30 Dec 2009

Bill and I Don’t See Eye to Eye on Estate Taxes

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Check out this comment from “Bill” when Alex Tabarrok discussed estate taxes:

Having been the surprising beneficiary of an uncle’s demise, I can assure you that estate taxes, or rather the absence of them, are quite a surprising windfall.

You see, my uncle never paid taxes. He did all he could ever do to defer taxes, buying equipment when he didn’t need to, just tons of stuff. I mean tons of stuff, all for the purpose of avoiding taxes.

So, when he died, and I along with some cousins inherited his estate, I thought, well, at least my uncle’s estate finally paid taxes.

Nope. No estate taxes. No capital gains. Nada. When the tax lawyer told me I couldn’t believe it.

My uncle is probably laughing from the grave, but I’m wondering: how did we ever let people escape paying taxes? We probably got some chumps to repeat the slogan death taxes long enough so they were mesmerized into submission. Thank you for your generousity. Now, let’s talk about the deficit.

30 Dec 2009

Regrets, I’ve Had a Few…

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I made a joke comment at MarginalRevolution, and then another commenter wanted me to elaborate, so I did:

What I meant was, when I was reading Black’s collection of essays, and hit the one on interest rates as an option, I made an intuitive connection between the major project I was grappling with at the time. Namely, I was trying to enter the finance world as an economist with a dissertation in capital theory, and so I was trying to come up with a paper where I linked up standard finance papers explaining interest rates as random walks or whatever, with standard GE econ models explaining interest rates as the marginal product of capital. I thought I could provide more constraints on how interest rates evolved over time, by bringing in “knowledge” from macro econ models.

So anyway Black’s approach to interest rates clicked with me and made me think I was on the right track, but then I got a job offer and it’s 4 years later and I can’t really remember what my brilliant insight was. :(

30 Dec 2009

A Quick Note on Recapitalization

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In November of 2008 I had a long phone conversation with the impregnable von Pepe, which clarified the typical discussions of the financial crisis in light of my hazy knowledge of accounting. In fact I was so energized after the call that I set out to do a whole series of blog posts sharing my newfound understanding.

Well that never happened. But I had another talk with von Pepe tonight and something really clicked, so I thought I would share it verbally (i.e. without coming up with a hypothetical balance sheet to illustrate the idea) while it’s still fresh.

One last point before we dive in: I am going out of my way to “not get it” in the analysis below. Before my talk with von Pepe, it’s not that I doubted the conventional wisdom on these matters, but I just had my doubts and wasn’t sure how to dispel them.


Here’s the context: After the crisis, you heard many commentators say things like, “The banks took huge hits on their holdings of mortgage-backed securities and standard loans. After writing down their assets, they have very little equity remaining. They need to issue more stock to recapitalize themselves.”

Now here were two vague concerns I had with this type of statement:

(1) Why did the firms need to attract new capital through the issuance of stock? If they needed to raise money, couldn’t they just issue more bonds? But then that wouldn’t be a recapitalization, it would be borrowing.

(2) If these firms were on the ropes because of their huge losses, how does that get magically fixed by pumping in more capital? Or to put it another way, why would investors want to buy shares in a company on the verge of bankruptcy? To put it a third way, if the company is solid and outside investors are willing to pump in more money, then who cares if they currently only have a razor-thin margin of shareholders’ equity? What’s a billion here or there in extra losses on MBS holdings if the underlying firm is solid?

The answer to all of the above turns out to be really elementary, but for some reason it didn’t click with me until my phone call tonight. So here it is: When a corporation issues more debt, it is taking on fixed liabilities (to make periodic interest payments and eventually return the principal). If the corporation does really well and has high earnings, then it pays off the bondholders the contractual amount and keeps the rest. On the other hand, if the firm loses money, it still owes the bondholders.

In contrast, if the corporation issues new shares of stock, it isn’t committing itself to future payments. If times are bad, nothing happens. If times are good, however, then the pool of available earnings to be distributed as dividend payments must be spread over a larger number of shares.

