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Notes on the Crisis: Grexit edition.

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The Long Tedium of Euro Crisis perdures. It’s clear that Greek departure is a real possibility; it’s plausible that this brings down the whole euro as a currency; but it is also conceivable that for people sedulous in gaining actionable financial intelligence, trades into the new currencies — neo-drachma, neo-lira, neo-franc — are already extant, by means of synthetic sight-unseen derivatives trades.

Now and then we’re informed by pundits, or rather proffered an insinuation: that Greece is all tourism and street crime and communists. “They don’t make anything anyway.” Well, they do control some fifth of the world’s shipping in certain categories of vessel. What’s happened is not that the Greeks cannot, any longer, be a productive and enterprising people; it’s that their governments have promised them too much security and livelihood at public expense, combined with the detail that Greeks don’t pay taxes. So revenues do not match commitments and the borrowing power the euro provided only masked an underlying derangement.

Contrariwise some of my friends on the Right, I do insist on noticing that creditors to Greece were part of this derangement in a big way as well. One of those creditors, it turns out, was former New Jersey Governor and Senator, and former CEO of Goldman Sachs, Jon Corzine. His hotshot quasi-hedge fund sunk big capital into a bet that peripheral Eurozone debt would rebound because (one presumes) the ECB would finance its liquidity; but the hotshots really blundered and somehow (via fraud or incompetence) sunk unconsented client capital into this and similarly disastrous trades.

The US bank JPMorgan, meanwhile, labors under the bad press of its own disastrous trades. The distant inheritors of the great Morgan financial empire didn’t get caught plugging the holes in their balance sheet with client funds; but it’s plain that they got taken for suckers, whether in proprietary trading, hedging or whatever specificity your prefer.

In a now-familiar dynamic, all this uncertainty and volatility redounds to the benefit of the US Treasury. Treasury securities continue to sell like hotcakes. The US government can issue debt at historically low cost. Creditors are lining up to lend us their money.

I stand by my conviction that the amalgamation of commercial and investment banking has been a stupefying failure. Let me be more explicit: most of the bank deregulation of the 1990s (bills written by a GOP Congress and signed by Bill Clinton) should be repealed. The sooner we restore those old quarantines the better. The only reason I care that JPMorgan traders in London lost their shirts on synthetic credit derivative trades is that, like most very large conglomerate banks, JPMorgan is dependent on TBTF and the intimacy with government it implies. And one of the key foundations of that intimacy is JPMorgan’s enormous depositary unit being fused with its capital market prop trading units.

Let me note in passing that Eurozone banks are generally much bigger than ours. And half of them are nearly crippled by Greek, Spanish, Italian, Portuguese exposures. Even if, mirabile dictu, the US finance sector were cleansed of its insidious usury, we’d still be confronting a world full of TBTF banks, national champions, sovereign wealth funds, and mercantilism from Germany to China.

One thing I can predict with confidence is that the interesting times will persist.

Comments (34)

I stand by my conviction that the amalgamation of commercial and investment banking has been a stupefying failure.

Paul, what is the critical difference between "commercial" banking and "investment" banking? And are these categories themselves (at least partly) an artificial way of dividing up banking, or do they represent fundamentally different sorts of activity?

My impression was that MF Global's bet was long PIIGS- or PIIBS, Belgium rather than Greece; that it was, though a large number of complex positions, a single firm-wagering bet; and that client funds were used not for the bet per se but to fund margin calls as the value of the collateral went down. And as bet-the-firm bets go, it doesn't look all that crazy to me. Either the Euro zone shrinks to France, Germany, and two or three other countries, or the too-large-to-fail ones like Italy, Spain and Belgium get rescued, with Greece, as it now appears, maybe taken out and shot, pour encourager les autres. It's just, as far as I can tell from what little is provided in the SEC filings, Corzine's bet didn't involve Greece long or short.

Paul, what is the critical difference between "commercial" banking and "investment" banking?

The capital base. In commercial banking, the capital base is consumer deposits, FDIC insured; in investment banking, it is either the investment of the firm's partners or the investment of institutions (pension funds, endowment funds, mutual funds) or high-wealth individuals.

Basically, if you want to build a depositary banking institution, you should be prepared to build a boring, ponderous, workaday firm that abjures the wild side of exotic securities trading. If you want to get into the securities business, you should be prepared to leave insured deposits out of it.

Mr. Brandt, thank you for that correction. Maybe Corzine did have the sense to leave Greek debt alone. Wouldn't you say, though, that funding margin calls with client funds is plugging balance sheet holes with funds that should not have been deployed? If a firm cannot meet margin calls with its own capital, then it's by definition insolvent, no?

Contrariwise some of my friends on the Right, I do insist on noticing that creditors to Greece were part of this derangement in a big way as well.

I don't disagree with that observation, but I'm not sure the friends you cite are all that representative of the "Right". Most right-wing/conservative commentators I've read are thoroughly against the crony capitalism exemplified by the "Too Big to Fail" rescues and the actions of people like Corzine, or banks like MF Global and JPMorgan Chase; that doesn't make their criticism of the cultural weaknesses that have contributed to the affected European nations' problems any less accurate. You can condemn both the pusher and the addict for their decisions, even if the worst effects of those decisions only happened because they mutually enabled one another.

