Saturday, November 16, 2019

In 2008, Bailouts for Everyone! Fannie Mae, Freddie Mac, AIG Insurance, TARP, etc., But Mainly for Citigroup (Again!)

Many Americans may remember the fall of 2008 as a chaotic and frightening series of teetering dominoes—huge financial firms that had bet too much on the housing market. Many Americans may also recall experiencing a tremendous anger as the government rescued one stumbling giant after another. In September, Washington bailed out the government-created mortgage investors Fannie Mae and Freddie Mac. Then the feds rescued the insurance titan AIG, effectively a bailout of all the Wall Street firms to which AIG owed money. Among the great financial houses, only Lehman Brothers was allowed to fail.

But the Lehman moment of market discipline didn’t last long. The government then came to the rescue of money market mutual funds and issuers of commercial paper. By early October, President George W. Bush had signed the Emergency Economic Stabilization Act into law, creating the $700 billion Troubled Asset Relief Program. Roughly ten days later, financial regulators began spending this pot of rescue money, announcing direct investments in America’s largest banks. But was there one bank in particular that had regulators scared enough to engage in such radical interventions in the economy?

In the fall of 2008, few people in America had access to more information about the health of American financial institutions than FDIC chairman Sheila Bair. Four years later, she looked back on that season of crisis and wrote: “I frequently wonder whether, if Citi had not been in trouble, we would have had those massive bailout programs. So many decisions were made through the prism of that one institution’s needs.”

—James Freeman and Vern McKinley, Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (New York: HarperCollins, 2018), e-book.


Friday, November 15, 2019

Different Credit Expansion Channels Do Not Affect the Basic Mechanism of the Business Cycle But Cause Differences in the Secondary Features of the Cycle

These different credit expansion channels do not affect the basic mechanism of the business cycle (characterized by erroneous investments as a result of the artificially lowered interest rate) but are responsible for the differences in the so-called secondary features of business cycles that make them nonidentical despite obvious similarities.

Finally, it is worth noting that the course of the business cycle and the implementation of the Cantillon effect are influenced not only by the investment policy of commercial banks, but also by other factors. I mention a few of them here. First of all, central banks may conduct monetary policy in various ways and create a monetary base, which has varied effects on credit expansion and, consequently, on the course of the business cycle. For example, quantitative easing is a different mechanism of introducing new money into the economy, relative to traditional open market operations, generating a slightly different first-round effect. While in the open market operations the most frequently purchased debt instruments are short-term Treasury bonds, quantitative easing may take place through also buying long-term bonds, including non-treasury bonds (e.g. corporate bonds or bonds secured by mortgages). This entails different redistributive effects, also affecting the yield curve and the risk premium in different ways.

Second, the type of entity that creates new money through the credit market and the way it is created is also important for the course of the business cycle and the implementation of the accompanying Cantillon effect. At present, a significant portion of loans are granted for the purpose of converting them into securities or, in general, by entities other than commercial banks. Indeed, banking activity has changed significantly in recent years and banks have largely abandoned traditional commercial banking based on taking deposits and lending, and instead adopted a business model based on loan securitization and their distribution to the so-called shadow banks. The effects of increasing the money supply (in the form of credit) vary, therefore, depending on what type of bank (rural or urban, small or large) or institution provides the loan. Loans can be created not only by commercial banks. Other depository institutions (such as savings banks or credit unions) and the so-called shadow banking system also participate in this. The creation of money by shadow banks seems particularly important in the modern economy, because securitization enables traditional commercial banks to increase lending (including through transfer of credit risk outside the bank balance sheets to investors purchasing securities), and intermediation of liabilities allows the so-called shadow banks to create loans by themselves. The creation of a loan through a shadow banking system implies a different implementation of the Cantillon effect, because the shadow banks’ asset structure differs from the structure of traditional banks’ assets, and certain types of loans are more readily used in the securitization process.

—Arkadiusz Sieroń, Money, Inflation and Business Cycles: The Cantillon Effect and the Economy, trans. Martin Turnau, Routledge International Studies in Money and Banking (Milton Park, UK: Routledge, 2019), 91-92.


At the Heart of the Credit Crisis Is the Network of Highly-Leveraged Off-Balance-Sheet Vehicles—the Shadow Banking System

Pozsar’s initial paper outlined the “constellation of forces that drove the emergence of the network of highly-leveraged off-balance-sheet vehicles—the shadow banking system—that is at the heart of the credit crisis.”

Off-balance sheet (OBS) is an accounting maneuver used by companies to reduce their debt levels for reporting purposes. Enron perfected the use of OBS partnerships to hide its true liabilities from regulators and shareholders. Many at the Fed believed the OBS demon had been forever exorcized with Enron’s fall. But the demon had grown and metastasized, spreading little cancers throughout the financial system.

