the bank will experience a run. To deal with this problem, we have deposit insurance

TO BE NOTED: From Derivative Dribble:

"The Unbearable Lightness of Nassim Taleb In Uncategorized on April 13, 2009 at 7:30 am

Also published on the Atlantic Monthly’s Business Channel.

As Conor notes, Nassim Taleb offered up some less than sage advice in a recent “article” in the Financial Times. The article, which takes the form of a talismanic list, was crafted in order to the deliver humanity from its suffering by pointing our mind’s eye towards the failures of our regulatory dogma. Wielding powerful metaphors such as “Make an omelette with the broken eggs,” Taleb fails to meet even the lowest of standard for a statement on regulatory policy. “Counter-balance complexity with simplicity” might be an acceptable policy position for Deepak Chopra. But it is certainly unacceptable for an economist.

Looking beyond Taleb’s absurd delivery, the substance of his policies is, in large part, absent, and where present, addresses the real issues at play in a superficial and borderline whimsical fashion. It is unclear whether this is the product of haste, or the product of a complete lack of command over the issues and concepts. For example, Taleb states that:

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

To say that only Ponzi schemes depend on confidence — they don’t, since they’re the product of fraud and misrepresentation — is factually incorrect and suggests intellectual laziness. The extension of credit and contracting depend on confidence in the ability of a counterparty to perform. In a broader sense, the organizational structure of society depends on people being able to rely on the predictability of certain events around them (e.g., bus, train, and plane arrivals, banks maintaining deposits, etc.).

This organizational structure is itself a product of confidence. I am confident that the train will arrive shortly after I get to the train station in the morning, and as a result, I plan on taking the train to work each day. I am confident that my bank will maintain my deposit level, and so I don’t have a mattress full of cash. When confidence is eroded, the incentives of individuals become misaligned.

Take, for example, the case of a bank run. Each depositor has an incentive to withdraw its deposits based solely upon the assumption that all other depositors are doing so, since we have a fractional reserve banking system. Yet each would be better off if none of them withdrew their deposits. When the assumption rings true in the minds of enough depositors, that is, when confidence breaks down, the bank will experience a run. To deal with this problem, we have deposit insurance, which the Government provides to create and maintain confidence in the banking system."

"Given how messy all of these alternatives are, why not simply go down the nationalization route?"

The enormously talented Felix Salmon posts:

"Why Nationalization is the Best Alternative

Kevin Drum is a bit like Joe Nocera: he's reluctant to nationalize, but he doesn't really say why.

It's wise to be wary of nationalization. It should be a last resort( FIRST ), and I've gotten a sense recently that a lot of people are talking about it awfully casually( FOR 4 MONTHS ). Still, it's true that there are some benefits to nationalization, and one of them is that it allows us to avoid the problem of valuing and buying up toxic assets from troubled banks( BINGO! ). If the government owns the whole bank, then the bad stuff can be easily hived off without any kind of valuation at all, and then left to sit for a while before it's sold off -- which is what the Swedes did.
If we have to nationalize, then we have to nationalize. But we should understand the precedents before we do, and go ahead only if we have to.

The only argument I can find in here is an argument in favor of nationalization, not against it. Why should nationalization only be a last resort?( AMEN )

Let's work from an ex hypothesi assumption that a certain bank -- let's call it Citigroup -- is insolvent. This is not an unreasonable assumption, given what happened to the likes of Lehman Brothers and Washington Mutual. But I don't want to get into the details of Citi's balance sheet here: I want to ask what we should do if we've already determined that its assets, many of which fall into the "toxic" category, are significantly smaller than its liabilities.

Now the red-blooded American way of dealing with insolvent companies is bankruptcy: either Chapter 11, where the company continues as a going concern, or some kind of liquidation. For a bank, Chapter 11 is pretty much impossible, since you're not going to find anybody to provide debtor-in-possession financing to keep it going. Except the government. And if the government is in possession, then, hey, you've just nationalized the bank.( TRUE )

As for liquidation, that's not an option, because Citigroup is too big to fail. Dumping Citi's trillions of dollars of assets onto the market in a fire sale would depress asset prices worldwide so much that we'd enter a global depression, not just one in the US. ( TRUE. THE CALLING RUN WOULD PICK UP SPEED. )

So what about the bad-bank option? The government buys Citi's toxic assets, taking them off Citi's balance sheet, and leaving behind a healthy bank. Sounds good -- except remember that, ex hypothesi, Citi is insolvent. If the government buys the toxic assets for what they're worth, then that doesn't help, since the amount of money that Citi gets in return isn't enough to pay off the loans that Citi essentially took out against those assets. In housing parlance, Citi's underwater on its recourse loan, and when you're underwater on a recourse loan, selling the house at its market price doesn't make you any less insolvent.

So maybe the government deliberately overpays for the toxic waste( WHICH IS WHAT WILL HAPPEN )? That's a recipe for opacity, and it's very hard to systematize. If you're willing to pay 150% of market prices for Citi's bad assets, shouldn't you do that for everybody else's, too? Even perfectly healthy banks which don't need the money? Or do you just decide that Citi, because it's too big to fail, is going to get a big handout which no one else qualifies for? If you do make that determination, why not just go the whole hog and write a check to the bank outright, and put it straight into Tier 1 equity? Oh, wait, you can't do that, because that's called buying equity, and if you spent that much money on Citi's equity, you'd end up with a majority stake in the bank -- which is nationalization. ( TRUE )

Essentially, any government purchase of toxic assets can be split into two components: the market price, and a subsidy. If the subsidy is greater than half the market capitalization of the bank, and the government doesn't end up controlling the bank, then there's something very fishy going on indeed.( TRUE )

It's worth bearing in mind here the first TARP proposal, which envisaged the government buying up bad assets at some kind of long-term value price which was greater than the distressed market price. That never happened, the bad assets stayed on the banks' balance sheets -- and then, in the fourth quarter, we saw some absolutely monster write-downs from those loans' end-September marks, including $15 billion at Merrill Lynch alone. You still think that the end-September marks were distressed bargain-basement prices?( THAT'S BEEN MY POINT )

Then there's the insurance proposal -- which is cropping up now in the UK after being rolled out in an ad hoc fashion with Citi and BofA here in the US. Robert Peston explains how it works:

Our biggest banks would identify their bad loans and foolish investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets.
But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.

