James Grant: Put bankers’ own assets on the line again.

The market is the best regulator. After almost 100 years, it’s time we brought it back.

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Jim Grant has been the living best banking historian since 1995 when Murray Rothbard kicked the bucket. Last week in WaPo, he put forth is old-time solution to banking reform: make bank executives and even shareholders personally liabile for depositors’ losses.

The trouble with Wall Street isn’t that too many bankers get rich in the booms. The trouble, rather, is that too few get poor — really, suitably poor — in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.

Of course, there are only so many mansions, Bugattis and Matisses to go around. And many, many such treasures would be needed to make the taxpayers whole for the serial failures of 2007-09. Then again, under my proposed reform not more than a few high-end sheriff’s auctions would probably ever take place. The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness as they have not been focused for years.

“The fear of God,” replied George Gilbert Williams, president of the Chemical Bank of New York around the turn of the 20th century, when asked the secret of his success. “Old Bullion,” they called Chemical for its ability to pay out gold to its depositors even at the height of a financial panic. Safety was Chemical’s stock in trade. Nowadays, safety is nobody’s franchise except Washington’s. Gradually and by degree, starting in the 1930s — and then, in a great rush, in 2008 — the government has nationalized it.
No surprise, then, the perversity of Wall Street’s incentives. For rolling the dice, the payoff is potentially immense. For failure, the personal cost — while regrettable — is manageable. Senior executives at Lehman Brothers, Citi, AIG and Merrill Lynch, among other stricken institutions, did indeed lose their savings. What they did not necessarily lose is the rest of their net worth. In Brazil — which learned a thing or two about frenzied finance during its many bouts with hyperinflation — bank directors, senior bank officers and controlling bank stockholders know that they are personally responsible for the solvency of the institution with which they are associated. Let it fail, and their net worths are frozen for the duration of often-lengthy court proceedings. If worse comes to worse, the responsible and accountable parties can lose their all.
The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance. Bank shareholders used to bear the cost of failure, even as they enjoyed the fruits of success. If the bank in which shareholders invested went broke, a court-appointed receiver dunned them for money with which to compensate the depositors, among other creditors. This system was in place for 75 years, until the Federal Deposit Insurance Corp. pushed it aside in the early 1930s. One can imagine just how welcome was a receiver’s demand for a check from a shareholder who by then ardently wished that he or she had never heard of the bank in which it was his or her misfortune to invest.

Nevertheless, conclude a pair of academics who gave the “double liability system” serious study (Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law), the system worked reasonably well. “The sums recovered from shareholders under the double-liability system,” they wrote in a 1992 Wake Forest Law Review essay, “significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured.”

Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it. And when the inevitable happens? Congress and the regulators dream up yet more ways to try to outsmart the people who have made it their business in life not to be outsmarted…

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For the record, I agree 100% with Grant’s solution. Moral hazard is THE cause of the de-facto bankruptcy of nearly every major bank in the US.
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The US banking system pre-1913 was not perfect (unscrupulous bankers were always trying to use the power of the government’s guns to game the system), but it was much safer and more honest than today’s.
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Bankers did not yet have a license to blow bubbles, since there were no black checks from their creation, the Federal Reserve, which can simply print paper money to bail them out in the inevitable busts. Before the Fed, their own assets were on the line, and before FDIC, the depositors’ assets were at risk. These two parties had a very strong incentive to keep lending standards prudent.
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There were booms and busts, but they were localized, and at no time did the entire banking system become insolvent like it has been since 2008. Weak banks lost their depositors to those who had been prudent, and depositors knew that they were taking a risk when they chose a bank paying higher interest.
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In sum, the market is the best regulator. It’s time we brought it back.
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List of Texas ratios for all US banks

Just in time for failure Friday, Chris Bruner has assembled a list of Texas ratios for all US banks. This data is all publicly available, but is not often assembled in one place. This is a large html file, posted here on Lew Rockwell’s server. It can be searched using the keyboard command Control-X. The data is as of Q2 2009. From Wikipedia:

The Texas ratio is a measure of a bank’s credit troubles. Developed by Gerard Cassidy and others at RBC Capital Markets, it is calculated by dividing the value of the lender’s non-performing assets (Non performing loans + Real Estate Owned) by the sum of its tangible common equity capital and loan loss reserves.

