Moldbug On Fractional Reserve Banking

Great Moldbug post on "maturity transformation," aka the fractional reserve banking scam:

Our financial system is not a new operating system. It is a very old operating system. Worse, there is only one of them: the whole world runs the Anglo-American banking system, more or less as described by Walter Bagehot in Lombard Street (1873). Lombard Street is our Windows. There is no Mac. There is no Linux. Our experts in finance are not experts in finance. They are experts in Lombard Street finance. Asking them to imagine an alternative is like asking a Windows programmer to imagine OS X - except that Windows isn't 314 years old. [...]

The end goal is to phase out this lending-counterfeiter business, and construct a new financial system - the motorcycle - in which lending is really, truly private, and financial intermediaries match their maturities. If Bobby needs money for three weeks, he asks you for a three-week loan. He does not ask you for a one-week loan and then get a surreptitious, covert, informal three-week loan from the Fed's "technology, called a printing press."

In any such financial system, we would see the true yield curve, the graph of interest rates at every maturity, uncontaminated by maturity mismatching. My suspicion is that at least at first, long-term rates would be quite high. Which means lower house prices. In the spirit of portfolio neutrality, USG might want to print some more money and kick it back to homeowners, such as, of course, myself...

It probably would not be possible to get 30 year loans to buy real estate in a free market system where you had to borrow the money from an actual investor. It would be more like 5-10 year money. And if you take a look at what housing finance was like 100 years ago, I think that is pretty much how it was.

The current system results in subsidization of residential real estate. It leads to an allocation of capital to houses that is much larger than you would see under a free market system. This system also creates a lot of financial intermediation "jobs". The herding behavior of these bankers seems really non-free-market.

It's interesting that the comment thread on that post in September 2008 was much more intelligent than any other blog I can think of. I think it's really hard for most people to grapple with the existence of a flawed (crooked) system that benefits the elite and will therefore be kept around, with modifications and tinkering, to the extent possible.

The Problem With Bailouts

Summary of Mises' Human Action:

"Mises stresses the importance of entrepreneurship because only entrepreneurs actually do monetary calculation. This fact puts entrepreneurs at the center of all progress (and failure). Entrepreneurs who estimate costs more correctly than their rivals earn high profits while also serving consumers. Such men rise to top positions in industry. Entrepreneurs who err seriously in their calculations experience financial losses and cease to direct production. Mises described this market test of entrepreneurial skills as the only process of trial and error that really matters."

The problem with bailouts is that the nitwits that made mortgages to deadbeats, or who invested in Greece, never cease to direct production!

Ray Dalio: "Be Careful When Betting Against Human Nature"

"[W]e think the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with the money to make all these debts good should not be taken for granted. Said differently, we think there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a Plan B in place. This 'fat tail' event must be considered a significant possibility."

Isn't the European crisis just a demographic problem - the endgame when social safety nets meet an aging population caused by low birthrates? Is it a coincidence that the lowest IQ, lowest birthrate European countries are the first to go down the tubes?

How Accurate Was the Clint Eastwood Superbowl Chrysler/Obama Ad?

I am officially tired of Clint Eastwood. Here is a parody of the propaganda piece I refer to:



The automaker bailouts are another example of the broken window fallacy. What did we know about the automakers, ca 2009? That they consistently manufactured goods which were worth less than they cost. So, why keep those firms, and those managers, making automobiles? Why not let new firms bid for the defunct automakers' assets, and hopefully use them in a new way, making products that are worth more to consumers than they cost.

Meanwhile, despite what Clint said, Detroit does not seem to be doing so well.

The people of Detroit are taking no prisoners. Justifiable homicide in the city shot up 79 percent in 2011 from the previous year, as citizens in the long-suffering city armed themselves and took matters into their own hands.

Actually, that is the most bullish Detroit news story I have heard in a long time.