This has all the same problems of the create-a-bad-bank idea: the government still has to come up with a price (a/k/a expected default rate) for the bad assets, and there will still be a huge implicit subsidy, in many cases greater than the bank's market capitalization, for any institution which takes the government up on its offer. After all, the mark-to-market value of the insurer is certain to be massively negative, otherwise Warren Buffett would have set up something like this already on a for-profit basis.( TRUE )

Finally, the government could take the Irish approach, and target the banks' liabilities rather than their assets. Keep the assets on the banks' balance sheets, and simply guarantee all of their unsecured debts. After all, there's a government guarantee on a lot of the unsecured debt already, and there has been for years: it's called the FDIC deposit guarantee.( TRUE )

This is basically a massive bailout for all the banks' bondholders, who thought they were buying risky leveraged single-A bank debt, and who will suddenly find it backed by the full faith and credit of the US government. At this point, it doesn't matter if a bank is insolvent, because it can roll over its debt indefinitely, since that debt has a government guarantee. Indeed, it should be quite happy to lever up as much as it's allowed, and spend its cheap new funds on all manner of risky assets, since that gives shareholders the best chance of making lots of money and recovering some of the billions of dollars that they have lost. It's akin to taking a man with a large debt, pointing him in the direction of a casino, and telling him he has unlimited credit to try and pay that debt off.( YIKES )

The best way for the government to avoid the obvious outcome in such a situation is for the government to take over and run the bank: nationalization. Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well -- i.e., ownership.( TRUE )

Given how messy all of these alternatives are, why not simply go down the nationalization route? It's transparent and easy to understand( I'VE SAID THIS FROM THE BEGINNING. ): if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too.

So I'm interested in what Kevin means when he talks about a situation where "we have to nationalize". Does he mean any situation where a too-big-to-fail bank is insolvent? Or are there further criteria he has in mind?"

Well played! However, I believe that Drum will go for nationlization.

"But for now at least you have the means to understand what money supply is and how it is measured"

Another nice resource post from Jesse's Cafe Americain:

"Money Supply: A Primer

You walk into a Merchant and a sign says, "All Items on Sale Today for Cash Only No Credit."

You are interested in purchasing an item. The Merchant, being a crafty sort asks "How much money do you have to spend(in US dollars)?"

How would you answer that if you are being truthful?

You might start by looking into your wallet and pockets, and counting all the cash and coins you have with you at that moment.

M0: Monetary Base

This is equivalent to the monetary base, or M0. It is money you have that is immediately available requiring no change or conversion. There is very little risk to the merchant, unless it happens to be counterfeit which is easily verified.

"Not enough" says the Merchant. "I am sorry, but do you have more?"

M1

Then you remember that in addition to cash, you have your checkbook with a current balance in it, and a debit card to an account you maintain in a local bank, but with no overdraft or lines of credit provisions.

That plus the currency in your pockets is M1. See the difference? You do not have ALL your money in your pockets for immediate presentation, but with a little transactional effort the money is readily available and it is inherently your money, it belongs to you. It is just being held elsewhere besides your pockets and wallet. The merchant assumes a little more risk, but he can quickly call your bank to verify that the funds are available for the check, and the debit card is even more mechanized. More risk, a little more delay, but almost as 'good as cash.'

"I am sorry sir," says the Merchant, "but this is still not enough to exchange for such a valuable object as I have for sale here."

M2

You think about it, and remember that you have a savings account across the street at the bank, and a money market fund at your brokerage office next door, that have more of your money on deposit. You have no cards for those accounts, but it would be an easy thing to walk next door or across the street and obtain the cash.

This is M2. There is a more complex transaction involved, since the transfer is not electronic as in the case of a debit card, and you must leave the store to obtain the money in the form of currency unless they bring it over to you. But it is your money that is available to you on demand. There is a small amount of risk of your bank not being solvent when you need the money, but these are slight inconveniences compared to the safety of not carrying around large sums of money that earn no interest in the form of cash.

"I am so sorry," says the Merchant. "But this item is far too valuable to part with for such a sum as you have offered."

M3

You think about it, and remember that you have a large Certificate of Deposit at the bank across the street that matures in one year. There is a small penalty if you redeem it today to receive your money since you promised it to them for a time in exchange for a specific return, and you must fill out some paperwork, but it is still your money. It involves no sale of an asset or conversion.

That is M3. It involves money that is still yours without borrowing, but has additional conditions set up on it for its retrieval.

One could make the case, and perhaps appropriately so, that while certificates of deposit with a term contract that might effect their value are money, they are not readily available money since the terms of the CD's may differ greatly. They are not 'liquid' and the value before maturity is not always certain due to a penalty.

MZM

If one takes all the things we describe as M2, but takes out the time deposits or certificates of deposit, and includes ALL money market funds, that is what the Fed considers to be the broadest measure of liquid money, or Money of Zero Maturity (MZM). "Zero maturity" means that the money is not tied up for a period of time to mature to its full value.

Are credit cards or loans Money? No,those are all forms of borrowing something that is not yours that you promise to return with conditions. You are receiving money that was not yours.

Credit Is Not Money.

Credit, or debt, is the 'potential' for money, a way of receiving it.

Whether water is held in a canteen, a well, a cistern, or a private lake, it is still water and it is yours if you own it. So too money is still money if it is yours, no matter under what conditions you hold it or save it for your use.

The cloud of credit, or debt depending on your perspective, is the potential for money as it is defined in our economy. It is a source of money. At a given point in time, you either have the money as your property or you do not.

But the source is not the money itself, and the source can be different and can change over time. In our society borrowing is so common and so technologically convenient that there is little difference in most people's mind between credit and money.

