Dr. Peter T Treadway is an independent consultant and money manager and Adjunct Professor in Asia. He is currently is principal of Historical Analytics, a consulting and investment management. He pens a monthly letter (The Dismal Optimist) for clients. He is also Chief Economist for C T RISKS, a new Hong Kong company that will assist Asian financial institutions with their risk management problems.

Dr. Treadway previously served as Chief Economist at Fannie Mae (1978-81), and prior to that, was an institutional equity analyst at Smith Barney (1985-98). He was ranked as “all star” analyst eleven times by Institutional Investor Magazine. Dr. Treadway also worked at The Board of Governors of the Federal Reserve. He holds a PhD in economics from the University of North Carolina at Chapel Hill, an MBA from New York University and a BA in English from Fordham University in New York.


It’s the System

The public and the politicians have been outraged at the bonuses the recently bailed out banks have decided to pay themselves. In the United States, bankers are now held in lower esteem than politicians.

Unfortunately the public’s anger is misplaced. Yes the bankers are greedy but after all why else would anyone put up with the long hours and grueling machismo that a job on Wall Street entails? As Adam Smith taught us in 1776 in his Wealth of Nations, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love…” If the system works, greed is good.

Unfortunately, our monetary system – including its domestic and international components — is broken. It has been providing excess money supply and credit growth on a global basis which has promoted one bubble after the other and which has encouraged bankers and everyone else to take excessive risks. A surfeit of liquidity and debt combined with financial deregulation reeking of moral hazard. What a system! When the bankers are right they keep their rewards. The government absorbs the losses when they are wrong. You can’t blame the bankers for picking the ripe fruit from the trees that the politicians have planted.

The system didn’t get broken in one day. The next section is a brief review of some financial history. It’s taken just short of one hundred years to get to the broken system we have today. That’s the trouble. The prophets of doom have always been too early, too impatient. Change takes time; the black swan doesn’t fly every day. Most of the time, the optimists are right.

A Walk Through Financial History

The following are some of the most important events in our recent financial history that have gotten us our “privatize the gains, socialize the losses” bubble oriented economy:

• Creation of the Federal Reserve (1913) – In the nineteenth century two attempts to set up an American central bank—the now forgotten First and Second Banks of the United States– had ultimately been shot down. But finally in 1913 America got its central bank. The Federal Reserve was granted the power to create high powered money out of thin air, thus taking the first step to undermine the gold standard that had been working so well. Over time the Fed has taken it upon itself to bail out the financial system and indeed the whole economy whenever it got in trouble. By the end of the twentieth century, this became known as the “Greenspan put.” Maybe the public didn’t realize what had happened but the financial cognoscenti sure did.

• Creation of Federal Deposit Insurance (1933)—Like all government programs, deposit insurance started small and grew and grew. Signed into law by Franklin Roosevelt in 1933, deposits up to $2500 were covered by government insurance. But gradually the amount insured increased and the scope broadened. For example in 1982 the Garn St Germain bill upped the deposit limit to $100,000. Today all deposits are covered including money market funds. For the bankers, no need to worry about their depositors. The government will take care of them.

• Creation of Quasi Private Fannie Mae/Freddie Mac (1968/1970) – In an effort to get the depression era Fannie Mae off the government books, President Lyndon Johnson signed a law which “privatized” the corporation. The new Fannie had the modest goal stated in its charter of “providing supplemental liquidity to the secondary mortgage market.” A clone Freddie Mac came later in 1970. Out of these little acorns grew giant quasi-public sector monsters. Fannie and Freddie over the years were able to use their “agency” status (which gave them a lower cost of funds than their private sector competitors) and ridiculously low capital levels to muscle their way into becoming the major players in the American mortgage market. Along the way they succumbed to political pressure to lower their standards and buy or guarantee mortgage loans for virtually anyone who was able to sign his or her name on a mortgage application. Risk? Neither the companies nor their Congressional patrons seemed to worry too much about that. Fannie and Freddie were major contributors to the US housing bubble. When they had to be placed into conservatorship in 2008, in a rare display of attempting to avoid encouraging moral hazard, their preferred and common shareholders had to take a huge hit. But not their bond or MBS holders.

