Submitted by Rolfe Winkler, publisher of OptionARMageddon.
[Reader note: I thought it useful to add commentary around the FDIC data. Those that would prefer to skip straight to it, see the chart and read paragraphs 4-9].
Conventional wisdom says that financial companies are having trouble borrowing because credit markets are broken. This is dangerously wrong. The credit market itself is fine. It’s balance sheets that are broken. They have so little equity relative to their assets, there’s no cushion to protect creditors from losses. With few good borrowers available and with the price of credit capped by government, naturally creditors have little inclination to lend. Washington’s solution is to “guarantee” all manner of risky investments, to use the public’s balance sheet to absorb trillions of dollars worth of private sector losses. We’re told this will “restore confidence” in borrower balance sheets, leading to increased lending. But this policy is dangerously misguided and may very well lead to economic Armageddon.
In point of fact, our fractional reserve financial system is just a gigantic Ponzi scheme. It can only survive as long as it expands, which is to say, as long as new debt is flushed through the system to finance old debt. But like all Ponzi schemes, the larger it grows the more unstable it becomes. Eventually, it too will collapse of its own weight.
With this in mind, government should be concerned with paying down debt, not expanding it. Deficit-financed bailouts and stimulus only increase the size of the Ponzi. The bigger it grows, the harder it will crash.
(click chart to enlarge)
My thoughts came back to this recently when I looked at FDIC’s 12/31/08 balance sheet. Note at the bottom of that link the estimate for total insured deposits: from Q3 to Q4 it increased only a smidge, to $4.8 trillion from $4.6 trillion.
Odd, no? Why such a small increase even though FDIC dialed up deposit insurance limits so significantly during Q4? FDIC Senior Banking Analyst Ross Waldrop told me during an interview last week that it’s because so-called “temporary” increases in deposit insurance are excluded. If included, these would boost total insured deposits from $4.8 trillion to $6.2 trillion.
FDIC’s total commitments would increase an additional $224 billion to $6.4 trillion if you include debt issued prior to the new year under FDIC’s “Temporary” Liquidity Guarantee Program.*
In early October, FDIC boosted deposit insurance limits for individual non-retirement accounts to $250k, which, according to Waldrop, added $713 bilion to total insured deposits. He also noted that new insurance on non-interest bearing transaction accounts added $684 billion to the total.
Waldrop wouldn’t comment on the validity of excluding temporarily insured amounts from the total.
It seems intellectually dubious, if only because there’s little chance FDIC will actually allow the temporary increases to expire. Doing so would risk sparking depositor panic, precisely what FDIC is trying to avoid.
What does this have to do with Ponzis? When Bernie Madoff’s scheme collapsed, he owed somewhere north of $50 billion to his investors but had only a tiny fraction left in the bank. FDIC’s potential liabilities as of Q4 were $6.35 trillion. It has but a tiny fraction of that amount—$19 billion—in the Deposit Insurance Fund. Readers might argue that comparing the two is unfair; FDIC has an open line of credit on the U.S. Treasury. So FDIC’s credit is as good as Uncle Sam’s.
But how good is his? Already, the federal government has committed $12.8 trillion to fight this financial fire (a figure that doesn’t include FDIC’s $6 trillion worth of insurance commitments). Then there’s the trillions of unfunded liabilities for private and public pension schemes that Uncle Sam may be forced to absorb. Also there’s Obama’s budget deficits, which will commit us to borrowing trillions more over the next decade. Finally and most importantly, our unfunded liabilities for Medicare and Social Security surpass $50 trillion.
At the end of the day, after borrowing and money printing have been maxed out, the federal government’s credit is limited by the taxes it can collect from the American people. No way no how can Americans pay for all of the above. It would cost every one of us hundreds of thousands of dollars today. Yet society still feeds the collective delusion that government liabilities are “risk-free” because it has a printing press. But printing is just default by another name: inflation. And the more we come to rely on government guarantees, the more unstable they become…
With this in mind, it is for government to promote debt expansion, but that is precisely what government “guarantees” are designed to do. They are designed to boost lending.
Fannie and Freddie were just the most obvious examples of how terribly this can backfire. Perhaps trillions of dollars flowed through Fan/Fred into the mortgage market as a result of the government’s implicit (now explicit) guarantee of their debt. This helped inflate a bubble that is now bursting spectacularly.