So if we’re looking at a financial institution that took huge writedowns on its loan portfolio and holdings of MBS, such that there is only $1 billion in shareholders’ equity compared to (say) $100 billion in outstanding debt, then that firm is incredibly leveraged. If things go smoothly and no further writedowns occur, then it will slowly climb out of its hole and the shareholders will make a killing.

However, if they lose just 1% in the value of their assets, that could wipe them out and they would have to declare bankruptcy. I.e. their liabilities would exceed their remaining assets.

So rather than remain in such a precarious position, the corporation can issue new stock and spread the potential gains and losses among a broader base of capital. If the corporation does well, it dilutes the return to the original shareholders. On the other hand, if things go poorly, the original shareholders aren’t wiped out. In essence they’ve brought in others to reduce both the expected return and its variance.

30 Dec 2009

Is the Fed Monetizing the Debt?

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Some of us have been surprised at how low the yields on Treasury debt continue to remain, despite the government’s explicit and implicit promises of future deficits. Given all the shenanigans, I have suspected that somehow the Federal Reserve has been buying much more of the Treasury’s bonds than we are being told.

In this context I read with great interest a recent analysis from Zerohedge [.pdf] that claims the government’s own figures show that huge amounts of new Treasury debt has fallen into an accounting black hole:

So who really picked up the tab? To our surprise, the only group to actually substantially increase their purchases in 2009 is defined in the Federal Reserve Flow of Funds Report as the “Household Sector”. This category of buyers bought $15 billion worth of treasuries in 2008, but by Q3 2009 had purchased a whopping $528.7 billion worth. At the end of Q3 this Household Sector category now owns more treasuries than the Federal Reserve itself.

So to summarize, the majority buyers of Treasury securities in 2009 were:
1. Foreign and International buyers who purchased $697.5 billion.
2. The Federal Reserve who bought $286 billion.
3. The Household Sector who bought $528 billion to Q3 – which puts them on track [to] purchase $704 billion for fiscal 2009.

These three buying groups represent the lion’s share of the $1.885 trillion of debt that was issued by the US in fiscal 2009.

We must admit that we were surprised to discover that “Households” had bought so many Treasuries in 2009. They bought 35 times more government debt than they did in 2008. Given the financial condition of the average household in 2009, this makes little sense to us. With unemployment and foreclosures skyrocketing, who could afford to increase treasury investments to such a large degree? For our more discerning readers, this enormous “Household” investment was made outside of Money Market Funds, Mutual Funds, ETF’s, Life Insurance Companies, Pension and Retirement funds and Closed-End Funds, which are all separate reporting categories.

So that’s rather odd, right? But then you read this and start to get queasy:

This leaves a very important question – who makes up this Household Sector? Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can’t be slotted into the other group headings. For most categories of financial assets and liabilities, the values for the Household Sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the Household Sector. To quote directly from the Flow of Funds Guide, “For example, the amounts of Treasury securities held by all other sectors, obtained from asset data reported by the companies or institutions themselves, are subtracted from total Treasury securities outstanding, obtained from the Monthly Treasury Statement of Receipts and Outlays of the United States Government and the balance is assigned to the household sector.”…So to answer the question – who is the Household Sector? They are a PHANTOM. They don’t exist. They merely serve to balance the ledger in the Federal Reserve’s Flow of Funds report.

Now it’s true–as Robert Wenzel says in his pooh-poohing of this report–that the terminology is inaccurate. For one thing, it’s not really clear that this would be a Ponzi scheme, and for another, the Household sector obviously exists. Also, I had trouble following their argument, because they kept switching between fiscal and calendar years, and I wasn’t sure that they themselves were keeping the distinction straight.

Even so, I think Wenzel is quibbling over the authors’ use of headline grabbing vocabulary, when their underlying analysis (assuming it is accurate) is quite startling. It’s true that we might expect households to load up on Treasurys because of the crisis, but wouldn’t you expect them to do so through MMFs, Mutual Funds, ETFs, etc.?

Wenzel also says this: “In short, the Fed has been conducting business as usual, printing money, aka counterfeiting. It is highly unlikely they have attempted to cook the books when they have willingly reported the trillions in reserves they have otherwise pumped into the system. It makes no sense.”