• US Termination of the Bretton Woods System (1971) – After WW II, under the leadership of the US the Bretton Woods System was set up whereby the US would redeem its currency to other central banks at $35 per ounce and the rest of the world pegged their currency to the US dollar. Though it had its faults, the Bretton Woods System was a version of the gold standard and imposed a monetary discipline on all countries including the US. But in the 1960s during the Vietnam War the US under Presidents Johnson and Nixon embarked on a program of fiscal and monetary imprudence that resulted in a massive outflow of gold from the US. Forced to choose between giving up fiscal and monetary irresponsibility and the elimination of the heretofore successful Bretton Woods System, Nixon chose the latter. The massive current account deficits that the US has run up in recent years never could have happened under Bretton Woods. Nixon set the stage for a fiat money system that would crank out endless amounts of liquidity, allow countries to hold down the value of their currencies and pour kerosene on the flames of asset bubbles and banker enthusiasm to fund those bubbles.

• Bailout of American Banks (1982-1985)—In August, 1982 Mexican Finance Minister Jesus Silva Herzog trouped up to the US to announce that Mexico was broke and couldn’t repay its huge debt to the American commercial banks. Other Latin American countries soon followed suit including Brazil and Argentina. Not to worry. The US government, pulling money out of a variety of hats including the Federal Reserve, the US Treasury, the US Strategic Petroleum Reserve, the Department of Agriculture, the Bank for International Settlements and of course the IMF, bailed out Mexico. Bailouts of the other defaulting Latin countries soon followed, with the IMF taking a leading role. And by so doing the US government and the IMF also bailed out the American commercial banks. Just before the crisis former Citibank CEO Walter Wriston famously said “Governments don’t go broke.” Wriston was a prophet not a historian. Governments had been going broke since England’s Edward III stiffed the Italian Bardi and Peruzzi banks in the fourteenth century. But Wriston, perhaps smelling the moral hazard in the air, must have known what was coming. Countries wouldn’t go broke because the US government and assorted international institutions would bail them out. Bankers could lend with blissful abandon.

• The Second Mexican Crisis (1994-1995)—A recidivist sans pareil, Mexico in 1994 was back in crisis and on the verge of default. And this time it was Wall Street investors that were on the hook with, among other investments, a huge position in dollar linked Mexican bonds called tesobonos. Again not to worry. President Clinton, with the aid of the IMF, found money for the Mexican bailout in all sorts of places including the up till then obscure Exchange Equalization Fund. Wall Street investors, stuffed with tesobonos, smiled. Unspoken was the fear that Mexico had a “nuclear option”. If the United States didn’t bail out Mexico, millions of Mexicans might come flooding across the border.

• The Emerging Market Crises: Thailand, Indonesia, Malaysia, Korea, Russia, Brazil Argentina (1997-2002)—By the 1990s serious excess liquidity under the post-Bretton Woods international fiat money system was sloshing around the world. Typically, substantial capital inflows to recently and imperfectly liberalized domestic financial systems brought about domestic real estate, stock market and foreign exchange bubbles followed by bust and crisis. Each country’s crisis had its own peculiarities of course. But the crisis response pattern was the same: the IMF to the rescue. The IMF coupled its bailouts (Malaysia said no thanks) with an attempt at imposing reform. These reforms reflected a quasi free market view of the world called the “Washington Consensus” and at least brought some awareness of the moral hazard the IMF was bringing with its automatic rescues. But moral hazard was everywhere. Russia, which had real nukes and was running massive budget deficits, was unofficially dubbed “too big, too nuclear to fail.” The term “moral hazard play” became in vogue. True, sometimes investors and lenders did take losses, as even massive injections of IMF money couldn’t always put its Humpty Dumpty nation state clients back together. Russia was a case in point. Russia did finally default. But before that happened, a substantial portion of IMF money was stolen by oligarchs or redirected to repay foreign holders of a ruble denominated bond called Gosudarstvennye Kratosrochnye Obligatsii, a k a GKOs. Economists have debated whether the IMF’s conditions and advice in these crises were positive or negative. It should be noted that when the Western countries had their crisis in 2007-8, none of this IMF advice was applied to them. “Do as we say, not as we do” turned out to be the swan song of the Washington Consensus.

