LewRockwell.com 30 Luglio 2008

The bailout of IndyMac’s depositors will probably deplete 10% of the FDIC’s reserves.

Congress will back up the FDIC if the FDIC ever (1) runs out of T-bills to sell (2) to raise money (3) to pay off depositors of insolvent banks. But where will Congress get this money? From the Federal Reserve System, if lenders will not fork over the money.

The Federal Reserve System backs up Congress. This is the heart of the threat to the solvency of the dollar.

The $4 billion that the FDIC will pay to a handful of depositors at IndyMac is hush money. It is paid to them to silence every other depositor in the country. "Don’t spread rumors about any insolvent bank." Why not? "Because, in a fractionally reserved system, all of them are technically insolvent." They are all borrowed short and lent long.

NO PANIC . . . YET

The failure of IndyMac this month was unique. We have not seen a bank failure this large since 1984. In one sense, this reminded the general public that individual banks can go bankrupt.

The most common reason for bankruptcy is that the bank has lent money to purchasers of real estate, which is a long-term debt, yet depositors have the right to withdraw money at any time. The bank is lent long and borrowed short. Yet this is true of every bank. The ones that get caught, which is a rare event, have merely indulged in long-term lending more than the average bank.

The failure of an individual bank does not produce mass panic any longer. It has been so long since Americans have seen a bank run that they pay no attention to a rare bank failure. Because the FDIC presently does have sufficient reserves in Treasury debt to sell and compensate depositors, depositors around the country are not tempted to go to their bank and demand currency.

The fact that the FDIC could cover the deposits of no more than a dozen banks the size of IndyMac does not disturb them.

They know nothing about the FDIC, other than the crucial fact: the United States government stands behind it. The government will re-capitalize the FDIC.

The experts who really do understand the nature of the bank deposit insurance program, as incarnated by the FDIC, know that the Federal Reserve System in turn stands behind the Federal government. So, there is no question that individual depositors in individual banks will be bailed out by the FDIC directly, or by the United States government through the FDIC if the FDIC runs out of T-bills to sell.

What will happen when the Federal Reserve System runs out of Treasury debt to sell or swap? It has unloaded almost 40% of its holdings since last December.

When that day comes, a lot of geese will get cooked.

TWO KINDS OF BANK FAILURES

There is an enormous difference – a literally life-and-death difference – between individual bank failures and a systemic banking failure. I do not believe we are facing a systemic banking failure. But we are facing more individual bank failures.

Americans have seen very few bank failures ever since the establishment of the FDIC in 1934. Depositors trust the FDIC to intervene and protect the money in their bank accounts. They do not withdraw currency from their accounts in a banking crisis because they believe that the FDIC will intervene to protect them. This confidence has kept almost all American banks from experiencing bank runs since 1934.

This is the most important of all "moral hazards." A moral hazard is the expected subsidy from the government to protect investors from a major collapse that their own stupidity and greed has caused. All the talk by Ben Bernanke or anyone else about trying to avoid moral hazard is propaganda for the rubes. Moral hazard is at the bottom of the banking system, beginning with the Federal Reserve Act of 1913.

The entire banking system rests on this premise: the banking system must be saved from bad investment decisions of reckless bankers whose banks go bankrupt, thereby causing doubts about the solvency of an entire system that is borrowed short and lent long, a system built on a lie: "We will pay you interest by lending out your deposit, but everyone can get his money back at any time." This lie is more widely believed than even this one: "Of course I will still respect you in the morning."

The FDIC was set up to use government money, if required, to protect bankers against two groups: (1) depositors, (2) foolhardy rival bankers who go bust. Bankers fear depositors’ decisions to withdraw currency, thereby imploding the fractionally reserved banking system. They fear busted banks because of the potential domino effect: "all fall down."

WITHDRAWAL AND RE-DEPOSIT

When an individual withdraws currency from his bank account, he reverses the expansion process of fractional reserve banking. For every paper dollar that an individual deposits, the banking system as a whole multiplies the quantity of money by nine to one. It may multiply it even more if this deposit is not in an urban bank. Similarly, when a person withdraws currency from his bank, and does not redeposit it, the banking system contracts the deposits by nine to one.

Who withdraws currency from a bank? You and I withdraw currency from ATMs, but we intend to spend this currency. Whenever we spend it, it winds up in the cash drawer of a retail company. The company at the end of the day deposits this currency into its bank. So, the banking system as a whole does not experience contraction. The money supply therefore does not contract.

The only contraction that is permanent is the contraction of currency withdrawn from a local bank and then sent to relatives outside the United States. When this is done, there is a permanent contraction of digital money in the banking system. But this rate of withdrawal is fairly constant, and so the banking system does not contract unexpectedly. This process actually reduces the rate of monetary inflation and the rate of price inflation in the United States. Immigrants send money to their relatives, and American consumers find that imported goods are paid for in effect by pieces of paper with Presidents’ pictures on them. Foreigners do not use the money to buy American goods, leaving prices lower in the United States than they otherwise would have been.