Of course Wenzel is right in the grand scheme of things, but I think he is being a bit too glib here. Even the average investor, who doesn’t even know how a gold standard works and thinks money is supposed to be pieces of paper, understands the danger in the Fed “monetizing the debt.” Up till now, the Fed officially says that its purchases of Treasury debt are only to achieve its goals of monetary policy.

But if the average investor starts to think that the Fed is buying more Treasury debt because Obama needs to run a bigger deficit, then the fat lady needs to warm up her voice. At that point, even the dullest of financial analysts will realize, “Wait a minute, they’re just printing up new dollars to pay their bills! Prices will surely rise.”

Last point: The Zerohedge report says that in 2Q 2009, the Fed (through its “quantitative easing”) purchased 48% of the new Treasury debt issued! I hadn’t realized it was so high.

Eh, maybe Wenzel is right: If worldwide investors can see what’s right in front of their faces and not bat an eye, maybe the Fed has no reason to hide anything. Bernanke could say, “My parametric estimation leads me to conclude that a sustained yet modest recapitalization of my personal checking account by $1.8 million per week will be vital to achieving the Federal Reserve’s dual mandate of vibrant economic growth and low price inflation.”

29 Dec 2009

Thomas Schelling: Nuclear Weapons Are Like the Log-Plume Ride…

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…the anticipation is scarier than the realization (HT2MR):

In summary, a “world without nuclear weapons” would be a world in which the United States, Russia, Israel, China, and half a dozen or a dozen other countries would have hair-trigger mobilization plans to rebuild nuclear weapons and mobilize or commandeer delivery systems, and would have prepared targets to preempt other nations’ nuclear facilities, all in a high-alert status, with practice drills and secure emergency communications. Every crisis would be a nuclear crisis, any war could become a nuclear war. The urge to preempt would dominate; whoever gets the first few weapons will coerce or preempt. It would be a nervous world.

Now before you lecture me on unstable equilibria in the comments, please realize I am objecting not to Schelling’s overall conclusion–that the desire to ban nuclear weapons overlooks many strategic considerations–but rather I am pointing out that the particular argument above is silly.

29 Dec 2009

Bernanke Will Be Revered By Future Fed Chairs

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Afraid to ask Congress* last year for the authority to issue the Fed’s own debt to the public, Bernanke decides it’s better to seek forgiveness than ask permission:

The U.S. Federal Reserve on Monday pressed ahead toward the creation of a new mechanism it says could be used to withdraw money from the banking system once policymakers decide to tighten monetary policy.

The program, called the term deposit facility, would allow financial institutions to earn interest on loans of longer maturities to the central bank. The Fed already pays interest on banks’ overnight reserves.

“Term deposits would be one of several tools that the Federal Reserve could employ to drain reserves to support the effective implementation of monetary policy,” the Fed said in a statement that was the Fed’s first detailed proposal for the new facility.

Rates on term loans, whose maturity would likely range between one and six months and would not exceed a year, could be determined via competitive bidding at auction, the Fed said. They would be available only to financial institutions eligible for federal deposit insurance, not the general public. Once lent to the central bank, the money cannot be withdrawn.

Excess Problem

In its effort to battle the worst financial crisis since the Great Depression, the Fed has deployed an extraordinary array of emergency measures, leading to a surge in outstanding credit to the banking system to more than $2.2 trillion.

The amount of money sloshing around has fueled concern about the possibility of high inflation. Withdrawing the reserves at just the right time is seen as crucial to keep consumer prices under wraps.

“They have a big problem with excess reserves and this is one of the ways to deal with it,” said Raymond Remy, head of fixed-income at Daiwa Securities.

At the height of last year’s financial meltdown, the Fed had been discussing going to Congress to request the authority to issue its own bills. The term deposit facility achieves a similar purpose, but can be undertaken within the Fed’s existing authority and does not require congressional approval.

“This is more of a politically acceptable way of getting the same thing done,” said Tom Simons, money market economist at Jefferies.