• Long Term Capital Management (1998) — LTCM was a quant hedge fund associated with Nobel Prize winners Myron Scholes and Robert Merton and run by former Salomon trader John Meriwether. The best and the brightest. With their enormous brains, fearless approach to risk and huge leverage, LTCM got on the wrong side of the Russian crisis, among other bad trades. After turning down an offer by Warren Buffet, LTCM was then later bailed out on more favorable terms in a widely criticized deal arranged by the Federal Reserve. Then, in the midst of a strong US economy and a growing US stock market boom, just to make sure LTCM didn’t upset things the Fed lowered the Federal funds rate three times in the next three months. The Greenspan put in action. Meriwether himself by the way was soon back in business with a new hedge fund, which didn’t go bust until 1997.

• The Post NASDAQ Bubble Bailout(2002) — Fearing a deeper recession after the collapse of the stock market in 2000-2001, Alan Greenspan came to the rescue by dropping the Federal funds rate to below two percent. The Greenspan put in full throttle. Greenspan’s Fed was quite ready to intervene when the market went down. In a lapse into asymmetric behavior, he couldn’t bring himself to tighten when the stock market was rocketing upward in 1998-2000.

Investors Should Prepare for a Bumpy Ride– Capitalism Is In Crisis

Several things have now become very clear. First, as has been argued here many times here, the international monetary system is in dire need of reform. Since the US’s abnegation of fiscal and monetary responsibility in 1971 and its termination of the quasi gold standard Bretton Woods system, the international monetary system has dumped excess liquidity on the world and enabled bubble after bubble.

Second, the fiat international monetary system has allowed numerous countries – China being the latest – to hold down (I would never use a word like “manipulate”!) the value of its currency and export its way to prosperity. This export model has been at the expense of the US worker. Remember the real US unemployment rate, the U6 rate which includes discouraged and part time workers, is 17.3%. The American consumer is in a debt deflation mode. The US oriented export model is dead. Only a massive devaluation of the US dollar against Asian currencies will allow America to compete globally. The US has to become the exporter. If that doesn’t happen, protectionism looms.

Third, “too big to fail” has become an operating principle in the global economy. Not only banks, but insurance companies, auto companies, airline manufacturers, states and countries themselves are now too big to fail. Creative destruction, to use Schumpeter’s term, is a key feature of real capitalism.

Fourth, the US government has become the real capital of the banking system. The US has rigged the yield curve so that it’s virtually zero at the short end and very steeply inclined at the long end. Perfect for bankers who love to borrow short and lend long. And a myriad of bank support programs such as the TARP have been put in place. The market knows — Lehman was the exception– big banks won’t be allowed to fail. The government has in effect substituted its own implied guarantee for bank capital. “We are all Fannies now,” bankers ought admit. Bank balance sheets are consequently much more highly leveraged than they would be under pure free market conditions. Highly leveraged institutions make fortunes in good times. In bad times they go broke. Were there no hope of bailouts, no Federal Reserve and no special programs propping up the banks, the market would require that the banks carry huge amounts of capital as compared to what they have now. In the gold standard pre Federal Reserve days of 1900, the average equity/asset ratio of US banks was 17.9%. By coincidence, in a paper Dr. Michael Wong, the CEO of CT RISKS, and I have written, we created a simple model that allowed for a high stress situation such as the one facing the US in 2007. In this model, to avoid insolvency it turned out a bank would have to carry a capital asset ratio of 17.8%. Those huge bank bonuses should be going into capital or be paid to the government as a “government capital fee.” Mean spirited as some of his bank proposals might sound, Obama this time has economics on his side.

-Peter T Treadway, PhD
Historical Analytics LLC
305 761 4718
852 94091186

January 30, 2009

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