Category Archives: Banking

A Quiet Windfall For U.S. Banks

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A Quiet Windfall for US Banks

By Amit R. Paley

The financial world was fixated on Capitol Hill as Congress battled over the Bush administration’s request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention.

Section 382 of the tax code was created by Congress in 1986 to end what it considered an abuse of the tax system: companies sheltering their profits from taxation by acquiring shell companies whose only real value was the losses on their books. The firms would then use the acquired company’s losses to offset their gains and avoid paying taxes.

Lawmakers decried the tax shelters as a scam and created a formula to strictly limit the use of those purchased losses for tax purposes.

But from the beginning, some conservative economists and Republican administration officials criticized the new law as unwieldy and unnecessary meddling by the government in the business world.

>   
>   Strange that this only gets disclosed after the election.
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Agreed!


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Where do we go after these toxic assets problem?

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Seems at this late hour the payroll tax adjustment is about all that can get the job done to immediately support demand.

Yes, the banking model is to make loans to individuals and business that become illiquid assets and match that with liabilities that are not at risk either.

So if markets put a discount on bank assets due to liquidity, implied is a premium on the liability side of banking due to its unlimited ability to fund itself.

And yes, it’s when, via securitization, for example, relatively illiquid assets are not ‘match funded’ to maturity, liquidity risk is there.

This same liquidity risk is also there when banks are not provided with secure funding due to errant institutional structure that misses that point regarding the banking model.

Beyond that is the risk of default which is a separate matter.

In the banking model this is determined by credit analysis, rather than market prices.

This is a political decision, entered into for further public purpose, and requires regulation and supervision of asset quality, capital requirements, and other rules to limit risks banks can take with their government-insured deposits.

When banks are deemed insolvent by the FDIC due to asset deterioration, they shut them down, reorganize, sell the assets and liabilities, etc.

When it’s due to excessive risk due to a failure of regulation, regulations are (at least in theory) modified. It’s all a work in progress.

I see this crisis differently than most.

We had two thing happening at once.

First, by 2006 the federal deficit had once again become too small to support the credit structure as financial obligations ratios reached limits, all due to the countercyclical tax structure that works to end expansions by reducing federal deficits as it works to reverse slowdowns by increasing federal deficits.

At the same time, while the expansion was still under way, delinquencies on sub prime mortgages suddenly shot up and it was discovered that many lenders had been defrauded by lending on the basis of fraudulent income statements and fraudulent appraisals.

Substantial bank capital was lost due to the higher projected actual losses reducing the present value of their mtg based assets. This is how the banking model works. The banks were, generally, able to account for these losses due to projected defaults and remain solvent with adequate capital.

Outside of the banking system (including bank owned SIV’s – one of many failures of regulation) market prices of these securities fell, and unregulated entities supported by investors (who took more risk to earn higher returns) failed as losses quickly exceeded capital. And with this non-bank funding model quickly losing credibility, all of the assets in that sector were repriced down to yields high enough to be absorbed by those with stable funding sources – mainly the banking system.

But the banking system moves very slowly to accommodate this ‘great repricing of risk’, and all the while the fiscal squeeze was continuing to sap aggregate demand. The fiscal package added about 1% to gdp, but it hasn’t been enough, as evidenced by the most recent downturn in Q3 GDP, which is largely the result of individuals and businesses petrified by the financial crisis.

So yes, there are both issues: the financial sector stress and the lack of demand. While they were triggered by two different forces (loan quality deteriorating due to fraud and the budget deficit getting too small), it is the combination of the two that is now suppressing demand.

The TARP may eventually alleviate some of the lending issues but only addresses the demand issue very indirectly and even then with a very long lag. Just because a bank sells some assets (at relatively low prices) doesn’t mean it will suddenly lend to borrowers who want to spend. Nor does it mean they will want to fund euro banks caught short USDs that have no fiscal authority behind their deposit insurance and bank solvency, and now appear to be in a worse downward spiral than the US. The slowing US economy has reduced the world’s aggregate demand, which was never sufficient to begin with due to too small budget deficits, via reduced exports directly or indirectly to the US.

