23 September 2008

the banking business model is dead

In the upside-down economic universe America finds itself in these days, banks can no longer be viable businesses. Due to the government intervention in mortgage finance (e.g. ownership of the Governmental Special Entities like Fannie/Freddie/FHA) it has become impossible for private finance to compete with the artificially low interest rates that the government has on offer. Who would want to get a mortgage from a private bank for 8% when they would qualify for a government backed loan at 5%?

Banks simply don't have access to capital as cheaply as the government, and are therefore unable to lend at a profitable rate. The only market left to banks is lending to those who wouldn't qualify for a government loan, which pretty much means people who are virtually certain to default (i.e. even people with 620 credit scores can get 3% down FHA backed loans).

Sure, US banks are still making loans, but if you look closely the vast majority of those loans are government backed, in one way or another (GSE/FHA). Banks have simply stopped putting their own money at risk. Why should they, since they can't possibly get the rates they need that is commensurate with the true risk? This leaves banks with nothing much more than a transaction fee.

It is hard to see how any banks can possibly heal themselves, restoring their balance sheets, as long as the government continues to subsidize lending.

Ironically, the more the government bails out, or seizes, struggling financial instutions, the more difficult it becomes for the banking industry make money and establish a firm footing.

22 September 2008

The Hunger That Never Ends

The Paulson plan to relieve hundreds of billions in seriously de-valued assets from the financial industry can’t possibly succeed. The more successful the government is in purchasing “toxic” assets, the more they will be squeezing private money out of the global economy and preventing the natural discovery of market prices and the re-allocation of resources to where they will be productive.

Instead of stopping the collapse in house and debt instrument prices, this massive bail-out will instead speed up the deflationary process by hovering up whatever capital still remains. For every dollar the US government raises by auctioning off a treasury bond for the bail-out that is one less dollar available for raising capital and purchasing assets in the private market. Banks will find it even harder to raise additional capital (which would enable them to lend more freely) than it already was since the US government is sucking all the capital out of the system. Which pension fund, sovereign wealth fund, or central bank, will want to participate in a CitiGroup share issue in such an uncertain economic environment when they can buy safe t-bills?

Of course, this assumes that this super-sized bail out will even succeed in acquiring the troubled assets it is designed to consume. It is far from clear that this bail-out entity will be willing to offer sufficiently high (above market) prices that the lenders need. There is no way financial institutions will sell their defunct assets at anything close to market prices since doing so will render them immediately bankrupt. It’s possible the government might be willing to pay the high prices these institutions demand, but that is far from clear right now, and we won’t know until the final details emerge.

Worse, even assuming that the bail-out entity does buy derelict assets at inflated prices, the government will further be forced to hang onto foreclosed properties in its portfolio indefinitely, keeping masses of vacant properties looming over the market. Selling these millions of homes at the actual market clearing rates will further drive down prices even more, causing greater financial disruptions (requiring the bail-out entity buy even more over-priced assets), and cause political problems when it becomes apparent that tax-payers will be taking a bath on their investment after-all.

And none of this is even mentioning the difficulties with other forms of toxic debt assets beyond the scope of real-estate. Will the US government also be purchasing GM and Chrysler bonds that have dropped in value?

The more the government buys, the more prices will drop forcing the government to buy even more assets, which keeps the cycle going. At some point the whole bail-out concept will come to an ignominious end.

21 September 2008

Competition: The Key to Restaining Government Power

The famed balance of power between the three branches of the federal United States government is often credited with the success of the American government experiment. While this healthy competition between government powers certainly has some restraining powers, it constitutes only one of the many levels of competition which have slowed the usurpation of power by the government.

At the highest level between governments of countries. A government with poor policies encourages its citizens to emigrate. A sure sign of poor leadership comes in the form of restrictions on emigration. This constraint on poor government is only as effective as the quality of foreign countries willing to accept immigrants. It is also constrained by the natural inclination of citizens to "suffer, while evils are sufferable." Abandoning family and community is not something undertaken lightly.