Paul,

I continue to profit from this series, as I think it is important to think seriously about global finance; however, I'm not sure if your "conviction" makes sense. I've been reading this wonderful (new to me) blog on the issue of the Volcker Rule, and this guy just loves to rip into anyone who thinks the rule can do any good here, and even gets in some delicious swips at Volcker himself here, and he has some very smart things to say about the JPMorgan $2 billion loss and how it relates to the Volcker rule here.

Now, I realize that your "conviction" is actually more radical than the Volcker rule, but consider something that Sonic Charmer likes to point out frequently in his posts: what you describe as the "boring, ponderous, workaday firm" is still subject to risk. Banks are still using their depositors money to 'gamble' on loans -- and from time to time those gambles don't pay off. Should we get rid of deposit insurance because the taxpayers might have to bailout the occassional Broadway Bank? I could probably Google a couple of libertarian white papers on the subject and they might offer a vision of a world in which the private sector provides deposit insurance and its 'depositors beware' when putting their money in banks. Was the pre-FDIC world that bad -- before the Great Depression were bank runs and failures common? I think it is important to acknowledge the reasons we had deregulation in the first place and to acknowledge what an expanded finance sector has been able to do for the economy over the past 20-30 years. There are always costs and benefits.

Anyway, I'll leave you with one alternative to your solution proposed by one of my favorite economists, Arnold Kling, who thinks the problem is not that the banks are involved in risky trading, but that they are too big.

I don't want to get too technical to make too small a point. I'm quite willing to dislike Corzine for a number of reasons. I don't like his beard. But the closest we've come to criminal intent is uncorroborated, un-cross-examined testimony that leads one to think Corzine wanted some plausible deniability about one $200 million posting of additional collateral. (I said margin call before for convenience, but technically it was more a call for posting additional collateral- i.e. it was not so much a matter of the value of the bet dropping but of the counterparty feeling more nervous. A technicality, and an uncritically small point.)

The greater scandal, in the sense of what it might say to ordinary investors, is what MF was allowed by law to do with the idle cash in its futures customers' accounts. Anyone who has a standard vanilla margin account at a standard stock brokerage has given the broker a fair amount of play room with his holdings. Mostly it gives the broker a chance to grub some spare change from a third party without paying you or letting you know- commonly, for instance, lending your shares out for somebody else to sell short. And generally nobody gets hurt.... Nobody reads those voluminous pages of legalese when opening a brokerage account. Everyone should. And if you intend to hold your shares of Newmont or J. G. Boswell forever, you should probably go through the hassle of what used to be the routine matter of having your shares delivered to you in certificate form.

Sorry, I don't mean to jack the thread off track. But people need to be more aware of what they're allowing corporations to do with their information and their property when they fill out 'standard' forms, whether they're signing up for Facebook or buying gold futures options.

David, that kind of points to my major concern: the more you have "contracts" (really, interlocking series of arrangements) that hide the essential transfers of value and of risk behind 2 doors, 3 curtains, and a laser light show, you have inherently put the market at risk. Sure, some players are savvy enough to figure out some of the meanings of the interlocking parts, but demonstrably many of even the truly sophisticated players DIDN'T understand the implications of their own dreamed up products. Ultimately, when you have products that complex, some (or all) of the winners are fundamentally winning at least a portion of their winnings not off of actual creation of new wealth, but simply transferring existing wealth from the suckers' accounts to their own. That's not Christian wealth management, it's worshiping of golden calves, or it's just godless.

The US bank JPMorgan, meanwhile, labors under the bad press of its own disastrous trades. The distant inheritors of the great Morgan financial empire didn’t get caught plugging the holes in their balance sheet with client funds; but it’s plain that they got taken for suckers, whether in proprietary trading, hedging or whatever specificity your prefer.

That unit has made JPMorgan Chase billions in the past (which is why it was given more money to invest) and the net loss for this quarter is closer to $1 billion against a market capitalization of over $100 billion. It's not a trivial loss for JPMorgan Chase, but it doesn't pose any great systemic risk.

I stand by my conviction that the amalgamation of commercial and investment banking has been a stupefying failure. Let me be more explicit: most of the bank deregulation of the 1990s (bills written by a GOP Congress and signed by Bill Clinton) should be repealed. The sooner we restore those old quarantines the better. The only reason I care that JPMorgan traders in London lost their shirts on synthetic credit derivative trades is that, like most very large conglomerate banks, JPMorgan is dependent on TBTF and the intimacy with government it implies. And one of the key foundations of that intimacy is JPMorgan’s enormous depositary unit being fused with its capital market prop trading units.

TBTF is a problem, but Long-Term Capital Management, Bear Stearns, and Lehman Brothers were not the biggest fish in the pond. And most losses incurred by banks during the recent financial panic came from conventional loans, not exotic derivatives. In fact, Lehman did not fail because of its $35 trillion notional derivatives portfolio, but because of its commercial real estate loan portfolio. So the reactionary belief that restoring those old quarantines is the key to the answer is apt to give people a false and dangerous sense of security.

That's a very interesting perspective, Perseus. Would you say that this

And most losses incurred by banks during the recent financial panic came from conventional loans, not exotic derivatives. In fact, Lehman did not fail because of its $35 trillion notional derivatives portfolio, but because of its commercial real estate loan portfolio.

supports the more mainstream conservative perspective that the economic crisis has been in no small part due to overextension in the housing industry and to pressure to make risky real estate loans?