In other words, I don’t see how the TARP will restore US or world aggregate demand in a meaningful way.

Yes, the US budget deficit has been increasing, but not nearly enough. It’s only maybe 3% of GDP currently, while the US demand shortfall is currently maybe in excess of 6% of GDP.

Cutting the payroll taxes (social security and medicare deductions, etc.) is large enough (about 5% of GDP) and returns income to the ‘right’ people who are highly likely to immediately support demand as they spend and also make their payments on their mortgages and other obligations to thereby support the financial sector in a way the TARP can’t address.

It is the ‘silver bullet’ that immediately restores output and employment. But we all know what stands in the way – deficit myths left over from the days of the gold standard that are now inapplicable with our non-convertible currency.

The line between economic failure and prosperity is 100% imaginary.

And not to forget that if we do restore output and employment (without an effective energy policy) we increase energy consumption and quickly support the forces behind much higher energy prices, which reduces are real terms of trade and works against our standard of living.


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Can the euro payments system last the week?

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Euro equities and banks are now under attack, and the ECB is effectively borrowing hundreds of billions USD from the Fed via swap lines. The eurozone deposit insurance is by the national governments, not the ECN, which are credit constrained.

National government euro bonds have been supported by various CB/monetary authority allocations that are slowing with slowing net exports.

A major bank failure becomes infinitely more problematic in the eurozone than in the US, Japan, or UK, all who have deposit insurance at the ‘federal’ level.

The risk in the eurozone is the payments system completely shuts down, and re opens only when the ECB is allowed to conduct what amounts to fiscal transfers.

In a crunch, USD borrowings will need to be serviced from selling euros to buy USD and result in a sharply falling euro.

Yields on the national government bonds will move sharply higher due to credit concerns, as will credit default premiums in general.

For 10 years the euro ‘system’ has functioned reasonably well on the way up.

The systemic risk is only on the way down. And once in motion, it will unwind very quickly.

Protect yourself by not having any euro deposits, buying out of the money puts on the national government bonds and out of the money puts on the euro.

And then hope you lose those bets!


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Elaboration on the Mosler Plan

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The combination of removing the FDIC cap and extending FDIC insurance to include Fed deposits at member banks will normalize bank liquidity instantly, and at no ‘cost’ to government, by removing these ‘self-imposed constraints’ on bank liquidity that serve no function beyond contributing to the current liquidity crisis.

Supporting demand is a separate matter. Supporting lending will help, but there is no substitute for supporting incomes.

The TARP will not normalize bank liquidity or add to demand. It’s just an asset exchange. Not a bad thing, but nothing that dramatically changes anything.

And, unfortunately, and not to further complicate matters regarding the financial crisis, anything that does succeed in restoring growth will increase gasoline consumption and support prices at new highs in short order.

The over riding theme for Congress is the notion of ‘public purpose’.

New comments highlighted in yellow:

  1. Money fund issue:

    Remove the $100,000 cap on insured bank deposits. This adds no risk to government. And it will eliminate the need for money funds which the cap created in the first place.

Reasons for the cap: small banks will lose money to large banks.

When combined with 5., below, the Fed lending unsecured and in any size to any solvent member bank this objection vanishes:

  1. Banks:

    Lower the discount rate to the fed funds target rate and eliminate the need for collateral. This is how it should have been anyway. This goes hand in hand with eliminating the cap on FDIC insured deposits. The easiest way to facilitate this may be to extend FDIC insurance to Fed deposits at member banks. Then the Fed won’t need to demand collateral when it lends, and that alone will go a long way to normalizing bank liquidity. This would also mean banks would pay for FDIC insurance on any Fed deposits.

    Bank assets and solvency are already highly regulated, and how they are funded doesn’t alter the risk of loss due to insolvency for the government.

    An interbank market serves no public purpose. Eliminate it out to six months by offering discount lending out to 6 months.

