A Slightly Different Way to Prevent Bank Runs

A few weeks ago, while reading yet another book on the financial crisis, I had the beginnings of an idea about how to help financial institutions who have experienced a decline in assets relative to their liabilities. I thought about possible ways to recapitalize these firms without direct government intervention, as happened during the TARP. The idea I came up with was a quasi-convertible bond to be forcibly converted by a regulator during a time of crisis.

This bond is one that can be issued by a financial firm, usually an investment bank, in order to raise funds to use for trading and other proprietary investments. The bonds will have an intermediate to long-term maturity ranging from five to fifteen years. Under normal circumstances the bonds will act in a similar fashion to current debt issues. However, the bonds will have a provision whereby they automatically convert to equity when their government regulator determines that the firm is under capitalized or facing a liquidity short fall.

The purpose of this conversion is to quickly, and forcibly, lower a firm’s liabilities and increase its capital cushion. Such an increase in capital would allow the firm to maintain a sufficient liquidity position and prevent a need for capital injections or support by the government should the firm become sufficiently illiquid. This type of bond would allow financial companies to finance their normal functions under normal credit conditions, but allow the firm to recapitalize itself under excess financial strain.

The decision to convert the bond into equity would rest with the firm’s main regulator, the Treasury and/or the Federal Reserve depending on the type of firm. For example, the Federal Reserve Bank would decide institutions that maintain customer demand deposits. The government decision makers would base their decision on the firm’s capital strength, counterparty risk and balance sheet stability. If the firm is deemed to be illiquid, the debt will be forcibly converted to equity and creditors would become common shareholders. Several tranches of these bonds could be sold for any individual firms. The highest risk could be converted firms, followed by subsequent levels. The government regulators would determine the necessary ratio of this type of debt to overall debt issued by each firm. Likewise, during a conversion, the regulator would also determine the amount of the bonds to be converted.

The purpose of these bonds would be to protect the government from having to use taxpayer funds to bailout or otherwise support solvent but illiquid firms. If a firm begins to run out of liquid securities to post as collateral, it has a liquidity problem. During a crisis, firms become insolvent as they are forced to sell its assets to acquire necessary liquidity, often at a significant loss. A forcibly convertible bond would allow for the firm to tap a reserve of liquidity that would be sufficient for it to ride out the crisis. If the firm is not able to acquire the necessary liquidity, the government can be forced to put taxpayer funds at risk to protect the firm’s counter-parties from its collapse.

Obviously, this type of bond will be less desirable to debt purchasers as it would essentially force them to assume greater risk associated with a firm’s activities. To make up for this risk, the bonds would likely trade at a discount to normal debt. As a result, the government would have to use its regulatory powers and force firms to issue this type of debt. This would prevent the government from having to use taxpayer funds in the future to backstop an illiquid bank during a financial crisis by recapitalizing that bank when it is short of necessary liquidity.

Game Theory and Census Workers

I'd like to make a short thought exercise which might be an example of economic problems which the US census might ultimately cause. And, no, I am not trying to say that the census will cause problems but there might be unintended consequences.

Consider you are either an individual who has been unemployed for a long period of time or a new graduate just trying to enter the job-market. You have had a very difficult time finding stable work, but have found an opportunity to work for several months. This job offers you the chance to work from twenty to forty hours per week, and the choice is entirely yours. Along with hundreds of thousands of others in your situation, you've decided to take this job opportunity.

Being a person who is in need of money who would like a full time job, instead of working about twenty hours a week you would likely decide to work towards the forty hour mark. You do your work eagerly and try to get as many hours as possible to maximize your income. Much like you, the other hundreds of thousands of people likely decide to follow a similar course and work as many hours as possible.

So, here we are. Individuals who are working for the census have every incentive to maximize their hours worked. Unfortunately, there is a limit to the amount of work these people can do since most census workers were hired to go door-to-door and count those who have not filled out their forms. There were only so many people who failed to return their documents, so there is a upper limit to the trips census workers must take. With employees attempting to work as many hours each week as they are allowed, they will quickly visit all of those who's forms are outstanding.

