Wednesday, August 10, 2011

Quote of the Day: Too Big to Fail

"If banks are "too big to fail," they are too big. They must be allowed to succeed or fail on their own merit, without any hint of government support. The failed behemoths at the core of housing finance, Fannie Mae and Freddie Mac, should be wound down. Robust, dynamic competition is a far better way to allocate credit."

~Kevin Warsh and Jeb Bush in today's WSJ


At 8/10/2011 9:01 AM, Blogger morganovich said...

the thing that absolutely stuns me about freddy and fannie is that they became 40% of the housing market at the peak of the bubble.

then then failed spectacularly, became wards of the state, and are now, what, 70% of the market?

so they fail massively, singlehandedly cause TARP to lose money (it's well in the black ex fred and fan), have a potential costs tail of hundred of billions more in losses, and the get to increase their market share by 30 points with cheap federal money and guarantees that let them under-price everyone else thereby forcing banks to invest in levered us federal debt because they cannot compete in the mortgage space?

it's difficult to imagine a worse set of policy.

At 8/10/2011 9:31 AM, Blogger arbitrage789 said...

I hate bailouts as much as anyone. (Probably more so).

But back in 2008, the bankruptcy courts could have only handled so many liquidations of large, multinational banks.

At 8/10/2011 9:44 AM, Blogger Buddy R Pacifico said...

This complicated subject brings to my mind the question: did the Too Big Banks have to take on failing mortgage banks in order to receive TARP?

Countrywide folded into Bank of America is the albatross that won't go away for BAC. Wells Fargo took over Wachovia, which means it took over Golden West Financial, and its loan problems that won't go away. JP Morgan Chase took over Washington Mutual and its bad loan portfolio.

Yes, Freddie and Fannie should be wound down ASAP.

At 8/10/2011 9:47 AM, Blogger morganovich said...


a couple of points:

1. the problem was not handling the BK's, but containing knock on failures from counterparty exposure.

2. the banks were, for the most part, not bailed out. they were lent money that has now been paid back with interest.

that is the proper role of a central bank: lender of last resort.

a perfectly solvent bank can become illiquid. they may have lots of valuable long term assets (like mortgages) that cannot be readily monetized in the short term.

any bank that makes even one loan with depositor money can be caught in that position.

i think TARP should have been asset based to make sure that only solvent banks were aided (and they should have been charged interest to prevent them from wanting to use it and compensate the fed for risk), but such a program is no more a "bailout" than getting a home equity line of credit to fix your leaking roof is.

a bailout is when you give money to someone like freddy or fannie or GM who have no reasonable means to repay it.

At 8/10/2011 10:00 AM, Blogger arbitrage789 said...


The one thing that I would most like to see is that if a bank is "bailed out", the bondholders not be bailed out along with them. I'd like to see a forced equity-for-debt swap in the case of a large scale bailout.

If this policy had been in place 7 years ago, the bank managers might be been a little more risk-averse.

At 8/10/2011 10:02 AM, Blogger arbitrage789 said...


The other problem with bailouts, however well-intended, is that they beget more bailouts.

We bailed out "X", therefore we have to bail out "Y".

We bailed out "X" and "Y", therefore we have to bail out "Z".

And so on.

At 8/10/2011 11:03 AM, Blogger morganovich said...


again, i don't think you can call it a bailout.

banks were lent money.

they had to repay it with interest and have done so.

take out fred and fan and TARP has made significant money for the treasury.

that's what keeps banks from wanting to do it: it should be expensive. (and profitable for the lender)

i agree that propping up insolvent banks is a bad idea, but providing liquidity to those with a duration mismatch (and making money doing it) is precisely the same as a bank giving you a home equity loan to fix your roof.

would you call that a bailout?


bond conversion to equity does nothing to solve a short term liquidity issue. it does not provide cash.

at best, it eliminates coupon payments, but most bank bonds do not work that way. they tend to be discount bonds (which are much more tax effective for the holder)

At 8/10/2011 11:31 AM, Blogger Benjamin Cole said...

