When UR moved from Blogspot to Moldbug’s (?) own site, all the comments were left on the floor. This is a pity, because his comment sections had some of the best commenting and writing I ever saw. The best of the lot was Michael S., who seems to have been a middle-American aristocrat of Scots-Irish extraction whose family also held some estates in Scotland. Below, I post some of his old (good heavens, more than 10 years ago!) posts on money and banking, without editing except where I snip off opening salutations (marked by brackets). They are long, but I assure you they are well worth taking an hour or two to read through. You won’t often encounter material of such quality.
P.S. to Michael S. in the unlikely case that he happens upon this: sir, I apologize for republishing your content without permission. If I may claim extenuating circumstances, it was previously posted in a public forum and stayed up for almost a decade. And if I may further presume upon no acquaintance at all, please drop me an e-mail.
November 15, 2007 at 2:01 PM:
The benefit of the gold standard is that it is not utterly manipulable by politicians, because there is a finite amount of gold in the world (including what is still in the earth’s crust). The detriment of the gold standard is that the supply of specie cannot increase in proportion to real increases in the total amount of wealth. And there has been a real increase in wealth, as measured by improvement in the general standard of living. The probably unreachable ideal is a currency that represents a constant unit of purchasing power.
The hazard of the fractional-reserve gold standard as historically administered was that when the gold reserves that backed a circulating currency fell (due perhaps to a transfer from one nation’s central bank to another), the amount of currency in circulation also fell, and by a multiple of the amount by which the reserve contracted. This led to periodic liquidity crises like the panics of 1893 and 1907.
The pressure for bimetallism – William Jennings Bryan’s pet cause of “free coinage of silver at a ratio of 16 to 1 with gold” – arose from these panics. It was basically a plea for inflation, put in the only terms that a society which expected currency to be backed by a precious metal was willing to accept. The silver content in old U.S. coins is worth the face amount when silver is priced at $1.29 per ounce. The 16:1 ratio between the prices of silver and gold had roughly obtained through most of the 18th and early 19th centuries, but in the late 19th century the Comstock lode was discovered, and silver fell to a market price of perhaps 35 cents per ounce. This makes clear the extent of the inflation that Bryan proposed as a remedy for the evils of the panic of 1893, which he correctly understood was the result of the operation of fractional-reserve central banking based on a gold standard.
It is interesting to note that in the late 19th century, as great a political difference existed between the gold Democrats (exemplified by Grover Cleveland) and the silver Democrats (whose spokesman was Bryan) as did between Democrats generally and Republicans. Cleveland is a much underappreciated president. Mencken said that he was a good man in a bad job, which seems about right to me.
The torch of the silver Democrats was, in a little-noted way, passed to Franklin Roosevelt early in his presidency, when legislation was passed enabling him to cause silver to be coined freely at 16:1 with gold. He opted not to use this authority, choosing instead to devalue the dollar relative to gold by a lesser amount, and restricting the private ownership of gold. The time is within fairly recent memory when American citizens could not lawfully own gold bullion or coins that were not deemed numismatically collectible.
The key to the successful function of the gold standard appears to me to lie in the skillful administration of central banking. Not only that, but the premises of that central banking practice must be accepted by all of the developed economies in the world. In examining the last period of history in which this was true, roughly speaking a century between the conclusion of the Napoleonic wars and the inception of World War I, the purchasing power of the pound remained remarkably constant. It is noteworthy that during this period, the central banks were privately operated. The Bank of England remained private until the time of Attlee and the United States had J.P.Morgan as its unofficial central banker.
Morgan’s command of the knowledge necessary for successful central banking would undoubtedly have put Greenspan’s to shame, were there a way to compare the two men. Morgan’s mathematical genius is little known or credited today. He was said to figure out his foreign currency arbitrage transactions for the day at the breakfast table before going in to his office. Morgan was educated at Göttingen. It is said that when he let his tutors know he was returning to his father’s banking business, they told him he was making a mistake, and should stay, because he had a shot at becoming a professor. To put this in perspective, the leading mathematician at Göttingen at the time was Karl-Friedrich Gauss.
The Great Depression, as Milton Friedman and others demonstrated, was not caused by “market failure” as claimed by Keynes, but by the ineptitude of the central banks after World War I. The Bank of England bears some of the blame for trying to restore the gold standard at the previous valuation of the pound after its wartime inflation. Nonetheless, the Federal Reserve system in the United States was worse, and its response to the crash of 1929 was clumsy and wrongheaded. It may usefully be contrasted with Morgan’s handling of the panics of 1893 and 1907.
Central banking may not be able to prevent a panic or crash, but it can and should try to avoid causing one, while its response in the aftermath can make the difference between a brief contraction and a protracted depression like that of the ‘thirties.
Of the New Deal we must observe that not only didn’t it end or even very much mitigate the Depression, but worsened and lengthened it. Furthermore, the appeal of Keynesianism during this period lay almost entirely in serving to provide an intellectually respectable pretext to do what politicians wanted to do, and were in fact already doing when Keynes’s “General Theory” was published in 1936. As analysis, it is hard to imagine anything more perversely wrong, this side of Marxism.
January 3, 2008 at 11:42 AM:
I do not think the subprime mortgage collapse is so fundamentally related to the nature of fractional reserve banking. It is more simply explained by the perverse incentives created by the system of loan origination followed by securitization.
