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Saturday, October 18, 2008

Bailout Arithmetic

Zargon has left a new comment on your post "Reader Mail #67":

Even though Congress rejected the bailout, the Federal Reserve still has the power to create money out of thin air and loan/give it to banks. This is as effective a bailout as if it were explicitly allocated by Congress.

Ok, this makes sense. But then why didn't the fed simply issue a $700B 0% interest permanent "loan" rather than attract all this attention with an explict bailout? The bailout raised some awareness of the inherant unfairness in our monetary system, though I'm not sure how much. Printing a huge pile of money and giving it away would just be another unremarkable day at the fed.

This comment deserves its own separate post.

There are two restrictions on how much loans banks can issue.

The first is "reserve ratio". For each $10 in loans, banks must have $1 in reserves. Banks with extra reserves lend them to other banks. Banks with insufficient reserves borrow them from other banks. The rate that large banks charge each other for reserves is the Fed Funds Rate. Nearly every day, the Federal Reserve "monetizes the debt" to create new reserves.

The second restriction is "net capital requirement". The capital requirement varies by each class of loan. For example, stock margin loans have a net capital requirement of 7x. Investments in corporate/mortgage bonds have net capital requirements of 15x-50x. Investments in Treasury debt has net capital requirements of 100x-200x or more.

If a bank has $10M in net worth, it can't issue $100B in loans. There are restrictions on how much leverage may be used. Currently, most large banks have a negative net worth, which means they can't issue any new loans at all. Due to the Compound Interest Paradox, there is a risk of hyperdeflation if banks cannot write new loans.

It helps to illustrate with a specific example. I've never seen a mainstream economics source perform a calculation like this.

Suppose banks may use a 50x leverage ratio when investing in mortgage bonds. The yield of the mortgage bond is 6% and the Fed Funds Rate is 5%. The bank makes a guaranteed riskless profit of 50%. The actual profit for shareholders is less than that, because of expenses and salaries.

The bank is doing no real work. The bank is merely borrowing at the Fed Funds Rate of 5% and buying bonds yielding 6%. Bank management is taking no personal risk. They can always lobby the Federal Reserve or Federal government for a bailout. If necessary, they can declare bankruptcy and find another job.

The trade is so lucrative that banks successfully lobbied for permission to use more and more aggressive leverage ratios. If banks may use 50x leverage instead of 10x leverage, then superficially their profits are 5x bigger. However, that merely makes the crash during the next recession/depression that much worse.

This trade is only available to large banks. As an individual, I don't get the perk of borrowing at the Fed Funds Rate. As an individual, I don't get the benefit of "Level 3 Accounting", which means banks don't have fully to mark down their assets during a recession.

Suppose the bank has $10B in net worth. The bank has a mortgage portfolio of $500B and $490B in money borrowed from the Federal Reserve or depositors.

Suppose there is a mild recession. Due to default risk, the value of the bond drops by 3%. Debtors can't pay their loan, and the house is worth less than the face amount of the loan. For every $1 face amount of the bond, the bank expects to collect $0.97.

The bank is technically insolvent. It is borrowing at 5% to buy a bond yielding 3%. With 50x leverage, the bank will go broke in a hurry. The bank can't sell the bond, because the bond is worth less due to the default risk.

The Federal Reserve comes to the rescue/bailout. The Federal Reserve cuts the Fed Funds Rate to 2%. Now, the bank is borrowing at 2% to buy bonds yielding 3%. The banks' profit equation is restored.

Over time, inflation works in the banks' favor. Housing prices rise due to inflation. People are able to pay their mortgage or refinance. The bond starts yielding 6% again. The Federal Reserve raises the Fed Funds Rate back up to 5% to set up the next recession.

Suppose there is a severe recession/depression. Due to default risk, the value of the bond drops by 50%. For every $1 face amount of the bond, the bank expects to collect $0.50. (Some of these mortgage bonds are worth as little as 10% of the face amount.)

Now, the bank is borrowing at 5% to buy a bond yielding -47%. The Federal Reserve can't cut interest rates below 0%. The Federal Reserve can't inflate too fast. If the Federal Reserve doubles the money supply in a month, then people would start to notice hyperinflation.

The bank now has debts of $490B and a mortgage portfolio worth $250B. The bank has a net worth of -$240B.

Due to limited liability incorporation, the owners and management of the bank can merely declare bankruptcy and cheat their depositors/creditors in bankruptcy court. $240B is a huge amount of money. Many other businesses could be forced into bankruptcy if they are cheated out of their deposits.

Some of the mortgage bonds are "Level 3 Assets". The bank has no legal obligation to "mark to market". However, it is embarrassing that it is carrying these assets on its books for far less than the fair market value amount. A lie stretched too far is no longer believable. If a bond is worth $800M and you carry it on your books for $1B, that's a believable lie. If a bond is worth $100M and you carry it on your books for $1B, that starts becoming too doubtful. If the bond is overvalued by 20%, then 2 years of inflation gets you back to face amount. If the bond is overvalued by 1000%, then it would take many years of inflation to get the underlying assets inflated back to the face amount of the bond.

