What if there is another way? A better one

There is not a day that goes by without finding out some information that brings to the forefront the bond created between the banking sector and the state. The latest such information was provided by Bloomberg showing that in 2008 US banks borrowed 13 billion USD to survive. This was secret information until made public Bloomberg after a lengthy legal battle.

Now, the information is interpreted in various ways. The most prevailing one is saying that this is how a lender of last resort should act and should be a lesson to the ECB. I beg to differ.

I already wrote that lender of last resort does not mean bailout. But if my word does not carry any weight (I know it does not but this is a pretty good way to introduce a point) then maybe the words of Mervyn King the governor of the Bank of England do.

This is what he say about the lender of last resort:

“This phrase ‘lender of last resort’ has been bandied around by people who it seems to me have no idea what lender of last resort actually means, to be perfectly honest. It is very clear, from the origin, that lender of last resort by a central bank is intended to be lending to individual banking institutions, and to institutions which are clearly regarded as solvent. And it’s done against good collateral and at a penalty rate…That is a million miles away from the ECB buying sovereign debt of national countries which is used and seen as a mechanism for financing the current account deficit of those countries, which inevitably – if things go wrong – will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. And that’s why the European Central Bank feels, I think – and with total justification – that it’s not the job of a central bank to do something which a government could perfectly well do itself, but doesn’t particularly want to admit to doing. …I think it’s very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. ”

Of course, there will be an entire discussion about what a solvent bank which I do not want to get into here. To me things were very simple then as they are now: the banking sector in its current form has failed.

I hope that the central bankers asked themselves if:

– saving a banking sector with public money is the socially superior solution. In this way they had to consider the opportunity costs  which means that they had to  consider alternative destinations in the economy of those funds and their value to the society.

-saving the failing banking sector does a favor to future generations. Maybe it would have been better to allow this system to fail and this way a new system would have emerged. Actually, I think this will happen anyway but the actions of central banks in 2008 just delayed a bit the inevitable.

From their actions is not clear that central bankers considered the interests of the whole society. In fact the first results are seen today. To me the actions of central banks as agents of the state have created a monster. A bond that is not in the interest of the society.

In my view, banking sector in its current form was bankrupt in 2008. At the core the banking sector made a series of bad bets and poor investments which did not pay back. But it was not let to take its “stop-loss” to use a favorite term of traders when closing a losing position. It was given another chance but not in a transparent way. So investors still believed that they bought a share of company that was bankrupt. For all the talk of hot shot investors and gurus and successful managers none has seen that investing in bank was no different than investing in a loss making state-owned company which was kept alive via subsidies. If any of the gurus would have been asked if they would have ever considered investing in such a state company the answer would have been no. There is also the other possibility that they knew. Some already had shares and welcomed the intervention and some just bought shares because they knew the intervention was imminent. No matter how you slice it there is something very foul here. I for one cannot find the value to the rest of the society.

Let’s look at what happened after the bailout. Banks funded government deficits all over the world. I guess they were just returning a favor. How else would you call financing debt of countries that do not have a chance to ever pay back their investors? What investor would ever justify such a decision to his clients? How would you go about it?

Something like this? “You know, yes they are bankrupt but at some point the central bank will step in and bail them out. They will not allow so and so to fail. The whole system will go down. There is too much at stake here. etc etc etc”..

We heard this so many times in the last few years. Spending public money to save the world from the dark ages.I do not buy it.

Furthermore, I assume that all this bailing out of states and banking sector by one another implies that both create value to the rest of the society. They imply that current form of states and current form of the banking sector are Pareto Optimum. Again I beg to differ. The simple fact that they need to use extra resources to make just keep them alive proves that it is over.

This does not have to alarm us. It is over for the current form of those two, not the end. The world will move on with both states and financial sector. To have a chance it should do it without the current ones.

Related Story: Governments and banks in this mess together

Two other interesting links on the subject : link1 link2

 

P.S. This chart does not show how a lender of last resort works. It shows capitalism killed from inside by corruption.

4 thoughts on “What if there is another way? A better one

  1. I agree with you Florin, but more is needed to do in order to show that such bailouts have a more negative impact on the economy on the long term than their “benefits” on the short term. And the moral hazard created by the bailouts is not an argument, there has to be some real economic projections that need to reflect this negative impact.

    In the Bloomberg’s article there is this passage: In the September 2008 meeting at which Paulson and Bernanke briefed lawmakers on the need for TARP, Bernanke said that if nothing was done, “unemployment would rise — to 8 or 9 percent from the prevailing 6.1 percent,”.
    Now, three years after, the unemployment is 9 percent, even with all the bailouts and the TARP program.

  2. “In my view, banking sector in its current form was bankrupt in 2008. At the core the banking sector made a series of bad bets and poor investments which did not pay back. But it was not let to take its “stop-loss” to use a favorite term of traders when closing a losing position. It was given another chance but not in a transparent way.”

    The question is why the banks are not willing to take their “stop-loss” as long as these losses are acceptable? Maybe because as Nassim Taleb described in his book “The Black Swan”, there is a asymmetry of bank compensation. So the individuals are encouraged to maximize their bonus by taking enormous risk with the bank’s capital. When they win they make a lot of money but when they lose they get fired without having to pay any money. And that should be changed in some way, the asymmetry of bank compensation should be altered.

    “If any of the gurus would have been asked if they would have ever considered investing in such a state company the answer would have been no. There is also the other possibility that they knew. Some already had shares and welcomed the intervention and some just bought shares because they knew the intervention was imminent. ”

    This is very interesting for me. I could understand the vicious circle determined by governments saving banks, banks buying sovereign debts and so on. But I do not understand why some gurus or hedge fund managers join in to buy banks and help them to survive if they are promoters of value investing. Warren Buffet bought WFC, GS and recently BAC, John Paulson bought Citi and is still buying BAC etc. Given that BAC faces big challenges in this crisis, I wonder if it is something beyond our comprehension or there are simply some bad bets/investments?🙂

    P.S. Ironically, while writing my comment, the banks get a new bailout.😀

  3. Sergiu, those guyz are money makers, they don’t care about the big ideas the rest care about.You don’t make money from idealism. So, this is what they do, they try to make some money. Sometimes it pays off, sometimes not. You can’t win all the times.

    Value investing has nothing to do with these big ideas :)). Is a question of market multiples, and is actually buying depressed stocks in the market, that you don’t think they will go bankrupt. This is value investing, as an investment style. Buy low shares you don’t believe will go underwater. Low P/B, P/S, P/E, high dividend yield. Is not about “value”, as you understand it. Most of the guyz doing value investing are usually buying stocks that most of the market won’t buy (this is how they got cheap).

  4. Lavinia, I know what means value investing. In the last month I bought gold mining stocks because this sector is strongly undervalued. I dont care about the market, I dont care about the gold. I am sure there is a big opportunity to make a good investment. In the case of value investing the market cant stay irrational longer than you can stay solvent🙂
    Buffet is a great value investor, but I doubt he bought BAC as a undervalued stock that should outperform in future. Because it is not undervalued. Look at this:
    WFC: the market near to bottoming out, stocks strongly undervalued
    GS: the market near to bottoming out, stocks undervalued, preferred stocks
    BAC: the market is overvalued and BAC facing big challenges to survive in the worst case scenario of this crisis.
    So you can see why the Buffet’s 5 bln trade in BAC shares is odd for me. John Paulson is not necessarily a value investor, he is a hedge fund manager who seek to earn profits from a wide range of bets and investments. As you said, sometimes it pays off, sometimes not.

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