When a traditional mortgage lender makes a loan, the lender owns 100% of it and retains it to maturity. There is accordingly a strong incentive to assure the borrower’s creditworthiness and the adequacy of the collateral. Such a lender will probably insist upon a loan-to-value ratio no greater than 80% , so that even if the loan ends up in foreclosure and the property has to be sold at a distressed price, there will be no loss of principal – the amount by which the balance sheet account for “other real estate owned” is reduced will be equalled or exceeded by the addition of the proceeds of the foreclosure sale to “cash on hand and due from banks.”
The subprime mortgage situation was created by a departure from this system. Mortgage loans were originated by mortgage brokers who then bundled them into securities which were sold to financial institutions. Theoretically, this should reduce risk by spreading it, in the same way reinsurance reduces the risk of an insurance underwriter. In other words, instead of one lender taking the entire loss when a loan it has originated and held goes sour, a small fraction of the loss is borne by each of the many holders of the securitized mortgage portfolio. This advantage, however, is negated in practice because these mortgage brokers have had little incentive to assure the quality of their loans. Their primary incentive is to get the origination fees associated with each loan made and sold. Inflated appraisals are favored (I am personally acquainted with one appraiser that could get no work from mortgage brokers because his valuations were too conservative) and unacceptably large loan-to-value ratios are allowed in pursuit of that end. The buyers of the securitized mortgages, on the other hand, were given an unrealistic expectation that the loans were sound. The situation was inherently unstable.
Anyone who has observed the market for housing will be aware that the critical determinant of a buyer’s ability to own a house is not its price, but the monthly mortgage payment, which is a product of the prevailing interest rate and the price of the house. Most of the troubled subprime mortgage securities represent adjustable rate mortgages. The risk of the subprime borrower is that if he has bought a house at a payment close to the maximum he can afford (e.g. 1/3 of disposable monthly income) at a low interest rate, when the rate adjusts upward he will be obliged to make a payment he cannot afford. Such borrowers end up putting their houses on the market. When enough do, the resultant oversupply leads to a fall in price, so the collateral of the mortgages is soon under water, and when the inevitable foreclosures take place the lenders are not able to recover all their principal. We then have a classic liquidity crisis of the sort that good central banking is supposed to forestall.
An aggravating factor is the perverse tax incentive given to investment in residential real estate. The current tax code exempts almost all capital gains resultant from the sale of residential real estate from taxation. On the other hand, long-term capital gains on the sale of marketable securities are taxed at a Federal rate of 15%, and other capital gains may be taxed at rates up to 28%. It should be obvious that this has had a substantial role in creating the circumstance that the largest asset possessed by most working- and middle-class Americans is a house.
It should be evident from all the above – whatever criticisms might be made of fractional-reserve banking – that it is not, by itself, the cause of the subprime mortgage collapse. Rather, that collapse is the result of a combination of incentives that are products of the structure of taxation and regulation. It is worth pointing out that almost any time one hears the word ‘deregulation’ what it in fact means is selective relief from regulation. Traditional mortgage lenders (e.g. community banks) still have their loan portfolios strictly examined by state banking commissions, the FDIC, Comptroller of the Currency, etc. On the other hand the sort of loan production offices that have been set up in strip malls or office buildings by the mortgage brokers which originated most of the subprime mortgages has been almost completely unregulated. This selective relief from regulation has contributed to the entirely predictable results. Very few traditional mortgage lenders own bad loans.
January 24, 2008 at 10:33 AM:
I agree that gold, or some other commodity of which there is a supply not manipulable by government, would be a better basis for a currency of stable value than we have today. However, history shows that even specie standards have been repeatedly manipulated by states. Inflation happens because it is in the interest of the state (as defined by the politicians in charge of it).
The original currency of the Roman republic was the as, a copper bar weighing one Roman pound (12 oz.) The difference between this Roman pound and the present pound troy is negligible enough that for practical purposes they may be considered the same. The as was reduced from 12 oz. to 4 oz. in about 268 BC after the war with Pyrrhus, again to 2 oz. in 242 BC at the end of the first Punic war, to 1 oz. in 217 BC at the beginning of the second Punic war, and in 89 BC to 1/2 oz. during the Social war. The Lex Valeria of 86 BC allowed debtors to take advantage of the last devaluation in that they only had to pay 1/4 of their debts.
The devaluation of the as led to the introduction of a new unit of currency, the sesterce, worth 2-1/2 (semis tertius) asses. It is in sesterces that we find most ordinary transactions expressed during the time of the late republic and early principate. Four sesterces made a denarius. By the time of the Antonines (I have in my collection a denarius of Antoninus Pius) the denarius was a silver coin a little bigger than a modern dime.
These monetary units had a long survival, their descendants circulating in most of medieaval Europe. The denarius became the English penny and as such was debased on numerous occasions. Finally it became impossible to maintain it as a silver coin at all. Copper halfpennies were introduced tempore Elizabeth I and the ‘cartwheel’ penny that circulated in Britain until the late nineteen-sixties was introduced temp. George III. The sesterce, of course, was represented by the farthing, a coin about the size of the present U.S. cent. If one considers what 40% of an old copper U.S. cent (they are now copper-washed zinc) would be worth, one has the current value of the Roman as after 2,300 years of inflation!
England preserved the value of the old Roman units of coinage better than did most of the nations on the Continent. Twelve denarii made a solidus (shilling). The British shilling was a silver (later cupro-nickel) coin about the diameter of a quarter, and a little thicker. In France the solidus became a billon, later a copper coin of very low value – the sou. Twenty of these made up the livre, which by the time of the French revolution was a coin about the size of the 19th and early 20th-c. silver franc. So, when one says “I haven’t a sou” one is very poor indeed.
