Government to the Rescue

Bill Woolsey - 9/21/2008

While the government encouraged mortgage lending to high risk (low income) borrowers, the most serious problems are with private financial firms. They were all betting on housing prices rising. And when housing prices fell, they lost.

The government is working very hard to protect "bailout" people who lent money short term to the bad entrepreneurs. Mises somewhere argues that all lending involves an element of entrepreneurship. It is these entrepreneurial errors that are being bailed out.

Deposit insurance protects against bank runs (more or less,) and shields insured depositors from the entrepreneurial element of short term lending to banks. After the last crisis, the S&L mess, those borowing short through insured deposits were required to maintain "large" amounts of captial.

It is essential to understand that in banking and finance, capital means net worth. When described in terms of leverage or ratios, is attempts to measure how much of the firms activity is financed with the owners' funds (generally the stockholders' funds.) It isn't the same as total assets. The "capital stock" or anything like that.

Insitutions with insured deposits must finance 10% of the activity with the owners funds. That is a leverage of 10-1. Such an institution must lose 10% of the value of its assets before those it borrowed from take a loss.

In the last 10 years, investment banks have been borrowing funds overnight. Those lending overnight have what amounts to a checkable deposit. On any day they need the funds, they can collect payment, with payment wired into a checkable deposit, and then make a payment by check (or electronically.)

The investment banks have been operating with little capital. The owners are financing the activity with 3% of their own money and borrowing the rest. Leverage of more than 30. A good bit of the borrowing is very short--sometimes overnight.

The S&Ls (before the crisis) had 4% capital or a leverage ratio of 25. Of course, they fianced this with what amounted to savings accounts.

It is almost like the investment banks took over S&L model.

But the investment banks were not insured. Still, people lent to them.

One thread of the "free banking" literature claims that without deposit insurance, banks would need to keep large amounts of capital to obtain deposits.

The investment banks, however, obtained what amounted to deposits with very little capital.

The Treasury and Fed have been "bailing out" these "depositors" who have lent funds to investment banks. Basically, the Fed is lending the funds to these institutions so that they can pay off the money they owe to these "depositors."

The stockholders of the failed firms have all taken severe losses so far. Managements have been replaced. But those who have lent short term funds are being protected.

The lesson, then, is that there is no "entrepreneurship" involved with short term lending. Or rather, it is the similar to the sovereign risk of U.S. government default.

The Fed has not been "inflating" the problem away. The lending to all of these institutions has been matched by open market sales.

So far, aggregate spending has dropped. Total production hasn't dropped. It is growing below trend now, but too many resources had been put into housing and need to shift to alternative uses. That shift is going to involve reduced production.

Ideally, those financial firms that didn't bet on rising housing prices, didn't lend to other firms who did (or if they did, got out early,) shoud rapidly expand and take over fiancing sound activities. Those who made these errors, should take losses.

Perhaps there aren't enough sound financial firms. Perhaps it is impractical for them to expand rapidly. I can imagine that starting up new ones to take advantage of the profit opportunties for sound finance would be difficult.

But, my opinion is that it is important that total spending in the economy be maintained. And then, let people take their losses.