    If banks can borrow all they want from the Fed they have no reason to borrow from each other.

    In addition to the FOMC setting the fed funds rate target, it can also set the rate for 3 and 6 month borrowing at the discount window. This both gets the job done and also replaces the TAF and TSLF type of experiments.

The banking model that has served us well since the depression provides for:

  • Deposit insurance to prevent runs on banks, the eliminating the liability side as the place of market discipline. There was and is a good reason for this- it doesn’t work, and never has worked. In fact, using bank liabilities for market discipline is what triggered the bank runs of the early 1930’s and before, that resulted in the rule changes. Let me suggest it is counterproductive to let a bank like WAMU fail for, as stated by the FDIC, liquidity reasons and not insolvency.

  • Strict regulation of capital ratios, loan (asset) quality, diversification, interest rate risk, etc.

    Loan quality is measured by credit analysis, and not mark to market, also to better serve public purpose. Banking is a matter of liabilities provided either directly or indirectly by government, and regulated and supervised assets.

  1. Broker/dealers:

    Let them go. If they don’t survive, at worst their assets will be distributed by the bankruptcy court if it goes that far. They do nothing that I know of that serves public purpose and/or the real economy that banks can’t do. And the banks are already regulated and supervised.

  1. Insurance companies:

    Policy holders should be government insured and insurance company assets, and capital regulation should be updated. You will know insurance regulation doesn’t go far enough if there are too many government losses to make policy holders whole.

    AIG got short credit (sold insurance on securities at low prices) and lost all their capital as risk and the price of insurance went up. Looks to me like a failure of regulation that allowed that much risk.

  1. Home ownership:

    Continue to fund the agencies via the Treasury to keep costs of funds at a minimum.

    Have the agencies ‘buy and hold’ new originations, and thereby eliminate that portion of the secondary markets. The secondary markets serve no public purpose, beyond working past flaws in the institutional structure that should instead be addressed.

    Increase and enforce criminal penalties for mortgage application fraud. Its functionally the same as robbing a bank.

To the question of how to keep homeowners in their properties if it decided that suits public purpose:

  • Use the existing housing agencies to buy foreclosed properties at the lower of the mortgage balance or the appraised value.
  • Allow the agencies to rent to the prior owner at a fair market rent.
  • Give the owner a minimum of 1 year to arrange to buy his house back from the government.
  • Allow the housing agencies the right to sell the house on the market after one year is not already sold to the prior owner.

This will be a major administrative effort, but it’s the only way I can see to get that job done.

  1. Growth and employment:

    Offer (directly or indirectly) a Federally funded $8 per hour full time job to anyone willing and able to work that includes health care benefits. An employed buffer stock is a more effective stabilizer and price anchor. It’s also less costly in real terms, than the unemployed buffer stock we currently maintain.

    Eliminate the various payroll taxes as needed to sustain demand.

    Implement needed infrastructure upgrades and repairs.

The financial sector needs the above three proposals to restore long term solvency. Their financial assets are only as good as the borrower’s ability to make his payments. There is no substitute for rising employment and incomes to support all sectors, including the financial sector.

The quickest and easiest way to support demand would be a payroll tax holiday that doesn’t end until the economy recovers as desired.

  1. con’td

    Eliminate health care as a marginal cost of production. People aren’t more likely to get ill if they are employed; in fact, the opposite is likely the case.

    The current system distorts pricing, and results in a suboptimal outcome for the economy’s ability to sustain prosperity.

This is the absolute argument against business paying for health care. No economist would disagree, but it seems to get ignored.

Once again we are seeing that using the liability side of banking for market discipline doesn’t work.

That’s why deposit insurance exists in every sustainable banking system in the world.

The remaining weak link in US banking system liquidity is the interbank market.

The reason we have an interbank market is the remaining institutional structure that utilizes the liability side of banking for market discipline.

This includes the $100,000 cap on FDIC insured bank deposits, and the Fed demanding collateral from banks when it lends.

