We are developing the social individualist meta-context for the future. From the very serious to the extremely frivolous... lets see what is on the mind of the Samizdata people.

Samizdata, derived from Samizdat /n. - a system of clandestine publication of banned literature in the USSR [Russ.,= self-publishing house]

Samizdata quote of the day

The ultimate cause of the problem with the banks was indeed chronic government interference, in the form of implicit and explicit guarantees supplied to them free of charge, which hopelessly weakened the entire industry. Reserve ratios – the percentage of deposited cash which is actually retained by the bank rather than lent out – has fallen from over 50% in the 19th century to 2-3% today (or a negative percentage in Northern Rock’s case). That could not have happened in a free market, at least not on an industry-wide scale; nobody would lend to a bank if it tried to take on that much leverage without a government guarantee.

The banking industry had been rendered so unstable by government intervention that it was only a matter of time before it had a crisis, and the crisis could have been brought about by any number of proximate causes. Unfortunately most commentators blame the proximate causes, the particular individuals who happened to be involved at the time, and “free markets”.

In a free market, firms fail from time to time; they aren’t bailed out, people don’t expect them to be bailed out, people arrange their affairs accordingly and so the failure of one firm doesn’t bring down an industry or an economy. Banks were a long way from being a free market.

– “Some Guy” (that’s what he calls himself) commenting on the Bishop Hill piece also linked to below by Johnathan Pearce in connection with Matt Ridley’s inglorious career as a banker

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26 comments to Samizdata quote of the day

  • alecm

    Not to crit the general proposition that regulation screws things up, but:

    “nobody would lend to a bank if it tried to take on that much leverage without a government guarantee”

    …oh yes, yes they would. Any decent con-artist can explain how that works.

    Or are we specifically excluding the general public from “nobody” ?

  • Laird

    OK, so “nobody” is hyperbole. The point is a valid one nonetheless. Insert the modifier “almost” if it makes you happier, or weaken the whole sentence by changing it to “No rational person, in possession of the facts, would lend any substantial amount of money to a bank . . . .” (Which leaves room for knowing speculation and simple foolishness.) Feel better now?

    The whole point of the comment is that government guarantees (whether in the form of deposit insurance or explicit bailouts under the “too big to fail” doctrine) are artificially propping up the banking industry and enabling its excesses. Remove them and people would be more careful with their deposits.

    Which is not to say that I oppose either deposit insurance or fractional reserve banking per se. Both serve a useful purpose. What I oppose is government-run deposit insurance (it should be privatized) and undisclosed (or at least, inadequately explained) fractional reserve lending. And, of course, government bailouts of any type.

  • Paul Marks

    There is much in what Brian quotes that is important, but I will only go into some of this here.

    When people, including me, talk about “fractional reserve banking” there is a habit of leaving stuff out.

    To try and explain what I mean – it is true that someone can not be “a little bit pregent”, but most women can do a lot more when they are only a few weeks pregent than when they are nine months pregent and about to give birth.

    It may (or may not – depending on which side of the debate one is on) be “fraud” to engage in fractional reseve banking, and it certainly violates the basic economic principle that all lending must be from (not be “based on”) real savings. However, there is a vast difference between a bank that covers half its lending and a bank that covers 2% of its lending.

    There is also a vast difference between an economy (such as Victorian Britain) where banking is an important part of the economy – and an econmy which is DOMINATED by “financial services” (banking and related trades), due to the entire capital struture of the economy being twisted by an endless drip feed of funny money from government central banks (such as the Bank of England).

    I have no time for Walter Bagehot (third editor of the Economist magazine) either as a political writer (his supposed classic work the “English Constition” is a twisted mess) or as an economist – but the banking system (including possible Bank of England bailouts in a crises) is nothing like the system we have today (in Britain or the United States or…..).

