Banking bailout or economic bailout? Guest post by Joe Cambria

By skepticlawyer

[Joe Cambria – our in-house trader – takes a hard look at the arguments swirling around government intervention and buyouts in the recent finance fooferaw. It’s not as simple as it looks...]

No one needs another blog post telling him or her what’s been going on in the financial markets. I also don’t need to tell anyone about the caning the Fed and the US Treasury have been getting for the “bailouts” (AIG was a nationalization etc) and how the US is practicing ‘socialism’.

Free market types have been caning the US government for its intervention while the left is suggesting the interventions are being carried out to socialize losses and privatize profits. This is despite the fact that shareholders in these failed firms have lost almost all their investment (ignorance is bliss I guess).

Free market types and intelligent lefties need to understand that the Federal Reserve System was actually created to ensure security for the US financial system and to be a lender of last resort. It is the job – in fact it is a prime function of the Federal Reserve – to prevent during times of financial stress the deflationary impulse that could lead to a very serious recession or depression as a result of debt deflation. The Fed is carrying out its duties in the way meant to assist in liquefying the system, ensuring that institutions which are unable to borrow money can borrow through short term Fed loans during the crisis. In other words the Fed and other major central banks are trying to provide ample liquidity to the system during such times of stress.

Those with cool heads that understand how the current system works will, I believe, come to the realization that Ben Bernanke and Sec Treasury Paulson have done an outstanding job in fulfilling their responsibilities by acting intelligently and with foresight so as to avoid the possibility of a full on depression both in the US and the rest of the world. I think given time the history books will judge these two men very highly.

People have suggested that the US authorities are in the process of creating new levels of moral hazard, which in my mind is frankly hard to see and doesn’t hold up to close examination. The Equity owners in all these firms have lost their capital. Sure the bondholders come out a little better but imagine having to sit around wondering if your loan money will be returned while the Fed’s managers liquidate AIG; people forget the Fed now ranks ahead as creditor. The management of all these firms have lost their jobs and most of their net worth. I can’t see an argument for moral hazard through the way the Fed and Treasury have conducted their activities. In fact I see the US taxpayer walking away with a big profit as a result of the Fed’s AIG loan terms and conditions.

However, I am quite conflicted with the Resolution Trust type bailout that was announced on Friday and which we should hear more about early this week. I believe the basics of the deal is that the Treasury will create a structure whereby banks and some other financial institutions will sell the toxic waste held on their books through a reverse auction process. The main objective is to clear the banking system of nearly all the radioactive crap so as to help the banks start lending again. I can understand the misgivings free market types have about this arrangement and I can also see how lefties would argue this is a bailout of the rich and wealthy Wall Street types.

Even so, the cost of this proposed rescue package would be quite small if the US and the world went into depression. And that’s the trade off: act now and contain the costs or act when the US and possibly the rest of the world is in depression.

People are now suggesting we need to look at ways of adding more regulation – even more than before.  The inference is that somehow more bureaucracy than we have at present will somehow rescue us from future financial crises. It won’t and the suggestion is pure nonsense. Financial crises will be with us forever. In any event Wall Street is about to be history, as Morgan Stanley and Goldman Sachs will not exist in their present form; they will merge or die. It’s clear that the Fed and the US Treasury prefer to see universal banks rather than investment banks in the post crisis world. Ironically investment banks came about as the result of depression era regulation that demanded a separation of traditional commercial banking and investment banking businesses. Universal banks will likely be much more capitalized and carry less risk than before. However both Citigroup and UBS (a Swiss bank) – which are both considered universal banks – have suffered huge losses too.

If people think speculation will be curtailed in a post crisis world think again. Traders will simply move to boutique type operations funded through equity such as hedge funds. We’ll still hear about a 30-year-old making a 50 million dollar bonus in a year, although not at banks so much. They will simply be operating out of hedge funds.

28 Comments

  1. Posted September 22, 2008 at 5:36 am | Permalink

    I agree that most of the current bailout process is attempting to avoid the moral hazard problem – shareholders lose the lot, etc.

    But those that say that lack of regulation isn’t the problem do seem to completely ignore the natural experiment we have. It does seem to me that in countries with more regulation, the problems are less. Here in Australia, for example, I have heard bankers complain about APRA not letting them get capital credit for securitisation approaches that would be allowed in the US. And our system seems reasonably stable, (or at least orderly).