The unfortunate consequence to this exercise is that census workers will likely complete their door-to-door visits well ahead of schedule. As the documents are gathered in each area, the workers will be released from their employment earlier than they were expecting. The census has caused a major boost in hiring and has helped to lower the national unemployment rate. As the newly hired census workers finish their jobs, they will be released from their employment and will reverse any positive effects from their hiring. The unemployment rate will likely again spike as many hundreds of thousands of former census workers file new claims.

In the coming months, the unemployment rate will increase even though the economy is improving. Potentially, as these people again lose their jobs there can be severe negative effects on the national economy. Companies get scared when unemployment rises and consumers spend less when they lose their jobs. The ultimate loss of employment may cause these concerns to return and output to decrease. The census jobs, once lost, can potentially damage the fledgling economic recovery for these reasons.

Who's Really At Fault

I've been doing quite a bit of reading recently, mostly books about the recent American economic downturn. As is expected, each author tries to determine the causes of the fall and the guilty parties who allowed malfeasance or tried to pull the US financial system apart. The list of guilty parties is quite long: greedy bankers, deceptive borrowers, inept credit ratings, government ignorance and so on.

However, I put the blame for economic crash on those and countless others. In sum, everyone is to blame for a rather simple reason - no one did enough to learn what was actually going on and that a bubble was expanding. People simply became joyfully ignorant at what was actually going on with the economy and financial system. The fault can follow the path of the toxic assets that polluted the system.

First, loan originators looked to find borrowers to buy houses without regard for their ultimate ability to afford those houses. They didn't do the necessary research to learn that the loans couldn't be paid off, only hoping that prices would continue to rise. The borrowers they found to purchase homes did so without understanding the contracts they were signing. They didn't do the necessary research to learn what they were agreeing to, only thinking they were getting a great deal and that they could continue to pull more money out of their homes. The loan originators then quickly sold off the loans to banks to form asset-backed securities. The banks which purchased these loans did so without determining whether they would continue to be serviced over their life-span. Again they did not do the necessary research. Shortly after their purchase, the loans were usually pooled together into larger and larger bonds.

Once these bonds were put together, they were taken to ratings agencies. These agencies were responsible for determining the creditworthiness of the new bonds, however, they lacked the knowledge of the assets they were rating. The agencies did not do the necessary research to understand the bonds and accurately rate them. Instead, seeking higher payments, they often slapped inflated ratings to the bonds and sent them on their way. Once these bonds were rated, they were then sold to investors (often foreign banks, pension funds, etc.) or held by the banks. Again, these investors did not do the necessary research to understand what they purchased, and instead were fully dependent on the ratings from the agencies. They did not do their own research.

In the end, the bonds fell apart as home buyers became unable to pay their mortgages. Their payments often adjusted upwards catching many of them off-guard because they did not understand their contracts. The banks and investors then began to take losses as their investments slowly stopped paying their necessary interest. Once this happened, they stopped purchasing new loans which brought new loan issuance to a halt, bankrupting the loan originators.

Ultimately, the government had to step in and bank-stop a large number of institutions in order to protect the whole financial system. This occurred at great loss to taxpayers. Again, the government did not intervene until the problem was too great. Believing that home ownership was good for the country, government agencies and legislators acted to allow the bubble to continue expanding until it popped. Again, they failed to realize the consequences of its actions.

On the whole, the economic downturn was everyone's fault. People simply did not understand what they were agreeing to, who they were loaning money to, ratings they placed on securities, what they were buying or the actions they were encouraging. If greater due diligence was done, or consequences considered before action, the great recession could have been avoided.

Where Does The Money Come From?

Some fairly interesting numbers were released last week by the Bureau of Economic Analysis concerning the American public's income. Their statement showed that personal income from private wages (money earned through working at non-government jobs) has fallen from 47.6% at the turn of the century to 41.9% last quarter while income from government transfer payments (Social Security, Food-Stamps, Unemployment Insurance, etc.) has risen from 12.1% to 17.9% in the same period. Simply, less money is earned from private employment while much more comes from the government.

