Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn’t together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Big bad banks?

QE3, Operation Twist and Balderdash

“What’s in a name?  That which we call a rose
By any other name would smell as sweet.”

–Juliet, from Romeo and Juliet, William Shakespeare

Balderdash – A senseless jumble of words; nonsense, trash (spoken or written)

— Oxford English Dictionary 

The Federal Reserve is likely to take action today to “boost the economy.”  This is yet another attempt in a long line of failed efforts that not only won’t work, but will almost certainly make problems worse.

Whether they call it QE3 (quantitative easing, part III) or Operation Twist (named for the 1960’s dance and first tried during the Kennedy administration) or Glimdragbig (a word I just made up), it will feature the Fed toying with interest rates (most likely by creating money) in an attempt to get the economy “moving.”

The Fed may call it something other than what it is, but it will still smell.  They may use elaborate jargon (nonsense) to mask its true nature, but that won’t change the facts.

The Fed’s underlying premise is that free markets work…until they don’t.  Has the Fed ever correctly forecast when markets will stop working?  Of course not.  In fact, they are almost always too ebullient when they should be cautious, and overly worried when they should be upbeat. 

But, despite these consistent failures, they still pass judgment on markets and they supposedly know when markets have stopped working, and therefore when they should intervene to “get things going.” 

As Dr. Phil likes to say, “how’s that working for you?”

In case you haven’t noticed, economic growth is anemic at below 2%, and unemployment is high at over 9%.  And, this is after countless fiscal and monetary (and regulatory) interventions over the last 3 years.

Why aren’t interventions working?  Because the first part of the Fed’s premise is right: markets do work.  If you let people freely choose and act, and prevent them from initiating force against each other, they will–over time–rationally allocate capital and other resources to productive ends, thus resulting in real growth and higher employment. 

What the Fed has been doing is preventing this mechanism from working.  Interest rates are at the heart of any modern economy.  It’s the time value of money, and therefore drives economic choices at the most fundamental level.  If you screw with those rates, people will mis-allocate capital and the economy will stagnate or shrink.

Sound familiar?  If you need more empirical support, please see Japan over the last 20 years and America during the 1930’s as examples of interventions galore resulting in anemic growth, stagnation, or shrinkage (or the Soviet Union, or China under Mao, or North Korea, or Cuba, East Germany, Venezuela, you get the picture!).

Stock, bond, and commodity markets are likely to respond favorably to any Fed intervention–just like they always do (after all, everyone loves a party when someone else is paying).  The dollar is likely to sink (except perhaps relative to Europe, which is even more of a basket case than America) and gold is likely to rally.

That doesn’t mean the economy will grow, nor does it mean unemployment will shrink.  Once again, interventions are leading to greater and greater mis-allocations of capital and thus will cause slower growth than would otherwise occur. 

There is good news in all this, and that’s that much of the American economy is relatively free.  In such places, people are innovating, adapting, employing and growing.  As long as the bone-heads bureaucrats don’t intervene too much, such productive people will eventually create enough growth to overcome the negative effects of repeated intervention.

It may take time, though, so patience will be necessary.  In the meantime, lets all hope the interventionists will stop distorting markets so they can do their thing.  At that point, we’ll have an upward spiral to be truly optimistic about.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

QE3, Operation Twist and Balderdash

The Fallacy of Too Big To Fail

I’ve tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, “too big” assumes some standard.  It assumes that something of a certain size is “good,” but when that size becomes “too” much, it becomes “bad.”  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  “XYZ Bancorp is so large that it can take down the whole financial system” seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you’ll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn’t the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can’t possibly crash nationally (note: I’m being sarcastic).  Oops, that argument didn’t float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren’t back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn’t have crashed due to too much leverage. 

If home ownership weren’t explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn’t driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren’t encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it’s always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn’t happen, though, without national coordination–in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn’t greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp’s community banks.  You can’t come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions–which frequently take the form of national (or international) regulation.

