It has been recognized for well over a century that the central bank must intervene as “lender of last resort” in a crisis. In the 1870s Walter Bagehot explained this as a policy of stopping a run on banks by lending without limit, against good collateral, at a penalty interest rate. This would allow the banks to cover withdrawals so the run would stop.

Once deposit insurance was added to the assurance of emergency lending, runs on demand deposits virtually disappeared. However, banks have increasingly financed their positions in assets by issuing a combination of uninsured deposits plus very short-term nondeposit liabilities (such as commercial paper). Hence, the GFC actually began as a run on these nondeposit liabilities, which were largely held by other financial institutions.

And here is where the issue gets complicated. As I argued in a previous blog post, banks and other institutions relied largely on “rolling over” short-term liabilities (often, overnight). But when reports about the quality of bank assets began to surface as subprime mortgage delinquencies rose, financial institutions began to worry about the solvency of the issuers of the liabilities. As markets came to recognize what had been going on in the securitization market for the past half-decade, “liquidity” dried up—no one wanted to hold uninsured liabilities of financial institutions.

In truth, it was not simply a liquidity crisis but rather a solvency crisis brought on by all the risky and fraudulent practices.

Not only did all “finance” disappear, but there was also no market for the trashy assets—so there was no way that banks could sell assets to cover “withdrawals” (again, these were not normal withdrawals by depositors but rather a demand by creditors to be paid). As markets turned against one institution after another, financial institution stock prices collapsed, margin calls were made, and credit ratings agencies downgraded securities and other assets. The big banks began to fail.

Government response to a failing, insolvent, bank is supposed to be much different than its response to a liquidity crisis. It has always been the standard view—dating all the way back to Bagehot—that lender of last resort does not apply to an insolvent institution. Indeed, since 1991 the Fed has been prohibited from lending to “critically undercapitalized” institutions without first obtaining explicit prior approval of the Secretary of the Treasury. And no matter what the Fed officials or the banksters claim, the big banks were “critically undercapitalized”, and the Fed did lend to insolvent banks—against the 1991 statute that was enacted precisely to prevent the Fed from avoiding the fiscal discipline of congressional appropriations. (Walker Todd 1997) I’ll have more to say about that in a later blog. But let’s turn to other problems with the bailout. continue reading…

(cross posted at EconoMonitor)

Yves Smith at Naked Capitalism has long been skeptical of the negotiations by the State Attorneys General and the banksters over the foreclosure frauds (see here). And while I had held out some hope that California and New York would either refuse to join, or would insist on good terms, today’s announcement of the settlement makes it clear that the banksters had their way. I expect that the US Attorney General, Eric Holder and HUD Secretary Shaun Donovan played important roles in making sure the bank frauds would only get little slaps on the wrist.

Some of the details are not clear, but apparently the 750,000 people who had their homes stolen from them will get a mere $2000 a piece in compensation. That is how this Administration values homeownership. Yep, a bankster can take your home and you might get two thousand bucks–and with that you can pay first and last month’s rent on a cheap, run-down apartment if you are willing to live in a low rent city.

It also gives you some idea of the cost of buying out 49 states: $2.75 billion. Yep, that is all that the states get out of this settlement. They’ll look the other way and let you move in, completely destroy property records and proceed to steal the homes of your citizens while destroying your economy and tax revenues–and for under 3 billion measly dollars you can buy off their chief prosecutors.

What about underwater borrowers? Well after crashing the real estate markets, the worst of the banksters have agreed to provide $3 billion for relief. How far underwater are homeowners? $700 billion. So far. continue reading…

Dimitri Papadimitriou and Randall Wray deliver a second installment of their joint assessment of the risks that a renewed global financial crisis might be triggered by events in Europe or the United States.  In their latest one-pager they move past disputes over etiology and lay out their solutions for both sides of the pond:  addressing the basic flaws in the setup of the European Monetary Union (“the EMU is like a United States without a Treasury or a fully functioning Federal Reserve”) and outlining how to place the US financial system and “real” economy on more solid foundations.