Excellent Essay: "Banks - Expensive at Every Price"

"We're not in the habit of making heretical statements, but we believe banks are not an appropriate investment at any price for the thoughtful value investor." [pdf]

- Value Investment Institute, March 2011

"Bernanke: No Fed Plans to Aid European Banks"

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. [...] Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks.

Tim Knight Makes an Excellent Point

I'm starting to understand the bullish mindset, because a little voice in my head has been whining - - "why don't the leaders DO something? They are SUPPOSED to help the markets. What's wrong with them? Why don't they announce something HELPFUL?" (Try to read these words in the grating voice of a five-year old).

This is how bulls think in a bear market, because they want someone Big and Strong to help bail them out. It's somewhat shameful for me to have such thoughts in my head, but my ulterior motive, of course, is that I want another chunk of Big News in order to get prices to shortable levels once more. The reason I bring it up is that I never hear the voice the rest of the time - - it's wholly novel to me - - because bears don't HAVE any government heroes ready to leap to their aid. We are, and always will be, completely self-reliant, trading in opposition to every other entity on the planet.

I have had the same experience that Tim describes. If I wasn't net short right now, I'd be wishing and hoping for bailouts every day. I think that speaks volumes about how weak the bullish case is.

The "QE3 Indicator"

Someone forwarded me a Citi research note about their "proprietary QE3ON indicator," which "tracks the likelihood of the Fed moving on QE or a liquidity injection."

It is hilarious that they have a "QE3 indicator." That tells you everything you need to know about what drives the market. They go on to say,

"We believe that the Fed is standing on the sidelines prepared with liquidity to replace any that is destroyed but market conditions are not quite yet at the point where they do that. A continued fall in equity markets, taking the SPX down to the 1100 liquidity put region, would likely spur the Fed into action."

Of course, their indicator merely addresses the perceived need for liquidity without addressing the constraints, e.g. $100 oil.

Bailout Rumors are Bearish

From Hussman:

The most depressing display of math-illiteracy by investors last week was the excitement over a report suggesting that France and Germany had agreed to a 2 trillion euro bailout package for Europe, which triggered a "risk-on" tone for the rest of the week, even after the report was retracted as inaccurate. Notably, 2 trillion euros is more than the GDP of France, and is half the GDP of Germany and France combined. Moreover, Europe has just gone through a tooth-pulling process just to approve 440 billion euros for the European Financial Stability Fund (EFSF) from all EU members combined.

Repeating a pattern from 2008: massive rallies in response to bailout "plans" that are either untrue or irrelevant.

Hussman on Bailouts

The Fed's creation of the Maiden Lane companies to purchase bad assets was, and remains, illegal under the language and intent of the Federal Reserve Act. Keep in mind that we have only three branches of government: the executive, the legislative, and the judicial. The Federal Reserve is not an independent fourth branch of government, but operates under the legislation of Congress and therefore cannot be "independent" of Congressional control.

Sheila Bair Admits: "They should have let Bear Stearns fail"

"Let’s face it," she said. "Bear Stearns was a second-tier investment bank, with — what? — around $400 billion in assets? I’m a traditionalist. Banks and bank-holding companies are in the safety net. That’s why they have deposit insurance. Investment banks take higher risks, and they are supposed to be outside the safety net. If they make enough mistakes, they are supposed to fail. So, yes, I was amazed when they saved it. I couldn’t believe it. When they told me about it, I said: 'Guess what: Investment banks fail.'"

Read the article. One of the things that it makes clear: Geithner is a little weasel.

Too bad Bair didn't talk this tough during the crisis. 

This Time Is Not Different

Barron's says the only way out is for Greece to restructure. "Europe's official approach has been to muddle along and hope the problem will go away. It won't." The European banking system is like the U.S. banks in the summer of 2008. Total reality denial mode. It will cause a panic flight to Treasuries when their house of cards finally topples.

Greece talks about setting up a "bad bank". Doesn't anyone notice this is right out of the 2008 crisis playbook? Kicking the can is what you do when a crisis is too big to solve. They have been having "emergency meetings" every weekend. Does that remind you of anything?

