"Too Big To Fail": Financial Reform

As you would expect, the mainstream “experts” have it all wrong. Their idea of reform of the financial market is to attack the companies. They, the “experts”, decided when the financial crisis hit that some financial companies were “too big to fail”, and that the government must step in and “save” them by pouring mountains of money down drain holes. These companies were insolvent and needed to be liquidated, but the “experts” argued that the government must not let that happen, the consequences, they said, were too dire. But, people in general didn’t really buy off on that. There was enough of a ruckus about the massive amount of money spent in the bailouts that the “experts” then argued that something had to be done to avoid this problem in the future. Now, of course, that “something” did not include any suggestion that bailouts shouldn’t be made, or that the cause of the problem in the first place might be to government policy.



Now the Congress is considering what to do. We are now hearing from those same “experts”. As pointed out elsewhere (e.g., Meltdown by Thomas Woods) these “experts” are the same people who said that the rise of residential real estate prices was not a problem, that the types of mortgages being offered wasn’t a problem, that the increasing foreclosures wasn’t a problem, and that the initial problems with financial institutions wasn’t a problem. Why is anyone listening to these people now? Apparently, no one in the government and the media has the capability to learn from past mistakes. They certainly do not posses the ability to question any belief that they hold, let alone the ideas of the “experts”.


So the Congress is considering the issue of “reforming” the financial industry. The answer is of course, more regulation, which will mean more unproductive cost and layers of government employees with arbitrary power. But there is one proposal to which we should pay particular attention.


The answer to the “too big to fail” problem, it is shouted, is to reduce the size of the American financial companies. This is said, ironically, in the face of the fact that the solution to the potential failure of many financial companies was to push them off on other not-so-bad-off large financial companies, making the resulting companies much bigger. All of those companies that assisted in the “solution” to the last bust are now to be reduced in size.


One of the architects of the original mess, the crisis, the bailouts, and the lack of recovery, the Chairman of the Federal Reserve Board, Ben Bernanke, was recently speaking to a banking conference. He said, “If, in the end, funds must be injected to resolve a systemically critical institution safely, the ultimate cost must not fall on taxpayers or small financial institutions, but on those institutions that are the source of the too-big-to-fail problem,” Bernanke continued in his speech to the Independent Community Bankers of America. “It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms,” Bernanke said. “If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.”


Any history of the world financial markets will record that the push to increase the size of the major financial firms came from two sources, one is the market and the second is the actions of governments. The market would make the scope and range of activities in our world market pushing toward the ability of a financial firm to meet the demands of large, international companies, both in the lower costs of scale of a large company and the ability to work in the large size of the transactions required. The governmental actions were, to name a couple examples, the additional costs that regulations impose, which are easier to absorb for larger firms, the fact that the size of the funds is made larger than necessary by the constant inflation that central banks create, and the success of larger firms in receiving government handouts and favors (and giving the support that legislators require; this list of government influences is not meant to be exhaustive).


To the extent that American financial firms are forced to downsize, in contrast to their competitors in other countries, American firms will encounter a competitive disadvantage. The financial center of the world could and most likely will swing away from New York toward the East. We will see a self-imposed degradation of the United States and its ability to maintain a competitive position. American non-financial firms will tend to move toward foreign companies to meet their international financial requirements. American financial firms, being smaller, may be picked off and purchased by the larger Eastern institutions.


It may be the case that the U.S. government “experts” will attempt to encourage their foreign counterparts to follow their lead and downsize foreign financial firms. To the extent that all financial firms are downsized, we will see a curtailment of international activity as financing becomes less available. But, some countries will see the benefit of being financial giants, in a world of pigmies.


We will be seeing another step in the continuing destruction of the United States of America as a economic powerhouse and standard of freedom and individual liberty.

PARALLELS, NASTY ONES

My perspective is economics, not that I am unaware of or concerned about the philosophic, moral, or political issues, but other people are writing about those and doing a fine job. I don’t see a reason for duplication. I don’t see much written about the economic implications and that is more where my experience and education lies, so, with that in mind, let me ask:



Do you notice the parallels between FDR and BO? Both began office after a huge dive in the economy: the stock market dove spectacularly in both cases, unemployment has soared to similar heights, there were financial crisis in both cases, both were preceded by Republicans who are regarded as somehow pro-capitalism but aren’t, both have pushed through public works bills, both pushed for overhauls of major parts of the economy, both are presenting themselves as saviors, and both are more concerned with power than any other issue. I am sure that there are more economic parallels.