But the difference is that if you spend real money, you incur no obligation for it in the future. You receive no payment request from another at the end of the month.

That is what money is, at least in our economy, and the various measure of money as it is held and shifts through the economy and a variety of transactions, where it flows and rest in pools, and moves again. A measure of the money supply is a snapshot in time.

How money increases or decreases, and how it is stored or held, is a significant indicator of economic activity for those who study such things. It is also significantly affected by custom, technology, and the prevailing mood and perception of the public.

The best and broadest measures of money supply are either MZM, or M2, now that M3 is no longer being reported by the Fed. This can easily be seen from the illustrations.

As springs feed into brooks, and brooks streams, and streams into rivers, and rivers into lakes, so the money supply components change in size and shape over time as money flows from its various sources. The speed of the flow is the 'velocity of money' and as one can easily understand that flow will have a different force and speed depending on when you measure it, and whether you are measuring one of the streams or a major river.

People often prefer to jump into discussions and turn them into debates (arguments) with hair-splitting definitions (what is 'control' of the money supply) and red herrings (why does a dollar cross the road?) before defining any terms or facts and setting some boundaries for the analysis, because their goal too often is not understanding, but to promote some theory or point of view. 'Winning the argument' is their objective, not a search for the truth.

Money is the instrument of the official economy. This gives money a certain arbitrariness over time because, after all, it is the product of a committee. Official money is the creation of government, managed by its agents, validated by the people who use it.

Official money rises and falls from favor to disfavor, as do governments. What if you were a citizen of Zimbabwe? Or the US in the 1860's? Or Germany in 1922? How would you feel about your official money then? Why is it different for you now? What would change your opinion?

What is the 'natural growth rate' of the money supply? Zero?

The discussion of how money supply increases, and who or what determines the supply, and what an appropriate level of growth would be is a matter for discussion on another day. So too is the strange phenomenon of 'natural forms of money' that keep turning up in every era and nearly every society.

But for now at least you have the means to understand what money supply is and how it is measured, and how it is different from potential money, or credit, the representations of money, and asset stores of wealth."

Now David Friedman, with a good resource post:

"The Price of Money and Other Errors

It is common for people who think they understand economics to describe the interest rate as the price of money. If it were true, then printing more money would lead to lower interest rates, and many of the same people think it does.

The next time someone tells you that the interest rate is the price of money, ask him what he thinks a reasonable interest rate is and offer to buy some money from him—at ten cents on the dollar if the rate he suggests is ten percent. As that example illustrates, the interest rate is not the price of money. The price of money is what you must give up to get it. If apples cost fifty cents each, the price of money is two apples. More generally, the price of money is the inverse of the price level—when prices are high, that means that money is not worth very much.

The interest rate is the rent of money measured in money. Suppose you borrow a hundred dollars at ten percent. If the price of a dollar is two apples, you are borrowing the price of two hundred apples and paying the price of twenty apples a year in interest. If the money supply doubles, prices double, including the price of an apple, you are borrowing the price of a hundred apples and paying the price of ten apples a year in interest. If you prefer, you could do the same real transaction as before by borrowing two hundred dollars and paying twenty dollars a year interest, still at ten percent.

As this example suggests, there is no connection between the amount of money in circulation and the interest rate. There is a connection between the rate of change of the amount of money in circulation and the interest rate, but it goes in the opposite of the direction implied by the error I am discussing. When the money supply is increasing and prices are rising, nominal interest rates are high, not low, because lenders must be compensated for the fact that they will be paid back in dollars worth less than the ones they lent.

Much of the confusion here comes from the multiple meanings of the term "money." When we say someone has lots of money, we don't usually mean that he has a lot of green paper or a large balance in his checking account; we mean that he is wealthy. His wealth might be in money, it might be in valuable real estate, it might be in stocks and bonds. If there is lots of money in that sense—more precisely, if lots of people have wealth they would like to lend out—that will tend to lower interest rates. But that has nothing to do with the amount of money in circulation.

What brings up this particular confusion at the moment is the attempt to link the current crisis with the events that led to the Great Depression. Those events produced a sharp drop in the money supply, due to banks going broke and depositors either losing or withdrawing their deposits. Given the nature of a fractional reserve system, replacing a mix of currency and deposits with just currency reduces the total amount of money in circulation, in that case by a lot. The problem could have been prevented if the Federal Reserve System had kept those banks from failing, which was part of the purpose it had been set up for, a purpose that had been served earlier by the private arrangements among banks that it effectively replaced( A GOOD POINT ).

That series of events cannot happen now because the FDIC insures bank deposits( TRUE ). What we are observing is not a drop in the money supply. It is a loss of wealth, as firms discover that their assets, in particular mortgages and securities backed by mortgages, are worth less than they thought. That explains why the proposed bailout is enormously greater than would be required to prevent a run on bank deposits( TRUE. BUT NOT A CALLING RUN. ). $700 billion is roughly half the total money supply of the U.S. (M1—currency plus checking accounts and similar assets)--and about half of that is currency, which isn't going to vanish whatever happens to the banks. The total wealth of the economy is enormously greater than the total amount of money in the economy, and the bailout is a response not to a reduction in the amount of money but a reduction in the amount of wealth.

That also explains why the bailout has very little to do with preventing another Great Depression. The U.S. money supply at the moment is at or near its all time high, and it is hard to see how anything likely to happen, with or without a bailout, will reduce it by much. The mechanism that set off the Great Depression isn't happening.( I AGREE )

What is happening is the failure of lots of firms. The failure of a firm doesn't wipe out wealth, except to the extent that the firm itself—its firm culture, web of relationships and such—has some value. When a firm fails, that is at least some evidence that that value was negative, which is why nobody chose to buy out the firm and keep it going. The ordinary assets of the firm—its buildings, land, stocks, bonds, mortgages, and whatever it owns—don't vanish when the firm fails, they get sold to someone else.

