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Fortune magazine and the N-word

July 11th, 2008

Nationalization, that is. In this piece on doomsday scenarios for Fannie Mae and Freddie Mac (H/T Calculated Risk) the cutely named and quasi-private mortgage packagers and guarantors, Katie Benner says

So what might it look like if the government had to lend a hand? Outright nationalization is an unlikely option given that neither the current administration nor the presidential candidates could afford to support such a move in an election year.

but goes on to imply that the likely alternatives could be far more costly, citing a Standard & Poors estimate of a trillion dollar cost to taxpayers, and possible loss of the US government’s AAA rating. Agency ratings aren’ t reliable indicators, but the US government has been in the category of issuers who are assumed to be exempt from scrutiny. A change in this status would be a huge problem for a big debtor like the US.

Either a bailout or a nationalization of Fannie and Freddie would make the Northern Rock fiasco in the UK pale into insignificance. The Northern Rock case shows that a policy towards financial enterprises in which both failure and nationalization are regarded as unthinkable cannot be sustained. The shareholders of these companies have been happy to accept the higher returns associated with an implicit government guarantee and they (the shareholders) should pay the price when the guarantee is needed.

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  1. smiths
    July 14th, 2008 at 14:23 | #1

    Unlike Bear Stearns, which got decimated by the JPM buyout using Federal Reserve money, Lehman Brothers is probably in line for a massive bailout from the Fed.
    At least, that’s what its CEO Richard Fuld seems to believe. The June 4, 2008 Financial Times of London quoted him as stating, “The Federal Reserve’s decision earlier this year to lend directly to investment banks should take questions about Lehman’s liquidity off the table.”
    Whether Lehman can come up with the “liquidity” to meet its debts is no longer an issue, because it expects to be feeding at the trough of the Federal Reserve, just as JPM did when it bought Bear Stearns at bargain-basement prices.

    The difference between the two “bailouts” is that Lehman Brothers, unlike Bear Stearns, will actually get the money. Why is Fuld so confident of this rescue operation? Olagues notes that Fuld, like Dimon (and unlike Bear CEO Alan Schwartz), sits on the Board of the New York Federal Reserve.

    A conflict of interest? It certainly looks like it. Indeed, Olagues points to a statute defining this sort of self-dealing as a criminal offense. 18 U.S.C. Chapter 11, Section 208, makes it a felony punishable by up to 5 five years in prison for members of the Board of Directors of a Federal Reserve Bank to make decisions that benefit their own financial interests. That would undoubtedly apply here:

    “Fuld, at last count, owns 1.9 million shares of Lehman . . . . Although Mr. Fuld sold over $320,000,000 worth of stock at near all time highs in 2006 and 2007, received through the premature exercise of his stock options, he still has value in his present holdings of approximately $100,000,000.”

    Likewise, says Olagues, “James Dimon holds almost 3 million shares of J.P. Morgan stock worth over $120 million with taxes already paid and executive stock options equal in my estimate of another $70 million. His dispositions of stock equaled $140 million over the past few years.” Olagues adds:

    “Fuld, like Jamie Dimon, was at the luncheon on March 11, 2008 with Bernanke, Rubin, CEO of Citigroup, Geithner, President of the New York FED, Thain of Merrill Lynch, and Schwarzman. Some claim that the meeting was about Bear Stearns and how to handle the situation.”

    Needless to say, Bear CEO Schwartz was not invited to the luncheon. “Lehman Bros. is one of the original stock holders of the New York Federal Reserve Bank,” Olagues observes. “Bear Stears does not now have any ownership in the FED banks.”

    The luncheon was held three days before the March 14 collapse of Bear Stearns stock that led to the bank’s demise. If the luncheon attendees were indeed discussing the Bear problem on March 11, testimony before the Senate Banking Committee in which the principals said they first heard of the problem on the evening of the thirteenth, says Olagues, was “less than truthful.”

  2. July 14th, 2008 at 15:22 | #2

    smiths (#49)
    It is perfectly possible to repay a loan of 110oz when there is only 100oz of gold in the system – make staged repayments of (say) 1oz a month over an extended period. As the gold is used for multiple transactions within the economy this is perfectly do-able.
    In fact, removing the physical gold from transactions will improve the ability to do this as transport time is reduced – holding bearer gold certificates (i.e. paper money) is one way and then moving to a purely electronic system is another way. This way that 100oz of gold can be used for thousands of transactions a year without ever moving. This is the process that has happened over the last few centuries (with the exception of the relience on a commodity currency) in our society. Measured M3 would go up and the 100oz may have been used for many deposits into banks during that period, but the actual amount of money in the system has not changed – it is still that original 100oz.
    In this example the question may be whether we have an inflation problem? The question then comes down to whether the efficiency with which that stock of gold has been used for transactions has gone up with the efficiency with which the economy produces goods and services for consumption / investment.