It is certainly more difficult to trick the citizenry by debasing the metal of coinage or reducing its size than it is by, say, cutting the discount rate by 75 basis points. Nonetheless, people wise up sooner or later. I recall touring through Argentina and Brazil in the early 1980s, when both those countries were experiencing severe inflation, the effects of which were palpable from week to week. Every hotel or retail store had a little exchange window at which foreign tourists could get a supply of the local shinplasters. The operators of these places were, I suspect, rather sophisticated arbitrageurs. If one presented a traveller’s cheque rather than American or European currency, they would always ask that it not be dated. They’d fill in the date a week or two later, I suspect, and get more of the local currency than they could have done had they cashed it immediately.
I do not think that fractional-reserve banking (in “blue dollars”) is possible to eliminate. It grew up outside the state, even before the Medicis started broking pawn, and will continue outside the state, because banks are not the only sources of credit. As long as there is credit, there will be monies of account and some sort of bills of exchange, even if all these are are the little chits one used to get from the manifold books of grocers and druggists when buying on open account from them as one did when I was a boy.
The way to have sound money is rather to manage fractional reserve banking properly under a gold standard, as (for example) it was done by the Bank of England from about the end of the Napoleonic Wars to the beginning of World War I. During that approximately century-long period, the pound was very stable and price levels fluctuated very little. It is worth noting that during this period the Bank of England was privately owned (mostly by the Cavendishes, the family of the dukes of Devonshire). The most drastic inflation of the pound took place subsequent to its nationalization in 1946 under the Attlee-Cripps Labour government, illustrating my initial point that inflation takes place because politicians think it is in the state’s (or their own) interest.
October 20, 2008 at 5:57 PM:
I can assure you that banks pay a great deal of attention to the duration both of loans and of deposits and apply sophisticated methods of analysis to balance them. A failure to do so is not the reason for the current financial crisis. There are a great many commercial banks that have not been directly affected by it, and are indirectly affected only because of the financial stresses placed on their customers arising from sources outside the commercial banking system.
The collapse began in the secondary mortgage market, which was for all practical purposes created by Fannie Mae. Fannie Mae (the Federal National Mortgage Association) was created in 1938 as one of FDR’s New Deal Agencies. In 1968, during the Johnson administration, it was spun off the Federal government as a “GSE” (government sponsored enterprise) in order to get its debt off the Federal balance sheet. Shortly thereafter, Freddie Mac (the Federal Home Loan Mortgage Corporation) was created by Congress to compete with Fannie Mae, so that Fannie would not have an effective monopoly. Between them, Fannie Mae and Freddie Mac hold or have guaranteed over 50% of the residential mortgages in the United States.
Many of these mortgages were and are badly undercollateralized and were made to borrowers of doubtful creditworthiness. The GSEs accepted loans of up to 97% of appraised value. Loan originators made their money from origination fees and had little incentive to underwrite their mortgages soundly since they stood to lose nothing if the loans went bad. Furthermore, appraisers learned that they had to be generous in their appraisals in order to do business with the store-front mortgage brokers. An appraiser we use at my bank told us that he could not get work from such operations because his appraisals were too cautious. Thus, not only were the loans undercollateralized at 97% of appraised value, but the appraised values were unrealistically high.
Fannie Mae and Freddie Mac did not operate under the same rules regarding their lending practices and capital-to-assets ratios as do commercial banks. In addition, under HUD supervision, the GSEs were told how to allocate loans. In 1992, Congress pushed them to increase their purchases of mortgages going to low-income borrowers. For 1996 they were given an explicit target – 42% of their loans had to go to borrowers with incomes below the median in their geographic area. In 2000 this target was increased to 50% and in 2005 to 52%. But politically mandated credit allocation did not stop there. For 1996, HUD specified that 12% of the GSEs’ mortgage purchases be ‘special affordable’ loans to borrowers having incomes less than 60% of the median in their areas. This target was increased to 20% in 2000, to 22% in 2005, and to 28% in 2008.
Fannie and Freddie obtained the funds for these loans not by soliciting deposits from the public, as commercial banks do, but by selling bonds, backed by the mortgages they bought – mortgages we now know, and which we should have known all along, were largely unsound. Why didn’t we? First, because a buyer of such investment securities does not and cannot examine each of the mortgages by which they were backed with the same level of scrutiny that he might investigate an individual borrower applying to him for a loan. He instead relies on bond rating agencies like Moody or Standard & Poor to evaluate the obligation. He further looks to bond insurance companies for guarantees of payment. Second, the bond buyer, like the rating agency and the insurance company acting as guarantor, assumes that- whether or not it be explicitly provided by contract – that a GSE has the implicit backing of the U.S. government. As we now know the U.S. government has been called upon in that role, and has accepted it.
The Federal Reserve’s manipulation of interest rates brought about the first wave of defaults, as customers who had borrowed on 5-year adjustable-rate mortgages with balloon payments at the end of their term found they had to re-finance their remaining balances at rates 2 – 3 percentage points higher than they had paid for their first 5 years. It may not seem like a great rise in rates, but when applied to a mortgage on a 25- or 30-year amortization schedule, such an adjustment can nearly double the monthly payment. Since it is not the price of the house but the monthly payment that really dictates whether a buyer can afford it, many of these houses went on the market when their owners could no longer meet their monthly payments. As more houses came on the market than had willing buyers, the prices at which they could clear the market fell. Now many of them were worth less than the outstanding mortgages on them, which had been made at excessive loan-to-value ratios to begin with. The result was a cascading fall in the price of housing, akin to the fall in the price of stocks in 1929, when people who had bought them on margin could not meet their margin calls. In both cases, the bubble was inflated by easy money and excessive leverage, and punctured by a reversal of the easy-money policy. As housing prices fell, mortgages began to go into default; as mortgages began to go into default, mortgage-backed securities began to fall in value.