FDIC deposit insurance is an even more insidious guarantee, the “crack cocaine of American finance” as Martin Mayer put it in his definitive book
Depositors didn’t care how much risk bankers took with their money. It was federally-insured. Might as well go with the bank offering the highest interest rate. One of my favorite contemporary examples is the ad I see for GMAC’s above-market CD rates in WSJ’s A section every week. GMAC is insolvent. It’s asinine for depositors to keep funding them.
The government is encouraging precisely that with $5 billion of TARP bailout money and the protective wrap of FDIC deposit insurance. GMAC now operates courtesy of the government’s promise to insure its creditors. This is true of the entire banking system at this point…
The dirty little secret, as noted above, is that the government has no reserves with which to fund its guarantees. As they become payable, its only recourse is to borrow.
This guarantee shell game continues only because Uncle Sam has borrowing capacity to keep it going. That capacity derives not from balance sheet strength (again, no reserves) but from the dearth of investors’ options. Everyone worldwide knows Uncle Sam is broke. But government-insured accounts remain the last refuge for their accumulated paper wealth, which—in a fractional reserve banking system—is largely an illusion to begin with. In such a system, paper wealth exists only to the degree that debts are serviced. And debts are serviced only to the degree that credit continues to expand. Remember, it’s just one giant Ponzi scheme.
This is not hard to grasp, actually.
The vast majority of the economy’s wealth exists only on pieces of paper that record the accumulated funds stored in financial accounts. Contemplate your own bank statement for a moment: what does the balance figure at the bottom represent? Money that you previously gave the bank that it has since shoveled out the door to borrowers. In other words, your paper wealth only “exists” to the extent that bank borrowers pay back their debts. Money and debt are mirror images of each other: your money is someone else’s debt.
Here we have arrived at the cause of the present crisis. Credit expanded so spectacularly during the recent asset bubble, paper wealth itself expanded spectacularly. But this wealth was an illusion of course. As debtors default, paper wealth disappears. The Ponzi unravels.
Ponzi schemes aren’t “solved” through continued expansion. This delays the day of reckoning, sure. But only at the cost of magnifying losses fantastically. No one would have suggested extending Madoff investors a government guarantee. Why then are we offering guarantees for customers of Chase, Citi, BofA and Wells Fargo, far larger Ponzi financiers all of them?
The answer, of course, is they are “too big to fail.” Had Madoff been sporting a trillion-dollar balance sheet, you can bet the government would have offered bailout funding to prevent a disorderly collapse.
But there’s a fine line between too-big-to-fail and too-big-to-rescue. Ask the folks in Iceland, Ireland, and most of Eastern Europe. The Ponzis at work in their financial systems grew so large there is simply no orderly way to unwind them. We risk the same fate here in the U.S. by offering open-ended guarantees to bank customers.
The fact is, a bank run can be a healthy thing as it discourages investors and depositors from allocating too much cash to unstable institutions. Unfortunately, by removing all discipline that the possibility of failure provides, we have permitted our financial institutions to grow totally unchecked. The just desserts of moral hazard you might say.
A counter-argument here is that government guarantees have actually prevented capital flight. Without all these new guarantees, the system would have crashed back in October as investors and depositors raced to cash out simultaneously. But the guarantees we’ve extended haven’t prevented that, they’ve merely delayed it.
The longer the government leaves its various guarantees in place, the more capital will flow to protected investments, much as it did to Fannie and Freddie. The Ponzi will continue to expand until confidence in Uncle Sam’s balance sheet is itself destroyed. At that point, the unwind will be far uglier that if we had paid down the national debt while executing a proper bank recapitalization, i.e. wiping out shareholders and forcing losses onto creditors.
What was true for Madoff is true for the U.S. financial system: In order to contain collateral damage, it’s best to unwind Ponzis as soon as possible.
(Readers can visit this guest author’s blog here)
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*Total TLGP-backed debt issuance was $321 billion through the end of March. Because data for FDIC’s other “temporary” insurance schemes is only available thru 12/31, that’s what I’ve included for TLGP in the chart.
23 comments
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In point of fact, our fractional reserve financial system is just a gigantic Ponzi scheme. It can only survive as long as it expands, which is to say, as long as new debt is flushed through the system to finance old debt.
Uh-huh.