Banks with ratios of 100 or higher are often considered very likely to fail soon, and those with scores of over 50 are sometimes considered risky.

The banking system is in much worse shape today than 12 months ago, with default rates up and collateral values down across the board. Loan loss reserves are absolutely pathetic relative to non-performing loans:

Source: St. Louis Fed

Remember that bank failures did not end with the crash of 1929, but continued to pick up steam into the 1930s, culminating in Roosevelt’s bank holiday in the spring of ’33, in which he stole the citizens’ gold and devalued the dollar. The Dow bottomed in July ’32 and had already doubled by then.

Update: Failed banks announced

Here are the losers this week, and their respective Texas ratios:
Partners Bank, Naples, FL (393)
American United Bank, Lawrenceville, GA (161)
Hillcrest Bank Florida, Naples, FL (286)
Flagship National Bank, Bradenton, FL (259)
Bank of Elmwood, Racine, WI (180)
Riverview Community Bank, Otsego, MN (238)

Spontaneous Jubilee in the air?

Why shouldn’t someone walk away from overbearing consumer, student or mortgage debt, so long as it is non-recourse? I can’t think of any reason to keep servicing debt if you have no hope of repaying the principal. What good is a high FICO score if you don’t want to run up another credit card balance or buy a home? Yes, landlords run credit checks, but it is getting harder and harder to fill vacancies, and this is what deposits are for anyway.

The “just walk away” attitude is gaining traction.  It could snowball into next year as yet more mortgages reset and U-3 unemployment enters the double digits. What can the legal system do if tens of millions of people decide to stop paying their unsecured loans? This lady is right — there is safety in numbers and government inefficiency. You get a fresh start in five years anyway, which should be right around the time real estate has a chance of recovering.

This is exactly what needs to happen. The unpayable debt will by definition be defaulted on, so the sooner the better. The banks that issued it need to go under. Stories like this are refreshing, because we need to clear the air.

The bailout blackmail bluff.

The bluff is not that nothing will happen to the economy if the bailout doesn’t pass, but that the bailout will do nothing to stop the depression (but lots to deepen it).

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Scare tactics.

All of a sudden, the economy is in dire danger of unknown horrors, we are hearing from Bernanke, Paulson, Bush, and the US press, especially the financial press. Unless the bailout passes, and RIGHT NOW, stocks will crash, your bank will fail, your home will keep losing value, and your employer will go broke and fire you. All of the bankers’ stooges who were trying to get us to look the other way since the credit markets started to freeze up 13 months ago are trying to scare the daylights out of the US public. How to avert the crisis? Give the con men who created it a blank check drawn on the US Treasury, of course.

This campaign reminded me of a spot-on comedy skit by the British Comics, Bird and Fortune, that popped up on YouTube 12 months ago, back when nearly all of my acquaintances all thought I was nuts for stocking up on put options and gold.

I recommend the whole thing, but the end (jump to 7:20 if you’re in a hurry) was particularly prescient. I transcribed it below, but it’s more fun to watch:

These are the lines was I reminded of today:

Interviewer: “But now, you see, the people are saying that now the crisis is going to turn into financial meltdown. I mean can that be avoided?”

Investment banker: “It can be avoided, provided that governments and central banks give us, the financial speculators, back the money that we’ve lost.”

Interviewer: “But isn’t that rewarding greed and stupidity?

Investment banker: “No, no. It’s rewarding what the Prime Minister, Gordon Brown, called “the ingenuity of the markets.”"

Interviewer: “I see…and, and …

Investment banker: “We don’t want this money to spend on ourselves. We want this money just to go into the markets so that we can go on borrowing and lending money as if nothing had happened without thinking too much about it.”

Interviewer: “Yes, but, if the worst came to the worst, and you didn’t get this money, what then?”

Investment banker: “Well then, there would be another market crash, and then I would say to you what people like me always say, that it’s not us that would suffer, it’s your pension fund.”