Investment banks were affected more profoundly by the collapse in the secondary mortgage maket than were commercial banks, because investment banks were more highly leveraged. Those commercial banks that were affected were, not so much because they had bad loans on their books, as because they owned securities that had fallen so badly in value that when marked-to-market they devastated their balance sheets. Bad investments or loans are charged first to loan-loss reserves, then to current earnings, and finally to stockholders’ equity. It does not take many such charge-offs to burn through most or all of a bank’s capital, leaving nothing to support its deposits.
What is most sad and perplexing about this situation is that politicians – not least of them Barack Obama – have presented it to the public as the result of ‘deregulation,’ and the public has largely swallowed their explanation. Yet it is hard to see how bank deregulation, properly so called, has anything to do with it. The principal bank deregulation that has taken place in the past fifteen years was the relaxation of restrictions on interstate branching in 1993 or ’94, and the Gramm-Leach-Bliley act of 1999, which eliminated some of the barriers set up by the Glass-Steagall act between investment and commercial banking. As an owner of an independent community bank neither of these actions was particularly favorable to me, yet I can’t find particular fault with their effects under present circumstances. Interstate branching has probably strengthened commercial banking more than it has weakened it; the soundness of Wells Fargo and U.S. Bancorporation provide examples. Gramm-Leach-Bliley has permitted J.P. Morgan Chase to acquire Bear Stearns, and Bank of America to acquire Merrill Lynch. These former investment banks will now be subject to the stricter reserve requirements of their acquirers, which is all to the good.
The collapse of housing and the secondary mortgage market stemmed not from ‘deregulation’ but from the political allocation of credit through Fannie Mae and Freddie Mac. Now, under the Paulson plan, which has forced the country’s largest banks to accept senior capital investment from the Federal government (and all of the conditions attached to it) whether they want or need it or not, we shall see more, rather than less, politicized allocation of credit.
Alexander Hamilton’s project of a national Bank of the United States horrified Thomas Jefferson and his followers, because they foresaw that political allocation of credit would lead to favoritism, consolidation, monopoly, special privilege, jobbery, patronage, and theft by taxation. The First and Second Banks – the latter killed by Andrew Jackson – did not last long enough to yield the expected results, but in Fannie Mae and Freddie Mac we have seen the fulfillment of these predictions. Yet do you suppose that the voters of Connecticut will ever call Christopher Dodd to account, or those of Massachusetts do likewise of Barney Frank? I don’t. Like beaten dogs they will return to slobber and fawn over the hands that abused them. The worst irony is that these people claim to represent the party of Jefferson and Jackson, while exemplifying everything those historical figures feared and detested.
October 21, 2008 at 12:25 PM:
I can’t speak for other commercial banks, but mine holds no loan at a fixed rate for more than 72 months, which is the same length as our longest-term CD. Mortgage payments may be calculated on a 25- or 30-year amortization schedule, but all of our mortgages so amortized have 5-year terms with a balloon payment at the end, refinanceable at whatever is the then-going rate. Good funds management indeed tries to balance the maturities of loans and of deposits in what MM describes as a Misesian fashion.
The assets of a bank are cash on hand and due from banks (e.g., checks deposited but not cleared are ‘due from banks’), loans, investments, the banking house and its furniture and fixtures. Its liabilities are demand deposits, time deposits, other borrowings, and stockholders’ equity (comprising capital stock at par value, surplus, and undivided profits).
On the asset side one may hold investments (e.g., bonds) for longer terms than one has deposits. Indeed it is necessary to hold them because some large depositors require securities to be pledged against their deposits. Such investments do not need to be held to maturity, but can normally be liquidated at any time by sale. Hence the Misesian requirement to balance maturities of bank assets against bank liabilities isn’t ordinarily called into question by their presence on the balance sheet. The exception, of course, is if the investments have proven to be of less quality than expected, and there is no market for them. I suspect that if we look at the problems of several prominent banks we will find they originate with investments in mortgage-backed securities rather than with loans the banks intended to hold to maturity.
Misesian requirements were not really breached by operations that held long-term fixed rate mortgages, because those operations (e.g., Fannie & Freddie, Countrywide, etc.) obtained funds for them by the issuance of long-term bonds – the infamous mortgage-backed securities. The problem with these, as explained in my earlier post, is that the collateral of the underlying mortgages was inadequate to begin with, and in many cases the borrowers were not creditworthy. Had these circumstances not existed, the securities might have been sound instruments.
What MM’s discussion of Misesian vs. Bagehotian banking failed adequately to emphasize – a glaring omission! – was the role of a bank’s capital. Stockholders’ equity appears on the liability side of the balance sheet, but it is a liability of a very peculiar kind. Unlike a deposit it can neither be withdrawn on demand nor redeemed after a certain term. If its owner wishes to liquidate he must sell it to a willing buyer, at whatever price the market may bear. This has no definite relationship to the amount of money actually paid in as capital at the time of the stock’s issuance, nor to its book value at any given time thereafter.
Adequate capital is necessary to provide sufficient liquidity when depositors wish to withdraw their funds. The ratio of capital to a bank’s total footings – i.e., how leveraged the bank is – tells whether it can continue to do business or not.
I think it is quite useful to note that the two great market crises of the past thirty years have mainly involved institutions other than normally-organized commercial banks, and that those institutions are distinguished from them by their capital structure.