FH, very interesting article by Kling. (Which is not to say that I know enough to evaluate his proposed solution.) Here are a couple of good quotations, apropos of regulation and the reinstitution of quarantines:

Second, policymakers could claim that as Dodd-Frank is fully implemented, regulators will devise means to make it impossible for large banks to fail. This requires confidence in regulators’ having God-like powers to perceive everything from the big picture in financial markets down to the details of how banking units operate. All that would be needed in order to make this work is regulators who know more about banking than Jamie Dimon — who might be rather difficult to find.

Third, policymakers could renew the cry for the “Volcker Rule,” which would prohibit banks from engaging in speculation. The problem here is that the line between speculative activities and “real banking” is often clear only in retrospect. For example, nobody would have said that the mortgage-lending activity of savings-and-loans in the mid-1970s was speculation, but they suffered large losses when interest rates soared. In words often attributed to Warren Buffett, you find out who is swimming naked when the tide goes out.

A final option is to concede that there is no foolproof way to regulate banks.

I believe that our best hope lies somewhere other than making our largest financial institutions impossible to break.

One thing I do like about this: I have always said that there is something dangerous, not to say perverse, about holding that we really must find a way by regulation not to let banks (or companies) fail. Failure is an important part of life. It's called a reality check. It doesn't seem to me to make any more sense to say that we must a)commit ourselves as a country to massive bailouts and then b)commit ourselves to massive regulation to make massive bailout (we hope) less likely to be called for than it would to apply the same approach to individuals, declaring that certain adult individuals must always be protected from the consequences of their actions and then must be subjected to massive control over all their actions so that they will never mess up their lives. There is far too much of a whiff of magical thinking there for my taste.

It's not a trivial loss for JPMorgan Chase, but it doesn't pose any great systemic risk.

Fair enough, Perseus. I think that this JPMorgan story has more bark than bite. The real uncertainty lies in Europe, now concentrated, once again, on Greece.

And most losses incurred by banks during the recent financial panic came from conventional loans, not exotic derivatives.

I presume you mean the 2007-08 crisis. That's true, with the qualification that one supremely important instance of loss came from exotic derivatives. I refer to AIG.

So the reactionary belief that restoring those old quarantines is the key to the answer is apt to give people a false and dangerous sense of security.

I don't mean to supply false hope or undue security. Panics and bank runs will always be with us. But I think that the market has demonstrated the folly of these "financial supermarket" business models. The chief reason to invest in their equity or debt seems to be the backdoor TBTF promise. Half of that promise is achieved by the fusion of insured deposits to investment and money management, and above all trading operations.

Look, the Reagan boom that lifted America's burden of stagnation, futility and enervation, and funded the military expansion which supplanted and finally overthrew the Soviet Empire, was all serviced by a banking sector disciplined by those reactionary old quarantines.

I realize that your "conviction" is actually more radical than the Volcker rule, but consider something that Sonic Charmer likes to point out frequently in his posts: what you describe as the "boring, ponderous, workaday firm" is still subject to risk. Banks are still using their depositors money to 'gamble' on loans -- and from time to time those gambles don't pay off.

I wouldn't dream of supposing otherwise, FH. But what the FDIC does is, after all, handled pretty well. Banks go under every weekend and normal folks with deposits in them hardly notice.

Also, I'm not sure "radical" is the apt modifier. Perseus's "reactionary" may be better. I prefer "restorative." Remember that under my structure (Glass Steagall plus a push toward private broker-dealers) the securities trade is mostly left alone. It a sense it becomes more deregulated because the main firms are private capitalists rather than representatives of public shareholders (or impostures for fiduciary representatives of taxpayers). No one normal cares a lick what Wall Street's doing because they are doing it all with their own money.

Now, do I suppose that my structure is likely to present itself to our weary eyes by means of the legislative or regulatory will of the Republic? Hardly. My general supposition is that, in high finance, things are going to get much more interesting and less boring and workaday -- in other words, get worse. Usury is intrenched alright; won't be easily curtailed.

A question for Paul:

If things are going to get worse in the exotic world of high finance, is there any point in having savings (which earn virtually no interest and get eaten away by inflation)?

Would your advice be spend, spend, spend on bread and circuses - at least while the bread holds out?

Absolutely not. My advice would be to continue saving as best you can -- insured deposits are safe, short of the crack of doom; but you probably want to throw in some precious metals, trustworthy mutual funds, real estate, etc. High grade corporate debt and equity investments have some real advantages.

I would also avoid going into debt for any kind of consumer good. Your home mortgage should be your only debt burden -- and even then only if you feel secure in taking it on. Avoid student loans.

Also, maintain a healthy skepticism of all financial advice, including the foregoing.

Lydia: "Would you say that this supports the more mainstream conservative perspective that the economic crisis has been in no small part due to overextension in the housing industry and to pressure to make risky real estate loans?"

I agree with the first part, but I think that conservatives and libertarians somewhat exaggerate the pressure to make risky subprime loans.

The problem here is that the line between speculative activities and “real banking” is often clear only in retrospect. For example, nobody would have said that the mortgage-lending activity of savings-and-loans in the mid-1970s was speculation, but they suffered large losses when interest rates soared.

Kling makes an excellent point. All banking is inherently risky because banks borrow short-term and lend long(er)-term. So an unexpected interest rate spike or a real estate bubble can just as easily devastate a commercial bank making "boring" conventional loans as an investment bank involved in exotic derivatives (and, of course, those "exotic" subprime mortgaged-backed securities were deemed to be relatively safe because of the historical performance of the real estate market). The biggest problem in the 2007-8 panic wasn't so much the riskiness of the portfolios held by financial institutions as much as the very high levels of leverage.