There is going to be another deflationary bust that ruins the delusional, moral hazard crowd. Albert Edwards agrees with the Credit Bubble stocks thesis: "we still expect to suffer another deflationary bust that will take government bond yields to new lows before government profligacy and the Fed's printing presses take us back to both double-digit inflation and bond yields."

No one remembers the obliteration that happened three years ago. Here is a reminder: Arizona Land Sells for 8% of Price Calpers Group Paid at Peak.

Thirty years of non-stop rally has created a mainstream investment management community whose investing styles expressly exclude the possibility of severe bear markets/depressions. Most investors - and all long-only investors - are resigned to failure and capital impairment should a severe bear market occur.

This doesn't bother them because they figure they will "make it up" on the next wave up. And, as Prechter puts it, "most of the time, ill-timed optimism is harmless because most of the time, recessions are indeed mild and brief. [...] Small, mild retrenchments occur more frequently than large ones so forecasting errors are only mildly damaging."

The bull-market-only investing genotype is an evolutionary dead end. Investors need a money manager whose style contemplates severe bear markets, otherwise they are doomed to severe capital impairment. Picture a plane crashing into mountain with full afterburners on. There is a lot of money to be made at the expense of the dip buyers before they figure out what is happening.

Thursday Links

Government Bonds

• Bill Gross still can't figure out who will buy bonds if the Fed doesn't. But, "don't cry for Pimco."
• WSJ's Kelly Evans is with us on bonds now:"Wouldn't surprise me to see 30yr below 3% someday. I realize that sounds crazy."
• People also complain that German bond yields are too low. The German 30 year bond yields 70 bps less than the US 30 year bond.
• Why didn't European banks sell Greek debt when they had the chance? The captioned chart is great.

Bubbles & Bailouts

• Latest bubble IPO "LinkedIn" got crushed at the end of day today. We are watching from the sidelines, as the stock is extremely expensive to borrow. Bloomberg understatement: it "may not be growing fast enough to justify its valuation."
• Howard Marks on How Quickly They Forget. "What makes for cheapness? The attitudes and behaviors of others."
• Paper: "construction starts of record-breaking skyscrapers predict subsequent US stock returns. In the three to five years after the construction of a record-breaking new skyscraper began, per annum stock market returns are around 10 percentage points lower than in other years." Prechter would be proud!
• A secret Federal Reserve bank bailout program that is only now being revealed.

Tech

• "Microsoft's total revenue in China, population 1.3 billion, is less than what it gets in the Netherlands, a country of fewer than 17 million."
• "Absolute must watch" video of Paul Graham at TC Disrupt.

Gary North on the Fed and Central Banking

At the center of almost every national economy today is a central bank that has been granted the government-sanctioned authority to intervene in the financial sector on behalf of large multinational banks. In the city of over-leveraged multinational banks, the New York Times wants no limits placed on the ability of the Federal Reserve System to bail out over-leveraged multinational banks.

Today's Speech by Dallas Fed President Fisher: "'Is America's Decline Exaggerated or Inevitable?' The Role of Monetary and Fiscal Policy"

Dallas Fed President Richard Fisher is the fellow who brought us "Old Doc Nadler's Remedy". Today, he gave a speech called "'Is America's Decline Exaggerated or Inevitable?' The Role of Monetary and Fiscal Policy". He admits that the bailouts created moral hazard:

In saving the system, for example, it can be argued that we protected imprudent lenders and investors from the consequences of their decisions; we rescued sinners and penalized the virtuous.

Postcrisis, the “too big to fail” financial behemoths that had placed our economy in jeopardy have ended up with even greater financial power. (And, adding insult to injury, by the grace of their shareholders, most of their leaders retain their posts and few, if any, have suffered financial setbacks). This concentration of power comes at the expense of community and regional banks, an imbalance that the Federal Reserve and other authorities must now address through tough-minded, clear-eyed regulation.