Yeah, let's think about this.

At one time, the US government took anti-trust actions to make sure there were a lot of players in every market sector.

Then, there were chants of "government intrusion" and the need to be "globally competitive."

So, we ended up with behemoths in finance, too big to fail, and the same with auto companies.

So there might be some sense in limiting market shares--it would in fact promote competition (which every business hates), limit political influence, and make it easier to say, "Too bad suckers, eat shyt and die," when a poorly run company or bank flounders.

At 8/10/2011 11:55 AM, Blogger Benjamin Cole said...


We are getting Japanned.

Yes, absolutely the United States can inflate. Sheesh, if we ran five percent inflation for five years, the value of the national debt outstanding would be reduced in value by a little more than 25 percent, while our economy expanded.

Oh shocking, you mean the rates of inflation we had when Reagan was president? Oh, horrors!

BTW, check out the CPI. From July of 2008 to June of 2011, the CPI-U rose from 219.964 to 225.722, or a 2.62 percent increase in three years.

And this July is likely deflation, due to oil prices. Please bloggers, this August 20 (?) when July CPI figs come out, compane them to July 2008. I suspect we will be at about 2.5 percent inflation for the entire three year period (annual about 0.8 percent).

We are getting Japanned and hard!

Why all the hysteria about minute rates of inflation in the right-wing? It speaks to a type of dementia. The Chicken Inflation Littles are running the right-wing roost.

Ironically (and sadly) it was Milton Friedman who advocated aggressive and sustained use of QE in situations like we face today. He flat out told Japan to inflate. As did Bernanke!

There are times when inflation is good, and now is one of those times.

All the whimpering and pettifogging about debasing the currency comes from people with an unhealthy attachment to the symbols of money (gold or cash), as opposed to an appreciation of true wealth-building.

At 8/10/2011 12:21 PM, Blogger morganovich said...

hey look, it's benji the alleged free marketer once more demanding government intrusion into markets.

you are about as free market as Khrushchev.

and more nonsense on inflation and japan.

fortunately, i now have cut and paste responses to you bunny, and don't need to waste time proving you wrong over and over.

here, for the 17th time, is the study of WHAT ACTUALLY HAPPENED.

there has been no correlation between monetary stimulus and real growth in japan.

not all problems are monetary or susceptible to monetary solutions.

if loose money has the effects you claim, there would be a correlation.

that fact that there isn't means that neither you nor freidman can possibly be correct.

given the magnitude of their policy, there is just no way there would be no visible R squared if it were working.

as ever, you'll slink off and return spouting this nonsense again on the next thread in blissful denial that once more you have been proven wrong and been unable to offer anything but appeals to misunderstood authority and ad hominem, but that's why i instituted this cut and paste bunny response file


if running high inflation creates growth and diminishes debt, explain the 70's.

the biggest problems in our budget deficit are all inflation indexed bunny.

inflation is true wealth building?


it's just debasement of money.

once you go over about 1-2%, there are no beneficial effects of inflation on real growth.

over 5% (old CPI, not the new one) you start to hurt it.

Volcker saved us and greenspan sold us back down the river.

i've made 5% so far this week in REAL returns by holding my savings in swiss francs instead of greenbacked toilet paper. 27% YTD.

yap all you want, but your savings are degrading in buying power while mine surge.

congrats on your brilliant economic policy.


how is your big "time to buy" call working out?

if there were a double short benji etf, i'd own the hell out of it.

as a contrary indicator, you are priceless.

At 8/10/2011 12:48 PM, Blogger morganovich said...

oh, and riddle me this bubble bunny-

we have around 15tn in debt and 65 tn in unfunded liabilities, mostly indexed to inflation.

that means that if we inflate to reduce bond debt, every dollar we save will cost us $4+ in entitlements.

how can you reduce deficits by spending $4 to save $1?

as ever, your plans lack any grounding in reality and even basic common sense.

and this: "Oh shocking, you mean the rates of inflation we had when Reagan was president? Oh, horrors!"

is just nonsense.

when reagan was president, the inflation we have now would have been called 8-9%.

the calculation changed.

using current CPI, inflation under reagan would have been 1%.

you are comparing apples to oranges and revealing your ignorance again.

