depositors, which of course it does not control. If the bank is solvent, it can meet a wave of withdrawals (failures to roll over) by selling assets – but this wave of selling feeds back into the market for those assets, causing the effects described above.

    A non-MT bank is not dependent on rollovers at all. Its cash-flow pattern will be perfectly intact even if its clients redeem all liabilities at maturity and never, ever roll over. Thus, there is no feedback and no wave.

    And – perhaps most important – if you knew that there was no lender of last resort, you would not lend your own money to MT banks. Because who needs bank runs? Thus, it is the old story of the solution creating the problem.

    Without MT, the concept of “liquidity” is not particularly meaningful. “Liquidity,” in the sense commonly found today, represents the presence of MT-created demand in a loan market.

    When the MT engine shuts off, markets shut down. Those who hold MT-disabled securities on their books at the MT-on price do not, in general, care to sell in an MT-off market. So there are no transactions, or almost none. And when there are, the prices seem to have no relationship to the default risk of the loan.

    Basically, the hellacious interest rates we’d see, if the whole financial system switched to MT-off, the quantity of money was fixed at M0, and the Fed did not fill in the gap with lending of its own, are why any attempt to turn MT off and keep it off, without producing dreadful debt deflation, requires an equally unprecedented level of monetization. The payoff, however, is a stable financial system with a fixed, closed-loop money supply and a complete absence of central planning.

  • Posted by JKH


    Moldbug,

    “The key to the problem is that it’s mathematically impossible to distinguish a low price of S-MBS as caused by astronomical default risk, from a low price of S-MBS as caused by the astronomical interest rates of the MT-off state.”

    Whether risk premiums for credit and liquidity are differentiable is not critical to the issue of what the logical risk hierarchy is as between solvency and liquidity risk. In fact, one can distinguish between pricing for liquidity and credit risks to some degree by comparing floating rate note spreads (no or low interest rate risk) for different maturities of the same credit.

    “A non-MT bank is not dependent on rollovers at all. Its cash-flow pattern will be perfectly intact even if its clients redeem all liabilities at maturity and never, ever roll over. Thus, there is no feedback and no wave.”

    Even in a non-MT system, equity as a source of funding must be invested in assets with some maturity and liquidity profile. Funding supporting a bad asset at a non-MT bank must be repaid by liquidating equity investments. This runs down equity and solvency. Depositors realize that they must stand in line for repayment of their deposits according to maturity, in case of bad assets. Obviously they can’t get their money out before maturity. There is no bank run in this sense, because they are locked in. But perceptions of solvency over the long term still matter, and even if they get their money back, such depositors may not fund new assets on a non-MT basis because of this risk. Non-MT hedging precludes conventional bank runs, but may still cause depositors to run away from the franchise once they get their money back. This is an issue for banks that are actually solvent who still want to grow. So liquidity is still an issue and solvency still drives liquidity.

    I’m not disputing the fact that liquidity and MT are fundamental issues, or that MT affects pricing of assets comprehensively. They just aren’t the core issue, which is solvency. And MT doesn’t account for all liquidity risk, as noted above. Even in a non-MT system, liquidity of equity investment and funding liquidity in terms of ready access to funding for new assets (again, a function of ongoing solvency) remain important. The solvency issues that cause an interruption to funding midstream in an MT system would still be present when borrowers want to rollover their financing in a non-MT system (the requirement for borrowing doesn’t suddenly stop system wide when current contracts mature). And both maturity structure and pricing would adjust systematically for both borrowing and depositing in a non-MT system, with a severe but non-apocalyptic pricing and financing term adjustment (the idea of 30 year fixed pricing on a mortgage is a joke to begin with, but something reasonable like 5 years isn’t, and can be funded in normal risk environments). A full non-MT system of course is not pragmatic, but given the obvious role of short funding in the current unfolding disaster, look for Basel and future US regulatory guidelines on liquidity to be much more severe than in the past, although mostly in relation to wholesale funding maturity constraints. This associates with the now predicted demise of the stand-alone investment bank model, although I doubt you’d be comforted much to see their current wholesale short-funding reliance replaced by the retail deposit base of a parent commercial bank.

  • Posted by Twofish

    pseudo: However lets not forget that in the meantime, while the boom was still going, hypocritical executives and traders made enormous fortunes. The taxpayer is now left to pay for the losses.