Remember the savings-and-loan crisis of the ‘eighties? In those days there were a great many savings-and-loan associations that were mutually owned – i.e., at least in theory, they were owned by their depositors. They did not have a separate group of stockholders whose equity was at risk standing between the depositors and any losses on loans or investments. If one looked at a mutual S&L’s balance sheet, where there would on a commercial bank’s have been an entry for stockholders’ equity, there was only a single line for what was called ‘surplus’ – viz., the amount left over after depositors had been paid their fixed ‘dividends’ and the operating expenses of the S&L had been paid. Things were well and good as long as the S&L had positive earnings after expenses, but these ‘surpluses’ were typically thin and they were really ‘nobody’s baby.’
In theory, the surplus could be touched only at the liquidation of the S&L, at which time it would be divided pro-rata amongst current depositors. In practice, control of S&Ls typically fell to boards consisting of their large customers, who were often real-estate developers. These worthies would finance their developments through their captive S&Ls, and as they sold houses would retire their debt as they referred the buyers to the S&L for mortgages. Assuring the capital adequacy of the S&L was far down the list of their priorities.
S&Ls were the fair-haired children of politicians, regulatorily favored over commercial banks, which were subject to more stringent oversight. In the absence of stockholders and boards acting in their interest, the surpluses of mutual S&Ls were swiftly dissipated and at their liquidation there was nothing for the depositors, who had to be bailed out by the (then) FSLIC. Within relatively little time there was a great contraction and consolidation of the thrifts. At the same time commercial banks were largely unaffected, because of their superior capital structures.
The secondary mortgage market collapse, as we have seen, first affected specialists in it such as Countrywide, and the two GSEs, Fannie and Freddie. It then spread to investment banks such as Bear Stearns, Merrill Lynch, and Lehman Bros. A characteristic of all of these institutions was that they were much more highly leveraged than commercial banks – i.e., were less well capitalized.
As far as ‘deregulation’ of investment banks goes, my recollection of that industry goes back to a day when the stock exchanges had their own rules about who could hold seats. One of them was that member firms had to be proprietorships or partnerships, and could not be corporations. This rule was swept away by the Federal government along with fixed commissions, the requirement that all trades take place on the floor, etc., all being regarded as constituting anti-trust violations. Here is a classic instance of the conflict described by Nock between state power and social power.
There are many differences between corporations on one hand and proprietorships or partnerships on the other. The salient one here is that the liability of corporations is limited to the capital paid into them, whereas the liability of partners and proprietors is unlimited – if the capital they have invested in their business is not sufficient to satisfy their liabilities, their personal assets, down to the clothes on their backs, may be attached for the purpose. For an example of how this works, see Lloyd’s of London.
I cannot help but think that the old rule the stock exchanges, exercising Nockian ‘social power,’ imposed on their members, was right, and that government thoughtlessly discarded this vital baby along with the bathwater of fixed commissions, etc. If one is going to operate with as much leverage as investment banks customarily did, would it not be well to have the caution that potential loss of one’s whole net worth would bring to bear? The limited liability of their status as publicly traded corporations enabled the management of Bear Stearns, Lehman, and Merrill to operate on the principle of the auld Scots saying, “dinna fash – it’s nae our siller” – and not a penny of (for example) the half a billion dollars taken home from Lehman by Jeffrey Fuld from 1993 to 2007 can be touched.
Genuine deregulation levels the playing field in an industry and destroys the monopolies and other rent-seeking opportunities that are the inevitable concomitants of political interference. Can anyone sincerely argue that deregulation of, say, the telephone or truck freight industries has been anything but a benefit to consumers?
By contrast, what has passed for ‘deregulation’ in the financial sector has often been the selective relief of regulatory requirements for politically favored constituencies. It has facilitated rent-seeking rather than eliminated it. Dealing in the delivery of such favors is the stock-in-trade of politicians. There is little to distinguish them from gangsters in the ‘protection racket,’ save that politicians have the great advantage of making the laws.
[A]ssuming we can’t go back to the requirement that investment banks be unlimited-liability organizations, the next best thing would be to emulate the French bankruptcy law, which at least used to provide for a finding of ‘banqueroute frauduleuse.’ The corporate officers of a company that collapsed as a result of fraudulent bankruptcy were not only liable to criminal penalty, but were disabled for life from holding positions as corporate officers or directors. Fool us once, shame on you; we won’t give you a chance to fool us twice.
I don’t know how we could go back to requiring investment banks to be organized on an unlimited-liability basis. Certainly no new ones will be so organized voluntarily, and the existing players would of course complain vehemently of such a change being forced upon them. There is a sort of corollary to Gresham’s law at work here: bad and unsound forms of industrial organization chase the sound and good ones out of existence.
It would not be so difficult to require these firms to be better capitalized. In fact this has already happened to some extent. The acquisition of Bear Stearns by J.P. Morgan Chase, and of Merrill by Bank of America, effectively require them to adhere to commercial banking standards for capitalization, which will force them to be less leveraged. As I noted in an earlier post, these serendipitous outcomes would not have been possible without the passage of the Gramm-Leach-Bliley act – part of the ‘deregulation’ which Obama and Biden (the latter of whom voted for the act in 1999) are now blaming for the crisis!
Years ago commercial banks were subject to ‘double liability’ – i.e., although they were limited liability corporations, should circumstances require it, the stockholders could be assessed for an amount equal to the par value of the stock they held, in addition to what they had already paid for it. This requirement was eliminated years ago, but with the understanding that banks would henceforth carry a surplus above the total par value of their stock at least equal to the latter.
