Uncle Sam's Big Gamble on Derivatives

Back in May, as Rep. Barney Frank (D-Massachusetts) and municipal bond dealers were considering a federal insurance policy against muni bond defaults, I marveled at Frank's courageous, damn-the-tape desire to plunge taxpayers into the murky pond of complicated debt derivatives. I even suggested they might want to take the deal to the next level of post-modernity:

Maybe if Treasury goes along with this plan, we could get some Department with a lot of free time (Homeland Security maybe?) to start writing insurance policies against the risk of default by muni bond insurers. What could possibly go wrong?

From my mouth to God's ear. At the Federal Reserve's symposium in Jackson Hole, Wyoming, following a rewarding day spent putting on coconut-bra drag performances and hunting human prey on a walled-in game preserve, attendees got to hear a presentation by M.I.T. economists Ricardo Caballero and Pablo Kurlat. The subject? Getting the government permanently into the credit-default swap business:

The two professors say the underlying idea - selling insurance against extreme financial risk - should be in the Fed's arsenal to manage financial crises.

"Insurance is an effective and cheap tool during a panic," they say in their Jackson Hole paper. The Fed did provide an ad-hoc form of insurance during the crisis -- guarantees to Citigroup Inc. and Bank of America Corp. on the value of more than $400 billion in assets they held. More broadly, the Fed provided insurance to the whole financial system when officials there vowed to do "whatever it takes" to stabilize markets last fall and extended their safety net beyond banks to AIG. The professors say the bank guarantee program should be formalized in instruments called tradable insurance credits which could be triggered by banks and even hedge funds if another crisis erupts.

Apparently, the schedule also included a rebuttal of this presentation, which I hope included the question: "What planet do you live on?" In any case it's exciting to see my ideas in action, even though the Fed isn't really the government, just an old-fashioned bank run by simple folks.

Comments

[brotherben]

WTF, is it April 1st?

[Kant feel Pietzsche]

Apparently, the schedule also included a rebuttal of this presentation, which I hope included the question: "What planet do you live on?"

The answer? Planet Massholia. It's part of an alternate universe, where reality as we know it does not exist.

[ceanf]

i am surprised they didn't think of this sooner. when it comes time for them to pay up on a default, they can just print more money... like they already do in a 'crisis'. just another reason the sham fed needs to go.

[Tulpa]

Wait, didn't we all gangbang Krugman over his writing that the Fed should create a housing bubble to replace the .com bubble back in 2002? Shouldn't we do the same to Cavanaugh now?

[ed]

At the Federal Reserve's symposium in Jackson Hole, Wyoming, following a rewarding day spent putting on coconut-bra drag performances and hunting human prey on a walled-in game preserve, attendees got to hear a presentation...

Maybe it's the consequence of too many Dewar's rocks, but I don't know what the hell that means.
I defer to the (presumably) sober experts.

[Kant feel Pietzsche]

Perhaps a snide comparison to Yalie retreats of the early-mid 1900's?

[Rich]

The professors say the mere presence of the insurance -- which would only be used in a panic -- would reduce the likelihood of a panic ever happening.

So, insurance protects our lives, cars, and houses through its mere presence by reducing likelihoods?

IANAE, but this seems flat out unbelievable to me. Guess I'll have to check out the proceedings ...

[JW]

Maybe it's the consequence of too many Dewar's rocks, but I don't know what the hell that means.
I defer to the (presumably) sober experts.

Not to speak for Tim, but I'll pick "What the Masters of the Universe, the Best and the Brightest, do in the company of the peers" for $800, Alex.

[anon]

ed - you do know that the whole point closed door fed meetings is so that fed members can partake in ritualistic human sacrifice, shed their human skin disguises and have group sex, lizard style, and chart the destiny of the human race via preverted mind-meld? It's sickening.

I understand their extra-dimensional brain sacs allow for some truly outside the box thinking, but for the life of me I can't imagine how it is possible to "insure" third parties against financial risk. Invest with, yes, bet against, yes. But insure third parties against failure? If an insurer thinks they know the risks better than the investor, shouldn't they bet big against them? But then, I have a soul and walk on two legs not four.

[Russ R.]

Rich,

"So, insurance protects our lives, cars, and houses through its mere presence by reducing likelihoods?