The bailout is not a way of preventing the loss of value. The loss (or transfer) of value occurred when people made bad mortgage loans( TRUE ). What happened more recently was the recognition of that loss. All the bailout can do is to shift( SOME OF THE ) the loss from some people to others, from the stockholders and creditors of firms that are now effectively bankrupt( THESE BUSINESSES I AGREE ) to the taxpayers( I AGREE ).

All of which comes back to confusion over the meaning of "money."

Now, Bob McTeer:

"Is the Fed Printing Too Much Money?

For as long as I can remember people have referred to the Fed printing money-usually when they disapprove. The implication is that printing money is inflationary.

I've always assumed that those who use that terminology understood that "printing money" shouldn't be taken literally. Nowadays, I'm not so sure. Several financial talking heads I've heard recently sound like they mean it literally. Often the context has been whether the Fed might buy longer-term treasuries.

While most of you know this, I feel compelled to point out that the Fed doesn't literally print money. That is done by the Bureau of Engraving and Printing, which is under the Treasury Department. The amount of printed or paper money that gets into circulation is not determined by the Bureau, the Treasury, or the Fed. It is determined by the preference of the public for holding currency as opposed to deposit accounts in financial institution.

If the public collectively decides it wants to hold more of their money in the form of currency-as they normally do as the Christmas season approaches-they simply cash more checks at their banks and take the currency. The proportion of the money supply (however we define it) held in paper money rises relative to the proportion held as deposits. More checks cashed at banks are paid for by the public with deposit balances. The banks will, in turn, order more currency from the Federal Reserve, paying for it by drawing down their reserve balances on deposit at the Fed. When the Fed's own inventory of currency gets low, it orders more from the Bureau of Engraving and Printing and pays for it by increasing Treasury deposits at the Fed. So the amount of currency printed is up to the public.

I should mention that when paper money gets too worn or damaged, the Fed destroys it and replaces it with new inventory from the Bureau. That means there is a relatively steady printing of new currency even when the total money supply-currency plus certain deposits-isn't growing rapidly.

The Fed influences the creation of money while the public determines the portion to be held in currency. Substituting "creating money" for "printing money" would correct many assertions that are made. However, the term "creating money" may also be misunderstood by those who aren't familiar with the process.

The Fed normally "creates money" by buying short-term government securities in the open market. The seller of the government securities gives up the securities and gets more deposits in his bank. He traded one asset for another. The banks owe more deposit liabilities to their customers, offset by more reserve deposits at the Fed-when it deposited the check received from its customer. The Fed has more government securities on the asset side of its balance sheet offset by more reserve liabilities owed to the banks. Everybody's balance sheet balances. New money was created in the process, but no net new assets or wealth. New money was created-not printed. If its growing deposits (money supply) causes the public to rebalance into more currency, more money might then be "printed," but it will be paid for with deposit money."

All three of these posts provide clear explanations and should be kept.

The question of whether the Fed is creating too much money these days is a different question to be dealt with separately."

"a new type of security tied to the Federal Deposit Insurance Corp.'s temporary program to guarantee bank debt, a move that could aid small banks."

From the WSJ:

"By Jessica Holzer

Of DOW JONES NEWSWIRES

WASHINGTON (Dow Jones)--Barclays Capital is preparing to sell a new type of security tied to the Federal Deposit Insurance Corp.'s temporary program to guarantee( THAT'S THE POINT ) bank debt, a move that could aid small banks.

The securities firm believes the product will boost small banks' participation in the program by allowing them to issue FDIC-backed debt more cheaply, according to people briefed on the matter by Barclays executives.

Other securities firms are preparing to launch similar products, those people said. The vehicles would be among the first developed by the private sector in response to one of the temporary federal measures to contain the financial crisis.

To shore up confidence in the banking system, the FDIC in October said it would guarantee( YES ) for a fee certain newly issued senior unsecured debt of U.S. banks and savings institutions. About $220 billion in debt so far has been issued under the program, according to an FDIC spokeswoman.

Large banks such as JP Morgan Chase & Co. (JPM), Citigroup Inc. (C) and Bank of America Corp. (BAC) are among the biggest issuers. However, smaller banks, which typically rely on home loan bank advances and deposits to fund themselves, are still trying to gauge whether it makes sense to participate in the program, according to Jim Reber, president and chief executive of ICBA Securities, the broker-dealer subsidiary of the Independent Community Bankers of America.

It is often costly for such banks to tap the bond market because they can't issue debt in large scale. Investors typically require higher yields on debt that is sold in small blocks because it is more difficult to resell( ILLIQUID ).

Barclays, the investment-banking arm of U.K.-based Barclays PLC (BCS), is proposing to pool FDIC-guaranteed debt issued by U.S. banks and sell securities backed by the debt to investors, according to Reber and others familiar with the matter. The pooled debt likely would carry a single yield and maturity date.

Barclays intends to target the same investors who buy debt issued by Fannie Mae (FNM) and Freddie Mac (FRE), Reber said. The firm's executives have spoken with officials of the American Bankers Association and the Independent Community Bankers of America to gauge banks' interest in the product.

"Barclays' premise is that it will allow some small issuers to issue at large-scale yields," said Reber, who was briefed by Barclays executives about their idea.

Reber said that he told the executives that he wasn't sure the product will lure enough small banks to participate in the program. Many are shying away from the FDIC program because of the 1% annual fee on issuance of debt with maturities of a year or more. The bulk of the more than 8,300 FDIC-insured banks and thrifts are small institutions.

A spokesman for Barclays Capital declined to comment.

Barclays and other firms seeking to lauch products tied to the FDIC debt guarantee are likely to roll them soon because all debt under program must be issued by June 30, 2009. The FDIC guarantee will phase out for debt that matures after June 30, 2012.

The FDIC will only guarantee up to 125% of the value of senior unsecured debt outstanding as of Sept. 30, 2008 or, in cases where a firm has no such debt, 2% of its liabilities.

Firms will need to file disclosure documents with the Securities and Exchange Commission before they can begin selling such securities.

-Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com"

The Place Of Government Guarantees In Avoiding Bank And Calling Runs

I want to briefly talk about the causes of this crisis before the silly explanations like lack of regulations and complex investments win day, as they surely will, guaranteeing that this system will go on and even implode again in the near future, although hopefully not to the this extent.

I want to ask a simple question: Does FDIC Insurance on individual accounts help prevent bank runs? Bank Runs being a result of depositors running to the bank to get their money out before the resources of the bank run dry, leaving a number of depositors to lose their money. If you think that FDIC Insurance is stupid, illegal, unconstitutional, a gift to moral hazard, doesn't help stop bank runs, and should be gotten rid of, then my points going forward won't matter to you. I do, however, address this position at the end of the post.

Now, our current crisis is a Calling Run. As the credit rating of a business goes down, investors or creditors that can demand money from the business do so, forcing the business to sell assets or borrow to fund these calls, which leads to a further deterioration of the finances of the business and a further downgrade, which leads to more calls... Now, if better regulations and higher capital standards are all that is needed to stop runs, why do we need FDIC Insurance? Surely higher capital standards and better regulation should suffice to stop a Bank Run. You see my point.

In the current crisis, the flight to Treasuries was in lieu of an explicit government guarantee concerning their assets. Investors fled into explicitly guaranteed, and hence liquid investments, since they can be priced, and even fled from implicitly guaranteed investments. In other words, investors fled to an equivalent of the FDIC. Simply put, you need government guarantees about losses to stop a run. Regulations and Capital Standards won't suffice. Well, they could, but they would be incredibly onerous and high, making them impractical, so, in effect, you need government guarantees to stop runs.

In the current crisis, it has all been about the extent and particulars of government guarantees. Certainly the gyrations of government actions have led to problems, but only in the sense of not making the extent of the guarantees explicit and particular. Anyone who believes that we could stop this crisis without government guarantees, like US Treasuries, is wrong.

From my analysis, it's clear that regulations and capital standards are not sufficient to stop a run. They might have effected this crisis in some manner, but explaining the crisis by seeing what has just occurred and writing laws that might have prevented it is of very little use, and has no real explanatory power. It's a help going forward, but, taken too particularly, it will result in a set of rules and laws that very smart people will manage to elude.

What to do then going forward?
1) Put in some sort of FDIC Insurance for these investments
2) Accept that runs might occur, and do your best to preclude them and be prepared for them
On 2, I say," good luck". Wishful Thinking at its worst. This is what will happen naturally.
On 1, what can we do? I suggest Bagehot's Principles. We need a LOLR I'm sorry to say in the modern world. All that we can do is make the guarantees explicit and adhere to firm standards going forward. But there is no practical solution without LOLR guarantees. They should be robust enough to preclude Calling Runs. One solution would allow some minimal use of FVA as opposed to MTM in supervised cases, with a government guarantee.

For libertarians, I'm sorry. This is the best that we can do for you. However, by averting Runs, we can avoid the kind's of crises that usher in enormous government intrusion. That should prove sufficient to the practically minded.

Finally, to the FDIC abstainers, a Burkean response. We don't have the FDIC for James Grant. We need it for:
1) Our actual Investor Class, which feeds on government guarantees and intervention.
2) Much more importantly, and let me put this in terms that the Investor Class can understand, in order to stave off social rebellion. A system that leads to mass unemployment, low wages, a very wealthy upper class, is not stable. Telling average workers to accept the pain of recessions and depressions is going to eventually lead to trouble. They don't have to. In other words, some people believe that we live in a world where such events as rebellions cannot occur. Of course, some people live in a world where depressions cannot occur. As a good Burkean, I know that isn't our world, and the bonds of civil society must allow compromise in order to stave off societal dislocations.

"that banking regulation is necessary because of moral hazard that results from deposit insurance "

Here's a strange exchange:

"[Eric Posner, December 27, 2008 at 6:58pm] Trackbacks

Have a lousy Christmas, with a note on banking regulation.

Some people are offended if you say “happy holidays” and others are offended if you say “merry Christmas.” Some people are offended if you are offended by one greeting or another, and some people are offended by efforts to explain why some people are offended when other people are offended by one greeting or the other. Makes one’s head spin. So let’s change the subject.

Megan McArdle disagrees with “a very common” point I made in an earlier post: that banking regulation is necessary because of moral hazard that results from deposit insurance (both formal FDIC insurance and the informal insurance where authorities end up compensating creditors not covered by the FDIC program). Yes, it’s a very common point, but it turns out to be wrong, she says:

Almost everything in the world has negative and/or positive externalities. But despite this, we do not intervene to subsidize everything with good negative externalities, or punish everything with bad. That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount. For example, if I am a bus driver, the negative externality of my suddenly jerking the steering wheel to the left and driving the bus off a cliff is much higher than the cost to me--many lives against my one. But my own life is very valuable to me. The threat of its loss is enough to deter such behavior 99.9999% of the time.

The problem with this example is that in the real world the bus driver has a continuous range of options as to how much care to take. Suppose, for example, that he slept badly the night before and knows that he will not be able to drive very attentively. He may well decide to drive even though he would not if he fully internalized the risk of harm to the passengers. We have all done this, and all kinds of laws and regulations, with the tort system as an overall backstop, attempt to deter people from acting in this way. McArdle continues:

Bankers take risk in order to make money, and they control risk in order to avoid losses. But the losses they are most interested in are not to their shareholders. Rather, they are worried about the loss of their jobs. As long as the bank regulators fire any managers who put the bank in receivership, I can see no difference between an unregulated private system without deposit insurance, and a system with. That isn't to say that there is enough regulation in either situation. But if there is a problem, it is that bankers have a socially less-than-optimal risk appetite, or that the punishment for driving a bank into insolvency is insufficient. The moral hazard from deposit insurance doesn't much enter into it.