Here we are into the second year of BO’s presidency, and, in spite of what the Fed and other government economists say, we are still in the recession. Unemployment is expected to remain high for years to come. Businesses and banks are unsure as to what to do because of the uncertainty as to what BO and his Congress will do to them in the near future. Further, what BO has done recently promises to weigh down the economy with massive expenses, higher federal debt, and tighter restrictions on production.


In other words, we have no good reason to think that our future will be any different now than the people in the 1930’s experienced. (It is true that BO has not started destroying food. Don’t put it past him.) To say this correctly, we are currently headed for continued recession that could last for years. Since BO, Treasury Secretary Geithner, and the Fed’s Bernanke do not know why the economy is not recovering, and would not consider freedom as an acceptable solution to the lack of recovery, we can expect more “solutions” that will sap our savings, and drive us further into recession/depression. Last time the Great Depression lasted 16 years without any questioning of the doctrine that kept us from prosperity. Even after the economy began working again, in 1946, when FDR was dead and Truman had put in his own people, no one questioned how the economy recovered without the government’s input. Today, no one is asking why the “recover” is so slow. Instead, they are doing everything possible to prevent recovery.


Further, after 70 or so years of encroachment by anti-capitalist measures, our economy has less vitality and room to maneuver than it did in the 30’s and 40’s. The government has more tools to manipulate and degrade economic performance today than it did before.


On the other hand, in some ways current businesses are more flexible and know more about their businesses than business managers in the 1930’s. Further, American businessmen have nearly a century of experience of how to work around government regulations and manipulation. That is not to say that they can bring our economy out of the recession, but they may be able to maintain their own and be modestly profitable. The large number of businesses dependent on government handouts will be a drag, as they continue to absorb savings and made-up money. It might sound as though this paragraph contradicts the previous one, but I am looking at the problem from first the restriction side and then the victim side. I don’t know which one will dominate, but both trends exist.


Frankly, what we have is uncertainty all around. But, keep in mind that uncertainty, in this circumstance, is a better condition than outright deterioration or a further dive.


In terms of your own situation, the best advice is to keep flexible. That doesn’t mean to stay in cash, including foreign cash, because cash is a guaranteed loss in a time period longer than a year. That doesn’t mean all gold, because the gold price, as we have seen over the last year, is bounced by many factors besides being a store of value. It doesn’t mean all foreign investments, because foreign economies are being buffeted by the same factors as the U.S. economy, including their own governments and central bankers. Foreign economies are also very dependent upon the U.S., so if we are failing, the likelihood of their flourishing is low.


What I think your best position includes is diversity, more so than ever, including foreign and domestic stocks, cash, foreign cash, and etf gold (least expensive way to hold it). No bonds of any kind. You do not want to be a lender in these circumstances.


Residential real estate is risky. If the situation is that your job could be in jeopardy, trying to hold on to the house could be a major problem. Buying today, even at low rates and lower prices is no guarantee that the purchase will work out for you in the next five years. If you have owned the house for some time and have equity in it, and the payments are relatively low, and you have some reserves, you are in a decent position. The biggest problem in these times is that the mortgage payment will tie you down, reduce your flexibility, and tend to present an inducement to remain in a perilous circumstance.


More than ever, you need knowledge. You need to know how these markets work. You need to know how the dollar relates to other currencies and foreign assets. You need to know how to watch your countries inflation monitors. You need to know what sources you can trust.


How long will this uncertain-stage last? It has lasted for several months so far, since the rush to dump employees slowed. We are waiting to see what effect BO’s massive new debt will have, we are waiting to see what the Fed does with all the money it created, we are waiting to see what consequences the new wave of regulations on all parts of the economy will have, we are waiting to see if BO can carry forward his massive expansion of government, and we are waiting to see if people are actually beginning to resist BO and the Dems. Combined, all of these issues are bad for even maintaining the current lull.


Prosperity is very unlikely if even a few of these economically stressful government activities come to fruition. I do not expect prosperity without at least some movement away from the future the present government and Congress have planned. Let’s say the Republicans win significantly in November. Will that mean that they will back us off of what BO will have instituted in his two years? It is unlikely. They may just decide that it is an opportunity for their brand of fascist state.