IANAE, but this seems flat out unbelievable to me. Guess I'll have to check out the proceedings ..."

Think about Federal Deposit Insurance. It exists to protect depositors in the event of a bank failure. However, its very existence reduces the likelihood of bank runs, since depositors know their money will be safe, even if the bank isn't sound.

Without deposit insurance, if people had any doubts, they'd be withdrawing their money first and asking questions later.

The same goes for credit counterparty risk without the existence of default swaps (assuming the swap counterparty is itself creditworthy... unlike AIG).

[ed]

anon | August 21, 2009, 9:47pm | #

ed - you do know that the whole point [of] closed door fed meetings is so that fed members can partake in ritualistic human sacrifice, shed their human skin disguises and have group sex, lizard style, and chart the destiny of the human race via preverted mind-meld? It's sickening.

Thanks. Now I won't be able to sleep tonight.
Barkeep! Another of the same. And call a cab.

[Graphite]

anon wins the thread. Posts like that are the reason I keep coming back to Hit 'n' Run.

Think about Federal Deposit Insurance. It exists to protect depositors in the event of a bank failure. However, its very existence reduces the likelihood of bank runs, since depositors know their money will be safe, even if the bank isn't sound.

Actually, I *don't* think my money is safe with *any* bank, because the FDIC is intentionally set up to spread weakness throughout the banking system by forcing strong banks to pay for deposit losses at the weak ones. The "special assessments" they've been ramming the small- and medium-sized banks with this year are preventing the good, liquid banks from recapitalizing themselves and building reserves.

So, I've taken all my money out of the banking system entirely and put it in Certificates of Indebtedness with the U.S. Treasury. And since the FDIC is effectively bankrupt and coming perilously close to fumbling their little 75-year "let Uncle Sam pay for it" confidence game, I think I'm probably at the forefront of a major trend.

The moral hazard in deposit banking created by the FDIC was actually a major contributing factor in the concentration of the U.S. banking sector. One of the reasons Citigroup, JP Morgan Chase, Wells Fargo, et al were able to leverage themselves into causing the Mother of All Crises is because none of their depositors were actually watching what these banks were doing with their money (nor did they have a reason to, since the FDIC had their backs).

The same goes for credit counterparty risk without the existence of default swaps (assuming the swap counterparty is itself creditworthy... unlike AIG).

Ah, the wonderful things that can be done in finance when you simply "assume" your counterparty (whether it's AIG or the U.S. government) is creditworthy!

[John Thacker]

Just remember, Tim, that the official position of Bernanke and the Federal Reserve is that the whole thing was a panic and liquidity issue, and the Federal Reserve's going to make TONS OF MONEY from the securities its bought.

[Stine]

Mr. Graphite:

The moral hazard in deposit banking created by the FDIC was actually a major contributing factor in the concentration of the U.S. banking sector. One of the reasons Citigroup, JP Morgan Chase, Wells Fargo, et al were able to leverage themselves into causing the Mother of All Crises is because none of their depositors were actually watching what these banks were doing with their money (nor did they have a reason to, since the FDIC had their backs).

Well technically the FDIC regs were created when it was assumed that your commercial bank wouldn't be doing things that your investment bank would be doing. The deal was that so long as you did boring, bread-and-butter banking, Uncle Sam would cover your ass if you experienced a run. This was a pretty save proposition because not too many banks go under doing such safe business.

When Congress repealed Glass-Steagall, the deal was pretty raw for Uncle Sam, which gives way to your moral hazard scenario. If repealing Glass-Steagall is a good thing to do in your view, we really do need to drop the FDIC guarantees.

[Graphite]

Oh man, maybe John Thacker wins the thread.

Yes, Ben, I'm sure all those suburban tract houses in Las Vegas being eaten by cockroaches right now are just PURE GOLD!

[Graphite]

Stine,

I have a different view on financial regulation than most, which is that societies in the grip of a financial mania will simply remove whatever legal obstacles are standing in the way of that mania. By the time the bubble reaches its peak, all the "fixes" that were put in place to 'prevent the next crisis' have usually been hollowed out, and serve only to give people the illusion that someone is watching out for them.