Such an income shift is potentially very troubling for the US economy. The key problem is that most of the government's spending comes from revenue generated by taxing private income. At a time when the share of privately generated income is falling by almost 5%, the government's share has increased by almost 6%. The government is paying a significantly higher share while its pool to tax is shrinking precipitously. Additionally, the government is also paying out another roughly 10% in wages for public sector employees.

Overall, out of every $1 in American income, over $.27 is paid by the government. So, the government must tax an average about 1/3 of Americans income just to pay for its workers and transfer payments. This excludes the costs of goods it much purchase to be used by their workers and in what they produce on behalf of the government. In total, for the government to pay for its obligations and services it needs to tax at a prohibitively high rate. Additionally, this would also need to include extra money to service existing debts.

In sum, the government is spending huge sums of money in proportion to what the rest of the economy is generating for personal income. Obviously, with a recession, incomes decrease and the government has stepped in to fill the gap. But, over the long run this is not sustainable. If the US government spends at an elevated rate for a brief time, there will be little overall effect on the economy. However, should such dependence on the government last for an extended period, the country will be forced to become increasingly dependent on financing itself through debt instead of taxation. Ultimately, this will lead to insolvency and economic collapse.

An Untenable Equlibrium

I recently concluded Crisis Economics and found one of Mr. Roubini and Mr. Mihm's ideas incredibly interesting. They build upon Lawrence Summer's idea that China and the United States are locked in a 'balance of financial terror'. In essence, they argue that the world is in a state of equilibrium that can not last. The Chinese are dependent on the US to purchase their goods and to make good on its debt obligation. The Americans are dependent on the Chinese to continue producing cheap goods and finance their purchase. Such a state is ultimately untenable.

While this is one example of an international equilibrium that will eventually fail, there are countless examples of others. Simply put, the world is teetering on a dangerous precipice. This type of situation was shown during the bursting of the housing bubble in the US. Americans financed the purchase of new homes by borrowing from lenders who created bonds which were then sold to a vast number of investors. A large percentage of this debt ultimately ended up in foreign hands in Europe and Asia. The world was in equilibrium as long as lenders continued to loan money, consumers continued borrowing and home prices continued rising. As soon as any of these conditions failed (home prices stopped rising), the house of cards collapsed.

The United States and China find themselves in a similar situation today. Once either stops fulfilling its end of the bargain the entire system will collapse. The Chinese could stop purchasing American debt which would cause Americans to stop purchasing Chinese goods. Any action by one party would likely harm the other.

However, the Sino-American relation is not the sole unstable equilibrium in the world today. Major oil producers find themselves in a similar suicide pact with the industrialized world. Should they stop selling oil, their economies (in addition to their trading partners') would likely collapse. Similarly; many nations, such as the Greeks, Portuguese and Spanish, are locked in pacts with their creditors. These nations have based their economies on debt-driven social spending and must roll their debt quite often. Should their creditors stop allowing them to do this, their national economies would collapse and those who financed their spending would probably take major losses in any default. Such are the problems faced by many European banks in the current crisis. Likewise, the entire Euro-zone finds itself in an untenable situation as it must help its over-indebted members refinance their debts. A shift could easily cause the currency to fail or break up.

Fortunately (or unfortunately), this world is not one of only a simply equilibrium. There are many possible equilibrium and the current one we are at is likely non-optimal. Many of the situations described above are untenable and likely can not last in the long term. Once those regimes collapse, the world will shift to another point of equilibrium. Such a series of events can occur countless numbers of times. In fact, each recession is just a movement from one point to another. Creative destruction will occur and move the world economy to a more advanced state. The recent recession did not totally reset the world economy. Yet, if there is a double dip the world will likely move away from its previous unstable state into a new, more optimal equilibrium.

The Tail Is Going To Wag The Dog

One of the formerly popular concepts in economics and global politics that was debunked during the recent recession was that of decoupling. The simple idea was that with the emergence of new economic powers around the world like China, Brazil, Russia, India and the European Union, the importance of the United States had begun to decline. In essence, these newly powerful countries were thought to have become able to thrive independently of the US and any American problems would not spread. Obviously the 2008-2010 recession proved this incorrect as problems on this side of the pond quickly spread abroad and recessions followed in many other countries.