I am not convinced that the credit market is fine, although I understand where you are coming from with the idea that balance sheets are broken or perhaps leveraged. Since government intervention to lend I don’t see financial companies having difficulty lending. I can see that some are not able to borrow at competitive rates and I can see both banks and investors being risk averse. The problem to me appears to be leverage and this applies to financial institutions and to large industrials. Unfortunately this results in a severe squeeze on smaller unleveraged institutions as everyone except the government deleverages.
While the FDIC’s insurance has escalated and the pretence that the insurance is temporary are laughable, all the FDIC is really doing is filling part of the role that the monoliners once did. Yes the FDIC most likely will run out of cash and need treasury money, but without a severe shock the insurance is likely to keep the full faith of investors. The government wont be getting a ratings downgrade anytime soon.
Since government has performed admirably in being able to hide and defer its debt I see no reason for this not to continue, so while you point out the 50 trillion deficit it will most likely be hidden away as usual. That government will not have a credible way to address the smaller stimulus deficits and avoid raising taxes will at some point prove the undoing of the dollar, but like any Ponzi scheme government finances will continue in the current vain until the black swan event occurs to reveal all.
The question is, which seemingly small event will start the cascade of events for the all to be revealed and will we have to wait long.
I don’t disagree about the Ponzi scheme thing, but I would take issue with the statement that “the government’s credit is limited by the taxes it can collect from the American people.” If I read Richard Koo’s presentation correctly, Slide 14 shows that the Japanese government is collecting roughly half of what it spends in taxes and has been doing so for some time.
As long as people as willing to treat the US dollar as a store of value it will remain so, and deficits and future obligations will not matter. When they stop, nothing else will matter.
As someone once said (I think about an Italian government crisis) “The situation is hopeless, but not desperate.”
I enjoy your blog, BTW. Thanks.
Rolfe,
Excellent post. You wrote the following:
“Here we have arrived at the cause of the present crisis. Credit expanded so spectacularly during the recent asset bubble, paper wealth itself expanded spectacularly. But this wealth was an illusion of course. As debtors default, paper wealth disappears. The Ponzi unravels.
Ponzi schemes aren’t “solved” through continued expansion. This delays the day of reckoning, sure. But only at the cost of magnifying losses fantastically. No one would have suggested extending Madoff investors a government guarantee. Why then are we offering guarantees for customers of Chase, Citi, BofA and Wells Fargo, far larger Ponzi financiers all of them?”
I have long been writing about how the global pension Ponzi scheme dwarfs the Madoff scandal as trillions of dollars went into hedge funds, private equity and real estate funds.
As you stated in your conclusion: “What was true for Madoff is true for the U.S. financial system: In order to contain collateral damage, it’s best to unwind Ponzis as soon as possible.”
The problem with pension funds is that they are lethargic and dumb money trying to reflate the alternative investment bubble, much like Uncle Sam is trying to do.
Sadly, we have not seen the end-game to all this. I cringe to think of what might happen, but maybe I am just a fool who doesn’t see that credit bubbles can go on in perpetuity.
cheers,
Leo
FDIC insurance is there to protect to banks not the depositors, It’s there to keeps a bunch of dummies from taking their money out.
I agree with Kolivakas, this is an excellent post and expresses a very logical and sensible viewpoint on this whole insane issue. The problem, however, goes even deeper than the alarming analyses offered by Winkler, Kolivakas, Krugman, Yves, and so many other knowledgeable, but also in some ways very naive, economists. The problem is that the government is trying so hard to paper over the true depths of the problem facing us, that it’s all too easy to see the obvious flaws in their thinking and miss the much deeper abyss they are hiding even from themselves.
When they say that certain banks are “too big to fail,” what they really mean is that failure to somehow prop up these banks by ANY means, fair OR foul, would lead to a catastrophe so huge that we have still not heard anyone even speculate about what the world would look like under such circumstances.
Since the economists picking at all the obvious holes in their strategy are certainly correct, the Ponzi scheme so desperately being maintained beyond all reason will in fact, sooner or later, totally collapse and we will inevitably be faced with the allegedly “unthinkable” catastrophe no one wants to talk about. Am I the only one who sees this? http://amoleintheground.blogspot.com/
I can’t add anything useful to this article, but I must say it is very very good. Thanks, Yves!
She gets it–as far as I can tell, and I have most definitely been looking, you’re the first econo-blogger or journalist to discuss how close to default we really are. Truly an excellent post.
Have you looked at precisely for whom a US debt default would be ugly for?