At any rate, Uncle Sam also got a raw deal when the FDIC had to resolve the S&L's, who were also doing imprudent things with insured deposits (anyone see a pattern here?). That predated Glass-Steagall's repeal.

[John Thacker]

S&L's, who were also doing imprudent things with insured deposits

Yeah, though part of that was a weird thing with how high marginal tax rates and various deductions meant that it was worth it for people to invest in money-losing real estate just for the tax breaks.

The tax reform under Reagan, while a very good thing in general, removed these stupid tax breaks and lowered marginal rates. That meant that a lot of people wanted to sell their tax shelters at the same time, which hurt the market in them, and indirectly S&Ls.

[Tim Cavanaugh]

And since the FDIC is effectively bankrupt and coming perilously close to fumbling

My open question is still open: Why can't the president just say, "I'm going to use my presidential superpowers to put $500 billion of ARRA funds or repaid TARP funds into the FDIC and then take no further action to prevent failures of financial institutions."? I think the whole panic about the FDIC trust fund is a red herring. If it were really an issue they wouldn't have upped $100,000 to $250,000 in the middle of the "crisis."

One of the reasons Citigroup, JP Morgan Chase, Wells Fargo, et al were able to leverage themselves into causing the Mother of All Crises is because none of their depositors were actually watching what these banks were doing with their money (nor did they have a reason to, since the FDIC had their backs).

I have to admit, I paid no attention to what Wells Failgo was doing, for exactly that reason. They had plentiful ATMs and decent branch hours, and I just figured they were funding it all with voyages to the South Sea Islands in search of breadfruit and organic phlogiston inhibitors.

[Graphite]

My open question is still open: Why can't the president just say, "I'm going to use my presidential superpowers to put $500 billion of ARRA funds or repaid TARP funds into the FDIC and then take no further action to prevent failures of financial institutions."?

For one thing, the Treasury would have to fund this action by issuing $500 billion in new bills, notes, and bonds into the bond market. Remember that from a Keynesian stimulus point of view, the ARRA funds are supposed to be putting people to work weatherizing houses in Detroit, not stumping up the cash to give depositors money they thought they had anyway. And only--what, $68 billion?--of TARP has been repaid.

Granted, the bond market does seem these days to have unlimited appetite for obligations backed by the full faith and taxing power of the federal government, but I think the Treasury is starting to recognize the danger in pushing that particular confidence game too far. Contrary to what the typical firebrand libertarian goldbug may think, foreign holders of dollar-denominated assets do have the ear of the Fed and the government, and their agenda conflicts with any attempt to smoothly liquefy deposits in this way.

It also goes against the government & Fed's desire to prevent asset prices from falling to a level that will clear the market. If the big banks are allowed to go into bankruptcy, they'll have to immediately liquidate all the assets on their balance sheets, and use these proceeds to start paying off the firms' creditors, starting with the most senior, the depositors. This would destroy whatever value is left in the real estate and equity markets. Administering all these failures would also be an administrative nightmare for the FDIC. (If I remember my financial history correctly, in the relatively tame S&L bailout some insured depositors had to wait as much as five years to get all their money back.) All this is not to say that such an outcome won't come to pass anyway, but unfortunately I think events will have to spin out of the government's control first, to the point where it is the best among many bad choices remaining.

Then there's the corruption issue. The big banks have bought and paid for Obama, so they'd have to land themselves in some pretty dire straits in order for him to just cut them loose in the way you describe.

I think the whole panic about the FDIC trust fund is a red herring. If it were really an issue they wouldn't have upped $100,000 to $250,000 in the middle of the "crisis."

That was just an attempt to bluff some confidence back into the markets, and it has worked, for now. But if you add in their corporate debt program, which is helping horribly indebted companies like GE raise more capital at low rates, the FDIC is guaranteeing nearly $3 trillion of obligations. If (when, I would argue) financial markets start seizing up again, the losses will mount and the FDIC's bluff will be called. Printing up all the money to fund their guarantees would risk a currency event, so I think the most likely scenario is that the FDIC will eventually fold and renege on one of its promises. At that point, the "symbol of confidence" becomes anything but, and the bank runs are on.

Hey, maybe I'm wrong. If so, I'm only out the 0.00001% yield I could have been earning with my money in some bank's checking account for the next couple of years.