Surplus in this context is distinguished from undivided profit by being part of a bank’s permanent capital, not being able to be paid out to shareholders except upon dissolution (and then only if it is still there!). It is the combined capital and surplus of a commercial bank that set its legal lending limit, a ceiling on the amount of credit it may extend to any single customer, expressed as a fraction of the bank’s permanent risk-based capital. Legal lending limits are intended to prevent banks from having “too many eggs in one basket,” since the ruin of a given customer cannot thus burn up more than a fixed fraction of the bank’s capital.
No comparable limit applies to banks’ investment portfolios, although prudent management dictates that securities be laddered in maturities, reasonably diverse in issuers, etc. I have run across a couple of delicious phrases attributed to Pierpont Morgan in this context. He once described a market in the doldrums as being due to the amount of “undigested securities” in circulation. Our problem today is that we do not know whether many securities are merely undigested, or are in fact indigestible. The available information about them is so opaque as to suggest deliberate obfuscation. In another circumstance Morgan described certain market participants as having an “undeveloped sense of trusteeship.” I suggest this has become much more common since his day.
Revising the bankruptcy law would be simpler than going back to unlimited-liability partnerships or double liability, but consider the difficulties the last revision of bankruptcy laws faced. All the usual bleeding hearts bled for the poor debtor who was supposedly going to be squeezed harder. It seems to me it would be hard to portray a stiffened provision for fraudulent bankruptcy of corporations as facilitating the eviction of poor widows and orphans from their humble homesteads by greedy financiers, but never underestimate the ingenious venality of politicians. They are almost invariably low fellows who conceal behind their bleatings about the poor the delivery of favors to rich constituencies that have bought them.
Our present problems are deeply rooted in current social and moral attitudes, and politics as much represents these as it serves to exercise influence upon them. When I was a child, two of the greatest disgraces that anyone could possibly face, short of being convicted of a crime, were bankruptcy and divorce. They led to ostracism from respectable society. Now neither is more than a passing inconvenience. The social and economic order under which we live reflects this. It is unclear to me whether efforts to reform behavior by passing laws can succeed if there is not first a transformation in popular moral attitudes. If recent history teaches anything about this, it is that laws can keep the door closed to bad behavior, but once it be opened, it is almost impossible to close again by legislative or judicial means.
February 2, 2009 at 2:18 PM:
The current American financial system is, to be sure, constructed and operated to a great extent under the laws of the U.S. government, but neither fractional reserve banking nor maturity transformation are artefacts of those laws. They are the inevitable concomitants of a credit economy and have existed since such an economy first emerged in Europe in the late middle ages. As organic elements of the commercial and industrial societies that have developed since that time, they cannot readily be eliminated by something as superficial as regulation.
Money is created upon a fractional reserve any time anyone (not just a bank) extends credit. If the ownership of the credit can be transferred, as for example by the sale of a merchant’s receivables or a landlord’s rents to a factor, that credit has effectively been monetized. The ability to engage in such transactions has been essential to the development of modern Western civilization. To suppress such monies of account based on a fractional reserve of specie (or some other arbitrary store of value) would be a cure worse than the disease, and furthermore very difficult to enforce..
The maturity transformation issue – speaking from my experience as a bank director, and at least at the level of an individual bank – is not quite as easy to identify as the source of economic fluctuation as it might have been in Bagehot’s time. As a matter of fact, well managed banks do not “borrow short and lend long.” Balancing the maturities of deposits and of risk-based assets (i.e., loans) is the central task of what bankers call ‘funds management’. This is an art made much easier today by computerized analysis, so that ordinary bankers can today determine easily about their loan portfolios what a century ago perhaps only the Göttingen-educated mathematical genius J.P. Morgan was able to envision about his.
The troubles of the financial system today do not arise from such fundamental issues. They are problems of liquidity and capitalization. Capital, of course, is the longest-term obligation on the liability side of a bank’s (or any business’s) balance sheet. Unlike demand deposits, which can be withdrawn at any time, and time deposits, which may be withdrawn at the end of a certain term, capital is perpetual. Its owners cannot withdraw it – if they wish to liquidate, the only option open to them is to sell their share of it to a willing buyer at whatever price he is willing to pay.
The crucial thing about bank capital is that there be enough of it – that it not be over-leveraged. The U.S. commercial banking system is restricted by its regulators to rather conservative leverage ratios. The same has not been true of investment banks, and it has not been true for non-bank mortgage lenders (e.g., the GSEs Fannie Mae and Freddie Mac, and outfits like Countrywide Financial). What distinguishes these operations from commercial banking is that they did/do not accept deposits from retail customers, a circumstance that put them outside the purview of commercial banking regulations (including capital requirements). To obtain the money they lent, or used to buy mortgages from others who initially made the loans, they issued securities, pledging the mortgages they held as collateral.
The way the financial collapse spread from mortgages on residential real estate to the commercial banking sector wasn’t mainly directly through its loan portfolios but indirectly through its investments. Commercial banks obviously cannot lend all of the money deposited with them. They must keep some cash to satisfy those depositors who wish to withdraw it. In practice a bank may lend only about 70-80% of its deposits. But they don’t keep the remaining 20-30% just as cash. They use some of it to buy securities. If there is a maturity-transformation issue in the commercial banking business, it is in its investments rather than its loans. Bonds are ordinarily long-term investments – perhaps as long as 30 years. This is of course longer than the longest time deposits ordinarily held at commercial banks, which normally have terms no longer than 72 months. However, maturity transformation in the investment portfolio doesn’t ordinarily pose a liquidity problem because the assumption is that securities are marketable and can easily be sold as the need arises.
