Browsed by
Tag: bailout

Cyprus and the Unraveling of Fractional-Reserve Banking – Article by Joseph T. Salerno

Cyprus and the Unraveling of Fractional-Reserve Banking – Article by Joseph T. Salerno

Comments 0 Comment
The New Renaissance Hat
Joseph T. Salerno
March 30, 2013
******************************

[Originally posted on Circle Bastiat, the faculty blog of the Mises Institute. Read Circle Bastiat for Austrian analysis of current economic events from today’s top Misesian and Rothbardian economists.]

The “Cyprus deal” as it has been widely referred to in the media may mark the next to last act in the the slow motion collapse of fractional-reserve banking that began with the implosion of the savings-and-loan industry in the U.S. in the late 1980s.

This trend continued with the currency crises in Russia, Mexico, East Asia, and Argentina in the 1990s in which fractional-reserve banking played a decisive role. The unraveling of fractional-reserve banking became visible even to the average depositor during the financial meltdown of 2008 that ignited bank runs on some of the largest and most venerable financial institutions in the world. The final collapse was only averted by the multi-trillion dollar bailout of U.S. and foreign banks by the Federal Reserve.

Even more than the unprecedented financial crisis of 2008, however, recent events in Cyprus may have struck the mortal blow to fractional-reserve banking. For fractional-reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system.

Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace).

Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity—especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.

Getting back to the Cyprus deal, admittedly it is hardly ideal from a free-market point of view. The solution in accord with free markets would not involve restricting deposit withdrawals, imposing fascistic capital controls on domestic residents and foreign investors, and dragooning taxpayers in the rest of the Eurozone into contributing to the bailout to the tune of 10 billion euros.

Nonetheless, the deal does convey a salutary message to bank depositors and creditors the world over. It does so by forcing previously untouchable senior bondholders and uninsured depositors in the Cypriot banks to bear part of the cost of the bailout. The bondholders of the two largest banks will be wiped out and it is reported that large depositors (i.e., those holding uninsured accounts exceeding 100,000 euros) at the Laiki Bank may also be completely wiped out, losing up to 4.2 billion euros, while large depositors at the Bank of Cyprus will lose between 30 and 60 percent of their deposits. Small depositors in both banks, who hold insured accounts of up to 100,000 euros, would retain the full value of their deposits.

The happy result will be that depositors, both insured and uninsured, in Europe and throughout the world will become much more cautious or even suspicious in dealing with fractional-reserve banks. They will be poised to grab their money and run at the slightest sign or rumor of instability. This will induce banks to radically alter the sources of the funds they raise to finance loans and investments, moving away from deposit and toward equity and bond financing. As was reported Tuesday, March 26, this is already expected by many analysts:

One potential spillover from the March 26 agreement is the knock-on effects for bank funding, analysts said. Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.

The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds—known as CoCos—to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, said Chris Bowie at Ignis Asset Management Ltd. in London.

“We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity,” said Bowie, who is head of credit portfolio management at Ignis, which oversees about $110 billion.

If this indeed occurs it will be a significant move toward a free-market financial system in which the radical mismatching of the maturities of assets and liabilities in the case of demand deposits is eliminated once and for all. A few more banking crises in the Eurozone—especially one in which insured depositors are made to participate in the so-called “bail-in”—will likely cause the faith in government deposit insurance to completely evaporate and with it confidence in the fractional-reserve banking system.

There may then naturally arise on the market a system in which equity, bonds, and genuine time deposits that cannot be redeemed before maturity become the exclusive sources of finance for bank loans and investments. Demand deposits, whether checkable or not, would be segregated in actual deposit banks which maintain 100-percent reserves and provide a range of payments systems from ATMs to debit cards.

While this conjecture may be overly optimistic, we are certainly a good deal closer to such an outcome today than we were before the “Cyprus deal” was struck. Of course we would be closer still if there were no bailout and the full brunt of the bank failures were borne solely by the creditors and depositors of the failed banks rather than partly by taxpayers. The latter solution would have completely and definitively exposed the true nature of fractional-reserve banking for all to see.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org. Send him mail. See Joseph T. Salerno’s article archives.