Interviewer: “Thank you very much.”

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George Bush, tonight: “The stock market could drop even more, which would reduce the value of your retirement account.”

Call the bluff.

I have zero hope for a sensible outcome from the US government. Politicians are not debating the concept of bailouts and moral hazard; they are debating which irresponsible parties get how much. ‘Compromises’ will be reached that allow for grandstanding all around, but the core of the bill will give bankers what they want.

The executive salary cap for bailout recipients is a red herring. Manhattanites will figure out other ways to get their hands on these trillions, ways that don’t involve holding executive titles at big banks. Those banks are dead in the water anyway — it wouldn’t surprise me if they were completely nationalized over time. Another dispute is over equity — the government will get its equity position, sure, but the equity is worthless. And of course, everyone wants to throw in money for the idiots who are underwater on their mortgages — they’ll get theirs, if not in this round, the next.

By the way, anyone else notice the tactical similarity to how seven Septembers ago we were subjected to the same kind of scare tactics and rhetorical bombardment while another huge and unconstitutional bill was being rushed through Congress?

All over but the shouting.

We will get a depression. We’ve got it already. If US still had any character, this would be a short and relatively painless lesson in giving government too much power, which really means giving power to bankers. I say painless not because nobody will go broke — they will, in spades — but the pain will be like the first weeks in fat camp or reform school, not the gulags.

There will be no reformation this time. Americans of all intelligences are confused and ethically bankrupt after 100 years of saturation in nationalist and socialist propaganda by schools and media. This lack of a moral compass or common sense assures us that this will be the worst depression in our history, and maybe the last.

As the depression deepens, a terrified populace will allow the government to grab more and more power, until society is completely transformed. Remember those emergency powers that the executive granted itself last year? You better believe they are being readied. This stuff happens, folks. This is what human beings do to themselves, with great consistency. Freedom and prosperity are the exceptions to the rule as far as history is concerned.

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PS — Buy the bailout rumor, sell the news? If I had to pick a date for the start of the Crash, it would be the day after Congress passes this bill.

Disclosure: I’m short the equity markets with put options and inverse ETFs. See disclaimer.

Why bailouts will not stop the depression

The market is a force of nature, like gravity. To use it is prosperity. To fight it is misery.

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By bankers, for bankers.

This is a bailout of bankers. The Fed was created by bankers, and the Treasury is run by a banker, so there are no surprises here.

The plan is to have the government take banks’ bad mortgage debt (will they add credit card, auto, student and corporate debt?), so that they are no longer insolvent. Solvency has always been the issue, not liquidity — that is a red herring. By no means will all of the bad debt (out of $50 trillion in total domestic financial and non-financial sector private debt) be absorbed by this program, which is going to move $700 billion at a time.

The fact that the government still relies on a market for its bonds puts limits on the pace at which debt can be socialized. There has been a great demand for Treasuries of late as safe havens, so the first tranche or two should be absorbed easily. Bonds may even rally more as assets prices continue to plunge.

Later, after the bulk of the deflation has passed and the bond market is saturated, this demand will ease and the Fed will have to buy greater and greater amounts of bonds with newly created dollars. The government’s spending needs are infinite, but the tax base and bond market are finite, so this phase of inflation can lead to currency failure. That can be chaotic, because contracts become meaningless when currencies are worthless. Out of such episodes arose Napoleon and Hitler.

Econ 101: Savings = Investment.  Lesson: reward savers with deflation.

We should embrace deflation, not fight it, because it restores sanity. The irresponsible go broke, and the prudent are rewarded. When money is tight, prices need to come down, and this encourages the savings that will turn to investment after the dust settles. Those who were smart enough to go into this crisis with savings are the ones you want allocating the capital for rebuilding, not the swindlers who beg for newly printed ‘stimulus’ money for their pet projects.

Your neighborhood, a government housing project.

Let’s assume the program actually removes all bad debt from bank’s balance sheets. Once again, they are fully capitalized and ready to issue loans, with assistance of course from an accommodating Fed. That will ‘fix’ one side of the reflation machine. On the other side, borrowers will still be choking on their existing debt and in no condition to take on more.