    That said, from watching it, the major problem with regulation in the US seems to me to be fragmentation, with far too much state based regulation (of mortgage lenders of a certain size and insurance companies, for example). That leads to people trying to find the cracks in the regulation and exploit them.

  2. Posted September 22, 2008 at 6:53 am | Permalink

    Great post Joe, one of the best pieces I have read on the bail out, the logic behind it, the consequences of it, and the need for everyone to settle down and not get into a regulatory frenzy.

  3. TerjeP (say tay-a)
    Posted September 22, 2008 at 7:19 am | Permalink

    There are other ways to deal with a deflation induced by a credit collapse. An orderly increase in base money being the obvious means. Of course this is the same liquidity injection game but not necessarily done via the same means. However with US interest rates so low any open market operation attempts to further increase liquidity would be bit like pushing on a string unless they abandon interest rate targeting. Which they should do in any case in my view. Joe may be right that those managing the current monetary system deserve some praise in the same way that a pilot successfully landing a broken airplane deserves praise. However the current system still deserves a bucketing. The problem being that there is no clear concensus on which alternative would be better.

    Serious Keynesians should be advocating a corporate tax cut at this point in the cycle. However few Keynesians ever support tax cuts in practice.

  4. Posted September 22, 2008 at 8:35 am | Permalink

    Hi Joe,
    Thanks for the informed opinion.
    I am interested to know how all of this is likely to impact on carbon trading.
    Cheers.

  5. jc
    Posted September 22, 2008 at 9:58 am | Permalink

    Jennifer:

    People that knee jerk demanding more regulation don’t really understand. The US financial system is littered with regulation… 70,000 pages.

    When I worked there we had;

    1. State banking examiners
    2. Federal reserve examiners
    3. Internal auditors
    4. External auditors
    5 compliance officers
    6 Whistle blowing phone numbers
    7. Future bodies examiners

    People who suggest the US needs MORE regulation are nuts. Even now it probably needs less.

    ——–

    Thanks John.

  6. jc
    Posted September 22, 2008 at 10:15 am | Permalink

    Jennifer M

    I think the financial crisis will tend to delay any ETS type proposal in the US as no prez. no matter which political party is going to impose a tax type arrangement on the American people during this period of pain. I say forget it, this side of 2012 as it won’t happen over there. That’s my rough guess.

  7. Jacques Chester
    Posted September 22, 2008 at 11:18 am | Permalink

    Joe — how long before hedge funds emerge to exploit arbitrage between different ETSes?

    “The price of Australian Carbon rose sharply today on the news that Germany is decreasing its solar panel subsidy program …”

  8. jc
    Posted September 22, 2008 at 12:05 pm | Permalink

    Jacques:

    Dunno, but it will be a very interesting market. I think they will subsidize the crap out of things and the price of carbon will collapse like it did in Euro during the phase in.

    Very funny. The price of a carbon contract fell from 30 Euros to a couple of cents at one time. What a magnificent short that would have been. LOL.

  9. Jacques Chester
    Posted September 22, 2008 at 12:17 pm | Permalink

    Elsewhere, a respected nerd has this to say about it all.

  10. jc
    Posted September 22, 2008 at 12:27 pm | Permalink

    That’s a good link, jacques. He makes a damn fine point.

    Ideally the government should clean all this up and then get right out of the way and introduce free banking where banks buy their insurance on the private market and customers assess the risk themselves.

  11. Posted September 22, 2008 at 5:55 pm | Permalink

    JC

    Here in Australia, we have pretty much every type of regulation in your list above – with the exception of the state and federal banking examiners – we only have federal, for banks and insurance companies. So maybe you are saying that the regulation is ineffective, but when I talk to actual traders, it is harder to do off balance sheet securitisation and get capital relief in Australia that it is (or was) in the US. We also seem to have had better liquidity rules. And nobody is bailing out any of our banks.

    Your suggestoin of free banking with customers assessing the risk ignores the enormous information asymmetry that goes with that. Much of the free market that we have just had has assumed that customers assess the risk in transactions that were not regulated by a banking regulator (“off balance sheet”). So the customers sensibly outsourced the risk assessment to S&P or Moodys. Look how well that worked!!