    However, you shouldn’t fall into the trap of thinking that only rich people are capable of corruption. The problem is that if you look at where most of the money ended up, it didn’t end up in the pocket of some rich person. The problem with the system that got set up is that you were better off if you went to a bank and lied about how much money you made, how much your house was worth, and how likely you were to pay your money back, and most of the money ended up in the hands of people with bad credit.

  • Posted by Joe Rotger

    Not again.

    I just wanted to stress the fact that regulators need to also be extremely vigilant.

    We all know that the final buyer of mortgages was getting tainted goods from predator mortgage agents in the field.

    This system was all wrong. If the regulator is vigilant, and detects and corrects this problem in due time, we would not be having this discussion.

    Improved mouse traps are well and necessary, but, keeping the guard up and being vigilant, can go a long way –remember that mice will always be trying to defeat the next mouse trap, and history tells us that they always do.

  • Posted by moldbug

    jkh:

    “Even in a non-MT system, equity as a source of funding must be invested in assets with some maturity and liquidity profile. Funding supporting a bad asset at a non-MT bank must be repaid by liquidating equity investments. This runs down equity and solvency. Depositors realize that they must stand in line for repayment of their deposits according to maturity, in case of bad assets. Obviously they can’t get their money out before maturity. There is no bank run in this sense, because they are locked in. But perceptions of solvency over the long term still matter, and even if they get their money back, such depositors may not fund new assets on a non-MT basis because of this risk.”

    Indeed. Non-MT accounting is not a recipe for eliminating banks, or bankers! The banker’s answer to solvency risk is (a) prudent diversification, (b) excess capital, and (c) independent accounting. None of these requires a central bank or other liquidity insurer.

    Basically, in a non-MT system with a fixed or near-fixed (eg, a physical gold standard) interest rates should be stable and market-determined, asset prices should not fluctuate systematically, and the price of future payments should reflect default risk and nothing else.

    The key to thinking about non-MT banking is to realize that in the absence of a liquidity insurer, lenders have an incentive to actually match the maturity of their investments to *their own* liquidity needs. If you need an investment that matures in one year, you won’t buy a five-year bond. And since there is minimal demand for one-month, one-week, or one-day loans (there are few productive uses of capital at this duration) the ultra-short lending market basically disappears. If people need to hold cash, they just hold cash (giro banking).

    At first this seems counterintuitive, because yield curves in a non-MT system will still slope upward. The rate on the five-year-bond is higher. But a rational investor will match correctly to avoid a liquidity crunch. The game theory is that if you are the *only one* mismatching your maturities, you can profit. But you won’t be the only one, so you shouldn’t.

    So the liquidity risk migrates out to the edge of the system and disappears, instead of collecting in a central single point of failure as it does now. And bankers can focus on the problem that they understand: default risk.

    Ie, solvency, which is of course the heart of banking. Basically, our present system tries to factor out liquidity risk, which is in Taleb’s fourth quadrant, ie intrinsically unamenable to modeling, by putting it all in one basket and having the government hold that basket. I can see how this seemed like a good idea in 1913. Or even in 1694. But it’s just wrong.

    “A full non-MT system of course is not pragmatic…”

    There are several ways to interpret this statement, which I’m afraid I’ll have to ask you to defend!

    What I think you mean is that a *transition* to a full non-MT system is not pragmatic, and I think you mean “pragmatic” in the sense of “politically plausible.”

    This, of course, is true, so you have an easy out. I am a blogger, not a banker, so I am interested in hypotheticals which are not politically plausible. Not everyone is, and I respect that.

    If you mean that a non-MT banking system is unstable or otherwise unworkable, or even socially undesirable, some clarification of the point is needed.

    If you mean that a transition from MT banking to non-MT banking is impractical, you are correct – but only with the strawman assumption that the transition is done in the worst possible way, ie reducing the money supply to M0.

    The straightforward way to close out MT is for the liquidity insurer to buy the securities whose liquidity, and indirectly whose solvency, it has been insuring. This means the whole banking system, as described above. The Fed becomes the RTC. Nor does this imply eternal Bolshevism: what is bought can and should be sold.

    Other band-aids, of course, can be found. And no doubt will be.

  • Posted by pseudorandom

    Twofish: However, you shouldn’t fall into the trap of thinking that only rich people are capable of corruption. The problem is that if you look at where most of the money ended up, it didn’t end up in the pocket of some rich person. [...] most of the money ended up in the hands of people with bad credit.