The banking system as a whole is not threatened by individual bank failures. The money that a failed bank has lent out does not disappear when the lending bank fails. It remains in circulation. The money that depositors might otherwise have lost is returned to them by the FDIC. So, individual bank failures do not alter the total money supply.

Those few individuals who deposited more than $100,000 in accounts at a local bank that fails will lose most of their money above $100,000. They have learned their lesson through IndyMac. It is likely that wealthy depositors have already taken steps by now to defend themselves against further bank failures. They have spread the money around. If not, they are slow learners.

THE REAL THREAT

The problem with individual bank failures is not the threat of a collapsing banking system. The problem is that bank failures send a message to depositors: the economy is being managed by people who do not have good economic judgment. Depositors begin to distrust the economy as a whole. It is not that they distrust the banking system as a whole. There is nothing they can do individually to pull the plug on the banking system as a whole, other than withdrawing all of their money from the bank and sending it abroad to people they barely know. This is not going to happen.

The threat to the banking system is that failed banks are a yellow flag to consumers. It warns them that the economy as a whole is at risk. Bank failures testify to the incompetence of supposed experts who manage the public’s money. When the average investor begins to lose confidence in the money managers, they may decide that discretion is the better part of valor. At some point, he will call his pension fund or stock mutual fund and tell the person at the other end of the line to sell the stocks. He will have to buy something, and what he will buy will be short-term money market instruments. He may also buy U.S. Treasury bonds.

The problem with this is that long-term money, meaning long-term capital to be used in long-term projects, will become less available. The government will spend any money that the public invests in Treasury debt. Businesses will find that it is more difficult to gain access to long-term capital. This will slow the rate of economic growth in the United States. This will remove the engine of economic growth. By moving their money out of the private sector, and especially out of equities, investors will contract the overall economy.

It is not that individual bank failures threaten the banking system as a whole. The banking system as a whole is a gigantic cartel, and this cartel has as its protector the Federal Reserve System. The Federal Reserve System is legally allowed to monetize anything it wants to monetize. It can buy any asset, and it can create the money to buy this asset.

The Federal Reserve can intervene to save individual banks, or large financial institutions. Not only can it do this, it is doing it on a constant basis. At some point, it will not be able to do this without monetizing assets that it cannot offset by the sale of existing Treasury debt in its possession. Beginning in December 2007, the Federal Reserve System has sold Treasury debt whenever it has increased its purchase of questionable assets that it has bought from banks and large financial institutions. It has unloaded about 40% of its holdings of liquid Treasury debt. This has kept it from inflating the money supply at a dramatic rate.

At some point, it will run out of Treasury debt to sell to the general public in order to offset the increase of its purchase of questionable assets held by the financial system. At that point, the great inflation will begin.

This could be a year away. This could be a month away. All we know is this: when the Federal Reserve system runs out of Treasury debt to sell, its purchase of all assets will be inflationary. The banking system as a whole is protected. What is not protected is the purchasing power of the dollar.

In order to guarantee the survival of the banking system as a whole, the existing legal structure has created an enormous risk factor: the destruction of the dollar. Legal solvency can be maintained by the banking system as a whole, but this legal solvency comes at a price: the threat of the insolvency of the dollar itself.

This has always been true. The public has never thought this through. It is beyond the voters’ comprehension. Congress, which has authorized the legislation that has led to this system ever since passing the Federal Reserve Act in late December, 1913, has also not thought about the implications of this system of guaranteed legal solvency for the banking system. But the insolvency of the dollar is the ultimate implication of the legal structure of today’s fractionally reserved banking cartel.

The major threat to the banking system is from outside the banking system. The major threat is the insolvency of a major company that has guaranteed the bonds of private corporations and agency bonds of the United States government, such as Fannie Mae and Freddie Mac. These supposed guarantees have made possible the system of bond portfolios that can be broken up into 125 levels of risk, with appropriate rates of return on each of the slices. The system is so complex that no one understands it.

Hedge funds have invested in these assets, called collateralized mortgage obligations. They have borrowed from banks to buy them. The leverage of the hedge fund system is enormous. It is probably a hundred to one. The guarantees against loss that undergird the financial system are guarantees made by organizations that cannot possibly fulfill their contracts during an anomalous event, such as an attack on Iran by the Israeli air force. When the promises cannot be fulfilled, interest rates will rise for all American bonds except those of the United States Treasury. This will trigger additional demands placed on the guarantors of these contracts, which will threaten the solvency of the bond system.

At that point, bank capital will collapse as a result of the losses that the banks have sustained because they lent hedge funds money to invest in the bonds. The collapse of the Carlyle Capital Corp. earlier this year took less than a week. It was borrowed at least 32 to one by ten major banks of the United States. Those banks lost 100% of these their investment in one week.

When banks lose capital, they must either find new investors, or else they must reduce their loans. When they reduce their loans, they refuse to roll over existing lines of credit to American corporations. This is the major threat to the system. It is not a threat of the bankruptcy of the banks; it is the threat of the reduction of lines of credit to American corporations – corporations that are dependent on these lines of credit.