The resurrection of OBS vehicles had been made possible because banking had been reshaped by deregulation, innovation, and competition. Then the Fed lowered interest rates, creating “an abundance of credit for borrowers and a scarcity of yield for investors.” (Thank you, Alan Greenspan!)

Pozsar pinpointed the 1988 Basel I Accord as the main catalyst for the growth and advances of “credit risk transfer instruments” like CDOs [Collateralized Debt Obligations], MBSs [Mortgage-Backed Securities], asset-backed securities (ABS), asset-backed commercial paper (ABCP), commercial mortgage-backed securities (CMBS), and so on.

Issued after the banking crises of the late 1980s, the new Basel rules required that banks meet a minimum capital requirement and hold even more against riskier assets. For investment bankers seeking to maximize profits, and thus their own compensation, the changes created the need to hide liabilities in the shadows.

—Danielle DiMartino Booth, Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America (New York: Portfolio Penguin, 2017), e-book.


Thursday, November 14, 2019

In September 2007, Northern Rock Triggering the First High Street Bank Run in the UK Since 1866

The British bank Northern Rock played a starring role in the unfolding drama of the financial crisis. In September 2007, news that Northern Rock had used emergency liquidity support from the Bank of England led to the first high street bank run in the United Kingdom since Overend, Gurney and Co. in 1866. Following unsuccessful attempts at finding a private-sector buyer, Northern Rock was nationalized in February 2008, a policy outcome that would have struck many people as unthinkable just a few months before. Indeed, the speed at which “the Rock” had gone from being the darling of the city to a symbol of the meltdown was breathtaking. Following its listing on the FTSE 100 in 2000, the share price had been steadily increasing, and the company posted profits of more than £440 million in 2006. Around 5 percent of annual profit was being paid into the Northern Rock Foundation, which grew to be one of the United Kingdom’s largest corporation foundations (giving grants of more than £27 million in 2006), and the company had emerged as a beacon of North East economic renewal through its sponsorship of local sports teams and the planned development of new headquarters. If loyal customers were surprised at the speed of the bank’s downfall, they weren’t alone.

The main problem with Northern Rock’s business model was that its rapid expansion entailed two things: (1) allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets. [Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding.]  In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007. And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA). Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors.” There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets].” Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.


—Anthony J. Evans, “The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 749-750.


With the 2007–2008 Crisis, the Instabilities Arising from Maturity Mismatches Appeared in New and Hidden Forms Such as Mortgage-Backed Securities

Austrian economics provides fundamental but too often ignored insights into the challenges of monetary and macroeconomic policymaking. The Austrian theory of the business cycle offers a persuasive account of the genesis of the 2007–2008 crisis: it was made possible by the reliance of central banks worldwide on the reduction of short-term rates of interest to promote private sector spending. This encouraged an unsustainable expansion of money and credit. The only substantive difference from previous financial crises, something that allowed the preceding credit boom to proceed for so far and so long, was that instabilities arising from maturity mismatches appeared in new and therefore hidden variants, through money market funding of mortgage-backed securities and other structured credit assets. Austrian economics also provides a valuable explanation of previous episodes of global economic instability, for example the breakdown in the early 1970s of the post-war Bretton-Woods fixed exchange rate system based on a gold exchange standard as a consequence of insufficient discipline on US monetary creation.

Austrian economics is also the only free-market orientated school of thought drawing full attention to the deficiencies of the global policy response since 2007–2008. Central banks and governments around the world have mitigated the impact of the crisis on output and employment, providing more than $10 trillion dollars of financial support to prevent bank failures, cutting short-term interest rates for all the major currencies close to zero and engaging in a sustained and aggressive fiscal expansion that has more than doubled the ratio of public sector debt to GDP.

These measures may have been effective short-term palliatives, but they have done little to deal with underlying causes. While substantial increases in regulatory capital requirements and a wide range of other regulations have reduced tax-payer exposure to banking risks, investors have been left in little doubt that they will be protected once again should the entire financial system once again be threatened. The resumption of growth in the advanced economies is based as before on credit creation and maturity mismatch. The mispricing of assets and misallocations of capital evident before the crisis have continued, in many cases becoming even more marked. Economic expansion has been much stronger than was generally expected in the 18 months following the collapse of Lehman brothers, but this recovery has not been strong enough to allow a winding down of fiscal expansion. A policy of temporary ‘pump priming’ has turned into a policy of permanent and unsustainable fiscal deficits.

—Alistair Milne, “Cryptocurrencies from an Austrian Perspective,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 223-224.


Wednesday, November 13, 2019

Since Credit Default Swaps Can Be Used to Take Down Banks, They Can Be a Financial Weapon of Mass Destruction

Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom. . . .