Paul J. Cella: "That's true, with the qualification that one supremely important instance of loss came from exotic derivatives. I refer to AIG."

AIG is an insurance firm, not a bank, so (strictly speaking) eliminating the firewall between commercial and investment banking does not apply (and AIG made insurance-like bets). Commercial banks are much more likely to be bailed out because of deposit insurance. But, as Kling, Fake Herzog, and I contend, "boring" conventional loans are not low risk. Hence, if you are serious about creating a more secure firewall, you should advocate placing even tighter restrictions on what can be done with bank deposits (like France used to do) such as allowing deposits only to be invested in short-term U.S. government debt, which would turn virtually all banking into investment banking. Alternatively, you could have much lower limits on deposit insurance.

AIG's London financial products office was definitely in the credit intermediation business, whatever the overall corporation claimed to be. It was swallowing the risk of default on massive mortgage securities in return for steady revenue through fees. In a word, AIG was a shadow bank. Another shadow bank, General Electric, nearly got skinned alive in early spring 2009 in the commercial paper market where it is a dominant player. However, unless these firms have depositary banking arms, you're right that my quarantine or firewall recommendation does not directly apply.

My view is that it's the integration of all these credit intermediation operations which introduces the contagion problem. Lehman Brothers goes belly up and a few hours later an enormous insurance firm detonates; not long after that, the oldest money market fund breaks the buck; etc, etc. The integration of capital markets has a major downside: perilous fragility in a panic.

I don't want to get too technical to make too small a point. I'm quite willing to dislike Corzine for a number of reasons. I don't like his beard. But the closest we've come to criminal intent is uncorroborated, un-cross-examined testimony that leads one to think Corzine wanted some plausible deniability about one $200 million posting of additional collateral.

According to Karl Denninger, Corzine violated Sarbanes-Oxley. Paul, do you know if Denninger's take is correct?

Nothing uncovered thus far about Corzine's behavior in the last days of MF Global's implosion rises above the level of distaste. Should he carry on as one of Obama's largest bundlers? That coats them both with appropriate glory, but it doesn't seem indictable.

Sarbanes-Oxley has done nothing but damage smaller companies and shareholders. As generally applied, the offense Denninger imagines would be met by an 8-k filed with the SEC confessing to a material weakness in internal controls, offering steps to be taken to correct said deficiency, and a promise never ever to do it again. Perhaps someone with experience in securities law and SEC enforcement actions could comment, but it just doesn't look like a gotcha moment.

The investigation of MF Global has been slow and expensive, wasting what's left of the estate while producing very little. An independent counsel might reduce the chance that Holder, Freeh et al. are going slow out of deference to a distinguished Democrat, etc. And maybe there is a bloody knife or a smoking gun in there somewhere. I would surely like to know how- or whether- $800 million in June 30 shareholder equity disappeared within four months. But it could well be that nothing criminal was required to make the billions vanish.

Thinking out loud here but I believe if one focuses on the problems of the banking system then the proper perspective is being missed. The main threat to the U.S. financial system is a hyperinflation of the currency or a run on the dollar. Deflation will not be tolerated as a matter of policy as the Fed can and will insure the solvency of any and all financial institutions needed to keep the economy running at the cost of maintaining the rent seeking opportunities for the privileged few. But hyperinflation will not be risked by propping up Wall Street as all of the Fed's solvency and liquidity operations take place in the monetary realm, not the physical realm.

Paul mentioned Treasuries in his initial posting. I think it's important to ask the question of who is buying our debt. The U.S. has had huge trade deficits for 37 consecutive years. The kind of deficits that the FX markets would have put a stop to long ago for any other currency. But the threat to our currency does not come from the financial plane as it did for Wiemar and Zimbabwe, the threat comes from the physical plane.

FOFOA has laid out the case for the hyperinflation of the U.S. dollar in the short term. Let me summarize. When the foreign political support for the dollar broke down with the end of Bretton Woods in the early 1970's, the world struggled for a number of years (first oil crisis) to make sense of the new regime where international trade balances were settled in a purely fiat currency for the first time on such a scale in history. The new system proved too fragile (second oil crisis) to function without the structural support of foreign actors. The Europeans stepped up and made the decision to fund our trade deficit by buying our debt to settle balances using the logic that uneven trade was better than no trade. They did this for about 20 years beginning around 1980 until they could bring an alternative international medium of exchange online. With this achieved the Europeans backed off their support and, luckily for us, the Chinese stepped into their shoes for the next 8 or 9 years. Bernanke spoke about this shift in 2005:

The collective current account of the industrial countries declined more than $441 billion between 1996 and 2004, implying that, of the $548 billion increase in the U.S. current account deficit, only about $106 billion was offset by increased surpluses in other industrial countries. As table 1 shows, the bulk of the increase in the U.S. current account deficit was balanced by changes in the current account positions of developing countries, which moved from a collective deficit of $90 billion to a surplus of $326 billion--a net change of $416 billion-- between 1996 and 2004.

http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm

The Chinese sacrificed a decade worth of trade surpluses in order to leverage the current system to develop their industries, massively expand their production capacity, accumulate hundreds of tonnes of gold reserves at breathtakingly low prices and build the wealth that's enabled their resource buying spree the last several years. In short, they sacrificed a decade worth of consumption in order to favorably position their economy for the next 100 years.