I can’t help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn’t its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn’t help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it’s useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in “profits” last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle’s $37 billion and ExxonMobil’s $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won’t even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fallacy of Too Big To Fail

There’s no free lunch

One of the most succinct propositions in economics is that there’s no such thing as a free lunch.  Put more plainly, when you think you’re getting something for nothing, you’d best check your premises.

Take free Internet search.  Is that really free?  No, it’s paid for by advertising.  Free news from over-the-air broadcasters ABC, NBC and CBS?  Advertising.  Free advice from financial planners?  Commissions on mutual fund sales.  Free roads?  Check out the taxes you pay on fuel.  Free lunch from an insurance salesperson?  Commissions, too (an insurance salesperson once bragged to me that he only needed 1 out of 20 people to buy insurance at those events–so you should know right away the “product” is a rip-off!).

There’s no such thing as a free lunch. 

In no case should this be more obvious than government support of the economy.  Hey, if all it really took were the Federal Reserve printing money to promote prosperity, then Wiemar Germany and Zimbabwe would have been the most thriving economies in history.  They weren’t/aren’t (both disasters on scales that make earthquakes and hurricanes economically boring in comparison).

And so, when the Fed ends it’s quantitative easing program this summer, we should all be on the lookout for economic tremors.  We ate the lunch, now the bill’s coming due.

I’m actually quite surprised market participants have been short-sighted on this issue.  I naively thought the quantitative easing program hinted at last summer would be seen for what it was–quite costly.  Instead, the market started partying like it was 1999.

This attitude will, however, prove short-sighted.  Unfortunately, John Q. Public has joined the stampede.  As usual, he waited until the herd reached full speed, long after the lead steers saw the Fed’s policy as a license to speculate.  My guess is that he’ll leap off the cliff only to look back and see the lead steers observing the slaughter from the sidelines. 

So was it ever.

Perhaps we’ll get a third round of quantitative easing and the day of reckoning will be put off.  If so, that lunch will be no more free than the last several. 

It will be interesting to observe how the lead steers react, and how long it takes for John Q. Public to learn that there are no free lunches.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

There’s no free lunch

Creating instability

I don’t envy the Federal Reserve.  They have an impossible job.  Can you imagine trying to set the price of t-shirts for the whole economy, much less the clearing price between suppliers and demanders of funds in capital markets? 

No matter how hard you try, you’d always set interest rates too high or too low, or supply too much or too little money.  This would lead to the inevitable shortages or surpluses that any Economics 101 course teaches to new students.  If you don’t believe me, please see the terrible record of any centrally planned economy.

And yet, the Federal Reserve still tries to make the economic system more stable through its control of the money supply and interest rates.  You’d think they’d learn.

Their failure can be seen, most recently, in the swing of commodity prices and interest rates.  Increasing the money supply to bring down interest rates has led to un-intended, but inevitable, consequences, like surging commodity prices and civil disorder in the third world. 

The Fed keeps insisting that inflation is low by reference to a) the corrupt Consumer Price Index (CPI) and b) the spread between bonds with and without inflation protection. 

The circular reasoning required for b) above just boggles the mind: 1) The economy is inherently unstable, so we need a Federal Reserve to prevent that instability from hurting people (they claim), 2) The Federal Reserve refers to free market interest rates (on the premise that market players aren’t just reacting to Federal Reserve talk and action) to decide whether they need to intervene, 3) So, if the Federal Reserve is supposed to prevent an inherently unstable system from becoming unstable, why is it using supposedly unstable misinformation from that unstable system to validate its need to act or not?

It sounds like a recipe for creating an even more unstable system.  And, so it has.

Below are three graphs.  A) shows a stable system where equilibrium is restored with damped oscillations over time.  B) shows a stable system where oscillations aren’t damped, but the system returns to equilibrium periodically and doesn’t fall apart.  C) shows an unstable system where the oscillations become greater and greater until things blow up or whatever is causing the divergent oscillations is removed. 


