Tuesday, September 30, 2008

The end-goal of any bailout or government takeover

The US is a current account deficit country.  Get used to it.  You (and I am not an American so I can say you) have been spending more than you earn for years. 

I can’t speak too rashly though because Australia and Aoeteroa (New Zealand) – the two countries to which I am closest – are also current account deficit countries.

If you run a current account deficit for long enough your financial system will be NET short deposits.  There will be (say) 130 of loans for 100 of deposits.  [If you are the UK it can be much more extreme – with Northern Rock having a loan to deposit ratio of a few hundred.]  Individual banks will have sufficient deposits but everyone is vulnerable.

Banking can be profitable even if you are short deposits.  Indeed it was silly-profitable for more than a decade before the insane lending started.  The high levels of profitability meant that people would lend to banks unsecured in quantity at thin spreads.

Banks became totally dependent on their ability to roll the loans.  If they can’t roll this senior unsecured funding they will fail.  No ifs, no buts.  That results in failure.

Most banks in current account deficit countries have such funding.  In Australia it is called Bank Bills.  Here it is called lots of names only because financial innovation has found lots of ways to name the same stuff. 

I have calculated out the losses of banks in the US numerous times – and in no sense are the losses not able to absorbed (at some cost) by the highly productive US economy.  There may be a period of austerity as America adjusts – but the economy should bounce back.

Under the presumption it can finance itself.

But it can’t finance itself unless it can assure unsecured lenders that it is a sensible place to lend. 

The end of this financial crisis will occur when unsecured lenders feel safe lending to financial institutions again.  If this does not happen the crisis will not end – and there will be a great-depression level event in the US.  That is real – factories will be idle, and good people will be roaming looking for jobs and unable to feed their children.  

So I am going to set up policy guideline here for a bailout and for all FDIC action.  All policy should be geared towards making unsecured lenders feel safe.  New regulation should be geared that way.  The takeover of banks will be well done if it gives the appearance of respecting the rights of unsecured lenders.  The WaMu deal was bad.  The Wachovia one was better (only from the position of an unsecured lender but that is the only position that matters).  

America has – through decades of excess spending become beholden to the whims of unsecured lenders. 

Face reality.  That is who you have to please.

Incidentally the Swedish/Norwegian solution did that but wiped out almost all equity and preferred shareholders.  Bank stocks would go down a bundle from here with anything that looks like Scandinavia. 



John Hempton


PS.  I have no dog in this race.  I am short a few bank stocks, long a few preferreds and have no position whatsoever in senior debt of banks.


Anonymous said...

I am still confused. Suppose in your example you have 130 in loans funded by 100 in deposits, 20 in bonds and 10 in stock. You make money from the spread between the interest you receive on the loans you make and the interest you pay on the deposits and bonds. Less expenses and defaults. Now suppose a bunch of bad loans default so your 130 in loans becomes 100. Now you are insolvent, your assets (the remaining 100 in loans) are worth less than your liabilities (100 in deposits, 20 in bonds). Since deposits are senior to bonds they get the 100 in assets and the bondholders (and shareholders) are wiped. Who do you want to take the loss and why would it be better?

Anonymous said...

Hi John,
I believe we need to worry more about Australian banks. IMO, no banking system of any CA-deficit country is safe during this credit crisis.


Anonymous said...

Any updates on your article:

Royal Bank of Scotland: CEO Deathwatch

Anonymous said...

There is a saying, "once burned, twice shy".

Even if every mortgage in the US was brought current (not paid off, just current), I don't think that it would lead to loose credit. At least not for several years.

I would think that most investors would feel "whew, that was a close one" and move their money. I just can't see investors rushing to make the same investemnts. I think that most would be cautious, until the returns are undeniable.

This is a game of confidence. Whether it is a bond holder, a stock holder, or a depositor, they must all be confident in the bank and the host government.

In the internet age, people are not able to keep their cash under their mattress (no direct deposit). While I'm sure that JPMorgan will make a lot of money off of WaMu, I think that the few regional banks who are fundamentaly strong will be the ones to really make out. They should be flush with deposits.

Anonymous said...

James Carville
" I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."

Anonymous said...

From Warren Mosler:

While the media continuously bemoans an assumed US dependence on foreign capital, a recap of the actual transactions involved reveals the reverse.

Let’s begin with the example of US consumer buying a German car.

If the consumer pays cash for it, the consumer’s checking account in a US bank is debited and the German carmaker’s account is credited, thereby increasing foreign savings of USD financial assets. Total deposits in the US banking system remain unchanged.

If the consumer borrows to buy the car, the bank makes a loan to the consumer, which results in a loan on the asset side of the bank’s balance sheet and a new deposit on the liability side (loans create deposits). After the car is paid for the German car company has the new bank deposit. Consumer borrowing increased total bank deposits and funded foreign savings of USD.

That’s what the finance behind the trade gap is all about - foreigners desire to net save USD financial assets and sell goods and services to the US to obtain those assets.

Following the above transaction the foreign holder of USD bank deposits may instead desire to purchase US Treasury securities. At the time of purchase, the seller of the Treasury security becomes the new holder of the bank deposit, and the foreigner the new holder of the Treasury security. (If the foreigner buys securities directly from the Treasury the result is the same.)

The US government is now said to have foreign creditors, and the US is said to be a debtor nation.

While this is true as defined, a look past the rhetoric at what the US government actually owes the holder of the Treasury security is revealing. What the government promises is that at maturity the foreigner’s security account at the Fed will be debited, and his bank’s reserve account at the Fed will be credited for the balance due.

In other words, the US government’s promise is only that a non-interest bearing reserve balance will be substituted for an interest bearing Treasury security. This is not a potential source of financial stress for the government.

Anonymous said...

Please don't use Aoeteroa to refer to New Zealand. Cultural cringe is the worst thing that's happening to a very beautiful country.

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