But the Chinese have, since 2008, significantly reduced their Treasury purchases having eliminated the reasons for doing so. The Fed has been forced to pick up the slack from time to time, we call it QE. And various international actors have formed a hodge podge of Treasury buying the last couple years. For instance last year, our trade deficit was funded by a combination of nations such as Japan, Taiwan, Switzerland, Russia, Luxembourg, Belgium, Ireland and oil exporters among others. But the structural support provided by Europe for 20 years and China for 10 is gone. And if this rag tag coalition of Treasury buying isn't maintained to the tune of $1.5 billion every day 365 days a year ($560 billion trade deficit for 2011 divided by 365 days) then the dollar prices for goods will begin rising steadily.

And something else of importance happened in 2008, our federal budget deficit overtook our trade deficit meaning that foreign support for our trade deficit is now entirely attributable to government spending. As a result of the 2008 financial crisis the U.S. private sector collapsed its consumption but the federal government stepped in and made up the difference and then some. (Compare: 2008 budget deficit of 438B vs. a trade deficit of $698B. And 2011 budget deficit of $1.4T vs. trade deficit of $560B).

The punchline is that the rag tag international coalition of support for our trade deficit will likely break down, is breaking down, which will engender rising prices and our government, as sole issuer of dollar currency, will not let itself be outbid for its "necessary" consumption simply because it costs more to buy what it "needs". Higher costs in dollars are no obstacle to the issuer of dollars, unlike the private sector. Does anyone here seriously think our faithful representatives in Washington will let higher prices get in the way of the "public good"?

But it could well be that nothing criminal was required to make the billions vanish.

That still leaves little satisfaction to the traders who lost their cash and gold bullion (which mysteriously vanished, despite being marked specifically as non-MF Global property). Technically, this might not be theft but then it is technically not theft when a cop simply seizes $20k of cash you have in your hand under civil asset forfeiture. That it isn't legally theft says only one interesting fact about our legal system: its definition of theft is mostly out of line with the vernacular meaning of theft.

So yes, technically Corzine might not be guilty of a crime, but in the common meaning of theft he presided over the theft of $1.6B in private wealth. If Penson ends up blowing up like MF Global, there may be a lot of people in the political class who will wish like hell they'd thrown Corzine under the bus and rolled it over him at least a dozen times in front of the public.

As a second- or third-degree survivalist (assuming that first degree survivalists are already hiding out somewhere, off grid, no Facebook status updates; second degrees are planning on eventually taking delivery of a five-year food supply, cases of ammo and Hoppe's #9, and bags upon bags of silver and gold coins; and third degrees are maybe investing for hyperinflation), you may own gold mining shares, like traditional Newmont or profitable junior Primero, you probably own the silver ETF, and you may own shares of Ruger or Smith & Wesson. You aren't sure yet that you really need or want rolls of Mercury dimes or Krugerrands clogging up your gun safe, but you're not completely satisfied with mining shares or bullion ETFs. Somehow you want direct portfolio exposure to bullion.

So you call up your broker, a buddy from the Chamber, and he tells you that A. G. Edwards doesn't offer bullion trades or safekeeping of physical assets. He tries to sell you more shares of the GLD ETF. You politely hang up, then go online and discover that you need an account with a company like MF Global. So you open an account with MF Global, actually one of their London-based subsidiaries, part of a recent acquisition binge, but the guy you talk to works out of Chicago. So you order your bricks of gold, to be bought at the noon London fixing, for such and such commission. Your gold bricks aren't mailed to you, not even DHLed. Instead, they're stored, for a monthly fee that varies in part on market-based gold lease rates. They're stored in a specialized secure warehouse in London, which is not owned by MF but by the London subsidiary of a Guernsey subsidiary of a Swiss bank with a Lichtenstein-based parent. Security is provided by a UK-based subsidiary of [chain of countries again] a Swiss company. The security guard who walked out with your gold bricks awkwardly dropped into his boots and his shoulder holster stole your gold.

Jon Corzine goes to jail for stealing your gold. It's justice like Al Capone, we get the murderer for tax evasion, we get the Obama bundler/corporate bungler for stealing somebody's gold bricks.

That doesn't seem right somehow. And I speak as someone whose clearing firm went bankrupt a few years ago, affecting my primary trading and retirement accounts. It screwed up my income, my budget, my IRS reporting, it was not a single bit of fun. I wanted to smack the guy running the brokerage upside the head with a gold brick. But it wasn't his fault, and the fiasco did a lot more damage to him and his firm than it ended up doing to me. It has not come even close to being proven that Corzine knowingly dipped into customer funds (to a greater extent than the very great extent that regulations permit commodity brokers to do already) to bail out either MF as a whole or his own private bet-the-company bet. I do not think anybody really wants to live under a rule of law that would send Corzine to jail for your brick having been stolen.

I will say this: When I read about Corzine being cross-questioned by somebody (Congress, I think?) and saying that something illegal may have been done but he didn't know, everybody was outraged at that line, but I wasn't really outraged. In a business that complicated, wasn't that an honest answer that could have been made by an honest person? I imagine somebody who runs a family farm probably sometimes says, "We may be doing something illegal here if, heaven knows what, maybe our cow stalls aren't exactly the federally required width, and it would be pretty much impossible to read all the regs. while actually running the farm, and, 'bye, gotta go, it's milking time."