    It may be true that the one (the system that Bagehot helped create) will develop into the other (the modern system) due to the “logic of interventionism” (one intervention leading to others) and the work of such things as “moral hazard” (the effects of “bailoutism” on the workings of the minds of men), but all this does not alter the fact that if Walter Bagehot was alive today and found out what people at his old magazine defend….. he would beat them and carry on beating them till there was but a bloody pulp left on the office floor.

    As for modern bankers (and other such)………………..

    I listen to these people from time to time (via business stations such as Bloomberg and CNBC – I have yet to watch Fox Business). Hopefully only the worst bankers (and other such) appear on these stations – at least I hope so as….

    What they say is astonishing – for example there is “little chance of international banking regulations being agreed” (said sometimes with regret), which is odd considering that Basel and Basel II (international banking regulations) were agreed years ago and have done great harm (of course Samizdata’s J.P. is a specialist in this field – and knows far more about it than I do).

    Are the bankers, and other such, really so ignorant that they do not even know that there already are international banking regulations? Or are they shameless liars?

    Another common statement from the bankers and …. is that some form of “international banking tax” would be “fair”.

    People asking for higher taxes upon themselves? Turkeys voting for Christmas?

    What is the meaning of this?

    Is it ideology (all those half remembered classes in collectivism at university) or is it a corrupt response motivated by the desire to keep bailouts and subsidies (not just open ones, but hidden ones like the “discount window” at government central banks) going?

    Of course what could be meant by “international regulations” is a fully formed world government (and it is true that this does not exist yet) and international taxation (“only on bankers” at first…..) would be part of this.

    Destroying all freedom and setting up world tyranny (as with no where to go there would be no effective limit, no “exit pressure”, on such a government) is this a price that these people are prepared to pay just to keep their subsides and the credit bubble economy going?

    I am often accused (perhaps rightly) of judging people too harshly – but this is such bad behaviour that I am astonished by it. I really did not expect people to act in such an unprincipled and dishonest (and plain wicked) way.

    But then I waited for years for such workds as Thomas Woods “Meltdown” to be reviewed in the Economist magazing or in other establishment media – it took me a long time to understand that it was not intellectual error that was the problem (if it was such best selling works would at least be reviewed) – it was moral corruption.

    And moral corruption on an astonishing scale – a whole international elite that was in moral bankruptcy.

    It is this (not their financial bankruptcy) that is the more serious problem.

  • Alice

    Paul is right — moral bankruptcy came first. The global financial mess is a symptom, not the cause.

    Still, bankruptcy is such an inadequate term. It is fascinating that people born into ordinary circumstances (Clinton, Blair) can achieve such dramatic financial benefits from “public service”. And while their countries are functionally bankrupt, those “public servants” are personally doing all right, Jack. No threat of bankruptcy for them as individuals.

    It is hard enough to tell fact from myth today, let alone in history. Yet is speaks to the power of certain myths that Americans in an earlier time would name their city “Cinncinati”. People liked the idea that their general would be found at his plow, would go & save Rome, and then would return to his plow.

    Chairman Mao’s Cultural Revolution was a disaster. But I can see the attraction in emptying the halls of academe, and making the pompous denizens of Harvard & Oxford pick potatoes for a while. Their academic understanding of economics could only be improved by the experience. For the current Political Class, the potato picking experience should be made permanent.

  • Chuckles

    ‘In a free market, firms fail from time to time; they aren’t bailed out, people don’t expect them to be bailed out, people arrange their affairs accordingly and so the failure of one firm doesn’t bring down an industry or an economy’

    As a simple engineer rather than a high flying economist, I have long been puzzled by some aspects of the above statement.
    Surely if these extremely poorly run institutions had been allowed to fail, individual mortgage customers would have been able to purchase their own mortgages from the liquidators for pennies in the pound? And the liquidators would have been bound to accept, since no-one else would touch them with a bargepole?

    The individual owners would have owned their homes free and clear, their future income would not be tied up servicing debt, etc etc etc. Whats not to like?