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

Comments 0 Comment
The New Renaissance Hat
Gerald P. O’Driscoll, Jr.
July 15, 2012
******************************

JPMorgan Chase & Co., one of the nation’s leading banks, revealed in May that a London trader racked up losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank originally stated the trades were done to hedge possible losses on assets that might suffer due to Europe’s economic woes. There is now doubt whether it was a hedge or just a risky financial bet.

A hedge is a financial transaction designed to offset possible losses in an asset or good already owned. The classic hedge occurs when a farmer sells his crop in a futures market for delivery at a specified date after harvesting. He sells today what he will only produce tomorrow, and locks in the price. If the price at harvest time is lower than today’s price, he makes money on the forward contract, while losing a corresponding amount of money on the crops in the ground. In a perfect hedge the gains and losses should exactly offset each other.

How did JPMorgan suffer such large losses on its hedges, and what are the lessons?

It appears the London trader entered into financial transactions on the basis of observed relationships among various bond indices. The market relationships broke down. The indices moved differently from what historical patterns or financial models predicted. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management (LTCM) in 1998 and a number of others during the financial meltdown of 2007–08.

LTCM invested the money of rich clients in financial bets based on the expected relationships among the prices of various assets. According to Nicole Gelinas in After the Fall: Saving Capitalism from Wall Street—and Washington, at the time of its collapse LTCM had $2.3 billion of client money. By borrowing, it leveraged that investment 53 to 1. Further, it employed derivatives to further magnify its bets so that its total obligations were a fantastic $1.25 trillion.

A derivative is any security whose price movements depend on (are derived from) movements in an underlying asset. “Puts” and “calls” on equity shares are relatively simple derivatives familiar to many. Asset prices, like various bonds, move in predictable ways with respect to each other, and values of derivatives linked to the assets similarly move in a predictable fashion with respect to the prices of the underlying assets—in normal times.

But the summer of 1998 was not a normal time. There was turmoil in Asian financial markets, then Russia threatened to default on its domestic debt. Global credit and liquidity dried up, and LTCM could not fund itself. It collapsed spectacularly.

A decade later there was turmoil in housing finance. The housing bubble was bursting. Mortgage lenders were under pressure, and some were failing. Many mortgages had been packed together in mortgage-backed securities, which were sold to or guaranteed by Fannie Mae and Freddie Mac. Fannie and Freddie, allegedly private entities but in reality guaranteed by the government, were failing. Lehman Brothers, an investment bank, was heavily involved in housing finance; it borrowed short-term, even overnight, to finance long-term holdings; it employed heavy leverage; and it made liberal use of derivatives contracts. It declared bankruptcy on September 15, 2008.

The specifics varied between 1998 and 2008, and between LTCM and Lehman. But the reliance on certain asset prices moving in predictable fashion was one shared element. So, too, was the heavy use of borrowed money (leverage) and the reliance on derivatives contracts. The volatility of complex derivatives contracts led legendary investor Warren Buffett to characterize them as “financial weapons of mass destruction.”

The Usual Suspects

In short there is nothing new in what happened to JPMorgan. It claimed it was not trying to make risky financial bets, but hedge risks already booked on its balance sheet. While details of the trades that led to losses are sketchy at this writing, they apparently employed both leverage and derivatives. As documented here, these are elements present in major financial blowups and collapses going back decades (and further). LTCM, Lehman, and Fannie and Freddie all thought they had at least some of their risks hedged. But hedges have a tendency to unravel just when needed most: in times of financial turmoil. Even so, financial institutions permit their traders to make the same kinds of dangerous bets over and over again. We used to have financial crises every decade or so. Now the cycle seems to be halved.

In the past I have dubbed today’s banking practice of placing dangerous financial bets “casino banking.” It differs little from the activities conducted at gaming tables in Las Vegas and has little or no reference to the fundamentally healthy activity of matching viable businesses with capital and credit.