He also comes down hard on monetization:

Our duty is most distinctly not to monetize―or even be perceived as monetizing―the debt of fiscally imprudent government. Throughout the history of nations, monetizing the budgetary excesses of governments has proven to be a direct path to economic perdition. Having already peeked inside that door, I feel strongly that we must now shut it, lock it and throw away the key.

In my view, no amount of further accommodation by the Fed would be wise—either by prolonging or “tapering off” the volume of purchases of Treasuries past June, or adding another tranche of large-scale asset purchases. Indeed, it may well be that we should consider curtailing what remains of QE2.

Finally, he admits that moronic risk taking has come back in a big way:

We have seen a resurgence of “covenant-lite” loans, with some $24 billion issued in the first quarter versus $100 billion for all of 2007; private-equity firms are back in size and turning to leverage to pay dividends; credit-boom acronyms most thought would never return after the Panic, such as “payment-in-kind,” or PIK, and “toggle” notes, are prominent once again; traditionally unleveraged asset managers, such as insurance companies and pension funds, are turning to leverage and exotic asset classes to juice returns. These are all signs of the intoxicating effects of the ambrosia of inexpensive and plentiful money. Further spiking the punch bowl with accommodative monetary policy would do nothing to rein them in.

This seems very bearish for risky assets (equities and commodities) and very bullish for the dollar and Treasuries. Which is very interesting, considering how cheaply you can buy Treasury volatility right now.

Ireland Looking to Jam the Bank Bondholders

I've mentioned Ireland's problem in the past; they "faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent [by bailing out the banks], and, for whatever reason, chose the latter."

Michael Lewis' recent article, "When Irish Eyes are Crying" also explained the situation well: "These private bondholders didn’t have any right to be made whole by the Irish government. The bondholders didn’t even expect to be made whole by the Irish government."

However, it appears that the Irish are now going to do what they (and we) should have done to the banks in the first place: reorganizations where the loss is borne by the creditors who lent money to the banks (i.e. bondholders).

If this idea (jamming the bondholders) catches on, it will make a big difference in sovereign risk profiles. If lenders to financial institutions must bear the risk of their loans to shaky financial institutions, all of a sudden sovereign debt like Treasuries look much more attractive.

"When Irish Eyes Are Crying": The Michael Lewis Vanity Fair Article About Ireland's Bank Bailouts

I meant to post the Michael Lewis article about Ireland's bank bailouts that ran in Vanity Fair last month:

In any case, if the Irish wanted to save their banks, why not guarantee just the deposits? There’s a big difference between depositors and bondholders: depositors can flee. The immediate danger to the banks was that savers who had put money into them would take their money out, and the banks would be without funds. The investors who owned the roughly 80 billion euros of Irish bank bonds, on the other hand, were stuck. They couldn’t take their money out of the bank. And their 80 billion euros very nearly exactly covered the eventual losses inside the Irish banks. These private bondholders didn’t have any right to be made whole by the Irish government. The bondholders didn’t even expect to be made whole by the Irish government.

In retrospect, now that the Irish bank losses are known to be world-historically huge, the decision to cover them appears not merely odd but suicidal. A handful of Irish bankers incurred debts they could never repay, of something like 100 billion euros. They may have had no idea what they were doing, but they did it all the same. Their debts were private—owed by them to investors around the world—and still the Irish people have undertaken to repay them as if they were obligations of the state.

I expect that in the next leg down, there will be a bigger push back against the idea of socializing the losses created by incompetent bankers. Maybe I am too optimistic about the public, but I like to think that after demanding bailouts, then pretending everything was fine and paying themselves huge bonuses and undertaking risky lending again, that the banks will have no political capital for bailouts next time.

You may remember my recent review of Michael Lewis' book, The Big Short.