    @Paul M, excellent comments there, thank you, most thought provoking.

  • alecm

    @Laird: sorry to contradict, but the point of nitpicking a statement is because it’s part of the the thrust of the argument.

    As you deftly put it: “weaken the whole sentence by changing it” — yes, that’s exactly what I am doing, and it’s relevant because starting form a hyperbolic premise does not yield a logical answer.

    I know a lot of fools – side effect of working in computer security – and I agree that “deposit insurance or explicit bailouts … are artificially propping up the banking industry”, and I also happen to agree that that’s a bad thing.

    Where I disagree is that “Remove them and people would be more careful with their deposits” – nah, that doesn’t happen. People don’t get wiser, and security education of that form doesn’t really work.

    I’d consider it both more honest and more accurate to suggest that Governments should be saying “You lost your money? Fuck you, that’s your problem.” – should such be your bag; but to expect people to get smarter as a response to evolutionary pressure of this mildness?

    No, that doesn’t happen. Nobody should present it as such.

  • Laird

    The only part of your statement with which I disagree, alecm, is your assertion that people don’t learn from their mistakes. Of course they do (some of them, anyway). We’ve been trained not to worry about the capital strength of our local bank because for 80 years the FDIC has been there to pay off our deposits if the bank fails. Why should we care if the bank is over-leveraged and/or poorly run? But if a few depositors lost money in a bank failure the rest of the public would sit up and take notice, and their deposits would flow into the stronger banks. Which, of course, is precisely as it should be.

  • John Galt

    In reply to Chuckles earlier comment:

    Surely if these extremely poorly run institutions had been allowed to fail, individual mortgage customers would have been able to purchase their own mortgages from the liquidators for pennies in the pound? And the liquidators would have been bound to accept, since no-one else would touch them with a bargepole?

    The problem with such a scenario is that the liquidator would not offer a mortgage back to the mortgage holder for pennies a pound. The liquidator would sell the entire mortgage book for its full value to another mortgage provider (bank or building society) and use the money received from this sale to offset the bad debt within the bank.

    This has happened time beyond count and it is why mortgage rates are relatively low, because although property prices fluctuate, there is always residual value in either the income provided by the mortgage or the capital value of the property itself.

    The only time this might not be the case would be in a hyperinflation scenario. However, in this case anyone with a job (and any sense) would keep on paying off the debt as it was rapidly inflated out of existence. The only problem with hyperinflation scenarios is that they have other associated problems such as civil disorder, societal collapse, the fall of governments (Yah!) and the rise of collectivist totalitarian regimes of the left (commies) and corporatist totalitarian regimes of the right (fascists).

    On the whole I prefer ineffectual incompetence, decline and gradual erosion of government power to revolutions as they are easier to deal with.

  • Tedd

    The question of whether or not people learn from their mistakes is largely irrelevant to the functioning of a free market. The point is that those who lose money affect the market less and less as their ability to make choices in the market declines, while those who make money affect the market more and more over time. The market as a whole gets smarter, regardless of whether people in general, or any one individual, get smarter.

    But only, of course, if the feedback of a free market is allowed to occur.

  • Alecm – You’re right that people will continue being foolish without government guarantees, but you’re as guilty of hyperbole as the OP when you say a rational change in behavior just “doesn’t happen.”

    In the absence of the FDIC, some people will be circumspect and others will be careless. *With* the FDIC, circumspection’s not worth the effort for the vast majority.

    The number of people who see fit to hedge against disaster will vary directly with the perception of risk. A pal of mine had $150K charged to insurance by the hospital, due to complications in the delivery of his daughter; fees of that magnitude are uncommon, but not unheard of. It’s tangible (and potentially disastrous) enough to scare me out of having kids sans health insurance. Likewise, we’ve all seen friends’ cars get totaled, and folks lose their nest eggs when the market tanks. Even when we’re not required to, most of us shell out for insurance and diversify our portfolios – there’s credible threat.