Read the newest one-pager here.

Their first one-pager focused on the reasons it is unhelpful to label the turbulence in Europe a “sovereign debt crisis.”  This way of framing the situation obscures more than it enlightens.  To recap:  prior to the crisis only a couple of countries had debt ratios that significantly exceeded Maastricht limits.  For most, the economic crisis was the cause of rising public debt ratios, rather than the other way round.  What we really need to look at, Papadimitriou and Wray suggest, are private debt ratios and current account imbalances within the eurozone.  And as for current public insolvency concerns, this has far more to do with the flaws in the institutional setup of the European Monetary Union than the particular size of a country’s debt ratio:  countries that control their own currencies aren’t experiencing comparable difficulties.

(For a more detailed investigation, Papadimitriou and Wray will be releasing a new public policy brief:  “Fiddling in Euroland as the Global Meltdown Nears.”)

Michael Hudson is giving a talk titled “The Road to Debt Deflation, Debt Peonage, and Neofeudalism” at the Levy Institute on Friday, February 10 at 2:00 p.m.

Hudson is a research associate at the Levy Institute and a financial analyst and president of the Institute for the Study of Long Term Economic Trends. He is distinguished research professor of economics at the University of Missouri–Kansas City and an honorary professor of economics at Huazhong University of Science and Technology, Wuhan, China.

The abstract for the presentation is below the fold. continue reading…

In his General Theory, J.M. Keynes argued that substandard growth, financial instability, and unemployment are caused by the fetish for liquidity. The desire for a liquid position is anti-social because there is no such thing as liquidity in the aggregate. The stock market makes ownership liquid for the individual “investor” but since all the equities must be held by someone, my decision to sell-out depends on your willingness to buy-in.

I can recall about 15 years ago when the data on the financial sector’s indebtedness began to show growth much faster than GDP, reading about 125% of national income by 2006—on a scale similar to nonfinancial private sector indebtedness (households plus nonfinancial sector firms). I must admit I focused on the latter while dismissing the leveraging in the financial sector. After all, that all nets to zero: it is just one financial institution owing another. Who cares?

Well, with the benefit of twenty-twenty hindsight, we all should have cared. Big time. There were many causes of the Global Financial Collapse that began in late 2007: rising inequality and stagnant wages, a real estate and commodities bubble, household indebtedness, and what Hyman Minsky called the rise of “money manager capitalism”. All of these matter—and I think Minsky’s analysis is by far the most cogent. Indeed, the financial layering and leveraging that helped to increase the financial sector’s indebtedness, as well as its share of value added and of corporate profits, is one element of Minsky’s focus on money managers. I don’t want to go into all of that right now. What I want to do instead is to focus quite narrowly on liquidity in the financial sector.

So here’s the deal. What happened is that the financial sector taken as a whole moved into extremely short-term finance of positions in assets. This is a huge topic and is related to the transformation of investment banking partnerships that had a long-term interest in the well-being of their clients to publicly-held, pump-and-dump enterprises whose only interest was the well-being of top management.

It also is related to the rise of shadow banks that appeared to offer deposit-like liabilities but without the protection of FDIC. And it is related to the Greenspan “put” and the Bernanke “great moderation” that appeared to guarantee that all financial practices—no matter how crazily risky—would be backstopped by Uncle Sam.

And it is related to very low overnight interest rate targets by the Fed (through to 2004) that made short-term finance extremely cheap relative to longer-term finance.

All of this encouraged financial institutions to rely on insanely short short-term finance.  Read the rest here.

Speaking of too big to fail, a petition organized by Public Citizen has been sent to the Federal Reserve and Financial Stability Oversight Council (FSOC) calling for the break up of Bank of America.  The petition identifies BofA, given its size and fragility, as a threat to the US financial system.  It cites a recent NYU study that ranks the financial institution as posing the greatest systemic risk among US firms, based on capital shortfall.  Public Citizen also argues that Bank of America is simply too large and too interconnected to be regulated effectively.