[hmm]

At any rate, Uncle Sam also got a raw deal when the FDIC had to resolve the S&L's, who were also doing imprudent things with insured deposits (anyone see a pattern here?). That predated Glass-Steagall's repeal.

The RTC turned a profit on its investment. (depending on how you look at it)

The 250,000 was a straight up bluff as mentioned before. When I interviewed with the FDIC, one of their major projects was actually winding it back down to 100,000.

Insuring municipal bonds would provide unprecedented control over municipalities. That is the truly scary part.

[DJF]

What next, will the government guarantee against catastrophic losses by high rollers at Atlantic City and Las Vegas?

[Rich]

What next, will the government guarantee against catastrophic losses by high rollers at Atlantic City and Las Vegas?

It's for the children: "Baby needs a new pair of shoes!"

@ Russ R.: Thanks for the enlightenment.

[Kolohe]

Graphite-
You understand that the while the FDIC fund may (or may not) be depleted, they still basically have a blank check to draw on money from the Treasury, right?

So keeping money out of banks but putting into US Debt instruments in no way* mitigates or otherwise changes your risk.

*neglecting friction.

[John Thacker]

So, I've taken all my money out of the banking system entirely and put it in Certificates of Indebtedness with the U.S. Treasury.

OK, you lost me here. The US Treasury will back the FDIC. You've taken your money out of one hand and put it in the other. I thought you were at least going to say something about foreign investments or gold or something.

Printing up all the money to fund their guarantees would risk a currency event, so I think the most likely scenario is that the FDIC will eventually fold and renege on one of its promises. At that point, the "symbol of confidence" becomes anything but, and the bank runs are on.

So, you really think that the Treasury would allow a situation where "the bank runs are on" instead of something that "would risk a currency event?" Did you notice the bank bailouts we just had? I'm pretty certain that the Treasury would allocate huge sums of money and gladly "risk a currency event" to prevent widespread bank runs.

[P Brooks]

"Insurance is an effective and cheap tool during a panic,"

If, by "during a panic" they mean "as long as nothing goes wrong".

[Rimfax]

Russ R.,

Think about Federal Deposit Insurance. It exists to protect depositors in the event of a bank failure. However, its very existence reduces the likelihood of bank runs, since depositors know their money will be safe, even if the bank isn't sound.

That's a good explanation of the theory behind the argument.

The trouble is that people are very good at adjusting to risk and risk mitigation. While the depositors are deterred from making a run that prematurely brings down a bank, the bank itself adjusts to the risk mitigation by engaging in riskier behavior that makes it MORE likely that the bank will fail.

The studies that I've read about suggest that the effect of insurance on the rate of bank failure should be roughly a wash. If the bank considers the effect on depositors as additional risk mitigation, the overall effect of insurance may actually significantly increase the risk of bank failure.

[Some Guy]

Well, as long as we have absolutely no faith in the government's ability to not throw money at failed banks, we might as well make them pay us some premiums for it. Of course, maybe they'll be like the FDIC and just not collect the premiums.

[Broad Way]

At the Federal Reserve's symposium in Jackson Hole, Wyoming, following a rewarding day spent putting on coconut-bra drag performances and hunting human prey on a walled-in game preserve, attendees got to hear a presentation...

Maybe it's the consequence of too many Dewar's rocks, but I don't know what the hell that means. I defer to the (presumably) sober experts.

Not sure of the connection, but here's an example.

[Graphite]

Graphite-
You understand that the while the FDIC fund may (or may not) be depleted, they still basically have a blank check to draw on money from the Treasury, right?

So keeping money out of banks but putting into US Debt instruments in no way* mitigates or otherwise changes your risk.

Actually, they don't have a blank check -- their credit line runs to only $500 billion. The idea that the Treasury will blithely raise that limit to "infinity" in a full-blown banking crisis is just a pat assumption, and not one I want the safety of my savings riding on.

The government is on the hook for a lot of different promises, but it does not view all these promises as equal priorities. I am making a calculated bet that it will sacrifice (at least partially) the FDIC's promises to pay off depositors before it takes the considerably more drastic measure of defaulting on its own debt or destroying the currency and thereby ruining its ability to fund itself.