At 8/10/2011 12:52 PM, Blogger arbitrage789 said...


"bond conversion to equity does nothing to solve a short term liquidity issue"


I agree with that. But if the bondholders know that they'll get taken to the cleaners in the event of a bailout, they'll impose discipline on the bank.

And as I said, there is a critical political problem with bailouts, or perceived bailouts.

It's important to make the investors in companies (and maybe the employees also) pay a big price when there's a bailout (or large scale loan). Other bailouts then become less likely.

I actually have a much bigger beef with all the bailouts that occured outside the banking industry (like GM, for example).

At 8/10/2011 1:02 PM, Blogger morganovich said...


i wish i believed that your point about bondholders was true, but i do not think it is.

the publicly balance sheets on major banks tell you damn near nothing you'd really need to know.

the information a bond holder would need to really assess risk is highly proprietary trading desk data. it is not shared.

banks were charged some pretty good interest for the liquidity (more than a borrower of comparable quality would have been in a free market).

TARP was expensive for them. (especially the guys who were forced to take money they didn't want and then told they could not pay it back until more interest had run up)

At 8/10/2011 1:13 PM, Blogger arbitrage789 said...


Probably true that if the government had had the authority to impose an equity-for-debt swap, the economy in 2008-2010 would have been a disaster anyway, and large scale loans to banks would have had to be made.

I still think it’s important to send the message to CEO’s and investors that bailouts (or large scale loans) will come with a big price.

I think that letting Lehman fail was the best decision that Hank Paulson made as Treasury secretary.

At 8/10/2011 2:02 PM, Blogger morganovich said...

they do carry a big price.

paying back TARP with interest depressed earnings and reduced cash flow.

what's the gain to be had from making bondholders convert to equity because of a liquidity loan?

any bank can get caught short in a maturity mismatch for reasons beyond their own control.

that is an indelible feature of fractional reserve banking.

if they do, they have to borrow and pay for it, but i don't see why turning bondholders into equity is needed or helpful.

it's just likely to cause a crash in bank stocks as bond funds unable to hold equity are forced to sell at the worst possible moment.

At 8/10/2011 4:19 PM, Blogger Mike said...


Please correct me if I'm wrong, but it seems the big problem with all the Fan+Fred red ink is the convergence of private with public. Bad government policy (doomed by 'fairness') being bundled and sold by private business in a reckless way - fearless of risk - because it was always backed by the government.

At 8/10/2011 5:19 PM, Blogger Methinks said...

2. the banks were, for the most part, not bailed out. they were lent money that has now been paid back with interest.

Morganovich, please don't tell me you've fallen for this line of horseshit!

Banks were recapitalized with a wealth transfer from savers.

I didn't lend them money and you didn't either.

a bailout is when you give money to someone like freddy or fannie or GM who have no reasonable means to repay it.

the banks were blowing up because they were holding the same toxic crap as Fannie and Freddie. Worse, Fannie and Freddie preferreds were used to meet many foreign and domestic banks' capital requirements.

Given this, there was no reasonable probability that the money would have been paid back.

Worse, whatever government "lent" was effectively our money. If it went bad, we'd be on the hook. If it didn't, the bank wins.

Please stop painting private gains and socialized losses as justifiable.

At 8/10/2011 5:22 PM, Blogger Benjamin Cole said...

You want to crap in your pants?

Take a look at page c8 today in the WSJ. CMBS down to 60 from 90 cents on the dollar, USA average, from start of this year.

Commercial loans going bust? Too? Now?

Please oh Gods of Lucre, inflame the heart of Ben Bernanke-san with inflationary lust and carnal desires for prosperity!

At 8/11/2011 9:08 AM, Blogger morganovich said...


please tell me you have actually looked at the math.