In a Cato Policy Analysis, “Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation,” Kevin Dowd and three coauthors examined some of the technical problems with standard risk models used by large banks. It is an exhaustive analysis, and I commend it to those interested. The authors delve into many issues, but concentrate on the many flaws of the complex mathematical models used by banks to control risks.

In August 2007 Goldman Sachs Chief Financial Officer David Viniar puzzled over a series of “25-standard deviation moves” in financial markets affecting Goldman. (Returns deviated from their expected values by 25 standard deviations, a measure of volatility.) Such moves should occur once every 10-to-the-137th-power years if the assumptions of the risk model were correct (a Gaussian, or “normal,” distribution of returns). As Dowd and his coauthors put it, “Such an event is about as likely as Hell freezing over. The occurrence of even a single such event is therefore conclusive proof that financial returns are not Gaussian—or even remotely so.” And yet there were several in a matter of days. In Dowd & Co.’s telling, the models lie, the banks swear to it, and the regulators pretend to believe them. All of this goes to answer how the losses at Morgan might have happened. Traders rely on flawed models to execute their trades.

Now to the Lessons

Major financial institutions continue to take on large risks. Why? Assume the trades made by Morgan really were to hedge the bank’s exposure to events in Europe. That implies, of course, that risky investments had already been put in place (since they then needed to be hedged). Additionally, the risks were so complex that even a highly skilled staff (which Morgan certainly employs) could not successfully execute hedges on them.

Reports indicate that senior management and the board of directors were aware of the trades and exercising oversight. The fact that the losses were incurred anyway confirms what many of us have been arguing. Major financial institutions are at once very large and very complex. They are too large and too complex to manage. That is in part what beset Citigroup in the 2000s and now Morgan, which has until now been recognized as a well-managed institution.

If ordinary market forces were at work, these institutions would shrink to manageable sizes and levels of complexity. Ordinary market forces are not at work, however. Public policy rewards size (and the complexity that accompanies it). Major financial institutions know from experience that they will be bailed out when they incur losses that threaten their survival. Morgan’s losses do not appear to fall into that category, but they illustrate how bad incentives lead to bad outcomes.

Minding Our Business

Some commentators have argued that politicians and the public have no business in Morgan’s losses. Only Morgan’s stockholders, who saw its share price drop over 9 percent in one day, and senior management and traders who lost their jobs should have an interest. But in fact losses incurred at major financial institutions are the business of taxpayers because government policy has made them their business.

Large financial institutions will continue taking on excessive risks so long as they know they can offload the losses onto taxpayers if needed. That is the policy summarized as “too big to fail.” Let us not forget the Troubled Asset Relief Program (TARP), signed into law by President George W. Bush in October 2008. It was a $700 billion boondoggle to transfer taxpayer money to stockholders and creditors of major banks—and to their senior management; don’t forget the bonuses paid out of the funds.

Banks may be too big and complex to close immediately, but no institution is too big to fail. Failure means the stockholders and possibly the bondholders are wiped out. Until that discipline is reintroduced (having once existed), there will be more big financial bets going bad at these banks.

Changing the bailout policy will not be easy because of what is known as the time-inconsistency problem. Having bailed out so many companies so many times, the federal government cannot credibly commit in advance not to do so in the future. It can say no to future bailouts today, but people know that when financial collapse hits tomorrow, government will say yes once again. The promises made today will not match the government’s future actions. There is inconsistency between words and deeds across time.

What to do in the meantime? The Volcker Rule was a modest attempt to rein in risk-taking. Former Fed Chairman Paul Volcker wanted to stop banks from making risky trades on their own books (as opposed to executing trades for customers). Industry lobbying has hopelessly complicated the rule and delayed its issuance.

Morgan’s chief executive officer, James Dimon, asserted the London trades would not have violated the rule. If true, it suggests that an even stronger rule needs to be in place. Various suggestions have been made to address excessive risk-taking by financial firms backed by the taxpayers. It is time to take them more seriously.

