Friday, January 22, 2010

The True Bank Bailout is Ongoing

I had a light bulb go off over my head the other day. Well, maybe it was less of an “aha” realization than an “oh yeah” recognition of the relevant facts. When we think about the bank bailouts that have occurred over the last two years we think of a number of measures. First, there were the direct interventions like the one the Fed engaged in by facilitating JP Morgan’s purchase of Bear Stearns. Another one that is still under the radar to most non-professional investors was the bailout of Fannie and Freddie. While the preferred share of those companies that had found their way onto banks’ balance sheets did get hurt by the fact that F&F were forced into conservatorship, the fact that the agency paper was not made worthless prevented the banks from suffering further losses. Then of course we have TARP, a bank slush fund created after Hank Paulson put a gun to the head of Congress. As Elizabeth Warren continues to attest, we have no idea what happened within these banks to the money they received. I understand that money is fungible (making it irrelevant what the precise funds coming from TARP were used for) but the goal of the TARP-enabling legislation was not have banks use the extra funds to engage in risky activities or hoard the money by refusing to lend it out. Based on just about any data you look at, this is exactly what the TARP money was used for.

Then of course was the FDIC’s backing of bank debt, a subsidy that allowed banks to issue debt at fractions of what it would have cost without the FDIC guarantee. Furthermore, allowing Goldman and Morgan Stanley to become bank holdings companies basically overnight was a bailout that allowed them access to additional cheap funding from the Fed and FDIC. We also must not forget (how could we—this is the story that unfortunately never dies) the bailout of AIG’s counterparties on all of AIGFP’s terribly ill-conceived derivative bets. Each detail that emerges in this ongoing saga suggests that the banks were paid 100 cents on the dollar for assets that were worth quite a bit less, without any regard for the consequences for taxpayers.

Next, the how can we forget that the FASB grudgingly relaxed mark to market accounting rules, a decision that may more than anything else have allowed the banks to postpone the day of reckoning when it comes to the worst assets on their balance sheets. I don’t think it is a coincidence that along with the confidence built after the so-called successful stress tests that the banks stocks have rallied massively since then. This fortuitous reversal has allowed banks to raise additional equity at prices that were not unreasonably dilutive and the increase in stock prices has inexplicably calmed creditors’ nerves and led to narrower CDS spreads despite many risks not having been eliminated. Finally, it appears that all of the new Treasury issuance and Fed activity through primary dealers has provided a windfall of trading revenue for the big banks. I haven’t really dug into the data on the profitability of government desks but you know the banks are making basically risk free profits from all of the government’s interaction with the markets.

Wow. I had never really enumerated the number of different full scale and quasi-bailouts before. It really is unbelievable and from what have I read regarding US history, also unprecedented, at least in terms of scale. No doubt I have also forgotten some events and details but the message that the government sent to the banks was clear: not only are you too big to fail, but we are also going to do whatever we can to help you get back to profitability and stabilize your balance sheets. Unfortunately, the message of US taxpayers has been commensurately blunt: despite the fact that the banks had a hand in this crisis, their health is pivotal to US economic prosperity and it is your job(my dear taxpayer) to backstop them and suffer the associated economic hardship as we nurse the banks back to health. It was within this context that I realized which bailout/subsidy was the most unappreciated and maybe even most harmful to people on Main Street.

What I am referring to is the zero interest rate policy (ZIRP) of the Fed. While the taxpayer losses that will eventually come out of TARP, FDIC debt guarantees, and the explicit extend and pretend policy are tough to quantify, the impact of miniscule rates on US savers is pretty easy to determine. According to this data from ICI, at the end of December 2009 there was close to $3.3 trillion in US money market funds. I don’t even have to include checking and savings accounts that are paying virtually no interest to illustrate the impact of low rates on savers. Specifically, according to, the current average high yield money market rate is 1.03%. So, if there were no outflows and the rate remained the same for the rest of the year (clearly this will not be the case but I want to illustrate a point here), that $3.3 trillion would earn total interest for a full year of about $33 billion or $110 for every one of the 300 million people in the US.

Unfortunately I had some trouble finding data on historical money market rates. But, on the Fed’s website there is data going back to 1964 on the average 6 month CD rates. Right now the average rate on standard six month CDs is about 1.03%, almost exactly what the money market rate is offering. Let’s just assume that rates on these short duration CDs are a reasonable proxy for money market rates. The 1964-2009 average is about 6.42%. If you exclude the high interest rate environment that was pervasive in the mid-1970’s and 1980s, the average rate from 1990 to 2009 was about 4.37%. So it is not hard to see the impact of the Fed’s low interest rate policy has had on people who depend on interest on their cash. Using the 1964-2009 average rate implies $211.89 billion or $706 of interest per year per person. Even the 1990-2009 average rate yields $480.70 of interest per year per person. I would say that when you have so many people struggling to meet end meat these differences are not trivial. In fact, I would even go as far to say that this is a form of stealing from the poor to give to the rich. Not exactly the kind of behavior that leads to a stable society.

I can already hear the Fed apologists and proponents of low interest rates as a cure for all our ills saying that higher interest rates would surely destroy an economic recovery and thus ZIRP is justified. This may be true to some degree. I do understand the need keep interest rates low to encourage borrowing in hopes that people will start to invest again and the economy will rebound. Unfortunately, the Fed’s position that interest rates should stay low for an extended period of time in order to help revive the economy is kind of like an arsonist leaving the fire hose on indefinitely after he puts out the fire he created. Yes, maybe it is necessary but what further damage is being done? My answer to that is the savers are being punished by the low interest rate environment while the banks use low short term rates, just about interest free funds from the Fed and a steep yield curve to literally print money. Yes, this helps banks earn their way through the cycle. Yes, we do want a functioning banking system in the US. But none of that takes away from the fact that in order to achieve those goals people on Main Street have taken another hit to their incomes. After the banks help precipitate a global financial crisis that caused many asset classes to plunge in value and severely damaged the retirement plans of millions of people, somehow that just doesn’t seem fair, does it?

I would be remiss not to mention that low interest rates cause people who are searching for yield to go further out onto the risk curve whether they can afford to or not. While there is little data out there that suggests that Main Street has jumped back into stocks, there is no question in my mind that banks, traders, and hedge funds have once again embraced risk. The problem is that the structural problems and risks inherent in our financial system have not disappeared. If anything, the risks are even more concentrated than before and with Congress locked in irrelevance we are unlikely to see meaningful reforms anytime soon that would address this problem. So when you have fewer players making bigger and more flammable bets with cheap money provided by the Fed, it creates a dangerous cocktail. What happens if it all blows up again? Well, even if Washington decided not to bail out the culprits (highly unlikely as that is) the impact on asset markets would surely only harm savers and retail investors even more.

So, as we employ all these means in an attempt to determine what went wrong and how to stop it from happening again, we can’t forget that not everything is solely visible through the rear view mirror. In fact, we can see the pain caused by ZIRP as we look out through the front windshield. Let’s just hope the people in charge of reforms and future policies remember that it is Main Street that loses the most when the Fed and the banks create huge booms and busts. For the US to create a sustainably prosperous economy and high quality of life society, I have no doubt this dynamic must change. And soon; before we have hit the point of no return.

(Picture courtesy of