A Capital Idea, Without Free Reserves, but Still Plenty of Room for Concern

To put this patient to bed so to speak, for banks the issue is not one of reserves, but one of capital. Reserves are what the regulator says you must hold based on formulas involving the size and nature of deposits you are holding. Capital is what you have to work with, the base from which you make loans and do business.

Liquidity relief from the Fed can help avoid a credit crunch, which is a short term liquidity problem that can come from a variety of sources, including operational problems like major snowstorms impeding check clearing, major events such as 911, and bank panics. The key phrase is short term imbalance between supply and demand.

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

Insolvency is the real financial problem here. Insolvency stems from insufficient working capital to meet the continuing business needs of the bank, not incidentally, but because of some major business loss depleting capital or a failure to make the appropriate growth provisions. Its working capital that banks are seeking to increase when they sell preferred shares to the SWFs, for example.

Capital is something the Fed cannot directly provide. It does not buy bank shares. It can help to arrange mergers and rescues. It can make capital sufficiently inexpensive to make deals between parties feasible. But it cannot (at this time) directly intervene in the corporate bond and equity markets. The Fed and Treasury did surprise us after the tech bubble bust, so let's continue working on our differential diagnosis , because the financial system still seems to be suffering from a sickness unto death.

Here are a few charts worth watching and perhaps becoming concerned about at some point although by the time it shows up here...

Buffett Blames the Banks

Expect to see more broadsides from academics for hire and think tank economists attacking the monetary moralizers and moral hazardists, as the financial situation becomes more dire, and it is put to us that we really have no choice.

A monetary moralizer is anyone who thinks that bailing out the banks with public monies, supplied by the middle and lower classes in inordinate amounts, is not the appropriate thing to do, creating future moral hazard, rewarding incompetency and thievery, et cetera. The neo-Keynesians like to portray those who are concerned with moral hazards as fussy old biddies who let principle get in the way of a really good time with the punchbowl.

Contrast that, however, with the illumination cast by the independently thinking (and independently wealthy), such as the famed Mr. Buffett, who on occasion prefers to like to tell it like it is, as he does at a conference in Toronto, as cited by the UK Telegraph:

Billionaire Warren Buffet has accused major banks of creating their own downfalls. Mr Buffett, known as the "Sage of Omaha" for his investment record, suggested that the banking fraternity has only itself to blame for its recent problems which have seen banks write off more than $130bn (£66.3bn) so far.

"It's sort of a little poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end," Mr Buffett said, making reference to the American soft drink.

The septuagenarian investor, speaking in Toronto, said that in spite of the meltdown in the sub-prime mortgage market and the impact on the banking system, funds remain available.

"I wouldn't quite call it a credit crunch," he said. "Money is available, and it's really quite cheap because of the lowering of rates that has taken place."

However, he said what had taken place was "a re-pricing of risk," leading to an "unavailability of what I might call 'dumb money', of which there was plenty around a year ago." (his point is that the problem is not liquidity, but a scarce supply of fresh suckers willing to buy into the familiar Ponzi schemes - J)

Mr. Buffett also reiterated his negative views on the subject of the US dollar, saying that over the next five-10 years, the dollar could seriously devalue if the US trade deficit persists.

Now, we don't necessarily believe that the bankers should be punished for what they have done; after all, there is the Ken Lay defence, that destroying the US economy and impoverishing millions was an unintended consequence of simple incompetency, fiduciary abuse, bad management and greed, without malice aforethought.

But we do think it is a bit much even by Wall Street's face-ripping standards to defraud the public, and then to expect the public to foot the bill when the scheme goes awry and money is left on the table, so to speak, or at least a hefty tab remains for someone to pick up.

Lowering interest rates and increasing the money supply is not going to fix this. The problem is not a shortage of funds. The problem is a shortage of suckers willing to buy into these Ponzi schemes, and to buy just about anything from the jokers that sold them damaged good last week. The music is stopping and the bankers don't quite have a seat, and are searching for a fresh supply of dumb money. Hence the grab for public funds from Congress and sovereign wealth funds (SWFs); it doesn't get any dumber than that.

What we recommend is to let the free markets work. Even if we don't allow the banks to fail, thereby impoverishing depositors and the public via the FDIC, the shareholders and owners and top management of these banks need to lose money, and lots of it. What the markets do not accomplish, heavy fines and judgements will have to do. Jail sentences are optional, but recommended for our consideration.

We would also like to see the reinstatement of Glass-Steagall, which the banks spent years and considerable political donations to overturn. A return to a sensible regime of banking regulation and policing, which obviously became a joke during the Greenspan chairmanship and the Clinton and Bush administrations, might be a step in the right direction. The public may wish to do its part by NOT continuing to re-elect these jokers even if they do shed a few crocodile tears.

That will do, for openers.

Free Reserves Go Negative, Blogosphere Goes Bonkers

There has been a recent circumstance where some of the occasionally reading public have noticed that in the bowels of the Fed's publications, in a series affectionately known as the H-Reports, that Non-Borrowed Reserves of the Banks went NEGATIVE last week. Oh my Lord, and heavens to betsy! This is surely a sign of impending insolvency, deflation, and probably the end of Life as we know it (TEOLAWKI).

We've grappled with this for serveral days now, not so much in trying to understand what is happening with the banks, which we think we understand, although there is enough opaqueness, if not outright deception, in the system to make us doubt just about everything, but rather, to try and figure out how to explain this to a group of readers who likely don't know much about central banks, monetary systems, and bank accounting. This is no deficiency on their part, and its probably healthy since we cannot think of a more useless waste of productive effort for those who are not specialist drones in some bureaucratic accounting structure, or a major university.