Today, of course, mortgage- backed securities issued by the GSEs and private-sector operations like Countrywide are not as easily marketable as the people who bought them expected they would be. Countrywide is in bankruptcy. Fan’s & Fred’s debt has only such worth as the implicit guarantee of Uncle Sam givs it. The preferred stock of the GSEs, sold as a gilt-edged investment, is now worthless.
How does this affect the commercial banks that bought such investments? Let’s assume that a hypothetical bank, before the events of last fall, had a capital-to-deposits ratio of 8%, i.e., for every $100 million of deposits it had $8 million of capital. It would accordingly have been considered ‘well capitalized’ by regulators. Let’s further assume that it was 75% loaned-up, i.e., for every $100 million of deposits it had $75 million in loans. The rest of its deposits were divided between cash and investments.
Now let’s assume that 5% of its deposits were invested in bonds and preferred stocks issued by the GSEs, Fannie Mae and Freddie Mac – securities once considered ‘bank-quality.’ All of a sudden the unsoundness of these institutions becomes apparent, as it did last year. The market for the securities collapses – buyers cannot be found. As a result, our once well-capitalized bank becomes illiquid. It cannot sell the securities for anything near their purchase price, if at all. This is expressed as a marking to (non-existent) market, and all of it is a reduction of capital from the well-capitalized 8% down to perhaps half of that. There’s now $4 million in capital for every $100 million in deposits. The bank is now no longer ‘well capitalized,’ but has insufficient capital to carry its deposits. This is true even if not one of the commercial or personal loans it holds is non-performing!
What has happened in the past few months illustrates the difficulty of relying upon regulation to stabilize the financial system. Commercial banks were subjected to very stringent regulation in the aftermath of the crash of 1929 and the subsequent depression. Contrary to much of what has been said in the popular news media, very little of this regulation has been removed. Indeed, it has been more added to than reduced for years. However, economic pressure is rather like hydraulic pressure – it leaks through all attempts to contain it, at the points of least resistance. During all this time, an extensive sphere of non-bank lending activity was allowed to develop completely outside the bounds of commercial banking. Because it didn’t fall within the legal purview of bank regulation, it didn’t have to meet standards of capitalization, and its loans didn’t have to be as well collateralized. Leading figures in the non-bank financial sector like Franklin Raines and Angelo Mozilo paid very effective court to politicians like Christopher Dodd and Barney Frank to assure that they were not regulated as strictly as commercial banks. It is a travesty that these politicians are now permitted by the ideologically blinkered news media to scapegoat others for the disaster they themselves were instrumental in causing.
November 22, 2008 at 11:52 AM:
I well remember bearer bonds. They were once common, but no new ones were issued after the passage of TEFRA in 1986. I think I clipped my last coupons one morning a couple of years ago. It was an occasion for nostalgic reminiscence of the Optimacy’s better days; I had lunch at my club, and visited my tailor that afternoon.
The excuse for doing away with bearer bonds was basically that the IRS didn’t like them. Since a bearer bond can be transferred simply by delivery to its new owner, large transactions in near-equivalents to cash could take place without being easily scrutinized by government. The nominal objection to this was that participants in organized crime might use such a means to conceal their illegal dealings – the same excuse offered many years ago for removing bills of denominations larger than $100 from circulation. The real reason, of course, was that the lack of a paper trail facilitated tax evasion.
However, if there were ever bearer equities, they disappeared long before bearer bonds, and I must suppose for other reasons. It must, for example, have been nearly impossible to determine the legitimacy of proxies, or indeed to know whether there was a quorum, at a stockholders’ meeting.
Of course, in MM’s futuristic world, how could we expect a sovcorp that could control its men-at-arms by means of cryptographically locking their weapons not to use similarly sophisticated technology to identify its shareholders? This strains credulity. You may recall Murphy’s law – what can go wrong, will. I offer these corollaries to it: what government can do, it will; what power it is able to abuse, it will abuse. History provides many examples.
February 3, 2009 at 1:31 PM:
[H]istorically, money creation through credit was accomplished by just such bills of exchange as were created by the sale of a promise to deliver payment in the future. This happened long before there was a Federal Reserve Bank or even a Bank of England. Fractional reserve banking, based on monies of account, existed in the days of the Medici and the Fuggers. It is worth pointing out that both those banks, after long expansion, eventually collapsed. The history of fractional-reserve banking has been one of trying to find, by a process of trial and error, the parameters within which it can safely operate. Someone or other is always exceeding them, with fatal results.
It is true that modern central banking has exacerbated the problem, but booms developed through the free expansion of credit even under the pre-WWI gold standard – and were followed by busts as gold reserves were drawn down. This was what led, as just one example, to J.P. Morgan’s bailing out of the U.S. Treasury in the second administration of Grover Cleveland, and to William Jennings Bryan’s famous “cross of gold” speech. Bryan’s platform plank of free coinage of silver at a 16:1 ratio with gold was effectively a call for inflationary monetary policy, since with gold at $20.67/oz. silver would be supported at $1.29/oz – the level at which U.S. silver coinage of the time contained its face value in silver. However, at the time, market value of silver was about $0.35/oz.
World War I brought inflation, as other wars had done, but it was more pronounced than previous wartime inflations had ever been. This was facilitated by the central banks and by the governments’ wartime suspension of the gold standard. Reintroduction of the gold standard in Britain at the pre-war ratio of £1 = US$4.86 led to profound deflation, and brought about a severe recession in 1921. Gradual recovery was followed by the even more dramatic crash in 1929 and the subsequent depression.