Gerald O’Driscoll is a senior fellow at the Cato Institute. With Mario J. Rizzo, he coauthored The Economics of Time and Ignorance.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Fed: Mend It or End It? – Article by Ron Paul

The Fed: Mend It or End It? – Article by Ron Paul

Comments 0 Comment
The New Renaissance Hat
Ron Paul
June 3, 2012
******************************

In early May 2012, I held a hearing to examine the various proposals that have been put forth both to mend and to end the Fed.  The purpose was to spur a vigorous and long-lasting discussion about the Fed’s problems, hopefully leading to concrete actions to rein in the Fed.

First, it is important to understand the Federal Reserve System.  Some people claim it is a secret cabal of elite bankers, while others claim it is part of the federal government.  In reality it is a bit of both.  The Federal Reserve System is the collusion of big government and big business to profit at the expense of taxpayers.  The Fed’s bailout of large banks during the financial crisis propped up poorly-run corporations that should have gone under, giving them a market-distorting advantage that no business in the United States should receive.  The recent news about JP Morgan is a case in point.  JP Morgan, a recipient of $25 billion in bailout money, recently announced it lost another $2 billion.  If a corporation shows itself to be a bottomless money pit of “errors, sloppiness and bad judgment,” the Fed shouldn’t have expected $25 billion in free money to change that or teach anyone a lesson in fiscal discipline.  But it determined that this form of deliberate capital destruction was preferable to one business suffering bankruptcy.  Clearly, some changes need to be made.

Several reforms for the Fed were discussed at the hearing.  One was a call for the full-employment mandate to be repealed, in order to allow the Fed to focus solely on stable prices.

Another reform calls for changes to the composition of the Federal Open Market Committee.  Still another proposal was for outright nationalization of the Fed or of its functions.  But if what the Fed does now is bad and inflationary, allowing the Treasury to print and issue money at-will would be even worse, and could possibly lead to a Weimar-like hyperinflation.

The problems and advantages of the gold standard were discussed at the hearing.  The era of the classical gold standard was undoubtedly one of the greatest eras in human history.  For a period of several decades in the late 19th century, the West made enormous advances.  However, the gold standard was still run by government.  The temptation to suspend gold redemption reared its head again with the outbreak of World War I.  Once the tie to gold was severed and fiscal restraint thrown to the wind, undoing the damage would have required great fiscal austerity.  Instead, the Western world proceeded to set up a gold-exchange standard which lasted not even a decade before easy money led to the Great Depression.

While returning to the gold standard would certainly be far better than maintaining the current fiat paper system, as long as the government retains the power to go off gold we may end up repeating the same mistakes.

The only viable solution is to get government out of the money business permanently.  The way to bring this about is through currency competition: allow parallel currencies to circulate without receiving any special recognition or favor from the government.  Fiat paper monetary standards throughout history have always collapsed due to their inflationary nature, and our current fiat paper standard will be no different.

It is imperative that the American people be educated on the dangers of the Fed and the importance of restoring sound money.  The laying of the groundwork must begin today, so that the American people will be prepared for the day when the mirage the Fed has created evaporates completely.  The full hearing footage is available on my website, and I would encourage every American to take a look.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Eliminating Most Foreclosures: An Innovative and Just Approach to Mortgage Delinquencies

Eliminating Most Foreclosures: An Innovative and Just Approach to Mortgage Delinquencies

Comments 2 comments
The New Renaissance Hat
G. Stolyarov II
March 25, 2012
******************************

The economic and personal consequences of foreclosure are devastating. Foreclosures leave behind not only blighted neighborhoods, but ruined lives. Furthermore, during the past three years, immense abuses of the foreclosure process have come to light – with numerous banks being found to have improperly foreclosed on thousands of homeowners. The banks have either been unable to produce documentation that demonstrated their right to foreclose – or, worse, have foreclosed on individuals who were never even delinquent or did not have mortgages in the first place (see, for instance, here, here, and here). The violations of due process, private-property rights, and the rule of law have been astounding.

