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Last week, we talked
about what happens when a bank, or a similarly levered financial entity like
a brokerage, SIV, certain types of hedge funds, etc., has a "bank
run." In other words, lenders (depositors) want their money back. The
bank has to either borrow from someone else, or sell assets.
March 16, 2008: How Banks Work 6: Liquidy Crises and Bank Runs
March 9, 2008:
How Banks Work 5: Selling Loans
February 24, 2008: How Banks Work 4:
Banks and the Economy
February 17,
2008: How Banks Work 3: More Elephant Poop
February 10,
2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008:
How Banks Work
If nobody wants to loan
them money, and they can't sell assets effectively, then they go to the
Lender of Last Resort, the central bank.
This is actually close to
central banks' original purpose. They were never intended to manipulate
interest rates and manage currencies. That is something that happened later,
after the Great Depression, when economists convinced themselves that
manipulating interest rates and fooling with currencies would be helpful.
Central banking was
originally developed, in the mid-19th century, to alleviate the
liquidity-shortage crisis. This was accomplished by making loans, effectively
increasing the supply of base money. The characteristic symptom of a systemic
liquidity-shortage crisis is high interbank interest rates.
Very high. Typically over 10%, when 3% might be a normal figure, and often
above 40% during the crisis. Today, central banks' interest rate targeting
mechanisms effectively keep something like that from occurring, so the
classic 19th century-style liquidity crisis doesn't really exist any more. You can read about it in Chapter 8 of my book.
1907 was the last liquidity-shortage crisis in the U.S. Interbank rates went
over 100% -- for best quality credits.
The risk of having to pay
such a high penalty rate, or perhaps not having access at all to funds, is
the reason that banks held much larger reserves in those days, on the order
of 10% of deposits. Banks today can accomplish a similar thing by holding
very liquid securities, such as Treasury bonds or perhaps deposits/loans with
other banks.
Central banks haven't
really used direct lending for many decades. They discovered that they could
keep interest rates from spiking via open market operations. This was done in
conjuction with the gold standard, but it was on
the slippery slope to interest rate manipulation and floating currencies. The
advantage of the old system of direct lending was that there was typically a
rather harsh penalty interest rate, of 10% perhaps. Banks would only borrow
at that rate in dire circumstances. And, when things settled down, they
quickly paid the money back. This is the "self-cancelling commercial
bill of credit" you sometimes read about in old economic discussions.
The involvement of the central bank in the monetary system was rare, brief
and self-reversing.
One advantage of the
system of open market operations is that it leaves questions of solvency to
the market. The central bank can buy a Treasury bond, paying for it by
"printing money." The money from this sale typically ends up at a
bank -- although, you should notice that the money was not directly given to
a bank. It was given to the seller of the bond, in trade for the bond. This
additional base money is often lent out on the interbank market, thus
creating a tendency toward lower interest rates. However, who is it lent to?
That is up to the receiving bank to decide. To someone solvent, presumably,
rather that to an insolvent entity.
An entity can remain in
business even if it is insolvent, if someone keeps lending them money. You
can probably identify many households with that characteristic. The bankrupt
S&Ls, like those of Texas, stayed in business for years in the 1980s
because FDIC deposit insurance kept people from withdrawing their deposits.
The central bank was
never meant to prop up weak institutions. Sometimes it is difficult for a lay
person to recognize the difference between bank illiquidity and insolvency,
but bankers understand well. Typically, an institution will be weak for
months or years, due to deteriorating asset quality (bad loans etc.), before
they suffer the final collapse in liquidity ("bank run").
Thus, in the Great
Depression, banks which were weak -- those that had made too many real estate
loans during the Florida property bubble for example -- were expected to go
under. After all, they didn't know they were in the Great Depression. That
label was applied many years later.
After the Great
Depression, it was determined that the government should have some role in
preventing a "systemic collapse." Probably they should have
"prevented" it by not hiking taxes to the moon. Central banks were
not supposed to be government agencies, but rather something like a banking
industry association, or simply a dominant commercial bank like the Bank of
England was. Since central banks were already in existence to "make
loans to banks," to serve as a "lender of last resort", etc.
etc., this new government role was laid upon the existing central bank
organization.
I am not particularly
opposed to government support of the financial system to prevent
"systemic collapse." (I put it in quotes because it is complicated
to define or describe, but everyone knows what I'm talking about.) Typically,
as in Japan or the U.K. recently, or in many other countries with banking
problems, this has taken the form of a direct government loan to the bank. In
the U.S., however, people seem to look to the Federal Reserve for this role.