  3. smiths
    July 14th, 2008 at 15:30 | #3

    i’m sorry andrew but that is simply not true,

    first, you can never repay 110 of anything with 100 of it,

    and second, when the fed prints money they do so with no gold backing, they just simply print it and physically increase the money supply

    that was the whole point of seperating from the gold standard, you can increase the money supply with no technical limits

    are you actually trying to say that the money supply has not increased in the last 35 years?

  4. smiths
    July 14th, 2008 at 15:38 | #4

    Banks actually create money when they lend it.
    Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts.
    Because the loan becomes a new deposit, just like a paycheck does, the bank once again holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.

    that is from the dalls federal reserves own site

    http://www.dallasfed.org/educate/everyday/ev9.html

  5. Smiley
    July 14th, 2008 at 16:13 | #5

    the fed is a private bank whose member banks are interested in making money,
    how can they seriously expect to be the chief warners for the consumer,

    That doesn’t quite correlate with my earlier quote from the Wiki entry on FRB which stated that central banks were put in place to protect against runs on the banks. Isn’t the fed also classified as a central bank?

    The question then is: protect who? If the answer is the bankers, then that really is a plumb job isn’t it.

    Except the NAB currency traders were sent to jail. And I imagine that there must be some mortgage brokers facing the same situation in the US right now. But the fact that we see these situations over and over again seems to suggest that the potential rewards outweigh the potential costs.

    It is the job of the banker to measure risk, and set appropriate costs for that risk. The sub-prime meltdown is an example of the catastrophic failure of bankers to do their job correctly. So if bankers cannot fulfil their job description, then we need some other mechanism to protect the banking system.

  6. July 14th, 2008 at 16:20 | #6

    smiths,
    I showed you how you can repay an amount of 110oz with only 100oz worth of gold in the system. Please identify where, exectly, I was wrong. A bald contention that “you can never repay 110 of anything with 100 of it” is unsustainable.
    Second – we were talking about gold backed money. If you want to talk fiat, fine, more than happy to, but let’s not confuse the issue, shall we?
    I know well what the Fed says. It has been repeated to me many times in these arguments. You may have found that link on Ozrisk. If you accept that bank call deposits are money they are correct – but this is like saying the sun comes up in the morning. It means nothing useful whatsoever. There is no new money actually available for transactions. Has the amount of money in the economy increased? Why does it matter? If there is new money it cannot be used.

  7. July 14th, 2008 at 16:45 | #7

    smiley,
    Spoken like a true banker – if we get it wrong, please subsidise our bad decisions or save us from making them again. Iain, at #38, would argue (correctly) that this would socialise the losses and privatise the gains.
    The answer is to allow them to fail, like any other business. The shareholders bear the main losses, the lenders bear the rest.
    A bank failure or two tends to concentrate minds wonderfully.

  8. Smiley
    July 14th, 2008 at 17:10 | #8

    if we get it wrong, please subsidise our bad decisions

    I don’t think I argued that… anywhere.

    Iain, at #38, would argue (correctly) that this would socialise the losses and privatise the gains.

    Huh, you’ve lost me.

  9. July 14th, 2008 at 18:34 | #9

    Smiley,

    It is the job of the banker to measure risk, and set appropriate costs for that risk. The sub-prime meltdown is an example of the catastrophic failure of bankers to do their job correctly. So if bankers cannot fulfil their job description, then we need some other mechanism to protect the banking system.

    How are you going to do that other than through nationalisation or subsidy? Either way, any losses would fall back on the taxpayer.
    (N.B. – I would regard either option as almost certainly going to produce worse risk management outcomes, but that is another argument).

  10. Ian Gould
    July 14th, 2008 at 23:51 | #10

    http://www.npr.org/templates/story/story.php?storyId=92510404

    The US Treasury is to provide a line of credit to Fannie Mae and Freddie Mac.

    The mortgage acceptance companies are in the classic situation of lending long and borrowing short with the result being a short-term funding crisis as funding dries up.

    There’s a simple rule to remember: markets are only rational on average and in the long term.

    Both institutions are profitable going forward and have substantial net assets.

    I know this is bad news for the socialists and gold bugs in the audience but that’s too bad – doomesday ahs been psotponed.

  11. Smiley
    July 15th, 2008 at 09:21 | #11

    How are you going to do that other than through nationalisation or subsidy?

    Well actually, my first suggestion was to increase the reserve fraction. But maybe this doesn’t necessarily have to be mandatory. If the banks offered accounts with a published reserve fraction, the consumer could choose. Sure you might earn less interest with a higher reserve, but a higher reserve should reduce the risk.