Those readers who have read my opinion on the “tool” of paying interest on overnight reserves can probably guess what I think of this: At best it simply pushes back the problem, and only for six months to a year. Really, this isn’t too hard, and I am astounded that nobody says this except in non-mainstream articles or in comments on official news stories. How in the world is it a “tool to drain liquidity,” to implement a strategy that results in more reserves in a few months’ time? I mean, that would be as crazy and Orwellian as the president of the United States calling for fiscal responsibility while he runs up the biggest budget deficit in histor–oh wait.

More serious, Bernanke is doing what all good political leaders do, in that he is exploiting a crisis to expand the powers of his organization. At the very least, this gives the Fed more options, similar to an individual getting a huge new line of credit. But someone (maybe one of the GMU bloggers?) said something like, “If I have a printing press, why do I want the ability to borrow money?” and I confess I am perplexed by this move as well. For all I know, this really is just a pointless accounting gimmick that Bernanke wants the bloggers to focus on this week, while he somehow takes assets away from Freddie and Fannie behind the scenes.

* At least, that was my recollection–that the Fed discussed the plan to issue its own debt, but never actually approached Congress and formally asked for this power. Please correct me someone if I’m wrong.

28 Dec 2009

John Cassidy Fails in His Critique of Markets

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I explain at Mises today:

While driving my son to school one morning, I heard a National Public Radio interview with John Cassidy, author of the new book How Markets Fail. Fortunately, we got to the front of the line before Cassidy let out the zingers. A few minutes earlier, and my son would have seen Daddy lose his temper.

Cassidy first caricatures the case for free markets, then tries to demonstrate the hypocrisy of a “free-market” financial bailout. Yet his arguments obviously don’t bear on whether markets fail or need government supervision. Indeed, Cassidy himself acknowledges that what happened at the end of the Bush administration was anything but the free market.

28 Dec 2009

How the Fed’s Massive MBS Purchases Harm Banks

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Editor’s Note: I asked “Mike in Alaska” to expand some of his intriguing blog comments into a full-length article. Note that I have added the underlining below, not the author. –RPM

How the Fed’s Massive Purchase of Mortgage-Backed Securities
Plays a Role in Harming Banks and the Overall Financial System:
A small town community bank perspective.
By Michael J. Dunton

Creation of Excess Reserves Earning 0.25%

Let me explain to the average reader what excess reserves mean in a context of a small community bank. Each day a young lady from my staff would come into my office and show me where we were at, in cash (paper and electronic), from the day’s course of business. I always had to know what time it was in the morning so as to be ready for her visit between 11:30 and Noon—I sometimes could be in a meeting in the building, or could be somewhere about town. If we needed cash, I would call up the Federal Home Loan Bank that we belonged to and borrow overnight funds—or I could borrow for 30, 60, 90, 12, 180, or 360 days if the rate was too good to pass up. We could even borrow on a term facility for up to 30 years, but going out that long on the yield curve, whether borrow or lending, is a bit dramatic for me. The same goes if we had excess cash: I could lend it out overnight, or buy a CD of varying maturities and rates.

That was then.

Fast forward to now and we get the situation where we haven’t had to borrow for daily liquidity for so long that I have forgotten the Federal Home Loan Bank’s phone number and our bank’s account number (don’t worry, I have it written down). We are swimming in excess cash. We see this as a result of several events: first, mortgage-backed securities we hold have been paying off at a faster speed due to the Federal Reserve’s purchase of MBS in the market; second, our loan demand is down—our loan balances are about 5% lower than normal; third, other bonds’ yields are being dragged down and issuers are calling the higher yielding securities and reissuing new bonds at lower yields; lastly, our customers are holding higher cash balances. I now needn’t worry if I have to borrow for my daily liquidity on any given day for the foreseeable future—I just need to worry how to stay in business with $15 million stuck earning 0.25% and flat to decreasing loan demand for the next year.