    OTOH, bank failures (in the recent past, at least) are much more ephemeral; I’ve never known someone whose bank failed and had to follow up with the FDIC. The remoteness of such failures is good in the absolute sense, of course, but rarity often causes people to round down the risk to zero and forgo cost/benefit analysis of, for example, deposit insurance or diversification plans.

  • Voluble

    Imagine a Vegas casino where all of your losses are made good by the government and you get pretty much what we had in the mortgage industry. Failure was assured and it was assured to be spectacular.

    As an engineer I can say that you NEVER want to have only one way of doing things and you NEVER want to have only one system in place to perform a critical function. By definition, any mistake the government makes will affect EVERY bank and EVERY financial institution to which it applies which means any problem you have will be multiplied to the largest possible extent.

    That was part of the brilliance of having the states hold much of the power in the US before the Constitution was shredded. It served as a firewall between men and their bright ideas. Unfortunately, realizing the fact that the founders of the country were so intimately aware of all of these problems is for too many people too close akin to that point in their lives when they realize their parents once had sex.

    There is nothing new under the sun and the more Obama promises you that there is and he knows better the more certain you should be that he reasons like a child. The same applies to all of his ilk. It takes maturity of thought to know humility and to prepare so wisely for failure. These qualities are sorely lacking in the modern breed of politician.

    Using one entity to firewall everything ultimately firewalls nothing. It only assures that any failure will be universal and catastrophic.

  • alecm

    Jeremy, Laird; ok, I agree that I too am making generalisations – my gloomy outlook is doubtless an artefact of too much negative experience.

    What, though, of the fact that it’s perfectly possible to make millions, if not billions, through fraud, even today – pyramid schemes – even cloaked ones like Madoff, say; or multi-level marketing?

    These are in spheres where people don’t expect bailout, and yet they take risk that they cannot afford to lose, and they do lose, and are ruined.

    One could make the argument that the state has nannied everyone into not understanding how the real world works, and with that I too would have some sympathy of the “occasionally your kid has to cut himself to learn not to play with knives – so long as it doesn’t result in actual decapitation”.

    What I feel is that _people_ – the collective noun – do not learn; but _individuals_ certainly do, exactly as you say…

  • There are some most excellent points being made here: Some Guy’s original comment, Brian’s selection of it as SQOTD, Paul’s point on the graduation of everything, rather than just right/wrong or similar, Laird’s emphasis of the dangers of implicit government insurance (on top of Some Guy’s) and Voluble’s raising of single point of failure.

    However, much of this is obvious, especially when one is looking overall at the whole history, rather than looking at the step-by-step reactions of the not-so-bright government actions in moving forward while not rocking the boat. So I’ll add a little motherhood of my own: people do learn from mistakes, but more from their own than those of others.

    Also, society, as embodied in its various levels of government and corporatism, does learn from its mistakes too. The trouble is that it tries too hard not to make (or allow to be made) the same mistake again. The reaction is to complicate the system with a single incremental protection against the last noticed mistake. This is very normal human and societal behaviour.

    Eventually the system becomes so complicated that it fails. It may fail because a tiny little bit of it fails (perhaps even one protecting against a danger that no longer exists). It may fail just because of unexpected ‘design features’ in the system that has over-evolved.

    What we need is government that is continually looking over what are its primary responsibilities (means for: defence, law and order, stable economic exchange), to make sure that legacy systems are replaced at appropriate intervals. Sadly, they spend most of their time building new systems to do additional (and less necessary) things, rather than maintaining the aged systems they have and replacing them, from time to time, as they wear out.

    Best regards

  • Chuckles

    John G,

    It is not at all clear to me that anyone would pay full value for those mortgages – that is the cause of their problems is it not, a total lack of confidence in their value?
    No one knows what they are worth, and the general consensus is ‘Not Much’.
    Under such circumstances, a prudent liquidator would be well advised to sell off piecemeal to the highest bidder.
    I do agree that the mortgage contract value and the value of the underlying asset are not necessarily the same, but again, prudence suggests that the lower of the two be expected.