And most losses incurred by banks during the recent financial panic came from conventional loans, not exotic derivatives. In fact, Lehman did not fail because of its $35 trillion notional derivatives portfolio, but because of its commercial real estate loan portfolio.

I thought that the major problem Lehman had came about through its use of bundling sub-prime mortgages, which were marketed in mortgage-backed securities. Such an animal is not as exotic as some other things out there, but it isn't simply the failures of individual mortgages: the reason they got so far overextended was principally the securitized arrangement of the mortgages.

The main threat to the U.S. financial system is a hyperinflation of the currency or a run on the dollar.

Andrew E, so does the ridiculously low interest rate scene we have now, along with very low inflation, do some sort of a slingshot past normalcy into a hyperinflation regime? Is it all at once, or does it take time to build a head of steam? And the other question is, what do you do to spare yourself personal day-by-day disaster (as opposed to retirement account disaster, which comes home to roost years from now) if hyperinflation comes?

Tony,

It could look something like that. Treasury yields have been falling non-stop for over 30 years, ever since the structural support for our trade deficit began. The trend will probably continue until the game is up. As far as inflation, it will probably show up overseas first as surplus nations cease recycling the dollars used to settle their trade balances back into Treasuries and instead bid for goods and services priced in dollars. There are no foreign actors left big enough with a long or medium term interest in supporting dollar hegemony. Europe has the euro, the oil states have been replacing their spent oil reserves with gold reserves for decades, China has modernized and built up its gold reserves, Russia has consolidated the control of its vast natural resources and no one else is big enough to matter. Our free lunch, courtesy of the rest of the world, will be ending soon. I imagine it will start slow--it may have already--and then gain steam. And when it does our government will choose to print more currency in order to maintain its level of real consumption. Prices will go higher as a result and the government will print even more money so as to keep on buying the same amount of stuff and so on into the feedback loop of hyperinflation.

What to do then if you think this likely? First protect your lives, have 3-6 months of supplies on hand. Have a reliable firearm or two with ammo and know how to use it(them). Avoid urban areas (this is something I need to work out for myself somehow) as the ongoing black-on-white intifada, and violence in general, could go parabolic for a while. Physical gold in your possession is excellent for protecting your wealth (or if you have the dough, call into a Sotheby's auction and put $120 million down on Munch's The Scream. Rich people are no fools, they see what may be around the corner). Physical silver in your possession is excellent for protecting your gold, in case you need to barter before the hyperinflationary event is over. If you have to barter away your gold for necessities during hyperinflation then you didn't plan ahead very well. And have some physical cash on hand because just before the price increases shoot straight up you'll start to see cash only signs in store windows. The money will be devaluing too quickly to accept credit or electronic payments which need to clear overnight before being re-spent. You may get some deals before the wheelbarrows show up.

The existence of the euro should keep the length of the crisis to 3-6 months. Recall that the thesis I subscribe to says that the system is broken because physical gold does not flow at true market prices to settle international trade balances. If the dollar dies, it will likely be the BIS which steps up after a short period of time to make a market in physical gold and the ECB's mark-to-market mechanism will set gold free to flow and trade will resume with most major commodities like oil being priced in euros. The dollar will be scrapped, a new one will be constructed and at that point even the goldbugs will see that the new dollar will need to mimic the euro and have gold float in price instead of fixing it as in a gold standard.

Rich people are no fools, they see what may be around the corner.

A number of rich people have invested in Facebook apparently. It's been valued at $104 billion for its stock market flotation. Isn't this part of a modern South Sea Bubble that when it bursts will make wealthy investors look very foolish?

(I'm inclined to credit your doomsday hyperinflation scenario because my pessimism never lets me down.)

Paul J. Cella: My view is that it's the integration of all these credit intermediation operations which introduces the contagion problem. Lehman Brothers goes belly up and a few hours later an enormous insurance firm detonates; not long after that, the oldest money market fund breaks the buck; etc, etc. The integration of capital markets has a major downside: perilous fragility in a panic.

Cascade effects are a problem, though they're not unique to finance. I would add that in one of the very examples you give, namely, money market mutual funds, government policy was a big part of the problem. Had the SEC originally refused to allow money market mutual funds to peg the price at $1, which implied bank deposit-like security, Reserve Primary Fund's "breaking the buck" would not have been such a big deal. That policy should be reformed so that money market mutual funds perform more like any other mutual fund, which means that the value will fluctuate.

Tony: I thought that the major problem Lehman had came about through its use of bundling sub-prime mortgages, which were marketed in mortgage-backed securities. Such an animal is not as exotic as some other things out there, but it isn't simply the failures of individual mortgages: the reason they got so far overextended was principally the securitized arrangement of the mortgages.

The bankruptcy examiner's report says otherwise:

"As some Lehman officers described it, Lehman shifted from focusing almost exclusively on the “moving” business – a business strategy of originating assets primarily for securitization or syndication and distribution to others – to the “storage” business – which entailed making longer‐term investments using Lehman’s own balance sheet. ...Lehman’s losses were largely concentrated in its commercial real estate portfolio and in certain less liquid aspects of its residential mortgage origination and securitization business." (http://jenner.com/lehman/)


 

A number of rich people have invested in Facebook apparently. It's been valued at $104 billion for its stock market flotation. Isn't this part of a modern South Sea Bubble that when it bursts will make wealthy investors look very foolish?