A vicious spiral may set in. Rising spreads indicate the market’s distrust of the banks, spurring even further demand for insurance, leading to even higher spreads on the debt, and so on, until the distrust in the bank reaches a point where the bank cannot receive further funding and it fails. Due to this self-reinforcing spiral of distrust and rising bank funding costs, reputable investors, commentators, and economists (most notably Warren Buffet), have called CDS [Credit Default Swaps]  instruments weapons of mass destruction. Indeed, CDSs can be used to take banks down by lowering the confidence in them. Yet they can only work if banks are vulnerable; that is, if they violate the golden rule of banking and mismatch maturities, or they mismatch currencies, or they do both. Only then will the distrust translate into funding problems that threaten the bank’s liquidity and eventually its solvency. When the bank matches maturities and currencies and holds 100 percent reserves to cover its deposits, the distrust may lead to a loss of consumers as some depositors do not continue rolling their funding over; that is, they withdraw their deposits. This, however, will not take down the bank, as no liquidity loss will result. Only a mismatch makes the banks vulnerable to this type of failure.

—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.


Hedge Funds Could Bet on the Downfall of Icelandic Banks by Buying Credit Default Swaps

Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.

—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.


Tuesday, November 12, 2019

A Price Deflation Might Bring Down a Fractional Reserve Banking System as the Real Burden of Debt Increases

A price deflation might bring down a fractional reserve banking system. This is so, because a price deflation can lead to bankruptcies as the real burden of debt increases. Especially in a recession after an artificial boom, a credit contraction and bankruptcies due to the malinvestments occurs. As a consequence of the bankruptcies that are induced by the price deflation, loans that banks gave out will turn bad. The stocks of the bankrupt companies that other banks hold will lose value, perhaps even to the point of becoming worthless. In general, the assets of banks will fall in value. In order to preserve solvency banks will restrict credits and put pressure on its corporate partners and other banks. The decline in one bank’s assets’ values might induce doubts in the solvency and liquidity of other banks. Due to the credit restriction, corporate partners might go bankrupt. Other banks also financing these corporations get into financial difficulty as well. Bank runs might occur. In a fractional reserve system, by definition, the bank cannot pay out all demand deposit claims that exist. The bank will go bankrupt. If one bank collapses this instability might spread to other fractional reserve banks due to their interconnectedness. The bankruptcy will induce fear about the solvency of other banks, further reduce the value of their assets’ value, and lead to systematic bank runs. A bank panic ensues. This might bring the whole fractional reserve banking system down if the central bank fails to bail out the banking system. This possible consequence of price deflation is beneficial as it purges the old banking system making place for a 100% gold standard as Rothbard points out.

—Philipp Bagus, In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International, 2015), 90.


Sunday, November 10, 2019

The Boom in Residential Real Estate in Toronto, Vancouver, and Sydney Far Outside the Commodity Producing Regions

These housing market issues become of particular relevance to small- and medium-sized economies under the regime of the 2% inflation standard.

The governments/central banks here face a particular dilemma, especially if there is an attractive narrative which could buoy speculative interest (carry trades) in their national currency. For example, a range of commodity producing and/or emerging market economies have found themselves during the present asset price inflation episode encountering huge demand for their still-positive interest rate monies. That narrative is sometimes rapid growth potential. And a sequence of capital gains on the related currency carry trade imparts positive feedback loops to still more participation in that. . . .

In the great asset price inflation of the present decade, policy-makers in a range of small- or medium-sized countries rejected following the defiant path of hard money. For example, Canada and Australia found their currencies under tremendous upward pressure in the first stage of the US monetary inflation as dollar depreciation and the China monetary boom drove the prices of their key commodity exports towards the sky. The central banks of both Commonwealth countries took the same tack—not allowing interest rates to rise in line with economic expansion fed by commodity export boom so as to contain the strength of their currencies. The result: a boom in residential real estate in the star cities (Sydney, Toronto and Vancouver) far outside the commodity producing regions. A lead narrative featured the flood of newly rich Chinese investors and occupiers of these. And though low, the interest rates had sparkled to a range of income-famished investors in the world outside, including European central banks and other sovereign wealth funds diversifying into these still-positive interest rate monies. Another feature of the monetary policies followed was the build-up of a consumer debt boom, in part taking advantage of the raised value of real estate collateral.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 140-142.



The Mercantilist Idea that Increasing the Money Supply Increases Prosperity Was Exposed as an Error Centuries Ago by Richard Cantillon

We now turn our attention to what happens with an increase in the money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases prosperity was exposed as an error centuries ago by Richard Cantillon. However, modern mainstream economists, including the monetarists, Keynesians of various sorts, and the now-fashionable market monetarists, fully embrace the idea that printing money is necessary for prosperity.

In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.

The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. Th e problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off .

—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 59-60.