Remove these two remaining obstacles for Fed member banks, and bank liquidity normalizes with no ‘cost’ or additional risk to government.

Unfortunately, no one in government seems to comprehend basic monetary operations and reserve accounting.


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WAMU and IndyMac — the perils of accounting control fraud and desupervision

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Just saw a regulator on TV saying WAMU went down due to ‘liquidity’ as they were running out of funds to give to fleeing depositors.

He also said it was not at capital problem, just a liquidity problem.

Taking him at his word (just for the purpose of making the following point), this totally flies in the face of our banking model and should not be allowed to happen.

It serves no public purpose to close a bank due to ‘liquidity’ when it has more than adequate capital.

It does serve public purpose to remove the issue of bank liquidity completely and let the Fed lend unsecured to ‘adequately capitalized banks’.

Anything less, like what the regulator says happened, is unnecessarily destabilizing and counter to public purpose.

If WAMU is in fact insolvent due to insufficient capital to cover losses on a matched maturity, hold to maturity basis, yes, it should be closed down. And that very well may have been the case, and the regulators may not have been doing their jobs in the public interest.


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Banking model

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Once again, we are seeing that using the liability side of banking for market discipline doesn’t work.

That’s why deposit insurance exists in every sustainable banking system in the world.

It’s also why a floating foreign exchange rate is ‘superior’ to a fixed foreign exchange rate. With fixed foreign exchange rates, there is no such thing as credible deposit insurance.

The remaining weak link in US banking system liquidity is the interbank market.

The reason we have an interbank market is the remaining institutional structure that utilizes the liability side of banking for market discipline.

This includes the $100,000 cap on FDIC insured bank deposits and the Fed demanding collateral from banks when it lends.

Remove these two remaining obstacles for Fed member banks, and bank liquidity normalizes with no ‘cost’ or additional risk to government.

Unfortunately, no one in government seems to comprehend basic monetary operations and reserve accounting.

Including most if not all of the FOMC and the Treasury Secretary.


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Bloomberg: China Halts Interbank Lending With US, China Morning Post…

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This may actually help bring LIBOR down as the US banks don’t need USD funds from China while the rest of the world does.

China Halts Interbank Lending With U.S., Morning Post Says

By Joost Akkermans

Sept. 25 (Bloomberg) China’s banking regulator told domestic banks to halt lending to U.S. financial institutions in the interbank market to help prevent possible losses, the South China Morning Post reported, citing people it didn’t identify.

The ban imposed by the China Banking Regulatory Commission is for interbank lending of all currencies to U.S. banks, though not to banks from other countries, the English-language Hong Kong newspaper said today.

The decree came after the regulator obtained data about the risk of local banks to bonds issued by Lehman Brothers Holdings Inc., according to the newspaper. The CBRC wasn’t available for comment yesterday, the Morning Post reported.


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Treasury plan cont’d

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This is what was submitted:

Treasury fact sheet on asset plan

Treasury will have authority to issue up to $700 billion of Treasury securities to finance the purchase of troubled assets. The purchases are intended to be residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans. The Secretary will have the discretion, in consultation with the Chairman of the Federal Reserve, to purchase other assets, as deemed necessary to effectively stabilize financial markets. Removing troubled assets will begin to restore the strength of our financial system so it can again finance economic growth.

While this won’t alter bank capital, bank asset sales shrink balance sheets and ‘make room’ for new lending.

In fact, that was the ‘originate to sell’ model.

This will support output and employment only to the extent it has been constrained by limited capability of banks to lend.

The major effect of having these problematic assets on the books has been in the secondary markets, including interbank lending, which have lesser and only indirect consequence for output and employment.

Supporting the housing agencies ability to lend at lower rates to any credit worthy borrowers directly supports housing and other sectors.

What banks need most is an increase in aggregate demand sufficient enough to increase employment and output.

This proposal for the Treasury to buy bank assists will have little direct effect on aggregate demand.