So the next step on the road back to inflation city will have to be debt relief for borrowers. As the owner of huge amounts of mortgages, the government is likely to be a very accommodating creditor. Can’t handle $2000 a month? Well, just pay $1000, but promise to spend the rest, ok! Or it could offer a quickie default: we take the house, but you can rent from us for cheap. In either case, the government has title to an enormous amount of housing stock, so all of America takes on the air of an inner city housing project.

(A side note: Once government becomes your landlord, it has a lot more leverage to force the installation of whatever it wants in your home, from ugly fluorescent lighting and those ‘efficient’ toilets that clog, to monitoring devices for your ‘safety’.)

The Crash is the Market, and It cannot be stopped.

Crashes are the market’s way of correcting the perversions of bubbles blown by bankers and governments. They are not market failures. The Market never fails. It is a force of nature. Bankers and politicians can shackle us with their guns and laws, but they cannot change the way the universe organizes itself. Any scheme but freedom, the absence of force (such as theft, a form of which is inflation), will be thwarted by the Market. Tax cheats, corrupt politicians, crooked brokers, smugglers and prostitutes are as plentiful as the laws that create them. In the absence of force (as George Washington said, “government is not reason; it is not eloquent; it is force”), the Market will reward honesty and industry above all else. When force is used liberally, society rewards George Bush Jr and Angelo Mozillo.

The government has tried to thwart the Market for so long, from the New Deal to the S&L crisis and beyond, that the distortions have become too big to support, and this time the Market is taking its revenge. Saving some big banks and some borrowers is certainly possible with bailout programs (rent seekers should call their lobbyists ASAP to get on that list!). But $50 trillion is way, way beyond anything the government can handle, so there will still be massive debt deflation left and right, and asset prices will continue to crash.

Debt revulsion is the fly in the reflation ointment.

To reflate, we need willing and able borrowers and lenders (inflation is the net increase of money and credit, deflation is their net decrease). Even if all bad debt is taken off the books of both borrowers and lenders, can the Feds rekindle America’s affair with debt? The answer is yes, eventually, but it won’t be any fun this time.

If the government forces the issue before the Market has cleared the way for growth, people will only be willing to borrow again to protect against the decline in the value of currency. During the crash, currency will continue to gain in value, so for at least the next couple of years, borrowers are going to be very wary of debt. They don’t want to repeat this nightmare, and besides, with asset prices crashing, the economy in a tailspin, and new regulations restricting commerce, where on earth can investors profitably deploy this capital? China? Not so fast — investing abroad may be restricted. Even with a 0% loan, can borrowers generate any return at all in this environment? With poor investment prospects and no need to protect against inflation, few will be willing to borrow.

This is why the traditional reflation machine will stay broken. This is the machine that Greenspan operated for the bankers with such mastery. But try as Bernanke might, this machine will not start up again until money or credit is somehow flooded into the economy through other means.

¡Chavismo!

In Hugo Chavez’s Venezuela, people borrow not for productive uses, but to speculate in any kind of asset that will lose value at a slower rate than inflation plus interest. It is a sickening thought, because it totally perverts all economic decisions and leads to staggering waste. We have just experienced a milder version of this in the US, but at least we built a few useful things with the credit, though most will go to waste.

In Venezuela, people invest in new automobiles, sometimes fleets of them, because the sum of interest and depreciation on the vehicles is less than the rate of general price increases. Hence, cars bought new appreciate in Bolivars as they rust in driveways. Venezuelan society is in a later stage decay than the US, but it may resemble our future.

The new New Deal, and the Neverending War

So how do you get that stubborn price level (the rearward looking indicator, CPI, was negative in August — expect more and bigger negative numbers for many months to come) to start ticking up again with gusto? After a general asset price crash, which I emphasize cannot be prevented at this point, the government can spend and spend and spend.

