The System Is Broken

April 28, 2008 – In the last letter I quoted Murray Rothbard to help explain how the practice of keeping only fractional reserves – where a bank’s cash reserves are less than its total liabilities – makes banks “inherently unsound”. But fractional reserve banking is only one of several intractable problems that plague banks.

Another problem arises from the routine mismatch between the maturity of bank assets and liabilities. Banks lend long and borrow short. In other words, they make many long-term loans that are funded by deposits with short-term maturities. We are seeing today in the housing loans made by banks a good example of how this practice undermines bank liquidity.

Banks have loaned against house mortgages (they also make other types of long-term loans). Many of these loans have maturities of fifteen years or more. But who deposits money in a bank with a fifteen year maturity? No one, of course.

Thus, banks are susceptible to liquidity crises. If they do not have the cash on hand to repay depositors, banks have to sell their loans or take other steps to raise cash. They often do this when they find themselves in a pinch by borrowing from a central bank, which takes the long-term loan or other paper offered by the bank in exchange for the cash needed by the bank to enable it to meet its depositors’ demands.

It is clear though that the underlying problem remains. The illiquid paper has simply moved from the commercial bank to the central bank, which then hopes that because of its government sponsorship, no one will notice or care that the illiquid asset remains and simply changed hands.

Though central bank crises are rare, they are prone to crises too, as any reading of the history of the Bank of England will attest. It will be interesting to see how this current bank crisis will further impact the Federal Reserve.

In addition to this liquidity problem, the practice of lending long and borrowing short can also impact bank solvency. If short-term interest rates rise, as they often do, a bank’s profitability will be impeded because the margin the bank earns between the loan it has extended and its cost of money is squeezed.

If short-term rates climb high enough, they can actually exceed the interest income the bank earns on its loans, which of course makes the bank unprofitable. And unprofitability erodes the bank’s capital base, which can adversely impact its solvency.

Solvency is also called into question when a preponderate number of a bank’s loans to its customers go bad. When coupled with the high leverage employed by banks, a bank’s capital base will be eroded. This weakness of banks of course explains what is now happening with the ongoing subprime crisis.

Why are these problems of banks important? Because bank deposits form the major source of currency, and are thus critically important to commerce. If bank assets become impaired, then perforce bank deposits are also impaired, which undermines commerce. For this reason, a ‘too big to fail’ doctrine has emerged in recent years. But this policy of bailing out the big banks does not solve the underlying problem.

In an interview in its Monday April 14^th issue, Barron’s asked commodity guru Jim Rogers whether the Bear Stearns bankruptcy would have devastated the financial system. His reply clearly highlights the problem I have identified: “If the system is so fragile that the fifth-largest investment bank can bring it all down, then you better go ahead and have the problems now. What if three or five years from now it is the largest investment bank that fails or the largest five or six banks that fail? Then there will be a disaster.”

Then in the same issue of Barron’s noted author Martin Mayer wrote: “In the…derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty… The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps. Bear Stearns apparently had created trillions of dollars of positions this way, which is why it had to be kept in business…We should note in passing that the big beneficiaries of the Fed’s action on Bear Stearns were the sellers of credit derivatives insuring Bear’s obligations. The counterparties’ paper had been worth very little on Thursday night and quite a lot on Sunday afternoon.”

Mr. Mayer clearly explains what happened in the so-called Bear Stearns bailout. He does not mention the name of any beneficiaries, but the important point he makes is that it was not Bear Stearns that was bailed-out, though that is the way it was presented by the media. The Fed stepped in and actually bailed-out the major counterparty of Bear Stearns’ $13 trillion in derivatives, namely, JP Morgan Chase.

It is also interesting to note that JP Morgan Chase is the largest shareholder of the Federal Reserve. It therefore doesn’t take a rocket scientist to figure out whose interests the Federal Reserve was serving.

Today’s financial system is defective because banks are inherently insolvent. In my view, the fiat currency system in which banks and governments have become so interlocked we have reached the point where we are now facing an unprecedented upheaval. In short, today’s financial system is broken, probably beyond repair. Each and every one of us needs to face up to this reality, and prepare for the eventual outcome. And what will that be?

I happened to be watching CNBC last week when their guest was Nobel Laureate Joseph Stiglitz. He said the present financial crisis is the worst since the 1930s and the situation is likely to deteriorate further. I agree.