Truly wealthy people have plenty of real assets including gold, antiques, chateaus, rare cars in addition to direct ownership of productive assets and all their financial investments. I don't think their perspective of the equity markets is the same as that of a regular joe with a 401k, some mutual funds and a stock broker he speaks with once a month. Generational wealth always has Switzerland if things get really bad, the rest of us are going to have to stick it out.

Paul,

The latest from Sonic Charmer lead me to this Yglesias post (and he referenced it in a non-ironic way) concerning Glass-Steagall:

http://www.slate.com/blogs/moneybox/2012/05/14/glass_steagall_do_we_need_to_bring_it_back_.html

Lydia:

I have always said that there is something dangerous, not to say perverse, about holding that we really must find a way by regulation not to let banks (or companies) fail. Failure is an important part of life. It's called a reality check.

"Too big to fail" is part of reality, like the Rocky Mountains or clogged arteries. If you don't like it, and you want to keep the "fail" part as a reality check, the only other recourse is to do something - something inherently non-laissez-faire - about the "too big" part. Otherwise the reality check for the whole of society will be the sort of systemic reality check experienced by a fatal heart attack victim: it isn't just the heart that fails.

Generational wealth always has Switzerland if things get really bad, the rest of us are going to have to stick it out.

That, and the cars, paintings, and chateaux are great - until the revolution comes in which people no longer recognize former titles to ownership. If you retain your name on the deed to the chateau, and the squatters have killed you and your family and just live there, it's pretty useless. Same with the cars (which will be worth zip if there are no refineries, no pipelines, and no gas stations). But it's much worse for paintings: when people are scrambling for food and firewood, the frame may be worth 2 bits, but the painting itself will just be thrown in for free.

Swiss bank accounts are nice, but if you cannot get to Switzerland to collect, it may do you no good. If your deposit is in US dollars, and US dollars hyperinflate, your old holding of $50 million may not be worth the paper itself.

Zippy,

I didn’t want to respond to you in haste, so here are a couple of non-hasty points, in no particular order.

1) I realize that it is your opinion and the opinion of many others who know more than I do that if the bailouts (or some of the bailouts) in 2008 hadn’t happened, the entire American economy and something akin to the whole world of law and order that we live in would have come to a screeching end in anarchy. (I trust you will not be angered by this characterization, but that was my strong impression of your opinion at the time, and your present comment likening what would have happened to death further bears that out.) However, there were also people who know more than I do who disagreed with that and thought it would have been a correction and an unpleasant one but not a death-bringing one and (see 2) better to get it over with then than to continue bailing out.

2) It has always seemed to me a very real possibility that continual bailouts of the kind that we have become committed to will only, at most, put off the evil day and, a more sobering thought, make it worse when it comes. What, then? Do we kick the can down the road in hopes that the economic apocalypse–which will then be worse because of our kicking–will come to our grandchildren rather than ourselves? This does not seem to me to be right or just.

3) Related to 2, we should never be quick to accept a ceteris paribus assumption. Paul has raised right in this very thread the very plausible hypothesis that the expectation of bailout makes risky behavior more likely. Or so I understood him, though of course Paul and I don’t draw the same conclusions therefrom. Therefore, the commitment to bailout and the finance sector behavior that precede an actual bailout are not independent. If companies, banks, etc., know that they can fail and will not be bailed out, it makes sense that they will behave more circumspectly. The commitment to bailout is like teaching “safe sex.” It actually increases the incidence of risky behavior and of the diseases, etc., we were trying to avoid.

4) As you know, there are more proposals than one for making specific financial institutions “less big.” I’m interested to see that Arnold Kling, cited above, appears to be affiliated with the Cato Institute, of all things, and recommends making banks smaller but _not_ the type of regulation Paul is advocating. You can say that both are “non laissez faire,” and at some level that may be true. But there may be a reason why Cato is more likely to recommend one than the other. I can see an argument being made to the effect that it’s better to break up the banks into smaller banks and then not regulate their moves (a la Paul's proposals) *and not bail them out* then to continue in a cycle of bailout-regulate-oops-that-didn’t-work-bailout-regulate more.

I was sent this article by a friend who is a financial planning expert.

Critical quote:

We need to begin with context. It was toxic financial derivatives (not) backed by fraudulent liar’s loan mortgages (“green slime”) that drove the U.S. crisis. Paul Volcker urged the administration and Congress to bar any entity that received federal deposit insurance from investing in financial derivatives. The Dodd-Frank Act did so in a provision called “the Volcker rule.” Treasury Secretary Geithner and Federal Reserve Chairman Bernanke, who exist to serve the interests of CEOs of the largest banks, oppose the Volcker rule. Jamie Dimon leads the banking industry’s opposition to the Volcker rule. Dimon has a three-part strategy: stall the Volcker rule, gut its effectiveness by creating a massive loophole, and get the rule repealed by a future Congress. The loophole takes advantage of the fact that the Volcker rule was not intended to prevent banks from using derivatives to create (true) hedges. The current draft of the rule, however, renders the rule useless because it allows banks to call non-hedges “hedges” – it adopts a standard I call “hedginess.” A systemically dangerous institution (SDI) like JPMorgan has vast amounts of financial derivatives and it can (and does) call any speculative bet it takes in financial derivatives a “hedge.”