    I am sorry but this is nonsense. Maybe the financiers can believe this if it makes them feel better about themselves but most of the money did not go to the subprime borrower.

    All the subprime borrower (most of whom bought at the peak of the market in 2006-07 btw) got was an unaffordable house they could not afford. The Wall St traders and execs got billions in cold hard cash bonuses.

    Today the subprime borrowers are getting kicked out of their houses. The traders get to keep their bonuses. Now tell me who benefited from the boom times?

  • Posted by JKH


    Moldbug,

    “I.e., solvency, which is of course the heart of banking.”

    So I think we’ve in agreement on that fundamental point. MT is then a risk parameter or switch as you referred to it, overlaid on capital underpinning as part of a system of risks.

    Actually, I was thinking of none of the above with respect to the pragmatism of converting to a non-MT system. I believe that the demand for immediately en-cashable deposit balances (money of 0 maturity if you will) is one of the strongest structural demand functions in banking, particularly as demanded by retail banking customers. If solvency is the heart of banking, these deposits are key to the central nervous system and, of course, to MT. The MT parameter positions such deposits as self-insuring, in the sense of actuarial probabilities of regular in and out flows, subject to capital and solvency adequacy, decent franchise value, and ongoing relationships with retail banking customers. Note that these funds do tend to be a stable source of funding for commercial banks with sound enterprise value, as opposed to wholesale sources of funding. By pragmatic I mean that deploying these funds in corresponding assets of 0 maturity seems unduly extreme to me, although I can see it would be purist in the sense of a non-MT system. And I mean pragmatic in the sense that non-MT is indeed an extreme point on the continuum of asset-liability liquidity risk in the current world where limits on various risk types tend to be non-zero as a matter of business course. But I think your point is simply that MT risk should be excluded from the risks that bankers assume with their capital.

  • Posted by moldbug

    jkh,

    Yes. The problem is that MT is such a large parameter that the difference between MT-on and MT-off states, the liquidity signal if you like, completely drowns out the solvency signal, and replaces it with meaningless noise.

    That’s what MBS prices are now: meaningless noise. Except in the sense that they feed back into real estate prices, they are not an indication of solvency risk. The Hayekian price signal cannot be received, even by the most sensitive of antennas.

    That’s why the Mellonist attempt (which seems defeated, for the moment – at least Napoleon got 100 days, “Hank the Hammer” had only two) to solve the problem via liquidation can’t work. The solvency signal will not reappear until you either pull the whole mortgage market down to its flat MT-off level, liquidating to M0, or pull it back up to MT-on with fresh FRNs.

    Orthodox Austrians recommend the former, which is crazed. The latter is the only sensible alternative. And it’s what will happen, one way or another. So I’m just proposing that it be done wholeheartedly and for good, rather than in the usual bandaid fashion: pull the switch back to MT-on and then close out MT.

    Moreover, when you use CB insurance to eliminate liquidity risk, you have a choice between formal liquidity insurance and wink-and-nod liquidity insurance. The former creates moral hazard. The latter, well…

    You are absolutely right about the deposit pool. My view is that extremism in the pursuit of stability is no vice. Like Hazlitt, I would rather not split the difference between right and wrong.

    Most bankers are not constitutionally prone to extremism, but fortunately there is another view of the issue. As I said earlier, you can model any MT banking system as a non-MT system which is balanced by government loans.

    So our present deposit system is equivalent to one in which Y (the bank) stores its checking deposits as cash in the vault, and then borrows money from X (the Fed) to make its 30-year mortgage loans.

    This makes the problem transparent: how, in a financial system heavily dependent on government loans, do you close out said loans and return to a free market, in which every loan has a private lender and a private borrower? The answer strikes me as simple: pull the whole structure back onto X’s balance sheet, mortgages and all.

    This leaves a situation in which Y’s customers have tons of cash, Y is just a cash warehouse with no debt, and X has tons of future payments of uncertain default risk. X can auction those payments and see what the actual risk is. Then we are back to a free market. And a free market is a stable market. (This ignores the feedback effect on home prices, which might require further intervention.)

    In real life, of course, banking is anything but simple. But it is sometimes good to have a simple model in one’s head, when dealing with big, complicated realities.

  • Posted by JKH

    Moldbug,

    Interesting and worthwhile discussion. Thx.

  • Posted by moldbug

    Likewise…

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