  • John Galt

    Okay then Chuckles, but you are mixing two different things of different value.

    Say I purchase a property for 600,000 GBP in the current market. I place a deposit on the property of 100,000 GBP and get a mortgage for the remaining 500,000 GBP.

    So here we have 2 items. The house, with a nominal asset value of 600,000 and a debt with a FIXED value (before repayments) of 500,000.

    So say the UK debt bubble and unemployment get worse and because of this the ConDem Coalition puts an 40% CGT on all asset sales over 100,000 GBP. This causes all house prices over 100,000 GBP to plummet by 40%, so my new house is now worth only 60% of its original value of 600,000 GBP (i.e. 360,000 GBP).

    This causes the bank to go bust. Now there are two items of value in the loan book. The first is a mortgage against Mr. John Galt of 500,000 GBP, which is secured (but only secured) by a property worth 100,000 GBP.

    So what is the value of that mortgage to a prospective liquidator? Why clearly it is 500,000 GBP irrespective of the nominal value of the underlying asset. If I were to withhold payment on the mortgage and I had enough cash, shares, assets, etc. to pay the 500,000 GBP I could still be forced to pay 500,000 GBP.

    The only circumstance where the value of the mortgage isn’t 500,000 GBP is where I default on the mortgage. Then the value of that loan is whatever the liquidator can get for the property, plus whatever he can squeeze out of me (the mortgage holder) in an IVA or bancrupcy proceeding less costs.

    There is no scenario in either of the above where I would be offered the title of the property for less than 500,000.

    Equally, in the UK a mortgage default (and all associated costs) can be held against a defaulting creditor for 12-years afterwards. Only after 12-years has elapsed will the debt no longer be enforceable – although it will still appear on credit records as it was an actual default.

    NOTE: Laws in the US are very different in this regard and US mortgage holders cannot be pursued for debts if they just hand in the keys and walk away, although this will cripple their credit records for a number of years.

  • John Galt

    Apologies – in the above scenario, the line which says ” which is secured (but only secured) by a property worth 100,000 GBP.”

    Should actually say “which is secured (but only secured) by a property worth 360,000 GBP.

    — Lets see if I get Smote for posting this ?

  • Chuckles

    John G, Absolutely, very little I’d argue with there. We are talking about different things. I’d say you are describing business as usual, and need a ‘in the normal course of events’ after your sentence –

    ‘There is no scenario in either of the above where I would be offered the title of the property for less than 500,000.’

    I’m talking about everything hitting the fan, no bailouts, the banks have huge bundles of mortgages of dubious provenance, they are going under, and have a desperate need for cash.
    The securing values of the properties are nil, since no-one is going to buy them, except possibly the current occupants.
    At this stage the best course may be to unbundle those mortgages and sell them off individually, and it may be of greatest benefit to accept my offer of pennies in the pound for my mortgage.
    The alternative is to repossess and auction the property, at which point I make the same offer. No-one else bids….. Same outcome.
    Anybody want to buy Detroit? What’s the offer?

  • Laird

    John G, you are absolutely wrong in your illustration. First, if the value of the property is that far below the mortgage amount many people simply walk away. (Here in the US it’s called a “strategic default”, and the probability of such a default would be very high in your illustration.) In some states the lender can sue on the deficiency (the remaining debt after the property is liquidated), in some he can’t; but in either case what he has is an unsecured debt which is extremely hard to collect on, and impossible if it is discharged in bankruptcy (a common occurrence in such cases). Such “deficiency balances” are worth pennies on the dollar in the secondary market, and for good reason.