The claim is made that we need a Federal Reserve because the systems is inherently like B) or C) and the Fed will make things look like A).  But, look at the graph below of S&P 500 profit margins.  Does it look like the Federal Reserve is making A) happen, or C)?  Looks a lot like C) to me!

It is my contention that the economic system is inherently like A) above, not B) or C), and that Fed intervention is turning the economy into first B) and then C) above. 

This is by no means a proof or validation, but it should raise a question in your mind that perhaps markets should be setting interest rates and money supply just like it sets the price of t-shirt, TVs, computers and millions of other products.  Every experience with price controls in history has led to surpluses and shortages, and yet we have a Federal Reserve trying to set the most important price in the economy–the price of money. 

Maybe it’s time to dampen our oscillations by removing the thing that’s making our system unstable: the Federal Reserve.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Creating instability

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I’ve always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed’s mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan’s last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won’t boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That’s because most people haven’t been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won’t create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don’t the people at the Fed possess such common sense?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed wants MORE (?!) inflation

The week that was…

Most weeks, I choose one topic on which to spout my thoughts and opinions.  But, this week, there were just too many interesting things to ponder, so here are 8 brief points of interest.

1)  Earnings season is over and the results were better than expected.  Revenues didn’t dazzle, meaning that end demand is slow, but cost cuts more than made up the difference.  This just goes to show that companies and the stock market can do well even in a slow economy.

2)  Economic numbers continue to improve.  Unemployment claims improved, railroad loadings are up, leading economic indicators surprised on the upside as did the Philly Fed’s survey.  The economy is improving ever so slowly, but it is improving.

3)  There’s been a lot of speculation that the Fed’s quantitative easing program is merely an attempt to puff up the stock market to get rich people to spend, thus improving the overall economy.  Andy Kessler and Don Coxe made convincing arguments that the Fed is really worried about real estate and the financial institutions that depend on real estate values, and thus quantitative easying may be an attempt to support bank balance sheets.  Why did the economy roll over in 2008?  Oh, that’s right, real estate values tanked and financial institutions froze up.

4)  The mortgage documentation mess promises to have much more lasting impacts than most realize.  This issue goes to the heart of real estate titles and ownership, and the dinosaurs are going toe to toe to find out who will eat losses.  If the banks end up losing this fight, like they should, then we could be right back into a 2008 crisis again.  See 3) above.

5)  Ireland will likely take a bailout from the European Union (EU).  If you think this means Ireland is in a weak position, think again.  When you owe the bank $10,000, it’s your problem; when you owe it $10 billion, it’s the bank’s problem.  The EU is more worried about Greece, Portugal, Spain and Italy than Ireland, so they are hoping to draw a line in the sand at Ireland (after Greece).  Ireland has the stronger hand in this game.  Oh, and by the way, why is another bailout in Europe good news for markets?

6)  China is working hard to slow down their economy, mostly by slowing bank lending, because food inflation is making the natives restless.  China may succeed more than world markets anticipate.  Initially, markets will probably take that hard.  But, over time, this will lower the prices of input commodities, thus improving developing economies.  This may be a case where slowing for them is good news for us.

7)  Many state and local governments in the U.S. look like Portugal, Ireland, Italy, Greece and Spain in terms of fiscal health.  When these issues hit the front page, likely next year or the year after, it will rattle markets and lead to huge bailouts by the federal government.  This will be good in the long run (because budgets are out of touch with reality), but I don’t think many people, especially investors, are paying attention to the short term impacts.

8)  Long term bond yields spiked over the last couple of weeks.  An almost 5% decline in the 10 year U.S. Treasury bond over a couple of weeks should be a wake up call for investors who think bonds are risk free.  It should also give pause to equity investors who should know that stocks should go down when long term bond yields spike.  But, why worry about that, the market is rallying!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The week that was…