If you think the bridge to nowhere was ridiculous, you haven’t seen anything yet. Our sociopathic leaders, with hearty encouragement by esteemed professors, seem to have no problem with the old Keynesian theory of burying bottles stuffed with cash and letting people dig them up. Hey, it puts people to work and raises the price level! Let’s all pray for more hurricanes while we’re at it. Think of the boost to GDP!

Expect lots of pork for ‘green’ energy projects, and expect those projects to cost more than they produce and have all kinds of perverse effects. Expect national ‘service’ programs (if mandatory, they are national enslavement programs) such as have been touted by Obama, Hillary and the media wing of the Fascist party (now the only party in power in the US).

We were all taught in school that although FDR’s valiant efforts helped put Americans back to work, what really saved the US from sinking into a big hole the earth was War, glorious War. How lucky of us to already have two of them going and plenty more enemies lined up just in case!

Bond sell-off just a correction. Bailouts will not stop deflation.

Bottom line: Paulson brings a bazooka to an H-bomb fight.

Bond update first:

As usual of late, today’s action in Treasuries was the exact opposite of the stock market: a massive sell-off.  High bond prices reflect fear, which hit a new high earlier this week. Today’s action was not just a short-squeeze. It was collective relief, a pause for our nerves. We will need them for what is yet to come. Here are the bonds (Bloomberg):

Click image for sharper view.

Does he even know how that thing works?

Like all of the bailouts, the planned socialization of (admittedly bad) mortgage debt puts another chain around Lady Liberty’s neck for the short-term of benefit of a few bankers. But hey, what’s another trillion or so when taxpayers are already on the hook for $100 trillion?

Here’s Paulson on the program’s ostensible goals:

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible. The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even as it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative – a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.

*Opposite rule of government action

According the rule of opposites (the most reliable indicator for predicting the outcome of government actions), we now know that the program will threaten the economy, not protect the taxpayer, cost far more than the alternative, and impede economic expansion.

The Sum of All Debts

And yes, these kinds of programs are highly inflationary, but they still pale in comparison to the size of the debt and equity that is imploding. The Fed’s balance sheet is 900 billion and growing, the deficit next year will certainly be over $1 trillion, and GDP, which used to ostensibly be $13.8 trillion, is shrinking fast. These figures put upward bounds on the payload of government’s bazooka.

To put this in perspective, Paulson’s gang is squaring up against the following:

  • Private debt is roughly $50 billion (Federal Reserve: sum of domestic non-financial and domestic financial).
  • The total capitalization of the US stock markets is roughly $15 trillion.
  • Total residential real estate has been estimated at over $23 trillion.

The amounts by which the latter figures are contracting exceeds the government’s reflation efforts by some multiple. Deflation will continue — accelerating in the near term — and not abate until so much wealth has gone to money heaven that government’s expenditures finally surpass its rate of implosion. Despite the bailouts, and what will surely be a new New Deal and probably an expanded war in Asia, that point of equilibrium will arrive years from now. In the meantime, cash is king once more.

Risk hangover

One more point on the banks: they may be relieved of their bad debt and provided with fresh reserves, but the inflation machine will remain impaired because individuals and corporations have just learned a very hard lesson about debt and will be averse to borrowing for many, many years to come. Borrowing like we have seen in recent decades requires an appetite for risk, but the stuff now makes people nauseous.

*Rule of opposites as applied to government action: Every action that government takes results in the opposite of its stated intention. (credit to Mish for identifying this law of nature)

  • Affordable housing programs make housing unaffordable.
  • Deposit insurance makes the banks unsafe.
  • The SEC creates risks for investors but does not protect them.
  • Free trade agreements are thick books of rules restricting trade.
  • Social welfare programs create poverty and poor health.
  • The Ministry of Peace (er, I mean Department of Defense) conducts offensive wars.
  • Homeland Security makes Americans feel insecure at home and relaxed abroad.
  • FEMA inhibits recovery from emergencies.
  • The FDA keeps Americans hooked on drugs, many of them dangerous, and inhibits accurate labeling on food.

The list goes on ad infinitum.

PPS — For a full rundown of why these bailouts won’t stop deflation, read chapter 13 of Robert Prechter’s Conquer the Crash. He predicted this exact scenario years ago.