Micah Hauptman explains that the break up and reorganization could be carried out under the authority given to the Fed and FSOC under section 121 of the Dodd-Frank Act (if a financial institution is determined to pose a “grave threat”).  The petition argues that taking action now under section 121 is preferable to attempting an orderly liquidation in the midst of a crisis:

If the Agencies do not use section 121 in advance of financial distress at a firm that poses a grave threat to U.S. financial stability, they risk undermining other critical Dodd-Frank Act provisions. Many Dodd-Frank Act provisions related to systemic risk would be far easier to implement if systemically important institutions were smaller and less complex. One of the most critical is the orderly liquidation authority in Title II.

If a large, systemically dangerous institution such as Bank of America were to fail, regulators would have only one course of action—to attempt orderly liquidation. To permit the institution to fail without intervening would result in financial disaster; to bail it out would sharply contradict the Dodd-Frank Act’s express policy of “protect[ing] the American taxpayer by ending bailouts.” But the Dodd-Frank Act’s orderly liquidation procedures are untested and could prove difficult to implement in practice, particularly with respect to the largest and most complex institutions such as Bank of America.

One potential problem with the orderly liquidation authority is that U.S. officials lack jurisdiction over extraterritorial entities and therefore may be unable to put globally significant institutions through resolution. Currently, there are no existing international agreements regarding the resolution of a domestic institution’s entities that operate in foreign countries. Without such agreements in advance, regulators would need to try to reach agreements, potentially requiring changes in the laws of multiple countries, in the midst of a crisis.

You can read the petition here and a related letter, signed by economists, legal scholars, and various public interest groups, here.

The Financial Times has been running a series for some time on “Capitalism in Crisis.” In yesterday’s paper Martin Wolf provided a summary of the discussion and proposed “Seven ways to fix the system’s flaws.” The first and most important task, he notes, is to manage macro instability. In this regard, he pays homage to the late Hyman Minsky and notes that

… his masterpiece, Stabilizing an Unstable Economy, provided incomparably the best account of why this theory (of a stable capitalist economy) is wrong. Periods of stability and prosperity sow the seeds of their downfall. The leveraging of returns, principally by borrowing, is then viewed as a certain route to wealth. Those engaged in the financial system create – and profit greatly from – such leverage. When people underestimate perils, as they do in good times, leverage explodes.

What is the answer to macro instability? According to Martin Wolf, the first answer is to recognize that crisis is inherent in free-market capitalism. Second, macroprudential policies matter, including restrictions on leverage and better capital buffers in banks. And finally, governments, including central banks, have a role to play in stabilizing the economy after a crisis.

As for the financial system, Wolf wants “to protect finance from the economy and the economy from finance” by building bigger shock absorbers in the form of better capital buffers and less leverage. There should be no more “too big to fail.”

Wolf notes at the end of his article the close links between wealth and politics, but his suggestion to partially fund political parties and elections will not solve this problem, even though it may represent a good start. The crisis has shown that the links between finance and politics are deeply entrenched both in the US and Europe, and unless deep structural reforms are enforced, the problem of TBTF is not likely to go away.

The increased recognition of Minsky’s outstanding theories is indeed welcome, especially by Martin Wolf (who also has become somewhat of a Godley follower in his analysis of the current global crisis). But whereas his diagnosis of the global financial crisis is largely in line with Minsky’s financial instability hypothesis, his policy advice falls short of what Minsky would have prescribed. continue reading…

I previously summarized research that two of my graduate students, James Felkerson and Nicola Matthews, are conducting on the Fed’s bailout. Using data that the Fed was forced to release, they demonstrated that the cumulative total lent and spent on assets by the Fed was over $29 trillion. (See the first paper here: http://www.levyinstitute.org/publications/?docid=1462) Their estimate was larger than previously reported because others have focused on loans, and in some cases, guarantees, outstanding at a point in time. The Fed’s own estimate is $1.5 trillion (loans outstanding), while Bloomberg’s number was $7.7 trillion (including commitments that were promised but never used).