$245 billion was paid out under TARP.

repayments now exceed $243bn.

take out the big 3 autos alone, and you are in profit.

take out freddy and fannie, and you are deep in profit.

even with them, profits are now estimated to exceed $20bn.

i do not like the way tarp was structured.

they should have gone with paulson's original idea to lend vs assets not the equity kludge the dems rammed through, but the math is clear.

you don't get paid back on a bailout.

when you get paid back with interest, that is called "a successful loan".

short term capital markets shut down, and banks were illiquid, not, for the most part, insolvent.

if you want to be pissed about somehting, be pissed about the free money the fed is giving banks to lever up and by govvies. that amounts to a huge giveaway to fund deficits cheaply and creates real structural risk, but TARP will not cost taxpayers a dime.

take out F+F, and it makes $80-100bn.

that's a pretty good return on a $250bn investment.

i think you'd be hard pressed to find a federal program that has done better.

At 8/11/2011 9:10 AM, Blogger morganovich said...


how can you run a fractional banking system without a lender of last resort?

to my mind, that is one of the few proper roles of a central bank.

At 8/11/2011 11:16 AM, Blogger morganovich said...


the key issue around fred and fan was government backing.

F+F had a cheaper cost of capital than anyone else. this let them take 40% and now 70% market share.

they also had the implicit (explicit as it turned out) backing of the US treasury.

thus, any crap the produced could be bundled into AAA securities because the ratings agencies viewed them (correctly) as backed by the feds.

this created a terrible set of incentives.

fred and fan could kick out/buy/guarrantee surreal amounts of complete crap especially as congress (read: barney frank, chris dodd) cheer led for lowered lending standards.

this crap could be bundled into AAA MBS's and held by everyone and anyone.

clearly, the underlying risk in the mortgages was much, much higher, but essentially everyone was betting (mostly correctly) that the feds would step in if the F's got into trouble.

with a set of incentives like that, it's hard to see how any result other than disaster was possible.

At 8/11/2011 11:21 AM, Blogger morganovich said...

ironically, the with F+F now taking 70% of the mortgage market, they are destabilizing banks still further.

boxed out of their traditional revenue source, banks are just borrowing cheap from the fed and buying US govvies at 20:1 gearing.

this is an deliberate policy from the fed/treasury.

it keeps us borrowing rates low, lets the banks make an easy arb, and finances absurd deficits that would never be so cheap otherwise.

the whole reason bernank gave (for the first time ever) an explicit date for rates to be low was to let banks duration match their arbs.

the trouble is going to come when rates do rise.

federal interest costs will increase.

banks will take huge, 20:1 levered hits on the prices of their bonds.

no one will want to buy the new auctions.

this is not so much kicking the can down the road as painting yourself into a corner.

this is not going to end well.

At 8/11/2011 3:32 PM, Blogger Mike said...

Thanks for the reply.
I think that's pretty much what I said... so I guess your answer is, yes, my statement was true.

At 8/11/2011 3:37 PM, Blogger Methinks said...

i think you'd be hard pressed to find a federal program that has done better.

Way to set the bar so low worms can clear it :)

if you want to be pissed about somehting, be pissed about the free money the fed is giving banks to lever up and by govvies.

Oh, I am. That's but one thing on my long list of complaints.

With the fun market we're having I don't have much time to dig into this with you. We'll leave it for another day. I'm sure it'll come up again.


At 8/11/2011 3:38 PM, Blogger OBloodyHell said...

I personally accept the notion that "too big to fail" is a possibility.

I just argue that the solution is self evident -- if you're "too big to fail", then, you're too big to continue to exist. In order to be rescued, you must break yourself up into five component parts with roughly equal liability, and we will then bail out those five parts.

Oh, and you must select 25% of your upper management to be fired without benefits for rampant malfeasance and incompetence.

At 8/11/2011 4:58 PM, Blogger morganovich said...

"Way to set the bar so low worms can clear it :)"

actually, 80 bn in return (leaving out F+F) on 250 in investments is a pretty good return for anybody over 3 years. that's 10% IRR/yr.

it's not the banks that were the problem.


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