By making a loan to the bank, the government acts as the Lender B we
described last week. Note that this is a loan. It is supposed to be paid
back, just like a commercial loan. If it is not paid back, the bank is bankrupt
just as if it defaulted on a commercial borrowing. Thus, ideally,
"taxpayers" get all their money back. The government's role is to
step in when fears of insolvency prevent a significant financial institution
from finding another lender. The government turns something of a blind eye to
asset deterioration, in recognition of the risk of "systemic
collapse." In the midst of high drama, it is hard to tell what assets
are worth anyway. The Fed, via its discount window lending and other such
direct facilities (we seem to get a new one every week these days), is also
able to turn a blind eye to asset deterioration. This isn't really
"nationalization" either, as the government doesn't have any
ownership in the bank (equity). The bank would be nationalized, at least
partially, if the government recapitalized it. However, even this is not
really a "bailout" in the sense of free money. Existing
shareholders would be diluted, and likely take a loss overall.
This lending doesn't
really do much for insolvency, alas. Lending affects the Liabilities side of
the balance sheet, but not the Assets side. If assets are deteriorating,
lending can't help. However, it prevents a fire sale of assets, and also
takes care of short-term liquidity issues, which alleviates the "systemic"
risk. If the bank has troubles but manages to right itself, it eventually
pays back the goverment loan and continues as a
regular bank. If the bank is unable to right itself, then it has an
"orderly liquidation" or perhaps a sale and merger with another
entity.
The Fed has invented many
different types of "loans," including repo agreements and various
swaps. They generally function much like loans, however.
Unlike the government, or
other commercial entities, the Fed actually creates fresh money when it makes
a loan. In many cases, this fresh money is likely "sterilized" via
the interest-rate targeting mechanism, so that overall base money doesn't
necessarily change much. In effect, the Fed's assets show an increase in
lending, and a decrease in securities related to open-market operations,
mostly government bonds. Indeed, the recent swap facility accomplishes this
rather directly. Roughly 50% of the Fed's capacity to make direct
loans/swaps/repos/etc. has apparently been used thus far, for a total of $400
billion of such activities on an $800 billion-ish
balance sheet. The Fed can't exceed its $800 billion-ish
without resorting to direct money-printing. It would be rather exciting if we
got that far.
All in all, I don't think
the Fed has done anything particularly unseemly thus far regarding its
lending activities. Probably a rather good job, given the situation. The
problem is that, while doing so, the Fed is allowing the currency to become a
big problem. Also, the Federal government should at least ready itself to
take a bigger role, perhaps by recapitalizing financial institutions, or by
making additional loans if the Fed's capacity to do so is exhausted.
Notice that we haven't
once mentioned either interest rate manipulation or changes in currency
value. The Lender of Last Resort function is independent of these later
functions, which didn't really come to full bloom until after 1971. Thus, we
see that the role of the government/central bank (it should really be the
government instead of the central bank) in preventing "systemic
collapse" does not require a floating currency or interest rate
manipulation, or even a central bank. Nor are these functions contrary to a
gold standard. A gold standard just keeps the value of the currency stable.
That's all it does.
Later, we will talk about
floating currencies and interest rate manipulations, and how those are also
outgrowths of the Great Depression.
* * *
Bailout Watch: If there's anything happeni
ng that most resembles a
"bailout," it is the defacto
nationalization of Fannie Mae and Freddie Mac last week. Fannie and Freddie
plan on buying $200B up to "trillions" of mortgage paper. Doug
Noland of prudentbear.com has the details. Like other closet Mogambo fans, he seems to share a fondness for Dramatic
Capitalization!
http://www.safehaven.com/article-9751.htm
* * *
People talk about the
S&L "bailout." S&Ls weren't "bailed out." They
were liquidated. However, the depositors were FDIC guaranteed, up to a
certain point. Thus, the depositors got their money back. It was the
depositors that were bailed out. There was a lot of thievery and fraud going
on at the time too, mostly within the government (and the Bushies
were heavily involved), to pocket a piece of this bailout for themselves.
Then, the S&L assets were liquidated. This was another great chance for
certain insiders to make a bucket of easy money. They just sold themselves
loans/assets that were worth perhaps $0.50 or $0.20 for $0.02. I believe they
even got easy government financing to buy these loans. Thus, they had $0.02,
but bought $5.00 of loans for $0.20, using 10x leverage. This is pretty much
like hitting the lottery, except that no luck is involved. Bankruptcy and
liquidation are great times to make a lot of money, without much risk, when
nobody is noticing.
* * *
Interesting little essay
on similar themes here:
The Shadow of the Depression and the Lesson
the '70s
* * *
Nice series of articles
on naked shorting of smallcap stocks, by the CEO of
Overstock.com, Patrick Byrne. This is some serious research by a smart guy,
who has experienced this first hand.
http://community.overstock.com/deepcaptureblog/
* * *
Meanwhile, back at the
ranch ... MBIA and Ambac are still without plan or
rescue (although Ambac has a little more capital),
and the housing/mortgage market continues to deteriorate. Now, we're starting
to get economic issues like job loss and declining revenues. I think that
this year, the housing market is going to start seeing some "give
up." Prices are still way too high. We could get a
"dislocation" to the downside.
The Subprime Crisis is Just
Starting
Nathan
Lewis
Nathan Lewis was formerly the chief international economist
of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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