The $240B loss is too big. It can't be hidden by "Level 3 Asset" accounting. The bank is "too big to fail". The Federal government must explicitly bail out the bank, lest depositors lose money.

Perhaps the bank will only receive a $40B bailout. The remaining $200B will be recovered over time via inflation. As inflation occurs, housing prices will rise again, and the bonds will be able to be repaid.

I've never seen a mainstream economics source perform a calculation like this. This calculation illustrates the completely immoral nature of the US monetary system and banking system.

The US government has delegated its money-printing power to the Federal Reserve and the financial industry. Physical Federal Reserve Notes are printed by the Treasury. However, new money is put into circulation only when a bank creates a loan. Since the bank is technically insolvent, it may no longer issue new loans. The bank is in violation of the net capital requirement. If banks stop issuing new loans, the dollar collapses in hyperdeflation due to the Compound Interest Paradox.

The Federal government bailed out the banks by directly investing/giving the banks money. Now, the banks are satisfying the net capital requirement. They may begin issuing loans and reinflating.

The bailout isn't free. The cost is already paid as inflation. The wealth stolen in the bailout is already gone. Some of it was used to build too many houses during the boom. Some of it was used to pay executive salaries and bonuses. Someone must be cheated. In bankruptcy, the banks' depositors and creditors get cheated. With a bailout, everyone else is cheated as their dollars lose value do to inflation.

The Federal government is the only entity that may have unlimited dollar-denominated debt without being forced into bankruptcy. Deficit spending by the Federal government helps alleviate the Compound Interest Paradox.

The bailout could have been accomplished just as well by giving $3000 to every American, than by giving $700B to a handful of insiders. Some people would have chosen to invest that money in the stock market, forming new banks or investing in the old ones. Even if someone uses the $3000 check to purchase groceries, then someone else would have the $3000 and they could use it to invest in a bank. The $700B bailout was entirely corporate welfare for a handful of insiders. Alternate proposals are not discussed, because the purpose is to loot and pillage. If you view government as a massive criminal terrorist organization, then the bailout makes sense. There have to be some semblance of accounting standards, lest the scam be too obvious. The bailout allows the politicians to say "Accounting standards/regulations *MUST* be enforced!" while bailing out their buddies.

There is one set of accounting rules for "too big to fail" banks and another set of rules for businesses that produce useful goods and services.

If a small business has problems, then the owner loses everything. Large banks are "too big to fail". This bailout and recession/depression is further consolidating the financial industry. This practically guarantees that the next bust will be even more severe. There will be 3-5 "too big to fail" banks that are responsible for nearly all loans. The Federal government has practically insisted that only a "too big to fail" bank is a viable business.

Large banks get a perk that nobody else gets. They may borrow at the Fed Funds Rate and buy bonds or other assets. Via "Level 3 Accounting" and the concept of "too big to fail", large banks *ALWAYS* qualify for a bailout. The bailout can come indirectly via a Fed Funds Rate cut. The bailout can come over time via inflation. Management of large banks like a controlled rate of inflation, because they're profiting off leverage and the spread between the Fed Funds Rate and the loan rate. Bank management is not investing in the underlying assets. In a severe recession/depression, an explicit bailout is needed.

If you don't like the US monetary system, then you should start your own monetary system! Technically, that's illegal, so an alternate monetary system must be completely decentralized and off-the-books. In order to boycott the Federal Reserve, you must also boycott income taxes. Income taxes must be paid in Federal Reserve Notes. According to the IRS bureaucrats, all economic activity is subject to taxation. Agorism is the only resistance strategy I've read that doesn't seem like a complete waste of time.

1 comment:

Zargon said...

Thanks for the explanation. The calculation was very helpful.

Followup question: Ok, the company has managed to get $490B in debts and a $250B mortgage portfolio in the case of the bonds declining by 50%. But they owe all that to the federal reserve. Now, on the side they have other creditors - the people who will be screwed if the bank goes under. It seems that in a bankruptcy situation, if we simply pay the federal reserve last, nobody gets directly screwed (everybody takes the inflation hit, but nobody notices that anyways).

Is there a reason they don't do that (let the bank go bankrupt, but pay the fed last)? The execs still get to make off with the cash from the boom years. They could use any number of tricks to ensure their friends are in control of whatever bank replaces them in the list of 3-5 in the oligarcy. And they would have another talking point to show how fair everything is.

I suppose they might not do this because it might lower consumer confidence in our faith based market. Or perhaps paying the fed last still isn't sufficient to pay everybody else due to details outside the calculation? Or perhaps this is simply another opportunity for them. An opportunity to make a quick $700B (or whatever it is now) because they think they can get away with it. Letting the bank go bankrupt and them proceeding to set up a new bank is probably far less efficient at stealing money for insiders as a bailout. That seems most likely, having thought about it some more.

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