I’m inclined to agree with most of this analysis, and for my part think the next phase of this mess will start with a reserve currency/sovereign debt crisis. But I can’t agree that anything would be solved or averted by simply wiping out the banks’ shareholders and creditors. The point of the quasi-nationalization of AIG, Citi, and BoA was indeed to transfer their liabilities (to a different extent in each case) to Uncle Sam’s balance sheet without triggering a default–to assure creditors that these and other systemically important players wouldn’t default on their liabilities. Had this not been done, we would have seen a massive intensification of what we saw anyway after the collapse of Lehman–a “bubble” in sovereign debt, ie massive capital flight from all asset classes not guaranteed by Uncle Sam, and negative yields on everything with a sovereign guarantee. In which case, Uncle Sam would still be holding the bag, having to guarantee far more “paper wealth” than anyone would find credible for long–particularly because in this scenario, we would be faced not with the dismal uncertainty that the responses to the crisis thus far have produced, but rather with an economy in complete functional collapse and a deflationary death-spiral. The fall of the banks is at this point functionally equivalent to the fall of the Treasury.
Of course, the post seems to claim that such is inevitable anyway, and in some sense I can agree–this was basically Marx’s point, that the internal contradictions (read: ponzi-scheme) that make this economic order possible will eventually cause the whole thing to collapse. But the Ponzi scheme that is the basis of our economic order has been building since at least the advent of the modern nation state, and its collapse would mean the end of life as we know it, forever, the collapse of every government and institution, maybe even nuclear “armageddon.”
So there’s no point in talking about “contain[ing] collateral damage”–a systemic collapse, one that shows Uncle Sam to be wearing no clothes, whether in October of 2008 or at any point in the foreseeable future, would mean the obliteration of 400 years of global accumulation and the collapse of every economic/political/social/cultural apparatus it has spawned. Collateral damage in this case is everything we can imagine, and quite possibly more even than that.
But What Do I Know…
A good point about government borrowing. I refer to that very point in the paragraph that begins: This guarantee shell game continues only because Uncle Sam has borrowing capacity to keep it going. That capacity derives not from balance sheet strength (again, no reserves) but from the dearth of investors’ options.
Borrowing (and printing) are not sustainable sources of government finance. Not when used to borrow to infinity. Japan is the perfect example. Sure they’ve been able to borrow tremendous sums for years, much of it at one point supported by quantitative easing, but they can’t borrow to infinity.
Everyone refers to their “lost decade,” but here we are nearly 20 years after their bust and their downward spiral is among the fastest in the developed world.
Borrowing in other words, only delayed the inevitable for them. The massive public debt they’ve accumulated is probably unpayable, and default (indirect via inflation) is probably inevitable.
Maybe we can expand our borrowing a little while longer, though I suspect for not more than a couple years max. But default is inevitable for us as well. The cleanest way to handle it would of course be to write off unpayable liabilities. They’re a fantasy anyway so it makes no sense to burden the system with them. The more we build up, the more we’ll have to write down, the more painful the correction.
DocG: I certainly agree that there’s likely little to be done. Government is doing everything it can to paper over the problem because we can’t handle the truth. It’s why I think government guarantees are so destructive; a collective way for all of us to bury our heads in sand, pretending there are these things called risk-free assets when of course no such asset could possibly exist…
The more we pile into them, the more unstable they become. The system works until a catalyst takes it down…
Detailed analysis of Enron’s trading strategies by the state of California’s grid operator:
Part 1: http://www.hks.harvard.edu/hepg/Papers/CAISO_enron.trading.analysis_10-4-02.pdf
Part 2:
http://www.hks.harvard.edu/hepg/Papers/CAISO_supp_enron.trading.analysis_6-03.pdf
Anonymous writes of the inevitable “obliteration of 400 years of global accumulation and the collapse of every economic/political/social/cultural apparatus it has spawned. Collateral damage in this case is everything we can imagine, and quite possibly more even than that.”
Quite a depressing prospect, indeed! But are there really NO alternatives?
Mr. Winkler: I’m glad you agree with me that there’s little to be done to rescue the old system. But, knowing what we now know, why would anyone WANT to rescue it? In other words, why are you not shouting for joy, rather than acting so gloomy? If you’re curious, some interesting alternatives are presented on the following blog: http://amoleintheground.blogspot.com/
Rolfe said: “Government is doing everything it can to paper over the problem because we can’t handle the truth”
First, thank you for the excellent post.
To be honest, I think we can handle the truth–if we couldn’t, why are we reading this blog? (and I think the non-readers can handle it, too).