A key fact in that is often overlooked in the decoupling myth is the effects that the rest of the world have on the United States. The term 'decoupling' is obviously incorrect, however, the US is no longer as dominant a power as it was over the past few decades. This will become increasingly evident as the European Union faces an existential crisis caused by a number of its Mediterranean members.

Starting with Greece and quickly followed by Spain, Portugal and perhaps Italy and Ireland, the EU's common currency is going to be threatened. It is a serious possibility that the currency will fail or be forced to eject some of its members. When either of these events happen, the Euro zone will be thrust into its most serious recession since the Second World War. Trade agreements will break down while new currencies will be introduces and experience severe growing pains. The entire Euro area will face growing civil unrest as draconian fiscal austerity will be introduced and currencies devalued.

Much like the American problems emanated across oceans in 2008, the European problems will quickly spread around the globe. As the contagion moves into the United States financial institutions will again begin to experience lending and borrowing problems due to fear of counter-party exposure to European sovereign debt emerges. This problem will probably not cause a return to the 2008-2009 state of frozen credit but will hamper lending to governments around the world. When this happens, interest rates will quickly rise and threaten the young economic recovery.

In the end, the likely threat to recovery caused by the European contagion will likely be enough to force the US, Europe and many other parts of the world back into recession. A double dip will be experienced. This second dip will likely be much longer in duration than the 2008-2010 dip because governments, such as the US, will find it difficult to finance artificial stimulus measures which could mitigate the decline.

Unlike the past recession where the United States drove the rest of the world into decline, a future recession will likely be an event where the US is driven into decline by the rest of the world. The tail is going to wag the dog...

The End of the Euro

With recent events in Greece, Portugal, Spain, Italy and Ireland, the common European currency has been threatened. The governments in these, and other countries, have made a practice of running huge fiscal deficits to finance lavish social spending. Those deficits were often far beyond the agreed upon limits defined by the treaties which created the European Union and the common currency. The large deficits are becoming more and more problematic because the borrowing countries are reaching the point where they are no longer able to service the interest on the debts.

When countries run up huge national debts, there are often a number of ways for them to repay the debts. A common method is to cut spending or raise taxes. Unfortunately, this is not a popular practice in Europe when major unions riot and protest whenever cuts are made that can threaten their income. Additionally, in a number of European countries tax avoidance is a common practice, so raising taxes might not necessarily raise revenue. Another method to lower national debts is to grow out of the problem. If a country can increase its GDP and national income enough, the debts will be swamped with new, increased, tax revenues. However, Europe is currently only recovering from a major recession, to which it might fall back into. With such a shady economic outlook, growing out of debt seems unlikely. Another of the most common methods to eliminate national debt is to inflate it away. Countries often print new money and use that cash to pay off their debts. This practice eliminates the debt at the expense of current money holders. Again, this would likely be impossible for Europe as it would pay off one country's debt at the expense of others.

Unfortunately it appears as though all of the common methods countries can use to eliminate their excessive national debts can not be used for the problematic European nations. What appears to be happening is that a major international consortium of EU countries and the International Monetary Fund are going to create bailout packages for the individual countries, starting with Greece. This will take some of the debt burden off of the Greeks and allow them to artificially reschedule their debt. They will also need to implement drastic austerity measures which will be incredibly unpopular domestically.

So, in the end, how does this all shake out? Simply, the Euro will either collapse or certain countries will be forced out of the common currency. For starters, the countries who are footing the bill for the bailout packages will do so grudgingly. Such packages will be incredibly unpopular and while initial packages may pass, subsequent requests for help may be ignored. Secondly, countries receiving the bailouts will be forced into draconian spending cuts. Such cuts will make governing impossible for incumbent administrations. Minority parties will simply run on platforms to eliminate the cuts - and they will likely be successful. This will result in countries receiving aid not cutting their spending per agreements. The countries giving aid will likely pull back their aid forcing their neighbors into default. The European Central Bank will be forced to print new money to stabilize the currency if the defaulting nations are not forced out. Either way, the Euro will collapse or break up.