Reading the tea leaves

“They made two mistakes, basically. One was they let the money supply contract very sharply. Prices fell. Deflation. So monetary policy was, in fact, very contractionary. Very tight during that period. And then the second mistake they made was they let the banks fail.” – Ben Bernanke on the causes of the Great Depression, March 15, 2009

Suppose our government’s leadership really believes that a major cause of the Great Depression was that banks were allowed to fail.  What would we expect to see?

First, what does “failure” mean if you are a bank?  Well, it comes in two flavors:

1. You lack the cash to meet your immediate obligations.
2. Your net worth is negative; i.e., the value of your liabilities exceeds the value of your assets.

The Federal Reserve has instituted a vast array of “liquidity provision” schemes to deal with (1).  Banks can take all sorts of assets and get loans against them to meet immediate cash needs.  And they can now issue debt guaranteed by the FDIC.  So running out of cash is not really a problem.

As for (2)…  Well, there is no law of nature (or finance) that says you cannot keep operating just because your net worth is negative.  In principle, you could continue until you ran out of collateral to take to the Fed.  What stops you is the FDIC, which requires not only that your assets exceed your liabilities, but that the difference is large enough not to put the FDIC’s insurance fund at risk.

The danger with FDIC insurance is the same danger as a gambler making bets with other people’s money.  As a bank nears insolvency, its owners will be tempted to make ever riskier bets.  The FDIC tries to step in before that process really gets going, while the bank is still gambling with its own money, as it were.

Thus, for practical purposes, the two kinds of failure are actually:

1. You lack the cash to meet your immediate obligations.
2. The FDIC seizes you.

“Now, it’s true, I think, that mark-to-market has had a–it’s been some gasoline on the fire in terms of financial institutions. … I think the best way to handle that, though, probably still, is to have the mark-to-market figures, but not have the regulators say, `We’re going to force you to put a lot more capital in based on these mark-to-market figures.'” – Warren Buffett, March 10, 2009

If I were in charge and I wanted to prevent banks from failing at all costs, what might I do?

I might relax mark-to-market accounting.  This would allow assets to be carried at inflated valuations, both for purposes of regulatory capital requirements and for purposes of getting loans from the Fed.

I might provide non-recourse loans to private equity to create inflated marks where mark-to-market still applies.

I might try to convince the FDIC to exercise forbearance in seizing banks.  Of course, the primary day-to-day mission of the folks at FDIC is to preserve the integrity of their insurance fund.  So they might object to my suggestion.  I might have to give them assurances that they will have the necessary resources should my great plan fail.  A $500 billion credit line from the Treasury, say.

If the FDIC agreed, they might suddenly go from 3-4 bank seizures per week to 0-1 per week.

Once my plan leaked to certain troubled banks, they might suddenly halt their attempts to raise capital at $0.20/share.

And of course, once Wall Street got wind of it, shares in financial companies would rocket higher.

Let me know if you notice anything like this happening.