The truth comes from deleveraging, letting the bondholders share the pain, and getting on with our lives in a new economic model not based on 3% GDP growth and excess debt accumulation every year.
I think it’s the government and the current financial “leaders” who can’t handle the truth.
What do you think the public would do if we started to wind-down Citi, BoA, and AIG? I tend to think we hunker down and get through it.
curlydan
Rolfe Winkler said “Everyone refers to their “lost decade,” but here we are nearly 20 years after their bust and their downward spiral is among the fastest in the developed world”
Damn good point – we need to start saying “Japan’s lost score”
Ashley’s post about Iceland leads to a scam software download. Please delete it. Don’t follow it.
Rolfe Winkler
Thanks for the comment. I don’t disagree with you that a government’s persistent creation of money to fill a budget gap is a bad idea, nor would I suggest that it is sustainable in the long run. My point is merely that we don’t know when things will finally come apart–do you have a sense of what could trigger it? To me it’s like having a big, dead tree next to your house–one day that suckers going to fall, and it will probably do it during a rainstorm or hurricane when conditions are worst. But it doesn’t have to happen for a long time. . .
Is it not interesting that one of the best business start-ups today would be a greenfield bank. Trivial funding costs and good yields on term Treasuries plus plenty of solid credits out there if you go look for them. In short, banks run as banks of old not as gamblers like so many of the present lot. And call James Stewart back to run it.
I would have to disagree that this is an excellent post. The logical conclusion here is not a Ponzi-like collapse but an expansion of the money supply, ie, monetary inflation. Since this will have the effect of lowering real (as opposed to nominal) wages and debts, it will lead to a new full-employment equilibrium. But at the end of the day American workers will be working for less and American savings will be a lot less than we thought. The whole society will be poorer. I think.
Rolfe,
Everyone refers to [Japan’s] “lost decade,” but here we are nearly 20 years after their bust and their downward spiral is among the fastest in the developed world.
I know what inflation looks like. It’s when gas prices went from 25 cents a gallon to one dollar while my hourly wage ($1.80 at the time) remained unchanged. As inflation got worse, I remember mortgage interest rates rising to something like 22% during the early Reagan years.
I’ll admit these are very simplistic examples. (Simplisticated, as Leo Gorcey would say.) But they’re how I understand inflation as an experience, rather than a concept.
But what does deflation look like? I expect that the value of my home will continue to decrease. Is that right? What about wages? Do they go down as well? Do subway fares go back to one dollar?
Finally, does deflation preclude the possibility of inflation, or even hyperinflation? That is, does the presence of one eliminate the possibility of the other?
Thanks, Rolfe, for a great post. And thanks in advance to all for the free education.
To answer But What Do I Know and Harlen Dad….
It’s hard to say what the unwind will look like. The deflationary catastrophe that government is trying to avoid is a worldwide systemic bank failure in which everyone’s bank accounts basically go to zero. You know the scene from It’s a Wonderful Life where everyone runs to the bank? Imagine that happening at virtually all banks worldwide simultaneously and you get an idea of how violent the unwind could be if not handled properly.
What worries me is that the policy being followed won’t actually prevent that outcome. Can Bernanke really manufacture inflation without destroying confidence in the dollar and the U.S. financial system?
If there’s a run on Treasuries because faith in them is lost then that’s all she wrote.
It would be better for government to let the economy contract, protecting its balance sheet and using whatever resources are left to cushion the blow. And I don’t mean infrastructure and education spending. I mean BASIC health care and making sure food is available on store shelves.
It appears our financial system is the equivalent of an elephant balancing itself on a marble. Not very sustainable.
I vote the next progression in the series will be a “tax haven” bubble.
If the G20 is against it, you can bet the markets are for it.
Rolfe at 5:34 pm wrote:
“You know the scene from It’s a Wonderful Life where everyone runs to the bank? Imagine that happening at virtually all banks worldwide simultaneously and you get an idea of how violent the unwind could be if not handled properly.”
Okay, now I’m really worried. Mostly because if such happens, it won’t be handled well. Mainly because when it does happen, the Administration will be caught flat-footed.
Did Japan experience this kind of bank run during their lost decade?
“Can Bernanke really manufacture inflation without destroying confidence in the dollar and the U.S. financial system?”
I doubt it. But this would suggest, per my original question, that Deflation and Inflation are not mutually exclusive.