But since the bankers appear to be going wild, and the economists are either in retreat up in the hills or selling whiskey to the angry villagers on behalf of some political warlord, we seem to be in a position where trying to lend insight into this might be considered a duty. We take this up reluctantly, believe us, because both the goldbugs (said somewhat affectionately) and the deflationists (leave a magazine but please go away) are both holding up their torches and chanting.

So if duty calls, we have decided not to belabor this one, but to just spit it out, provide a reference work for those who have extreme masochistic tendencies, and then run off to do more productive if not enjoyable things like making a living. Keep in mind this is a simplified explanation, will have a lot of technical holes in it, but the major foundations of the argument are pretty sound. We also wrote it at one sitting with no rewrites and precious little spell checking.

Banks are profit seeking, and to shareholders preferably profit maximizing in their behaviour. Put very simply, they have a portfolio of things they 'own' which they wish to use to generate profits. This implies that the must acquire things which is costly, and even the things they already own can cost plenty, as anyone who has ever married a trophy wife must surely know.

When banks put together that portfolio of things that they 'own' they consider the various costs of possessing or acquiring those things, and what they might get in return for doing things with them to generate some income, the net result being often referred to as 'profit.'

Doesn't that sound familiar? Portfolio? As in portfolio theory? Even the investor has often entertained the notion that if they have a portfolio of things, with different returns, risk, and maturities, they might have the ability to tinker with that combination to get the best bang for the buck, so to speak. That's where a little knowledge is dangerous, because the example of the individual goes sour pretty quickly when you start applying it to accounting for banks. But let's go with it a bit.

A bank can have a group of things it 'owns' including cash, Treasuries, loan portfolios, etc. Banks are the ultimate leverage machine. They don't like to hold reserves, because reserves are most often things that are not performing to their multiplying maximum. Very inconvenient and all that. In the UK as we recall, the reserve requirment is zero, but you better not miss it. in the US its some handwavy existential notion that people think of as 10 percent, but with sweeps and so forth its a little virtual. Still it does exist, and the Fed does track it.

Does it matter WHERE the reserves come from? After all they must come from somewhere. Vault cash (ugh no return there) is one example. Banks, contrary to popular belief, hate cash. necessary evil and all that. Pesky stuff.

As you probably know, banks borrow from each other to make reserve requirements (Fed funds rate or effective funds rate if you will) and from the Fed (Discount Rate).

What if the Fed created an extra groovily priced borrowing facility for the banks, that offered 1. privacy 2. ease of use with favorable durations and required collateral 3. a cost that is less than inflation.

Let's repeat number three. The Fed offers the stuff that banks use to make money, capital, and it does it for a cost that is less than inflation. Some might refer to that as 'free money.'

If you put enough of that into the system, what would happen? 1. The effective Fed Funds rate would drop faster than a local hardware store's prospects when the new Walmart gets built, 2. Relatively riskless investment returning even a little better than the super secret discount rate (aka TAF) would plummet in return as too much money chased them. 3. Relatively safe assets would start inflating as the search for return grew more intense.

If you don't believe us take a look at some of the whacky things going on with the yield curve, especially with the two to five year Treasuries since this is where the risk aversion return hungry genie is pointing.

This free money concept sounds great! Why don't they do it all the time? Beats working. Well, the trick is to provide free money without letting on that its free money, at least to the tourists, and especially your creditors who buy and hold your sovereign debt. Its a dollar dropping in value thing.

To do that you have to make people think there is less inflation than there really is. Check. Second thing you have to do is set up an opaque and somewhat exclusive mechanism by which you direct the 'free money.' TAF anyone? Anyone? Bueller?

So what else should a bank do. Acquire more depositors? Sure, and compete with money market funds, and scramble for high cost nickels when the Fed is offering low cost megabucks. Where's the unemployment line Rudy? The money machine is right down the hall in Ben's office.

What we are seeing are a lot of skewing and distorting of the data as the Fed takes extraordinary actions to push liquidity into the system by offering 'free money' to the part of the system where you want to put the juice to make things get moving again, the primary dealer banks. They would still like some non-supply side action in the form of a stimulus to consumers, but the Fed can't do that (yet) and must rely on Congress (where no stimulus goes forward without a hefty chunk for numero uno someway somehow).

This is NOT to say that there are not serious problems in the financial system. This is NOT to say that deflation is impossible (hey fiat cuts both ways and if the Fed raised Fed Funds, margin money and reserve requirments tomorroww to the max we'd probably see something in the ensuing chaos resembling deflation.

However, if and when the real cracks in the system show up, its unlikely to be in one of the H-series documents, as cool and esoteric as they might seem to someone who never looked at them before. They are not secret. They are on the web for God's sake.

The real problems will come like a thief in the night, and most likely with some exogenous shock from a foreign creditor, or an irrational panic like a market crash or a bank run that exposes the weakness hidden in the system. Well hidden until the tide goes out.

We warned you it would be simple, and full of technical holes, but it is sound. If you want the intermediate version read this free book online: Monetary Economics by Jagdish Handa. Its not the best but its fairly readable and the price is right.

As for the real source of the problem? Its not loose money. That's just a prerequisite.

We live in a time when lying is no longer considered dishonorable if you succeed in achieving your objective. It might even be your government sanctioned duty. Heck, you might be admired for it, get a really nice golden parachute, be knighted, or even elected president. And economists are no different, being sullied by their exposure to the marketplace, which is much more richly adorning than a quiet department office and admiring but amazingly similar students.

These are the times in which we live. We are no different than prior civilizations. We just are grading behaviour on a really exceptionally generous curve. No financier, lobbyist, businessman, or corrupt politician left behind.