    Second, you’re forgetting to factor in the time value of money. Even if the borrower actually pays as agreed (and there is a high probability that he won’t, or that he’ll be a chronic delinquent; such loans are very expensive to service) the holder of the debt has to make a return commensurate with the risk he is incurring. Banks can make (a little) money at a 6% note rate (fairly common in the US) because their cost of funds is so low, but no “distressed” debt investor can and this is not a “bank-quality” loan. Such investors require returns in the high teens, at best. Do the math: if the note pays interest at 6% and you require a 15% return on your investment, what would you pay for the note even if it were guaranteed to pay on time? Not 100% of its face amount. (If you would, please contact me and I’ll sell you some!)

    The time value of money issue arises in the default scenario, too. In some states it can take as long as 2 years to get through the foreclosure process (our “caring” local governments at work!), during which time you get no cash flow on your investment, and you almost never recover the lost interest.

    There is a lot more to it, of course, but the bottom line is this: in the US secondary market, nonperforming 1st liens are trading at around 60% of the collateral property’s “quick-sale” appraised value; performing 1st liens which are significantly “underwater” (as in your illustration) are trading at around the same price; performing 1st liens where the collateral value appears adequate are trading at 70%-80% of the loan’s face amount; and deficiency balances are trading at about 2% (on a good day). I have been in this business for many years; I know this market very well.

  • John Galt

    And so Chuckles, we get down to the meat of it. What is £1, £1 million pounds or £1 quintillion pounds worth. In actual fact it is worth only what people will exchange for it. I can give you absolutely no assurance that 5-years from now 1 KG of sugar will be worth £2 or £496,312,857.

    That is the problem with credit backed or fiat currencies. Ultimately, they are just pieces of paper. However, since a house has real value, it will always be worth something unless it has an equal or greater liability associated with it – e.g. £2,000,000 worth of Chancel Tax on the adjoining rectory.

    When all of your comparisons are against the fiat currency of every modern country, I can give you no answer other than the ones mentioned previously.

    The problem with fiat currencies is that all fiat currencies collapse eventually (usually due to inflation caused by overprinting or too much debt).

    However, it’s like playing hot potato. As long as you aren’t holding massive amounts of the currency when a significant devaluation, hyper-inflation or other event happens then you are fine.

    However, it’s difficult to pay for food with a house.

  • Laird

    Well, several hours ago I posted a fairly detailed response to John Galt’s property value / mortgage default scenario, but the Smitebot has eaten it. Perhaps someday it will be regurgitated.

  • Alice

    Tinfoil hat time, Laird. Have you ever considered the possibility (even just for a moment) that the Smitebot is programmed to delete posts randomly as part of a giant sociological experiment? Be honest, now!

    And if so, what is the inscrutable purpose of the experiment? How should we react to confuse the experimentalists?

  • Laird

    Actually, Alice, I thought that it just didn’t like me!

  • Nah, it’s an equal-opportunity smiter. Smitter. Smoter. Someting.

  • Alexander

    The problem with this article is this:

    Banking is a system where a corporation is given special privileges in return for heavy regulation.

    They should not fail. That’s the heavy regulation part.

    The people who say that they should fail should also recognize that in such a “free market”, there would be no special privileges for banks either. There would be no banks, as defined by banking laws, period.

    There would be no fractional reserve banking. The fractions required would be set by the market, as they are in the bonds market.

    The “free market” people should simply argue against having banks. Why are they needed? We can have our credit cards, ATMs, and accounts without banks backed by special privileges.

  • Paul Marks

    There would be banks Alexander – just not ones with the special privileges.

    For example, there would be no “suspensions of payments” during bank runs.

    If any bank refused to give people their money it would be held to be in bankruptcy and go straight to the bankruptcy court.

    Also there would be no “insurance” of bank deposits – because one can not rationally insure against bad business judgment (sorry it is not like fire or flood).

    All this might not instantly get rid of franctional reserve banking – but it would utterly transform it.

  • Laird

    Just what “special privileges” are you referring to? (Other than deposit insurance, for which banks do pay a premium, and which could [and should] be privatized, Paul’s derogatory comment notwithstanding.)