To be sure, using methodology similar to that of Felkerson and Matthews, the GAO had obtained an estimate of $26 trillion for the cumulative total. The value added of our research is the detail provided—how much lending was provided in each facility, how many assets did the Fed buy through each facility, and who were the major users of each facility—and how much did they get.  In coming weeks and months we will release a lot more analysis of this data.

Our figure of $29 trillion made headlines, and attracted a fair amount of commentary. Although we were very clear in our presentation, casual readers as well as many reporters from the media wrongly interpreted our results as a measure of the Fed’s exposure to risk. Chairman Bernanke’s memo emphasized that the Fed’s total exposure never exceeded more than $1.5 trillion—and since there is no way that it ever would have realized anything close to 100% loss on its loans, the real risk of loss was only a tiny fraction of that. Further, he (rightly) asserted that most of the loans were repaid, indeed, most of the special lending facilities have been closed.

To be sure, the total amount of loans still outstanding as of November 2011 was just under $1 trillion. In recent weeks the Fed has renewed its lending to foreign central banks (in “swaps”), so outstanding loans have climbed a bit. But the Fed and its defenders are correct: Fed maximum exposure to losses would likely be measured in tens of billions of dollars—maybe hundreds of billions, but most certainly not trillions.

So, should anyone care? Yes. continue reading…

J. Andrew Felkerson writes at AlterNet about the study he authored detailing the Federal Reserve’s bailout of financial institutions over the course of the latest crisis.  He explains some of the reasoning behind his study’s methodology, particularly with respect to his use of a cumulative measure of loans and asset purchases (the other two measures he uses involve the peak amount outstanding at a moment in time and peak weekly amounts):

Perhaps the largest difference in our analysis is that we learned our money and banking theory from the late Hyman Minsky. He taught us that the modern economy is essentially financial, and as such, is prone to systemic financial crises that if left unchecked can lead to “bone crunching depressions.” Therefore it is essential to have a LOLR. Thus, any transaction between the Fed and the markets which is not part of conventional monetary operations, such as lending from the discount window or open market operations, represents an instance in which private markets were not able to or were unwilling to engage in the normal financial intermediation process. If it any point in time the private markets were capable (or willing) to carry out business as usual, Fed intervention would not have been required. Thus, we need to account for each extraordinary event, and the best way that we know to do this is by summing each instance–which results in a cumulative total of over $29 trillion dollars.

Read the rest here.

Randall Wray has a new one-pager following up on the release of a report detailing and tallying up the Federal Reserve’s extraordinary efforts to prop up the banking system—a report with the rather eye-catching headline number of $29.6 trillion.  The Levy Institute working paper, the first in a series, is part of a Ford Foundation-supported project undertaken by James Felkerson and Nicola Matthews under Wray’s direction.

In the one-pager, Wray explains the methodology and justification behind the report’s presentation of the raw data that was released (after some persuasion) by the Fed.  As an example, he runs through the numbers for just one facility, the Primary Dealer Credit Facility (PDCF) created in March 2008, and explains the three different measures compiled by the report.  First, they present the peak outstanding commitment (loans and asset purchases) at a point in time ($150 billion); then the peak flow of commitments over a week ($700 billion); and finally, the cumulative total over the life of the facility ($9 trillion).  Again, this is all for one facility (PDCF).

What’s the point of all these numbers?  Wray explains:

Take your pick: the appropriate number chosen depends on the question asked. The smallest number answers the question, What was the Fed’s peak exposure to losses (assuming the Fed would let the institutions fail without extending even more credit to them)? The middle number indicates how much it took to meet liquidity demands during the worst week of the crisis, from the point of view of the dealers. And the biggest number tells us how much the Fed had to intervene over the life of the facility in order to settle markets.

Read Wray’s one-pager here.

Reading through the report, one can’t help but be struck by the contrast between the Fed’s fierce and, let’s say, imaginative approach to the banking crisis and the institution’s comparatively tame, chin-stroking acceptance of the needless waste of human potential represented by near-9 percent unemployment.