Central bank activities and government policies designed to stabilise the economy since WWI appear from present perspectives merely to have lengthened the frequency of the credit cycle at the expense of increasing its amplitude. But the cycle has existed since a much earlier time, perhaps even from the first emergence of a credit economy.
July 13, 2010 at 3:01 PM:
On the bank “bailout,” I can tell you from personal experience that the story behind it is radically different from what has been represented to the public.
Government money was forced by Paulson on many banks that didn’t need and didn’t want it. The rationale given for this was that the Treasury did not want a public perception that banks which had received the money were troubled. So banks such as J.P. Morgan and Wells Fargo had to take the funds, even though they didn’t need them, at the same time that Citi, which did, took them.
The conditions attached were onerous. The government was to be issued preferred stock, paying a 5% dividend for the first four years, and a still higher one if not redeemed before then. Not only (as with all preferred stock) did this dividend have to be paid before a dividend could be paid to stockholders of any other class, but the government asserted a veto power over the payment of any other dividend even after its own were paid. The preferred stock also came with warrants for common stock. Executive salaries and directors’ fees fell under government limits. Finally, government reserved the right to add other conditions unspecified at the time the funds were placed.
After the Treasury saddled the big nationwide banks with this, it began working down to the regional and larger community banks, where the reception was uniformly negative. My own bank was spared because it was limited by its charter (like many others) to one class of stock, and by the time government figured out a way around this conflict in its own laws, the public support for the TARP program had fallen even further from its initially low level, and seemed to be running out of steam.
It is very difficult to get anything like a 5% return on capital, especially in the environment that existed after October of 2008. All of the big banks that took TARP money have paid it back as quickly as they were able. Treasury actually MADE money on the TARP funds placed with banks – even Citi.
The speed with which the plan was unveiled and the conditions that surrounded it made me think that it had been on the shelf for a long time, just waiting for the opportunity – kind of like the Schlieffen plan, except more rewarding. What it amounted to was a huge power and money grab in which the earnings of sound banks were mulcted, initially perhaps with the purpose of shoring up the weak ones. Ultimately, even the weak ones have mostly paid it back. The real bail-out went to Fannie and Freddie, and to a lesser extent to GM and Chrysler.
There is a very odd distribution of bank assets in this country, which might be described as hourglass-shaped. A very few big nationwide banks hold over 50% of domestic deposits, and about 8,000 community and regional banks hold the rest, most of those having assets less than $1 billion. Your country gentlemen will be found amongst the owners and managers of these little banks.
The mega-banks – those deemed “too big to fail” – are the products of a fairly obscure banking law change called the Riegle-Neal Act of 1994. Everyone likes to blame Gramm-Leach-Bliley, which repealed parts of the Glass-Steagall Act’s prohibition on combining commercial and investment banking, as a cause of the meltdown. This doesn’t stand up too well on investigation. Riegle-Neal, on the other hand, is directly responsible for the creation of mammoth disasters like Citi, because it broke down the barriers to inter-state branch banking.
Before Riegle-Neal, bankers who wanted to do business across state lines had to charter separate banks in each state, separately capitalized. The banks could be held by a multi-bank holding company, but the separate capitalization requirement compartmentalized the risk. The wisdom of this requirement was not appreciated in 1994. Unfortunately, it still isn’t appreciated in 2010. Mega-banks play the Washington game very well, and legislators know that little ones could never pay nearly as rewardingly. And thus the court party burgeons!
July 16, 2010 at 2:37 PM:
‘[T]oo big to fail’ banks resulted from regulatory changes that altered systemic risk in a way that existing safeguards (e.g., FDIC) failed to take into account. The compartmentalized risk of the pre-Riegle/Neal commercial banking system was within the capacity of the FDIC to handle. FDIC failed to change its actuarial assumptions to account for the added risk posed by the Riegle/Neal changes. If it had, TARP would probably not have been necessary, at least for commercial banks.
Financial regulation has a history of this sort of failure. Remember the debacle involving mutually-owned savings & loan associations in the ‘eighties? At that time the savings and loan industry had its own deposit insurance agency, the FSLIC. It had been set up at a time when S&Ls were restricted to residential mortgage lending, and could not offer demand deposits. “Reg Q,” which restricted the interest rates S&Ls and banks could offer on time deposits, allowed S&Ls a preferential 1/4 of 1% advantage over commercial banks. The time honored maxim of S&L executives was “three, six, and two”: pay 3% on deposits, charge 6% on mortgages, and take 2 months vacation in Florida every winter.
Carter-era stagflation, and the phenomenon of ‘disintermediation,’ whereby depositors abandoned S&L and bank CDs for more lucrative returns outside insured institutions, changed everything. Reg Q was abandoned. S&Ls were permitted to offer demand deposits and to engage in other types of lending than residential real-estate mortgages. Unlike commercial banks, they were inexperienced in these activities, and the FSLIC did not change its actuarial assumptions to allow for the change in the risks it faced due to new circumstances. Soon, S&Ls began to fail, and the FSLIC’s resources were not adequate to deal with the consequences. This led to the creation of the Resolution Trust Corp., and the merging of the FSLIC with the FDIC. It’s noteworthy that very few commercial banks succumbed to the problems that the S&Ls did at this time, and the FDIC never faced the same challenges. The reason was that commercial banking’s underlying assumptions had not changed in the way the S&L industry’s had.
It is said that the generals always fight the last war, and in parallel fashion it should be said that financial regulators always plan for the last crisis. The lengthy and diffuse Dodd-Frank bill just passed by the Senate is a perfect illustration of this pattern. It will not only not prevent the next crisis, but may well set it up to be worse than the present one.
Candide III 