And yes, I already have some gold and I'm looking to move all this money into gold as well, but not at $950 per ounce.

So, you really think that the Treasury would allow a situation where "the bank runs are on" instead of something that "would risk a currency event?" Did you notice the bank bailouts we just had? I'm pretty certain that the Treasury would allocate huge sums of money and gladly "risk a currency event" to prevent widespread bank runs.

I don't understand what makes people so certain that either the Federal Reserve or the U.S. Treasury are going to destroy the dollar. It would result in a colossal loss of power for both institutions.

[Graphite]

By the way, the FDIC doesn't necessarily have to stick anyone with actual losses in order to create severe headaches for depositors. I think it's more likely that they would take a "bank holiday" approach and limit the amounts that can be withdrawn from accounts in a given month. This way they can claim they're acting to "preserve confidence in the stability of the banking system" while also making sure that "no depositor ever losses a penny in insured deposits."

[Tim Cavanaugh]

Thanks, Graphite. Has anybody done polling on depositor confidence?

It would be interesting to see a not-worried-at-all/very-worried spread on the question: "How worried are you that your bank could lose all of your deposit and the government would be unable to repay you?"

It would be nice just to say the forbidden words to 3,000 randomly selected Americans.

[alice bowie]

start writing insurance policies against the risk of default by muni bond insurers. What could possibly go wrong?

These are called Credit Default Swaps (CDS). They are used to mitigate the components of the structured product or collaterized debt obligation (CDO).

The problem is that the CDS was just as useless as the CDO.

The CDS or so-called insurance was not funded properly in the event of default. There were no true collateral for the CDS. This is a major factor that led to the Credit Crisis.

In fact, they called it Credit Default Swap instead of Credit Default INSURANCE for a real good reason...it was no accident. Had they called it INSURANCE, the capital withholding requirements would have been much much greater. And, it would have been regulated by the state and federal insurance commissions.

[Malto Dextrin]

I have complete confidence that the bars of silver I bought and took delivery of will not default.

[John Thacker]

I don't understand what makes people so certain that either the Federal Reserve or the U.S. Treasury are going to destroy the dollar. It would result in a colossal loss of power for both institutions.

Well, you'd have to grant that they are starting to realize that their actions so far have increased the chance of a massive loss in currency strength. However, they seem to spend all their time patting themselves on the back for what they've done so far.

I'd forsee something like, oh, the US Treasury guaranteeing deposits up to $100,000 in exchange for taking shares in the failed banks first.

[R C Dean]

Insurance is an effective and cheap tool during a panic

Refuted with three letters:

A,

I, and

G.

AIG insured the mortgage derivatives, and such insurance (a) did nothing to prevent the implosion of the credit markets when the derivatives began to fail, and (b) has turned out to be gargantuanly expensive.

[John teebone]

ROTFL, thats Uncle Sam doing what Uncle Sam does best!

RT
http://www.web-tools.us.tc

[Invisibe Finger]

Planet "Protection Racket"

[Invisible Finger]

However, its very existence reduces the likelihood of bank runs, since depositors know their money will be safe, even if the bank isn't sound.

Without deposit insurance, if people had any doubts, they'd be withdrawing their money first and asking questions later.

So what? You either lose your purchasing power by having you money taken away or you lose your purchasing power by the Fed inflating it away. The benefits of FDIC insurance are greater for the the bank than the depositor - attract capital that management otherwise would not be able to attract.

[Invisible Finger]

Well technically the FDIC regs were created when it was assumed that your commercial bank wouldn't be doing things that your investment bank would be doing.

That went out the window when the FSLIC was insolvent. The FSLIC performed the same function as the FDIC but for S&L's. When the FSLIC was teetering - thanks to high inflation - the cure was to let those institutions get into other lines of business. And the depositors would be protected!

Your point is valid, but immaterial.

[Invisible Finger]

I think the whole panic about the FDIC trust fund is a red herring. If it were really an issue they wouldn't have upped $100,000 to $250,000 in the middle of the "crisis."

Upping the amount actually proves it's NOT a red herring.

The Fed can print money and A) give it directly to depositors when the banks are closed as their insurance claims, or B) give it directly to the banks so they don't have to close them thus keeping the depositors in their current state.

They did B. For no other reason as that they didn't want to do A.