Let’s explore why the Fed has been affecting excess reserves by way of buying up mortgage-backed securities. The Fed is trying to stimulate the economy, help homeowners, and buoy the banks by re-inflating the housing asset bubble. Most mortgages are rolled up into securities (MBS) and sold to investors. We’ve written, through November, $126 million in mortgages versus $58 million last year. We’ve only kept on our books about $28 million in mortgages. Most of our mortgages are sold to Fannie, who then rolls them into large pools of MBS. Regular banks (the big boys), in the past, have done the same thing as Fannie and Freddie and rolled their mortgages into private-label MBS. As I will discuss later, Fannie and Freddie pretty much control the mortgage landscape right now and other players are living off the crumbs.

Depressed Yields and More Risk for Banks

Most MBS are good, but enough of the bad ones went south to affect the entire economy and paralyze the banking system. The Federal Reserve stepped in and bought up enough MBS so as to push mortgage rates down to bring buyers back into the market and prop up housing values. No one outside the Fed is certain what specific MBS were bought and from whom, but it was enough to pretty much control the pricing of all new mortgages. New mortgages were written up as refis and for new purchases. Now when those old loans were paid off at the new closing, the MBS that were connected to those old loans were quickly paid down, if not paid off entirely. That means those older, higher-yielding MBS that banks and other investors were holding gradually disappeared during this time—those MBS were paying a lot higher yield than the new MBS that took their place. Banks investments in MBS now earn less and if we want to replace the yield, on a one to one basis, we have to go out longer on the yield curve and accept more risk.

Let me now try to further explain why the Fed buying up these mortgage-backed securities is harmful to the economy and to banks in particular. When the Fed buys a bunch of MBS, it is overpaying for them—its like a rich guy early in an auction putting a ridiculously high bid on an valuable item that pretty much ends the bidding. This makes the yield on the MBS go down—it forces the mortgage market to offer 30 year mortgages between 4.5 to 5%. Now, no one in the mortgage market likes depressed prices like that for a 30 year income stream, but Fannie and Freddie were there to catch all that action. Don’t get me wrong, we made money doing the dirty work for Fannie and Freddie by originating and servicing the loan, but the risk is all on Fannie and Freddie right now. For the most part, they are the market for the foreseeable future. There are other institutions out there doing the same thing, but the real action is all Fannie and Freddie. Now Fannie and Freddie can push off any screwball regulation and fees on us with impunity. Each new rule and regulation costs a bank to implement through training and changes in systems. So now we’re getting increasingly pinched on the origination side of our business by Fannie and Freddie, which was made possible by the Fed’s involvement in buying up MBS.

Distorted Prices

Finally, the Fed’s foray into the mortgage market, by buying up MBS, has distorted true market prices for mortgage products, both in terms of revenue and costs. As it stands right now, the mortgage market is entirely dependent upon the federal government (the Fed, Fannie/Freddie, and the rest of the DC klunks). We essentially have people running the market, those pulling the strings from above, who derive the livelihood not from their financial performance, but from their position in government. Because banks, especially community banks, derive a large source of their income through mortgage activities, they will be forced to take what the government determines is right. There’s simply no viable alternative to the federal government’s heavy handed tactics in the mortgage market. The average homeowner may think he is getting an absolute steal by getting a sub 5% 30-year mortgage, but as a taxpayer he will receive a bargain he had not planned for. With virtually no private capital alternative to challenge Fannie and Freddie, the distortion will continue and true market prices will be an afterthought.


The Fed’s actions to help the economy by helping homeowners and banks through purchases of mortgage-backed securities is riddled with hidden costs and unintended consequences. Although mortgages have become cheap and commoditized, banks are earning less from their investments in MBS and direct holding of mortgages. Excessive purchases of MBS, by the Fed, have increased banks’ excess reserves while decreasing mortgage loan pricing. These extra reserves now sit at the Fed earning a paltry 0.25%. Furthermore, the mortgage market is almost entirely dependent on the federal government and this has created distortions in price and its correspondent risks. Finally, if the Fed and the rest of the Washington apparatchik decided to get out of the mortgage business, or play a diminished role, then it would do so with the risk of the housing bubble deflating, due to greatly increased mortgage costs to consumers and further weakening banks by collateral values plummeting.

Michael J. Dunton is a SVP at a community bank in Alaska.