Competition between government jurisdictions does not always require families to move. Businesses can take some of their operations, like the manufacturing and call centers, abroad without necessarily taking their employees. Such outsourcing is quite simply the result of foreign governments outcompeting ours to attract business. The solution is not laws forbidding such competition between countries, but rather to create a more competitive business environment at home. Government regulation against businesses moving operations abroad, like communist laws against emigration, indicate an unwillingness to accept the hard fact that jobs are leaving because the domestic environment is uncompetitive.

Below the federal level, there is competition between local city and state governments. A poorly run city government is easily evaded by moving outside the jurisdiction of the offending city. The same is true at the state level, albeit a little more inconvenient to move between states than cities. At an even more local level, there is competition between public schools, as families vie to find homes associated with quality schools. Companies shop around as well, looking for the most favorable environment for both the company and its employees.

By removing their ability to create money, the Constitution forces local governments to pay for their decisions through explicit tax revenues, be they immediate or delayed through bond issues. Cities with favorable trade and tax policies, like those of Hong Kong and Singapore, prosper as a result, without any substantial natural resources. Competition between cities, like the competition for Boeing's new headquarters in the early years of the 21st century, is healthy.

The most local level of government, the individual, is perhaps less controversial. That individuals should be judged by those with whom they interact based on how they govern themselves is fairly well accepted. If individuals can't find jobs or spouses, they need to work on themselves, to become more competitive rather than blaming others.

The sharing of power in the United States between the federal and local governments (all the way down to the individual) is a vital competition that has long kept the federal government from expanding as rapidly as it might have liked. Alas, this competition has been breaking down since the Civil War, when the federal government made it clear that secession, another form of peaceful government competition, is not allowed. Instead, the federal government extensively expanded its powers, beyond the intended limits, to include national railroads, national bank charters, fiat paper money, and conscription. In more recent times, the federal government has further eroded competition by increasingly adding social programs and getting involved with traditionally local issues like K-12 education.

Freedom, by definition, is the retention of decision-making power as locally as possible. In the upcoming U.S. Presidential election, it is important for voters to remain vigilant in not only seeking candidates who have noble intentions, but who want issues to be dealt with at right jurisdictional level. May we vote to localize power and maintain domestic competition between jurisdictions. May we vote for freedom.

Fascism: A Cure-all?

As diverse as the dissatisfaction with the economic, environmental, government status quo might be, there seems to be general agreement in the continued strengthening of central governments. The only disagreement lies in whose desires this power should obey. Virtually nobody suggests that strong central power will always attract a variety of powerful interests willing to pay to access that influence.

The environmentalists rejoice at the idea of using this power to force environmental legislation more universally upon the populous. They dream of invisible wind farms forests, and solar panel lakes, funded by government grants and subsidies, which are then funded by suffocating taxes on conventional nuclear and carbon-based power generation. Were such changes economical, they might happen in a free market, so implicit in these desires is the fact that they will reduce our quality of life, and must thus be achieved through via an enlightened, powerful government.

Likewise, a wide variety of conspiracy theorists, ranging from gold bugs to Lyndon LaRouche believe that big business interests control our current regime, but their solution is not to reduce government power, but to centralize it even further and put it in their enlightened hands.

The status quo major political parties also want more centralized power. Fascism, with a powerful central government exerting extensive control over private citizens and companies is the undisputed mainstream government of choice. The dominant parties differ only in how they propose to use that power and how enlightened a despot each leader claims to be. Though they may not have a complete plan for recreating utopia, they generally favor of bigger government, regulating more of our lives in everything from investment banking to education and health care. The resulting potpourri of policies are concocted with the intent of trying to please a wide variety of interest groups. A dollop of environmental legislation, a pinch of business deregulation, and a spoonful of income tax mollification.

Rather than continuing to dream that centralized power can avoid attracting power-mongers of all colors, perhaps we should consider allowing the markets to function. We can count on governments doing nothing efficiently and selling their influence to the highest bidder, so let us return government to its proper role defined in the Declaration of Independence. Alas, governments seldom willingly relinquish power. Any cure to encroaching fascism will likely involve war, revolution and depression. Let us hope, against most historical precedents, that the governments which follow such upheavals will protect our natural rights and freedoms, leaving market competition to bring sustainable prosperity to ourselves and our posterity.