The NYT article demonstrates that JPMorgan is speculating, not hedging, and that the current draft of the Volcker rule would render us defenseless against the next financial crisis. The article misses these analytics and presents a misleading portrayal of the purportedly good years of CIO under Princess Drew. It turns out that CIO’s profits and losses come from the same practice – gambling on massive amounts of financial derivatives – not hedging.

Tony,

I don't think it could have turned out any other way. Right now we have a global monetary system that uses the same medium, the U.S. dollar, as its primary medium of exchange as well as its store of value -- usually in the form of Treasury securities. The medium of exchange needs to expand to maintain price stability in a growing economy -- and fiat currency is notoriously expandable otherwise as well -- so the world's primary store of value is completely compromised. The only thing enticing savers to keep recycling their surplus back into the system, which is needed to maintain the viability of the system, is the promise of a return. (ie. Give me your dollars now and I'll give you back more dollars later) If all savers are also investors and thus looking for compounding returns, then the exponential function takes over and before long the whole system gets screwy. Credit has to keep expanding, balance sheets have to keep growing, when one securitization market (recycling and repackaging debt to draw more savings into the system) gets saturated, another one needs to be created so the savings can be kept flowing in. So put Glass-Steagall back into effect, shrink the banks, put up walls within the banks, between the banks, around the banks. None of this addresses the reasons for the inherent instability in the system. The ivy will eventually creep through whatever walls you put up as the system fights for survival. The savers have to be removed from the system so the exponential function can be held in check, so rational limits are put on the growth of credit and thus debt.

Here is the anonymous internet poster, FOA (Friend of Another) writing about the evolution of the dollar markets into a "trading asset arena" back in 2001 after the introduction of the Euro. (Just FYI, the comment comes in the context of a larger discussion about real estate)

Somewhere in the 1970s era I was exposed to the thinking of several different deflationist. It seemed that all of their conclusions came to the same end: that dollar deflation would rule the day, no matter what. Mind you now,,,,,, most of them were split on the finer points of the issue, but for all of them; inflation would have its day even if prices would rise somewhat. Deflation was always the final outcome.

One of the central themes, in these thoughts, was concerning how this coming deflation would impact plain old residential real estate. You see, most of these guys advocates selling excess residential property because it was, sooner or later, going down for the count. Mostly because the mortgage markets would be destroyed in the deflation and nobody could buy.

-- Note: The reader has to understand that these discussions were directed towards people and investors that had plenty of net worth. And I do mean Plenty! The argument wasn't about how to survive; rather how to balance a truly conservative estate portfolio. --

As time has passed we can see several major flaws in their thinking. Flaws that cost them a bunch of credibility, if not personal money. One point, that I have touched on here several times, was in understanding just how much ourselves and our economic structure would and did evolve into accepting fiat money use. Even though it was, "god forbid", separated from gold.

In one area alone, the bond markets, investors reacted far different than deflationist thought they would. Twenty ++ years ago, it was expected that just gross increases in money printing alone would be enough to crash the bond markets. Not talking about price inflation here, but money inflation and that should have started a deflationary fall in our credit markets. It almost happened, several times, but never followed thru. It seemed that the market function had evolved to accept fiat inflation as a prerequisite to modern economic function. In a like comparison to today's thinking; investors assumed that as long as we had an expanding economic stance, sourced by inflating fiat supply, price inflation would not impact long bond credibility. We saw confirmation of this over many years. We saw that our credit markets, especially long bonds, were used in spite of
the price inflation threat. Indeed, there was a ready market demand for bond purchases.

In hind sight, long term holders of bonds did do very well if their position was part of a balanced holding and they didn't need to sell at bad times. Even now, dollar bonds have gained as rates are pushed lower.

Back to the thought:

This whole IMF dollar system has always been based on an expanding fiat theory that swells GDP over time. Investors that bet on deflation coming along, after each of our bouts of inflation, were badly burned as deflation was overcome. Economic function returned, essentially because price inflation could not rout the overall market for long credit.

The flaw in all of this was in the reserve structure of our Dollar IMF money system. The fact that the world had to walk, lock step, with our money policy meant that their goods production would almost always be cheaper than ours; keeping local US price inflation under control. In other words; local US based price inflation could not get out of hand as long as the rest of the world was willing to use their economic production to control it by selling into our expanding fiat system.

In this, the dollar could be inflated without end while our credit markets functioned in a non inflationary environment.

But there is an end.

A money system like this has a definite timeline and that point is reached when the world can move away from keeping price inflation low in the US. That point is reached when Another money system comes along to challenge the dollar and, in the process, offer these other goods producing countries a chance to buy some "lifestyle" for themselves.

At first, the show is dull as investors keep right on buying into the dollar argument above: that an expanding fiat base builds non inflationary growth. This is one reason traders still buy US long credit, not to mention chasing rising dollar exchange rates; they expect more of the last several decades of economic theory to keep right on going. It won't.

The dollar faction saw its match early in the 90s as the Euro was taking shape. To counter this threat, as I have outlined here in several ways, they promoted derivative hedges as a way of insuring dollar dominance. These hedges, including gold derivatives, only served to leverage the entire dollar / IMF system beyond its ability to serve as a real fiat money system, today.

I mean; that our whole dollar landscape has now become just a trading asset arena: its now evolving away from any meaningful currency use to trade for real goods. It can head in no other direction because our local economic structure, the USA economic base, cannot possible service even a tiny fraction of the buying power currently held in dollars worldwide.

http://www.usagold.com/goldtrail/

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