In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets. If I win the lottery, I pay you back; if I don’t, I dissolve the bank and you go to the government for your funds. I wouldn’t bother to hide my investment strategy from you; you wouldn’t care because you would be paid in any event. I would set up hundreds of banks and give the managers a salary that they would receive if and only if they collect deposits and use them to buy lottery tickets; otherwise, they are fired. (Corporate law junkies will point out that the government will pierce the corporate veil and go after my lottery winnings, but in the real world, with thousands of shareholders and not-lottery but still risky investment schemes that unfold over decades during which dividends are paid and the money spent, that’s not so easy.) McArdle continues:

The moral hazard for depositors may be large. But I doubt it. Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either.

This can’t be true. In the nineteenth century, elaborate efforts were made to keep track of bank risk. Merchants discounted bank notes after consulting books that compiled risk estimates. The notes of larger and more stable banks were discounted less. Since people often made payments with bank notes, they must have had a sense of how risky different banks were, and taken the risk into account when making deposits, to say nothing of common memory about which banks have stayed in business and for how long. Today, people don’t pay attention to bank risk because of deposit insurance; but people certainly think about risk when they make uninsured investments, for example, when they buy stocks or corporate bonds or, for that matter, stereos and personal computers. She concludes:

The reason that deposit insurance requires tighter regulation is that the government wants to minimize the cost to itself--not society, for whom the losses would be the same whether the government or the bank paid them. I think this is wise, for many reasons. But not because of moral hazard.

The argument here seems to be that we should distinguish the perverse incentives of depositors and of bankers. Depositors have a perverse incentive to ignore the riskiness of a bank; ironically, the government does little to counter this incentive aside from capping the insurance payout (and not very credibly). One could imagine a different system where the government tried to regulate depositors the way insurance companies normally regulate insured parties—by demanding that the insured bear some of the risk with a copayment or deductible and take other actions to minimize the potential loss.

Instead, the government goes after the banker. This would be like an insurance company trying to regulate the activity of people who impose risks on insured parties rather than on the insured parties themselves. Imagine that I have health insurance and the insurance company tries to shut down the local polluter so as to minimize its expected insurance costs. Our system of banking regulation resembles this approach.

But moral hazard is the right term. Economists use the term moral hazard to refer to the perverse incentives that arise when a principal pays an agent to act in a certain way that benefits the principal where the agent would rather act differently, but cannot observe the agent’s action, so the agent acts in a way that ends up hurting the principal relative to a baseline of optimal behavior. There are various ways of mitigating moral hazard: one is to share risks, but another is to confine the agent’s choice set. That is what government banking regulation does. It reduces moral hazard by depriving insured depositors of the option of investing in a risky bank, which would presumably offer a high interest rate or other advantages."

I'm not sure that I follow this debate. Presumably, FDIC Insurance is in place to prevent a Bank Run. This has to do with the fact that banks do not have enough cash on hand to satisfy the claims of all of its clients if they came in all at once to withdraw their money. Regulation exists to make sure that the banks, among other things, keep enough capital on hand to be solvent. We've just seen a Collateral or Calling Run. Moral Hazard would be the consequence of the Bailouts, in that Investors would increase their risk in investing, in that they would expect to be Bailed Out by the government if their investments go sideways.

If a bank is guaranteed by taxpayers, it makes sense to have it limit its risk. This is because the government should take a much more conservative approach with the taxpayer's money, which should should generally used to supply goods and services to and for the taxpayers. The benefit to society of the FDIC is limiting the dire consequences of bank runs.

I agree that for explicitly government guaranteed financial institutions, we should have regulations to minimize possible losses. Moral Hazard will apply when a case comes up of a bank becoming or getting close to being insolvent. It should immediately be seized in order to keep Moral Hazard intact. Moral Hazard needs actions, not simply words, in order to be effective.

In our current crisis, Moral Hazard played the most important role, in that it was ineffective, and applying it at the point of the crisis, as Lehman showed, would have caused a financial meltdown. Why? Because past government actions, including the S & L Crisis, showed that the government would intervene in a financial crisis. One could even include Fed actions in this brief. The investors and markets were counting on this government intervention, and invested accordingly. As well, the poor record of prosecuting fraud, etc., caused many people to ignore the laws betting that they were unlikely to be discovered or prosecuted if they were. That's Moral Hazard. And, unfortunately for us, many of the people controlling actual money would have panicked even more were the government not to intervene, causing a possible meltdown.

Now, given Bagehot's Principle, that if the Fed exists, then it will be the Lender of Last Resort, and this should be taken into account in real world decisions, there will always be some presumption of a bailout. Therefore, the government will regulate these financial concerns, not just to avoid a bailout, but to avoid a crisis, which has social as well as economic side effects that we'd rather not face. Try looking at Iceland.

And that brings us back to the idea of a Central Bank. It exists because a significant segment of society does not trust bankers. The idea that average citizens are going to research the solvency of banks is not on. The reason we have these laws is because average citizens got enough power or were enough of a threat for government to realize that its existence depended upon these banking constraints. Lost totally in this quest for private banks, a purely silly one, is any Burkean sense of the nature of Politics and Political Economy. It is much more likely, in the real world, that government would control all of the banks than regulate or control none. In light of that fact, an intelligent and effective interest in limited government would attempt to compromise in such a way as to maximize liberty. As Burke might say, God spare us theorists. Whether on the right or left, they usually end up wreaking havoc in the name of their ideas.

"With higher levels of bank failures, the FDIC's resolution costs have increased significantly. ..." said FDIC Chairman Sheila C. Bair. ...

Calculated Risk with a post about the rise in fees for FDIC Insurance:

"From the FDIC: FDIC Adopts Assessments for Insured Institutions for 2009

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today voted to adopt a final rule increasing risk-based assessment rates uniformly by 7 basis points (7 cents for every $100 of deposits), on an annual basis, for the first quarter of 2009.

"With higher levels of bank failures, the FDIC's resolution costs have increased significantly. ..." said FDIC Chairman Sheila C. Bair. ...

Currently, banks pay between 5 and 43 basis points of their domestic deposits for FDIC insurance. Under the final rule, risk-based rates would range between 12 and 50 basis points (annualized) for the first quarter 2009 assessment. Most institutions would be charged between 12 and 14 basis points.