Reining in Government: Sound Money

The United States Constitution is a marvel to behold for its clarity, brevity and limitations on government power. Some of its unfortunate compromises, like the protection of slavery, are understandable given the context in which it was written, but others are perhaps less comprehensible. In the case of money, the founders understood intimately the dangers of issuing paper money, stating that, "No State shall...emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts." Such restrictions were unfortunately not placed on the federal government, allowing the Congress the vague rights to "To coin Money, regulate the Value thereof, and of foreign Coin," which have become (mis)interpreted in conjunction with the elastic "necessary and proper" clause to allow for the creation of fiat paper money.
While it is understandable that the founders were frustrated with Britain's restrictions on coinage in the new world and the general shortage of coin that resulted, they neglected the market alternative of allowing private mints to competitively create coinage. In a competitive currency environment where merchants have the freedom to accept or reject any form of currency, there is a natural incentive for mints/banks to create reliable, quality currency so as to not have their currency rejected.

In any monopolistic currency regime, the temptation to use the monopoly to tax users of the currency via inflation and debasement of the money supply is irresistible for the monopoly issuer. The main restrictions on such inflation, revolution, emigration and foreign currency competition, have delayed and muted effects proportional to the size of the domestic economy. Large economies, like that of the United States, can force domestic acceptance of the national currency, thereby taxing the substantial domestic wealth. Debtors, who benefit from inflationary monetary policy, then provide democratic support for the perpetuation of such policies, along with the largest debtor of all, the government.

Sound money favors prudence and saving, punishing excessive risk-taking and debt with bankruptcy and failure. While sound money does allow for periodic fluctuations in the value of currency, be it through changes to the supply of precious metals, wars or other exogenous events, such fluctuations are minor in comparison with the rampant inflation caused by fiat money. Small fluctuations are even healthy because they can be both inflationary and deflationary, rewarding the prudent and punishing the over-extended.

Without access to the ability to monetize debt, governments are unable to bail out industries as the U.S. government recently did with Fannie Mae, Freddie Mac, AIG and the bad debt purchases. Indeed, such industries would never have been allowed to become so insolvent without the rampant encouragement of debt possible in a fiat monetary system.

Unfortunately, rather than calls to return to private, competitive money, the general cry is for more government inflationary and regulatory intervention. Regardless of the outcome of the upcoming U.S. elections, the resulting regime will surely comply, inhibiting market forces in the financial markets until such time that the necessary re-alignments lead to depression and revolution. Is there an alternative route?

20 September 2008

Capitol Hill beats physicists to create black hole

The more I hear about the US government plans to accumulate bad loans and "toxic" assets from financial institutions the more it sounds like an astronomical phenomena: a black hole.

Not only is this new bail-out entity supposed to suck any tainted assets within its gravitational pull, but these assets will somehow be placed into an alternate universe, permanently removed from human contact. It is not enough to just buy these assets at above market prices to prop up the financial system, but it is also critical that the underlying assets (e.g. foreclosed homes, etc) never come on the market to be sold at cut-rate prices. Doing so would drive down other asset values which would in turn make even more assets insolvent (continuing to undermine the health of the financial system).

This is NOT a Resolution Trust Corporation 2.0. The intent of RTC 1.0 was to quickly dispose of seized assets in an orderly fashion. The purpose of this bail-out is to magically transmogrify vacant real-estate into nothingness.

This sounds very much like a black hole to me. Perhaps the $700 billion going towards the bail-out will result in the creation of the biggest under ground super-collider ever seen, running from Maryland and Pennsylvania to DC and Virginia. Who would have thought our politicians would beat all the world's physicists in creating a black hole?

19 September 2008

it's official: depression just ahead...

The US government’s decision to step in and acquire hundreds of billions of dollars worth of bad loans at above market prices pretty much guarantees that what was already looking like a dismal economic future will be an out and out disaster. I do not use the word lightly, when I describe the virtually certain outcome as a depression.