Calculated Risk Mentions a Possible End to "Quantitative Easing"

I'm hearing speculation that the Fed might taper off the QE2 purchases of treasury securities to "promote a smooth transition in markets". Currently the plan is to purchase $600 billion in Treasury securities by the end of Q2 or about $75 billion per month. The speculation is that the size will remain the same ($600 billion), but that the Fed will taper off the purchases through the end of Q3 or so.

WSJ: "When States Default"

There was an article in the WSJ today making the analogy with current fiscal troubles and the state defaults in the 1840s.

See also this Murray Rothbard piece on state defaults:

Although largely forgotten by historians and by the public, repudiation of public debt is a solid part of the American tradition. The first wave of repudiation of state debt came during the 1840's, after the panics of 1837 and 1839. Those panics were the consequence of a massive inflationary boom fueled by the Whig-run Second Bank of the United States. Riding the wave of inflationary credit, numerous state governments, largely those run by the Whigs, floated an enormous amount of debt, most of which went into wasteful public works (euphemistically called "internal improvements"), and into the creation of inflationary banks. Outstanding public debt by state governments rose from $26 million to $170 million during the decade of the 1830's. Most of these securities were financed by British and Dutch investors.

During the deflationary 1840's succeeding the panics, state governments faced repayment of their debt in dollars that were now more valuable than the ones they had borrowed. Many states, now largely in Democratic hands, met the crisis by repudiating these debts, either totally or partially by scaling down the amount in "readjustments." Specifically, of the 28 American states in the 1840's, nine were in the glorious position of having no public debt, and one (Missouri's) was negligible; of the 18 remaining, nine paid the interest on their public debt without interruption, while another nine (Maryland, Pennsylvania, Indiana, Illinois, Michigan, Arkansas, Louisiana, Mississippi, and Florida) repudiated part or all of their liabilities. Of these states, four defaulted for several years in their interest payments, whereas the other five (Michigan, Mississippi, Arkansas, Louisiana, and Florida) totally and permanently repudiated their entire outstanding public debt.

Also, read this amazing New York Times article from April 1876 regarding another debt catastrophe (this one involving state guarantees of railroad debt) that quotes the Alabama state auditor's warning in 1869 about these practices:

"While I fully concur in all legislation favoring the development... by giving credit in aid of material improvements... yet I am constrained to call your attention to the following facts: The total value of railroads in the State as per assessment returns made to this office, including right of way, main and side track, rolling stock, and other property, is less than $13,000 per mile. When it is remembered that these items include all of value that can be embraced in 'first mortgage bonds' upon any railroad... it will be readily seen that the State cannot be safe in the indorsement of railroad bonds to the amount of $16,000 per mile, nor would she be free from loss should default be made by the railroads in payment of interest or principal of said bonds."

The article regards Alabama's offer to pay about 30 cents on the dollar, on average, to bondholders, with some receiving less, and some of the railroad bondholders to receive nothing despite the state's guarantee.

I am not so sure that any of the states will default this time (and not because the states are solvent). I think it is fair to question whether Congress would bail out California by writing checks (e.g. a fiscal bailout).

But, what will stop Bernanke from buying California bonds? At this point, I wouldn't bet against it.

A Few More Notes on Diary of a Very Bad Year

Just following up on my Review of Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager. Taylor Conant posted his review at EconomicPolicyJournal.com.

One other interesting thing was that the hedge fund manager in the book (HFM) raises the end game of the bailouts, which so far have had sovereign states agreeing to take responsibility for private debts. (E.g. the guarantees of commercial paper in the U.S., or Ireland's guarantees of banks' debts.)

HFM suggests that someday there will be a concern about financial institutions' solvency - another credit crisis -  but "with no party that's creditworthy enough to be able to step in and soothe people's fears". In other words, a federal government bailout won't be meaningful because no one will perceive the federal government as having the wherewithal to make-whole the creditors of an institution with $0.5 trillion in liabilities.

He also articulates the illiquidity discount well at one point, saying "you need to find people, educate them, and convince them [that something] is actually a good deal."

I'll have a couple good micro-cap investment ideas coming out soon, probably next week.