  12. jc
    Posted September 22, 2008 at 6:23 pm | Permalink

    Here in Australia, we have pretty much every type of regulation in your list above – with the exception of the state and federal banking examiners – we only have federal, for banks and insurance companies. So maybe you are saying that the regulation is ineffective, but when I talk to actual traders, it is harder to do off balance sheet securitisation and get capital relief in Australia that it is (or was) in the US.

    Jennifer:

    Securitization was only recently touted as the panacea whereby risk would be spread rather than consolidated in bank balance sheets. In fact US regulators actively encouraged it.

    I don’t understand why you say it’s much harder for banks to carry off balance sheet items when the NAB and ANZ for example have a number of special purpose vehicles that led back to the holding company. They’ve taken hits too as a result of the US fiasco but luckily they weren’t so big.

    I might add that the RBA was actively promoting securitization here too but our market is too small and not sufficiently globalized to become very large.

    We also seem to have had better liquidity rules. And nobody is bailing out any of our banks.

    I think all major banks essentially work with the same broad Basle rules. The US situation is that real estate was far more highly leveraged than ours. We also didn’t suffer the distortions caused by Freddie and Fannie. In addition we didn’t have authorities more or less instructing lenders to go lend in poor neighborhoods and create the environment of lax lending standards.

    Your suggestoin of free banking with customers assessing the risk ignores the enormous information asymmetry that goes with that.

    Why? You think people are stupid and don’t the risks?

    Much of the free market that we have just had has assumed that customers assess the risk in transactions that were not regulated by a banking regulator (”off balance sheet”). So the customers sensibly outsourced the risk assessment to S&P or Moodys. Look how well that worked!!

    These were quite complex products you’re talking about. A plain vanilla balance sheet that doesn’t pay much interest could be easily assessed

  13. Posted September 22, 2008 at 6:37 pm | Permalink

    Andrew Reynolds had this to say about Fannie and Freddie – they were pretty much government anyway. I also didn’t realise that Obama wanted to fund his US-wide public housing scheme by dipping into Fannie and Freddie. Obviously that won’t be happening now the money has gone up the spout so his whole plan will likely be shelved.

    AFAIK the very brutal push to make mortgagees in the US lend to people who shouldn’t have been able to get loans in the first place was an attempt to unpick the effects of the Redlining FDR introduced during the depression (complex, but the upshot of the Redlining policy was to discriminate against blacks and poor whites). Govt overcorrected and now we have this mess.

  14. Posted September 22, 2008 at 7:04 pm | Permalink

    Obama wanted to fund his US-wide public housing scheme
    .
    Christ I hope he drops 70% of his plans. He thinks he’s God. Just clean up Washington and roll back the Empire old bean.
    .
    I doubt it’ll happen.
    .
    In 4 months he’ll be Prez and then he’s officially offal.

  15. Posted September 22, 2008 at 7:17 pm | Permalink

    To be fair to Obama the righties have been trying to hang the failure of various housing schemes in Chicago on him personally and while I’d like to agree with them (Obama has got ‘Jimmy Carter MK II’ written all over him), I don’t think that’s fair. He got handed all the crappiest housing tenants in Chicago – people who’d already shat in the nest at least once – and was expected to work miracles. That didn’t happen – the apartments were trashed in no time – and he was left to carry the can.

    It’s a dreadful thing to say, but there was a reason you had to kiss the bank manager’s butt in the old days in order to get a mortgage.

  16. Dallas Beaufort
    Posted September 22, 2008 at 10:49 pm | Permalink

    Yes Joe, more regulation is complete nonsense, considering that these inflated home mortgages (toxic waste) are the primary creation of the democrat & labor socialist left’s land supply regulations. When government regulation prescribes that its citizens must live in areas of little or not of their choice then housing supply inflation occurs. And the silly left argue that the transfer of this toxic waste is socializing losses, what hypocrisy.

  17. Nanu
    Posted September 23, 2008 at 12:46 pm | Permalink

    “And the silly left argue that the transfer of this toxic waste is socializing losses, what hypocrisy.”