As much as policy makers have attempted to avoid repeating the mistakes of the past (e.g. Messr Bernanke is an expert on the ‘30s depression) they have wound up following the script of past catastrophes to a T. Just as Hoover and FDR fell over themselves to attempt to bail-out the economy as dark clouds mounted, the global governments are doing the same thing today. In the feverish effort to stop the immediate pain, we are actually making it increasingly harder to come out the other side.

Not only have we not learned the lessons from the Great Depression, but we haven’t even learned the lessons from the .com bust of 2001/2002. Recall that in order to avoid a significant recession the Federal Reserve dropped interest rates to historic lows, and pumped masses of short-term liquidity into the financial system. The policy makers succeeded in preventing any serious economic contraction but wound up blowing another bubble into the real-estate and M&A sector --the mess of which we are dealing with now. What Bernanke et all failed to realize in their studies of the past is that when the apocalypse is staring you in the face, policy makers will always cave-in and try and attempt to bail things out. The only real choices occur in the decades before the crisis hits.

The irony is that every bail-out and intervention merely drives more good money out of the system, ensuring that more bail-outs will be needed. Every government subsidy, or bail-out, makes it that much harder for the private sector to be profitable on its own. Who would want to get a 30 year fixed mortgage from the private sector at 12% when they can get a government guaranteed loan for 5.5%?

There are so many bail-outs and interventions under way that I don’t even know where to start, and I am sure this is only the beginning. To take just one bone-headed idea, let’s look at the decision to ban short sales of financial stocks. This is tantamount to killing all the “repulsive” carrion beasts to prevent them from dis-respecting the deceased. Unfortunately, the dead animals are still with us and will just take MUCH longer to finally rot away. This is just another superb example of how the desire to stop short-term pain only makes things more dire.

Perhaps the most maddening thing of all this is how utterly ambivalent the public is to all of this. Hardly any voices are raised in protest. Expert after expert chimes in with agreement that all these interventions are simply “necessary”, albeit regrettable. Does no one realize that all of these interventions come at the price of shackling the global economy in even more red-tape and regulation? The politicians will want their pound of flesh in return for their help, in the form of extensive (and muscular) new regulatory regimes that will hold back economic growth for decades. Even the Wall Street financiers who ought to know better are begging for government help in their hour of need.

It’s like some medieval village that begs a Knight to defend them from a barbarian horde headed towards their town. The knight and his pals may well defend the town, preventing mass rape, looting, and death. The price, however, is that the goodly Knight will henceforth treat the villagers as his chattel, forever taking away their freedom. Sometimes rape and pillage is preferable to the cost of temporary salvation.

Yes, the governments of the world might succeed in delaying the onset of severe economic distress through their interventions, but they will ultimately push us even deeper into a long, dark, abyss. It would be far better to allow the real pain to be felt through the economy now, thereby allowing it to start recovering quickly thereafter.

17 September 2008

Government Bailouts Reinforce Irresponsibility

The recent bailouts of Fannie Mae and Freddie Mac, not to mention AIG, are indicative of a government determined to keep foolish investers from learning the necessary lesson about the risks they took when the bought into these companies. In fact, the bailouts rescue the most foolish of the investors, the ones who didn't get out earlier when it was clear that there were problems.

While it is not new for the U.S. government to use taxpayer money to bailout the creditors of failing companies, it is a trend that needs to stop if we don't want to strengthen the existing moral hazard. No company is too big to let fail and there is no "optimal" moment in the economy to let companies fail.

It is understandable that the government wants to avoid letting big financial institutions fail in the hopes of stemming a trend, in order to bail out foreign investors (especially foreign government investors), and in order to avoid letting the derivitives on the books of some of those institutions establish the new market price by which comparable derivitives on the books of other institutions must be measured. All of these reasons are short-term delays in the inevitable purging of over-extended companies and poor investments. Such interventions serve the political imperitive to postpone the inevitable pain of foolish investments, but may well make it worse and more prolonged in the process by deepening the moral hazard.

The standard response in times of crises of "we need more regulation" doesn't address the more fundamental problem of not letting investors bear the full risk of their investments. No matter how much regulation there is, if investors can count on being bailed out by the government when things get bad, they will make risky decisions assuming that the government will never force them to bear the full risk of their investments. There is only one clean remedy, let poor investments be liquidated automatically by the market.