In a financial panic, American investors will move from corporate bonds and stocks and put their money in Treasury debt. This threatens the solvency, not simply of individual banks, but of individual corporations that are dependent upon lines of credit issued by specific banks. American corporations are not dependent on the banking system as a whole. They are dependent on continuing lines of credit from specific banks. They do not have time to renegotiate loans with other banks. They have to meet their payrolls. This will become increasingly difficult to do in the environment created by constant reports of individual failures of specific banks.

This is the famous and widely denied crowding-out effect. The Federal government’s debt certificates are trusted; the private capital markets are less trusted. In order for the private capital markets to continue to operate in such a hostile environment, they will have to offer greater economic returns than Treasury debt. It will become more expensive for private companies to attract long-term investment, precisely because individual banks are failing.

Obviously, the companies would all fail if the banking system as a whole collapsed. The entire society’s existence would be at risk if the entire banking system collapsed. There is no a safe hedge against such a scenario. The division of labor would collapse. Cities would not be resupplied with goods. It would be like all the disaster movies combined. It would take only a matter of weeks for the death rate to jump. So, anyone who talks about the collapse of the banking system who has not retreated to a small farm located 100 miles from a major city does not take seriously his own scenario.

The problem is not the collapse of the banking system as a whole. The problem is the crowding out by government, especially the Federal government, of capital that would otherwise have gone into the private sector. The threat is the long-term erosion of confidence in the private capital markets.

This is not a minor threat. This is a major threat. It threatens the long-term growth of the American economy. It threatens the long-term growth of an economy which is heavily indebted to foreign investors. When foreign investors perceive that growth has stopped, they are going to cease lending money to Americans to sustain their present patterns of consumption. The dollar will fall. The price of imported goods will increase. The public will have to readjust its household budgets. When the public must readjust spending patterns, the result is recession. In a major readjustment of their budgets, the result is a deep depression. We have not seen this since the 1930s.

When we read of more bank failures, we will grow more nervous. It is not that tens of millions of depositors will go down to their banks and take out currency. A few million people may do this to a limited extent, but most people will not. This is because they do not have sufficient reserves in their bank accounts to enable them to take out $1000 in currency and not use that money to spend on household bills. So, they won’t do this. (You probably should.)

The long-run effectiveness of withdrawing currency to protect yourself from a complete collapse is essentially useless. You cannot buy much in a complete collapse. Most things are produced and delivered based on bank credit. We are hooked.

The likelihood of the complete collapse of banks is extremely low. It could happen, but it is highly unlikely. What is likely in a scenario of failing banks is the increasing loss of public confidence in the private capital markets. When that happens, the rush to buy Treasury debt, which means the rush to hand over our economic future is to the United States Congress, will lead to the de-capitalization of the private companies that increase our standard of living.

THE REAL PRICE OF BANK GUARANTEES

The public has encouraged the United States government to protect voters from unexpected bank failures. Congress has complied. The banking cartel has welcomed this cooperation. The Federal Reserve System has inflated. The dollar has depreciated by 95% since 1914. This is a result of the creation of the Federal Reserve System, which was created in the name of stable money. In other words, it is one more example of Ludwig von Mises’ rule: whenever the government interferes with the market, the result will be the opposite of what the legislators said they intended to achieve.

The greater the threat to the individual banks’ solvency, the louder the public will demand additional government intervention. Congress will respond. The result will be the creation of a set of conditions in which the Federal Reserve System will have to monetize the overleveraged hedge fund system which has grown up over the last decade. It will find that it must monetize so much, so fast, on all sides, that it will not be able to offset the creation of new money by the sale of existing Treasury debt.

Bernanke has done his best to keep the helicopter full of fiat money from having to take off and do its work. But he cannot resist the demands of Congress once it is clear the public that a series of bank bankruptcies is threatening the public’s confidence in the economy as a whole. The banks are protected. The purchasing power of the United States dollar is not.

Eventually, Bernanke’s hush money helicopter will fly.

So, we face a recession. We also face bankruptcies of overleveraged small banks like IndyMac. But the large banks are far more leveraged than the public understands. They have lent huge chunks of their capital to hedge funds that are leveraged 100 to one. A 1% move opposite to what a hedge fund has expected can wipe out 100% of a 100-to-one fund’s equity. It can be insolvent faster than you can say Carlyle Capital Corporation.

Warren Buffett says that the stages of the investment cycle is managed by three successive groups: first, the innovators; second, the imitators; third, the idiots. We are well into stage three.

CONCLUSION

In 1998, a weekend intervention by the President of the New York Federal Reserve Bank got a dozen banks to pony up $3.6 billion of new loans to keep the insolvent Long Term Capital Management hedge fund. The fund was leveraged 30 to one and would have to sell off $125 billion in assets at a loss. Since much of the portfolio was in assets that had fallen to zero – defaulted Russian bonds – this would be painful. Sales of the liquid assets would have tanked the international bond market. The bailout gave the banks time to sell the still-marketable assets over the next two years.

Now the hedge funds are international. The obligations are in the trillions.

Who can bail out a large busted fund now? The banks are in hock to all of them, and one of them can bring down the system.

Bernanke will need a lot of hush money.

by Gary North (author of Mises on Money. Visitwww.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible)

Source >  LewRockwell.com