In October, the FDIC also proposed changes to take effect beginning in the second quarter of 2009 that would make deposit insurance assessments fairer by requiring riskier institutions to pay a larger share.

This doubles (or more) the insurance rate for most insitutions. "

This seems sensible.

"With so many Americans relying on their credit cards as a major source of liquidity, it would be equivalent to a major pay cut."

Meredith Whitney makes some recommendations in the FT about helping consumers:

"Certainly, credit was ex­tended to unworthy borrowers, but the baby is now being thrown out with the bath water. I expect more broad-based credit contractions but, specifically, more than $2,000bn in credit lines to be cut in reaction to risk aversion, constrained capital and regulatory change."

I tend to agree with this. We will swing too far in the opposite direction because of the fear and aversion to risk. I also like that she blames poor loans:

"Here are some easily adoptable changes that would make a difference.

First, re-regionalise lending. Since the early 1990s, key bank products, mortgages and credit card lending were rapidly consolidated nationally. Banking went from “knowing your customer” or local lending, to relying on what have proven to be unreliable FICO credit scores and centralised underwriting. The government should now motivate local lenders (many of which have clean balance sheets) to re-widen their product offering to include credit cards and encourage the mega banks to provide servicing and processing facilities to banks that sold off these capabilities years ago."

I like this idea, and have agreed with it before.

"Second, expand the Federal Deposit Insurance Corporation’s guarantee for bank debt. Banks need to know they can access reasonably priced credit for an extended period to continue to extend new credit lines. Any semi-conscious bank management team knows that capital and liquidity are precious and therefore is hoarding both."

I'm not on board here.

"Third, delay the introduction of accounting rule FAS 140 until 2011 or 2012. These moves to bring off-balance-sheet assets back on balance sheet for the sake of transparency are a mirage. The primary assets that will come back on to balance sheets are credit card loans. Frankly, there is more transparency in off-balance-sheet master trust data than in on-balance-sheet accrual accounting. Banks cannot afford it now and it will further constrain credit. "

Sorry, bring them back on.

"Fourth, amend the proposal on Unfair and Deceptive Lending Practices that is set to be adopted in 2010. The proposal includes one major change that will lead to a severe unintended consequence – pulling credit from consumers. Restricting lenders’ ability to reprice an unsecured loan will cause them to stop lending or to lend less. This change could cut over $2,000bn in unused credit card lines, or over 40 per cent of unused credit lines. With so many Americans relying on their credit cards as a major source of liquidity, it would be equivalent to a major pay cut."

Nope. Too much borrowing as it is.

This is a plea for more borrowing. It seems to me that there's plenty of reasons to lend money, including making money. I'm just too suspicious of this special pleading for extra borrowing over and above what's sensible.

"This is no time for partisanship. The situation is too dire. These changes are ones I would never have imagined endorsing a year ago, but these are extraordinary times. "

No point in starting down the same road right off the bat either.

"Most of Citi's deposits are not, in fact, guaranteed, at least not by the FDIC. Why?"

This post exists because I feel vindicated. From Henry Blodget on Clusterstock:

"This is presumably part of Citi's global ad campaign to tell everyone to remain calm, all is well. Let's hope it's not also a response to some customers panicking and taking their money out.

As a reminder: Most of Citi's deposits are not, in fact, guaranteed, at least not by the FDIC. Why? Because most of Citi's deposits are outside the US. American depositors may not be panicking, therefore, but it's not hard to believe that international depositors".

( And he basically says panicking )

So, I didn't agree:

Don the libertarian Democrat (URL) said:

Nov. 23, 11:28 AM

Is everyone under the impression that guarantees need to be made explicit to be guarantees?

Hello!

Maybe I was unclear, but my point was that Citi was guaranteed, and that the foreign investors didn't have to panic. Anyway, another blogger disagreed:

He had some fun with my name, and, as near as I could tell, found the idea that foreign investors thought that their investments were safe insane. How could he know that we live in a time of insanity?

A lot of people don't seem to like my name, which I explained when I started this blog, and, truly, who or who isn't a libertarian bores me. Anyway, he might have misunderstood me, so I replied. Twice:

Don the libertarian Democrat (URL) said:

Nov. 23, 5:22 PM

John, Thanks for the comments. I was assuming that the guarantee was to save Citi, not the foreign investors. In doing that, they might or might not help out these foreign investors. But, given the implicit guarantees that have been acted upon so far, I might, as a foreign investor, have believed that the US Government would bailout Citi, and thereby guarantee my money indirectly. That might or might not be smart. I don't know.

I have also read, although not definitively, that we might have to save UBS, which, if I'm not mistaken, is a Swiss bank.

My only point, and I harp on it admittedly because I believe it to be so important, is that implicit guarantees can be as important as explicit ones, especially if you figure in the power of precedent.

One thing's for sure. If we did bailout foreign investors, we wouldn't call it that.

But feel free to comment more. I'm tempted to say something about the Titanic, but that ship has sailed.

Take care, Don

Don the libertarian Democrat (URL) said:

Nov. 23, 7:00 PM

John, I see this as favoring my position, but tell me what you think:

http://dealbook.blogs.nytimes.com/2008/11/23/plan-begins-to-emerge-to-rescue-citigroup/

"Federal regulators were considering a new rescue for Citigroup on Sunday, a step that could mark a third leg of the government’s broader efforts to bolster the nation’s financial industry, according to people briefed on the plan, The New York Times’s Eric Dash and Gretchen Morgenson report.

Under the proposal, the government would shoulder losses at Citigroup if those losses exceeded certain levels, according to these people, who spoke on the condition that they not be identified because the plan was still under discussion.

If the government should have to take on the bigger losses, it would receive a stake in Citigroup. The banking giant has been brought to its knees by gaping losses on mortgage-related investments.

If approved, the plan could serve as a model for other banks, heralding another shift in the government’s morphing financial rescue. The Treasury Department initially proposed buying troubled assets from banks but then reversed course and began injecting capital directly into financial institutions.