The timing and scale of any purchases will be at the discretion of Treasury and its agents, subject to this total cap. The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions.

The question of price is problematic.

This is vague as the Treasury doesn’t have clarity on how this might work. It is doubtful that Congress will either. Reverse auctions can result in gross overpricing, which they do not want to happen.

And note the congressional discussion on salary caps for institutions that sell assets to the Treasury – no telling how that will shake out!

The dollar cap will be measured by the purchase price of the assets. The authority to purchase expires two years from date of enactment. Asset and Institutional Eligibility for the Program. To qualify for the program, assets must have been originated or issued on or before September 17, 2008. Participating financial institutions must have significant operations in the U.S., unless the Secretary makes a determination, in consultation with the Chairman of the Federal Reserve, that broader eligibility is necessary to effectively stabilize financial markets.


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Bloomberg: Thoughts on Treasury plan

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My take is an RTC type solution only works when the government owns the institutions, so this will probably be different.

I suspect it will be more like Japan, where the government bought a new class of preferred stock in the banks to add capital.

Whatever they will do will cause credit spreads to come in, which will make the assets of AIG far more valuable and probably result in a ‘profit’ for the government.

Unsold Lehman assets will also appreciate.

More comments below:

Paulson, Bernanke Push New Plan to Cleanse Books

by Alison Vekshin and Dawn Kopecki

Government Options
Options that U.S. officials are considering include establishing an $800 billion fund to purchase so-called failed assets

I see this as problematic as above and as below.

and a separate $400 billion pool at the Federal Deposit Insurance Corp. to insure investors in money-market funds, said two people briefed by congressional staff. They spoke on condition of anonymity because the plans may change.

This puts money funds on par with insured bank deposits. Seems no need for both.

Instead, better to remove the $100,000 cap on bank deposit insurance to allow large investors use bank deposits safely. There is no economic reason for the low cap in any case.

Another possibility is using Fannie and Freddie, the federally chartered mortgage-finance companies seized by the government last week, to buy assets, one of the people said.

That’s already in place. They already have treasury funding to buy mortgages.

“We will try to put a bill together and do it fairly quickly,” House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said after the meeting. “We are not in a position to give you any specifics right now” on the proposals, he said when asked about the potential cost.

The likelihood of the government taking on yet more devalued assets, after the seizures of Fannie, Freddie and AIG and the earlier assumption by the Fed of $29 billion of Bear Stearns Cos. investments, may spur concern about its own balance sheet.

We need to get past this concern about government solvency. It’s simply not an operational issue.

Debt Concern
The Treasury has pledged to buy up to $200 billion of Fannie and Freddie stock to keep them solvent, while the Fed agreed Sept. 16 to an $85 billion bridge loan to AIG. The Treasury also plans to buy $5 billion of mortgage-backed debt this month under an emergency program.

“It sounds like there’s going to be a giant dumpster for illiquid assets,” said Mirko Mikelic, senior portfolio manager at Fifth Third Asset Management in Grand Rapids, Michigan, which oversees $22 billion in assets. “It brings up the more troubling question of whether the U.S. government is big enough to take on this whole problem, relative” to the size of the American economy, he said.

This is ridiculous and part of the problem that got us to this point.


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Agency take over

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Recap:

  1. If I’m reading it right, the agencies will fund directly through the Treasury. I’ve been suggesting this for many years. This lowers the cost of funds for housing, the point of the entire program, by removing a premium that’s been paid by the lack of an explicit guarantee.
  1. Agency portfolios being phased out, to be replaced by direct purchasing of the MBS (mortgage-backed securities) by the Treasury. This has no real implications for the non government sectors, just accounting on ‘their’ side of the ledger. But it does mean lending can continue and funds will be available for all eligible borrowers.
  1. Some kind of government preferred stock coming between profits and the remaining shareholders of various classes. This should leave stocks with some value depending on actual portfolio losses, unless I’m missing something.

 
I’d guess most markets have been pricing in worse outcomes than this.


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