We could also see the economy begin a slow dive, not a panic, but just a decline as businesses find that they are not able to pay their debts or payrolls. This decline will not be signaled by any specific event. It could even be hid by the government’s statistical procedures. Just keep an eye out for a lack of growth, lack of non-government hiring, government talk of some segment or other of the economy failing to do their part, and the housing sector seeing more foreclosures and lower sales.


We may end up wishing we had a John Galt to unplug the minds keeping this thing alive.


Now, my focus is our economy. But as I said at the beginning of this post, I know that there is connection between the moral, political, and the economic, i.e., without freedom we cannot have a productive, prosperous economy. Without the morality of reason, of self-interest, we cannot have freedom. I am an advocate of individual rights and lazi-faire capitalism, of the virtue of selfishness.


I am talking to those whose fight is to achieve freedom. I merely want you to protect as much of your personal wealth and wiggle room as possible.

"Eliminating Reserve Requirements"

There is one thing that is wondering around various commentators that I hope that you do not get caught up in. Ben Bernanke, Chairman of the Federal Reserve, is quoted, correctly it seems, in saying that he would like to see the eliminating of the reserve requirement.



Every commentator that I have seen so far is screaming and carrying on about how horrible this is that the Fed wants to eliminate bank reserves. They are a little confused. They apparently do not realize how banks function, especially within the United States and within the Fed.


Each bank in fact has two reserves. The bank keeps on hand possibly five layers of reserves. There is the cash on hand to meet the daily cash requirements of its customers. There is the digital balance it keeps on hand to meet the demand for check transfers and transactions. They also have reserves to cover loans that go bad, so that they can replace the demand deposit (checking account) balances. There is also part of their loan portfolio that consists of government bonds and other assets that may be turned into “cash” quickly. Finally, there is the capital account, made of the equity that was invested by the shareholders. (Note that the loan-loss account and the capital account may be kept in government bonds or other liquid assets.) Bernanke’s proposal has nothing to do with these account and reserves. He is not suggesting anything to do with a bank’s operating methods or what passes for safety in today’s banking environment.


The bank has one other “reserve”. It is the percentage of its demand deposits that it has to have deposited with the Fed. This deposit, called a reserve by the original legislation that set up the Fed, is not a reserve in any rational sense. The bank has to have these funds on deposit with the Fed by law and if by chance the percentage of the deposit vs. the amount of its demand deposits in the bank falls below the current requirement (today it is 10%, including cash in the bank’s vault, which is as low as I know of in the history of the Fed), then the bank must either move money immediately or borrow it from another bank (the inter-bank rate) or the Fed (the discount rate or Federal Funds rate).


It is this totally useless Fed deposit that Bernanke is suggesting be done away with. Which, on the face of it, doesn’t seem like a bad idea. I am interested in how Bernanke is going to carry forward the purpose of the Fed, which is to manipulate the money supply, expand bank lending, and make inflation a constant in our lives. It will be interesting to find out.


Actually, this isn’t anything worth paying much attention to, since it will not affect much that will make a difference. We will still have the Fed destroying our assets and ignoring that they are doing so.

Fed and the Money Supply: Details

A thoughtful consideration of my articles on how the Fed works to expand bank credit, the Fed’s massive expansion of Member Reserve Deposits, and the steady decline in bank loans could easily result in some head scratching. My explanation of expanding bank credit (similar to what you find in Meltdown by Thomas Woods) would lead you to think that bank lending would be going crazy now, with the reserves built up to such a massive amount. There are, however, other factors at work in the process that I did not include in my discussion. I thought that my explanation of the Fed’s basic activities was long, complex, and convoluted enough without adding many other things in as well. I should also say that the degree of complexity is not really apparent until something like the present situation occurs.




What other factors? Well, there are basic banking practices, bank profitability, bank capital and loss reserve needs, and other regulators. This last factor is not minor. The banks have a galaxy of people looking over their shoulders. These regulators insist, and have the power to insist, that the banks follow certain “risk” and accounting standards. It isn’t that everyone of these standards are necessarily bad, but that the application can be arbitrary and outside of context. The standards change constantly, especially in their detail, which sometimes makes what the bank was doing in accordance with the regs yesterday, but today, that practice is wrong and subject to penalty. How this is working out in today’s circumstance is explained in this Forbes article. The author is an administration cheerleader, but he inadvertently gives you a very good idea of what is happening.