The plan for Citigroup was still under discussion on Sunday afternoon, and it was unclear exactly how the arrangement might work. One question is how Citigroup and the government would determine the level of losses that the bank itself must bear before the government steps in. Another is whether any additional government money for Citigroup, which has already received $25 billion under the initial rescue plan, would come from the $700 billion industry bailout that Congress approved in October or from other federal sources, like the Federal Reserve or the Federal Deposit Insurance Corporation."

Take care,
Don

Anyway, I believe I proved...lucky. Still, my point wasn't that off that it needed to be mocked, as history has shown.

"the FDIC guarantee has been a real wet blanket"

Via Across The Curve:

"One trader said that the competition from the FDIC guarantee has been a real wet blanket for the entire sector and there is no active marginal buyer."

Here's my comment. It's a small example, but clear:

1. By Don the libertarian Democrat on Oct 20, 2008 | Reply

   “One trader said that the competition from the FDIC guarantee has been a real wet blanket for the entire sector and there is no active marginal buyer. So spreads can worsen from these levels and there is no rush to pick a bottom.”

   Isn’t this one more example of how government guarantees, either explicit or implicit, effect the markets.

2. By Mario on Oct 20, 2008 | Reply

   Hi,

   what exactly is that “agency market”? Google isn’t really helpful on that one…

   Thanks! - Mario

3. By John Jansen on Oct 20, 2008 | Reply

   agency market is the market for FNMA and Freddie MAC bonds. It would also include Home Loan Bonds as well as FFCB paper.

   Principally it is FNMA and Freddie Mac

Against The FDIC Guarantee

From Alan Blinder and Glenn Hubbard in the WSJ:

"Third, an unlimited deposit guarantee in the U.S. would pull funds out of other countries, just as Ireland's guarantee led to an inflow of money into Irish bank offices in the United Kingdom. The Irish-British deposit flow happened on a small scale; but the U.S. is the 800-pound gorilla of the world market. Even amidst all this chaos, money has been flocking to our shores.

Thus we might wind up worsening an odd sort of beggar-thy-neighbor game, causing a "giant sucking sound" as deposits fled other countries for the sanctuary of the U.S. and its FDIC. The implications for our international friends could be enormous. In a misguided attempt to create financial security at home, we might inadvertently make the world a significantly more dangerous place to live."

So, they don't care that deposits might flee the U.S., but rather the reverse.

They are against the FDIC guarantee because:

1) In going back to congress, confidence could fall.

2) Money would be pulled out of uninsured assets.

3) Money would come to the U.S. because of the guarantee.

4) It's not costless.

5) It doesn't address the main problem.

6) It might undermine confidence in the FDIC.

They've got me convinced, but are behind the curve on guarantees like many others.

A Few Points About The SEC And The New Bill

Today, the SEC adopted one of Anthony Randazzo's proposals from the free market proposals I recommended:

"Third, the SEC should suspend the "mark-to-market" accounting rules for long-term assets that are driving firms into bankruptcy. Essentially, these regulatory rules are forcing firms to value their assets at much lower prices than what they would be worth long-term. The intent of mark-to-market regulation was to keep firms from overvaluing themselves and deceiving investors. Instead the law has artificially devalued financial institutions as a whole, which hurts their investors. As Steve Forbes noted recently, "The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

This accounting clause has significantly contributed to the bankruptcies (or near bankruptcies) of Lehman Brothers, Merrill Lynch, AIG, Bear Stearns, Morgan Stanley, Citigroup, Washington Mutual, and many others. In order to keep firms from overvaluing themselves, Newt Gingrich has proposed a three-year rolling average mark-to-market policy.'

Here from the Washington Post:

"Under intense political pressure, regulators for securities and accounting standards this afternoon issued what they called a "clarification" to provisions that have come under fire from bank executives and some lawmakers for contributing to the credit crisis...

The standard, also known as "mark to market," has led portfolios to plunge in recent months as banks affixed fire sale prices to their assets, a move that sometimes required them to raise still more capital to meet regulatory requirements. The measure also led to clashes between corporate executives and independent auditors over how low the markdowns should be forced to dip. "

Also, I backed this proposal from Jim Harper of Cato which looks to be in the new bill:

"And from the “This May Make Some Sense” department, there’s H.R. 6986, which would raise the maximum Federal deposit insurance coverage to $200,000. This seems to update the amounts covered by federal deposit insurance not in response to the crisis, but in response to the possibility that it could be needed. Nice to see someone possibly getting ahead of the curve, rather than following along behind it. But I have to say “least bad” is not high praise . . ."

Here from the NY Times:

"But those Democratic opponents did say that they would be willing to back an increase to $250,000, from $100,000, in the amount of a bank deposit that would be insured by the federal government — an idea that on Tuesday gained fast currency as a consensus change in the initial plan.

Mr. Obama and Mr. McCain early Tuesday both embraced the deposit insurance proposal, sparking a bit of a political tiff over who deserved credit for initiating it. House Republicans claimed to have offered the insurance increase in weekend negotiations over the plan only to have it rejected."

I might also add that Randazzo advocated tax breaks, but probably not these being considered:

"The Senate tax bill would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power. The bill would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax and provide tax relief to victims of recent floods, tornadoes and severe storms.

Members of the House and the Senate say the bill would create tens of thousands of jobs and reduce the nations’ dependence on foreign oil. But the two chambers have been at odds over whether and how to offset the cost of extending the many tax breaks covered by the legislation. The major obstacle has been Representative Steny H. Hoyer of Maryland, the majority leader, and other centrist Democrats."

Maybe Randazzo would be for the business tax breaks.

"Second, Congress could cut corporate taxes and small business taxes in general. Trimming taxes for "the rich" opens up new capital to be invested in a struggling economy. At a time when investor confidence in the stock market is low, a tax cut for businesses would encourage innovation and entrepreneurial activity. The effects would be similar to that of a stimulus package, only without the government's involvement or a redistribution of wealth."

More about this new bill as I find out more about it, and understand it.