    Good point Dallas, the hypocrisy hadn’t even occurred to me.
    _____________________________________

    [Nice piece JC]

  18. Posted September 23, 2008 at 6:55 pm | Permalink

    Obama has got ‘Jimmy Carter MK II’ written all over him

    You reckon? He’s much more impressive than Carter. Carter beat Ford. Big deal! I have dishcloths that could beat Ford.

    Obama’s a much more impressive individual. I thought the only way you could do worse than Carter was resurrect Dan Quayle.

    But he could be total smoke indeed. I don’t know. I’ve been purposely not paying attention for months. I want to feel good in late January.

    For the five minutes it’ll take for the bitter and inevitable truth to sear my reeling brain. 🙂

  19. DeusExMacintosh
    Posted September 26, 2008 at 2:58 am | Permalink

    I’m a bit confused JC. The US seems to be persisting with this major cash injection but if the problem is the inability to price these dodgy derivatives, why don’t they just dissolve the derivative instruments and have the mortgages they contain revert to the original institution of origin? That way everybody knows what their exposure is, it can be properly accounted for on balance sheets and governments can tailor their assistance more accurately to domestic institutions.

  20. Nanu
    Posted September 29, 2008 at 2:47 pm | Permalink

    “They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire….”

  21. DeusExMacintosh
    Posted September 30, 2008 at 4:13 am | Permalink

    Yes, but these aren’t ‘naked’ options Nanu. They are financial instruments that contain concrete assets (ie. mortgages) but in a mixed bundle of risk exposures that makes them impossible to value.

  22. Posted September 30, 2008 at 5:18 pm | Permalink

    I’ll keep my purple pin-stripes dry
    And offer no apology
    I go to church’t ain’t a lie
    My Book of Ideology
    It tells me true, my greed’s no cause of all these horror farces
    God is great and so are we – the conspiracy of horses’ arses.

    Well you may say that this today
    Was vict’ry for democracy
    I’m sure you’re right but now I play
    Before they take my yacht from me
    .
    We bankers are the best y’see
    Pluckin’ feathers off the ducks
    Sprite ‘way with rainday cash in SUV
    And the rest of you: Get fucked!!

    The choice is hard, must needs thoughts deep
    This week it ain’t no lark
    Should we save these shonky lying creeps
    Or get used to eatin’ bark?

  23. Posted September 30, 2008 at 5:57 pm | Permalink

    I’m a bit confused JC. The US seems to be persisting with this major cash injection but if the problem is the inability to price these dodgy derivatives, why don’t they just dissolve the derivative instruments and have the mortgages they contain revert to the original institution of origin? That way everybody knows what their exposure is, it can be properly accounted for on balance sheets and governments can tailor their assistance more accurately to domestic institutions.

    Yes but Deus that takes all the fun out of the game. Nothing to speculate on, nothing to justify all those jobs serving the speculators. No point in that, be doing themselves out of a job. Self interest rules, Adam Smith believed that said that can work for the common good, he never said it would always work for the common good.

  24. DeusExMacintosh
    Posted October 1, 2008 at 11:01 am | Permalink

    Oh well, if THAT’s all that’s stopping them let the suckers drown. Those of us on ‘main street’ will just have to re-learn to live within our means in a low-credit environment.

  25. Posted October 1, 2008 at 11:39 am | Permalink

    The problem there Deus is that the Aus and US economies have been kept bubbling along by consumer spending, which has been driven by easy credit, which has been made possible by relaxed lending practices, which has been allowed to go on for so long by selling loans here, there, and everywhere, and so the vicious cycle is complete. What we have had over the last 10 years is a debt driven growth. Governments are now terrified, as are directors, because now they can no longer report increased growth and share value. They want the bail out to sustain what has been debt driven growth. Can’t continue, we need to reappraise our growth and dividend prospects. Probably more like European countries, which typically have much lower expectations than the US, Aus, or Britain.

    You are absolutely right, we need to adjust to a new financial environment. Economies should grow through productivity, not debt. We may end up in a situation similiar to Japan, where no amount of priming the economy gets its moving again.

  26. DeusExMacintosh
    Posted October 1, 2008 at 10:39 pm | Permalink

    Sustainability isn’t just an environmental concept… **headdesk**. [Gets out her well thumbed copies of “The Richest Man in Babylon” and “Think and Grow Rich”]

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