Most basic in considering a bank’s standard method of operating is that it is a business, with shareholders, employees, balance sheets, and standard operating practices that have been developed over centuries. Banks are in business to make a profit. Sound banking, to the extent that it can be found amid all of the nonsense required of banks today, also includes of many of the practices that any business needs to follow if it is to be profitable.


In addition, especially within today’s funny-money environment and the uncertainty of future of changes in regulation and government activity, a bank has to protect itself (think of the uncertainty BO’s TARP Tax created). The bank has several different accounts of its own that it maintains for financial protection. It has a capital account, what you could also call equity. The bank’s capital is reduced if it operates at a loss or if other assets are lost. The bank also has a loan-loss reserve, which is an account of cash that the bank keeps to cover bad loans and the failure of other assets, e.g., mortgage backed securities. During the financial crisis, many banks saw significant shrinkage in these two accounts. In order to restore the health of a bank, these two accounts have to be built back up. Banks cannot and will not expand their loans again until they have a healthy capital account (which would be a certain ratio to its obligations) and loss-loan reserve (also a certain ratio to outstanding and new loans). In the normal course of events, these accounts would be increased by either by going to the capital market or by retaining profits. The capital market is not functioning well right now, especially for banks, and profits are hard to come by. Sensible banking is standing in the way of the government’s (read BO and the Fed) demands for increased loans.


One might suggest that a bank could take some of the excess reserves that the Fed has given the bank and put that in either of these important accounts. But it can’t. There is no legitimate accounting method to do so. It is exactly the same problem for someone who wants to take stolen money or drug profits and put into a business. There is no way to account for it.


A bank can take money the Fed has created and placed in a bank’s “reserves”, but there is only one use that it can put that “money” toward: loans. When I wrote that a bank with an increased reserve could then make loans, I was implying a practice that is not the norm. I am not aware of any restriction preventing a bank from just expanding its loan portfolio when its reserves have been expanded, assuming that the capital and loan-loss reserves are sufficient. It may be that the accounting techniques available do not support that approach. For whatever reason, banks tend to take a different approach.


What happens is that the bank will take excess funds out of their Fed account, presumably a percentage that leaves the required deposit in their Fed account. This “money” (in quotes because it is stuff that the Fed created) the bank then loans.


The process probably goes like this. The Fed has selected a target interest rate below market for the Federal Funds/discount rate. To maintain that low rate, the Fed will be buying Federal bonds from institutions. When the bank presents the check for the purchase of the bonds to the Fed, the Fed puts the funds into the “reserve” account of that bank at the Fed. The bank now has more funds in their “reserve” account than they need for the demand deposits held by the bank. If a “qualified” loan applicant is available (qualified in quotes because low interest rates distorts, undercuts the real criteria needed to make loans, i.e., a market interest rate), the bank takes the “money” out of the reserve account, leaving at least sufficient funds to cover its reserve requirement, and loans the “money” to the applicant. And thus the money in circulation has been expanded. The funds loaned are used to pay bills related to the purpose of the loan, which means that the “money” shows up in other banks’ demand deposits, which those banks use as they use any money. They adjust their Fed reserve account to reflect the increase in demand deposits, and loan out a portion in new loans. After this process continues through its natural course of movement from bank account to bank account, the ultimate increase in the money supply comes close to equaling the reserve ratio. Today, large city banks are required to have 10% of their demand deposits in their Fed accounts (currently, they can count cash in their own vault as part of the “reserve”). Thus, an increase in the “reserves” of $1B can see an increase in the money supply of $10B.


As much as the Fed and, today, BO, would like to see an automatic process whereby the Fed can force up the money supply, just by increasing the Member’s deposits, as we see above, there are some countervailing forces. How long those forces will remain in effect is the current question.


It is also the case that as much as the Fed wants banks to begin lending again, it doesn’t want them to be lending as much as the current massively, over-funded Member’s accounts would allow. Currently, there is over $1T in excess reserves. That is more than any historical period by a factor of close to 100,000! Even the Fed, which normally ignores the actual pumping of money, is concerned about the amount of reserves currently sitting there.


But what is the Fed to do? Bank loans are actually still declining. Interest rates, according to mainstream economics, have to remain low to stimulate the economy. As soon as the Fed starts withdrawing the excess reserves, interest rates will start up, especially long-term rates, and all kinds of unwanted consequences will result, including increased interest expenses in an already bloated federal budget. BO will start yelling at the Fed and the Congress will start “investigating”! Also, the stock market will dive, (the dollar might actually strengthen, who knows?) housing purchases will decline as mortgage rates go up, and the economy will tend to slow. If it weren’t that we are all living in the middle of this circus, it would be fun to watch.