At this point, any solution that can reduce the number of foreclosures will be a welcome benefit to individual liberty, the US economy, and millions of Americans. Indeed, the concept of foreclosure – the expropriation of one’s home – resulting from a few late payments has always struck me as draconian. It disregards one fundamental fact: the homeowner has equity in his or home, even if he or she fails to make a few scheduled payments. So, suppose that a homeowner has a $150,000 outstanding mortgage loan on a home whose market value is $200,000. This means that the homeowner’s equity in the home is $50,000 – or one quarter of the home’s value. If the homeowner fails to make a $1000 hypothetical monthly payment on time, why is the bank entitled to appropriate the entire home and thereby deprive the homeowner of the entire $50,000 in equity? Suppose, as is often the case these days, that the foreclosure proceedings drag on for a year. A 5000% annual rate of interest for that one delinquent payment is quite steep indeed!

While delinquencies ought to be penalized, wholesale expropriation of a home is an unnecessary and disproportionate response in most cases. It would not have been possible on a truly free market, where roughly equal negotiating power would exist between lenders and borrowers. In today’s politicized financial environment, however, the large banks receive all of the privileges: bailouts, loan guarantees, access to “free money” from the Federal Reserve, barriers to entry for smaller competitors, the ability to “securitize” personal loans through means of dubious accountability, the ability to flout laws such as those pertaining to mortgage modifications, and a swiftly operating “revolving door” between bankers and politicians. Thus, homeowners are often left to acquiesce to terms that are far harsher than what they could have gotten for themselves in a truly free market.

A more equitable solution, that recognizes that the real value of the homeowner’s equity, is not to foreclose, but rather to reduce the homeowner’s equity for each delinquent payment. If the homeowner fails to make a scheduled payment, then the bank should be able to recoup its resulting losses – by seizing the portion of the homeowner’s equity corresponding to the amount of the delinquency, perhaps also incorporating an interest charge at the prevailing market rate. Only when all of the homeowner’s equity has been exhausted in this way should the bank have the right to foreclose. In today’s housing market, where many homes are “underwater” (i.e., the mortgage balance exceeds the market price, which has declined precipitously since the days of the housing bubble), this solution would still mean that some foreclosures would occur. But the number of foreclosures would be greatly reduced, and the majority of currently planned foreclosures would never occur. Furthermore, the “underwater” homeowners could still be helped by downward principal modifications that recognize the illusory and unsustainable nature of the inflated market prices that existed during the housing bubble and that were fueled by the expansionary monetary policy of the Federal Reserve. Homeowners should not be made to suffer for the Federal Reserve’s blunders.

Under my proposed approach, the mere involuntary loss of one’s job, or a catastrophic illness, would not put one’s place of shelter in immediate jeopardy. Rather, in the time that it takes for the homeowner’s equity to be exhausted, the homeowner would have the opportunity to attempt to regain his or her employment or health. Furthermore, with fewer foreclosures, the unsightly, wasteful, and dangerous effects of neighborhood blight would be greatly scaled back. A homeowner will still largely maintain his or her residence, even if he or she cannot make a regular mortgage payment. But once a home enters foreclosure, it suffers from deterioration and decrepitude at best – and outright vandalism and destruction at worst.

In rolling back the political privileges of the large banks, it is essential to compensate ordinary, law-abiding, innocent homeowners for the damage that these special privileges have wrought. The benefits of years of hard work and consistent mortgage payments should not be nullified overnight by a single delinquency. Over a year ago, in “Wrongful Foreclosures and the Free Market”, I advocated breaking up the bailed-out banks and declaring a temporary moratorium on foreclosures. Rewriting foreclosure law to require the exhaustion of the homeowner’s equity before a foreclosure can be initiated can be another step to wipe out most foreclosures at the stroke of a pen – while restoring an outcome more compatible with individual liberty, true market freedom, and natural justice.