  12. July 15th, 2008 at 16:05 | #12

    Smiley,
    You can easily work out the reserve fraction – at least to cash. The question is while we know the denominator, being total short term deposits – oh, wait, how short term is short term? Immediate call, 11am call, 24 hour call or some other period? OK, so we know the numerator – cash, of course – oh, but perhaps we should add in government bonds as they can be liquidated quickly. But then, so can deposits with other banks, including the Reserve. Should we count in only call funds or call periods that may work during a crisis? What about committed lines with other banks – these can be called on unconditionally in a crisis and these are not even assets.
    Historically, these sorts of calculations and simple ratios made sense when the financial markets were really simple and highly regulated (the two go together – regulators like to keep it simple). Now, any simple ratio will simply be laughed at and not worth the paper it is written on.
    Any mandatory raising of the ratio (however calculated) means banks will just hold more liquid assets than is needed to be prudent – as this is the current critieria (see APS 210 on the APRA website). This imposes a dead-weight cost, which customers and shareholders will need to pay. This means all of us will pay more for our banking. It will also encourage more unregulated lending (i.e. pawnbrokers) as they will not have to meet the liquidity criteria.
    This would socialise the costs as I said it would. The other option would provide a largely meaningless ratio that gives the illusion of increased security.

  13. smiths
    July 15th, 2008 at 17:03 | #13

    who are the socialists?

  14. smiths
    July 15th, 2008 at 17:05 | #14

    andrew reynolds,

    there is a very interesting post/discussion at
    globaleconomicanalysis blogspot about measures of money and how useful they are

    i tried to link there but my postr dissapeared permanently

  15. July 15th, 2008 at 17:32 | #15

    smiths,
    Thanks for the pointer – it is interesting. I would agree with the central idea (that M3 is close to , if not actually, useless) and while I normally hesitate to agree with Rothbard on much, TMS does look closer to the mark.
    One thing I would add, though – I think that in practice once economic decision makers start to focus on a particular measure it becomes worth less than it would otherwise have been, with the usefulness inversely proportional to the focus. This appears to have been the case with M3, as with so much else in regulatory statistics.

  16. Smiley
    July 15th, 2008 at 17:35 | #16

    oh, wait, how short term is short term? Immediate call, 11am call, 24 hour call or some other period? OK, so we know the numerator – cash, of course -

    I think that you’re trying to confuse the issue here. If I have a 6 month term deposit you know exactly when it is going to mature. Certain other factors (such as a daily drawing limit) also give the banker an idea of how much money they will have within any 24 hour period.

    Any mandatory raising of the ratio (however calculated) means banks will just hold more liquid assets than is needed to be prudent – as this is the current critieria (see APS 210 on the APRA website). This imposes a dead-weight cost, which customers and shareholders will need to pay.

    I’m not certain why the both the customer and shareholders should pay. I suggested in my last statement that the depositor should expect lower returns for a higher ratio. Therefore the lending margin for the bank could be slightly higher.

    It sounds to me like bankers would like any mandated ratio to be as low as possible. Or in other words, bankers like taking risks, and don’t like asking permission to do so.

    All I’m suggesting is that if the superannuation industry can provide customers with a choice between low risk and high returns, why not the banking industry? I get the feeling that bankers don’t like being told what they can do with other people’s money.

  17. July 15th, 2008 at 19:41 | #17

    Smiley,
    I did not want to go into the term deposit area. I could have added that there is no such thing any more. The traditional TD could not be broken in the period of the TD without significant penalty. Now you just pay the economic loss / gain to the bank to break one. I do this regularly with funds I have on 90 day deposit. The banker does not know when I am going to draw on those funds – they are effectively at call, along with everything else we have in the bank.
    It may appear as if I am trying to complicate, but I am actually simplifying.
    Onthe costs of additional liquidity – to be effective in a run liquidity (however defined) would have to be significantly higher – not merely 1 to 2% – as deposit runs typically involve the withdrawal of around 50% of the deposit base, or more if there is genuine concern. Liquidity levels like this would be very expensive. Levels in the 1950s were around 40% – achieveing that now would mean the sorts of margins would simply be ridiculous – and the capacity to borrow overseas would practially vanish (why invest here) and deposits would also vanish overseas – for the same reason.
    On the last paragraph – banks used to do this (remember the difference between the savings and develpment banks in the 1970s?). As soon as the market was opened up people sought the returns. In the final analysis, people trust the banks. With over 100 years of history without a bank failure in Australia, if they actually think about it, they are happy that the risks are being managed adequately. Returns are what they are after.
    If they want total security they can put the cash in a safety deposit box or under their bed. If they want reasonable security plus a return they can put it in a bank. The banks are where it (mostly) is.

  18. Ash
    July 23rd, 2008 at 15:29 | #18

    Gold? Why is gold valuable? I’ve never seen an answer to that that didn’t amount to “because it’s valuable!”.

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