As of yesterday, the Fed again reassured everyone that interest rates will remain low. Aren’t they nice?

My Return; Four Comments

Storms, cat sitting (my good friend, George), being sick – for way too long, and stuff have put me way behind. I haven’t touched this for weeks. I hope to get back to my efforts.



For today, let me hit a news story or two, err…four.


HEALTH CARE

Recent announcements from people who keep track of it put government spending on health care at almost 50% of the total this year and more than 50% next year. After that, especially with Medicare and then whatever BO gets into the system, government spending will soar!


What does this mean? You know already. More of the same annual inflation of the cost of health care, plus probable rationing, attempts at price controls (MA is approaching that now), and a lowering of the quality and quantity of health care in America. Because of the recession, the loss of our high health care standards will happen earlier than we might have expected. It is all interrelated, the economy and our quality of life.



RECESSION

Speaking of the economy, the recession is lingering. Yes, some have proclaimed the recession over. Maybe in some respects it is, but even then, it is a very marginal thing. I see no immediate reason to declare that our standard of living is recovering. In fact, it is just the opposite.


Now there are stories in the press that the economy will suffer a decline again very soon. You might say that it is good that the press is recognizing the failure of the approach accepted by both Dems and Republicans alike (does “Repub” sound like a nice fit with “Dems”?). You would be wrong. These “economists” who are forecasting renewed recession are doing so because the government hasn’t interfered sufficiently or in quite the right way for their taste. They want more government activity, in areas they think are important. How bizarre. The disconnect with reality is so severe for today’s “economists” that no level of failure will cause them to reevaluate their position.


As the decline in January of the housing market indicated, the stimulus programs that BO put in place are failing to get the economy going. In stead, the economy is still pretty much not going anywhere. Job losses have flattened, bank lending is still falling, and businesses are trying to do the best they can.



PRICE INFLATION

If BO does get some more of his programs in place I think that we will begin to see some more significant price inflation. He will be pumping massive amounts of money, new, made-up money (by way of selling bonds overseas or through the Fed), directly into the economy (as opposed to the method used when new money is created by the Fed via bank credit expansion), which will chase after the stuff already available, and prices will rise. We won’t be seeing the asset or commodity bubbles because bank lending is still declining. Price rises will confound everyone, including the Fed, and we may revisit price controls. We certainly will not see spending reductions from the Federal government for the next three years, even if the Dems lose a lot of seats in the coming election.



GLOBAL WARMING

I don’t write much about this because it is well covered by others and I don’t have anything new to contribute. I did see this on facebook, so I thought that I might mention it.


This was referenced by some conservatives as a good reply to the global warming croud. I’m not sure why. It may be a put up job. It certainly is a denunciation if you regard religion as wrong, but it is offered by the conservatives (?). It does take the science out of the global warming movement, which is a good thing. It doesn’t give any importance to the political aspect of the global warming people, which is their main objective.



GRAB FOR RETIREMENT ACCOUNTS

This subject should make you very concerned, if you have any significant amount of money in what are called qualified retirement accounts, i.e., IRAs (Roth or traditional), 401(k)s, Simple Plans, Money Purchase Plans, etc. The government, under the assertion that most investors are mismanaging their retirement assets, are suggesting that the funds be turned into annuities. Annuities give you a stream of income that lasts as long as you are alive.


The intention of the government is to move that money into government securities, i.e., bonds. Thus, it won’t matter what China or other overseas bond buyers do in the future, the government will have trillions of dollars to use from the retirement accounts.


There are many downsides to this plan for you, financially speaking. The biggest is that an annuity offers absolutely no protection form inflation. You are on a fixed income. But that, of course is a secondary point. Most important is their plan to forcibly separate you from your assets. Watch this carefully. If they get close to bringing their plan to fruition, you will want to pay the taxes and move whatever money you can to a non-qualified account. In the meantime, you will need to talk to your representation to stop it.


Like the attempt to subvert your health care, this attack on your retirement assets has personal repercussions on you. If you talk to make comments to the Treasury, I think that it is important to point out the principled and practical consequences on you, both moral and financial. You don’t want to lose this battle because the authorities did not realize that you feared for your financial health as well as your freedom. If they don’t care about your freedom, they still might be concerned about the other. We don’t know. Don’t leave out either issue.