LIBOR is not a free lunch

The latest banking scandal has some people yawning, some yapping, some yelling. Overall, there seems to be a clear lack of outrage except among those who have an incentive to find a reason to be outraged. What to think? Frankly, this case smells. All the telltales indicate that this is a false scandal. LIBOR is an interest rate derived from information volunteered by various banks periodically. What do the banks get for their effort? Nothing, really. The information they supply costs them time and effort, and they get nothing in return.

LIBOR is a free lunch, an attempt to concoct an important benchmark interest rate from voluntary statements  of a few banks. What incentive do they have to tell the truth? Apparently, the incentive is jail time if they lie, and nothing if they don't. So for the bankers, it is a negative sum game. Is it any wonder that Libor Case Documents Show Timid Regulators? The regulators must have been wondering whether it was an April Fools joke. You can imagine them talking to the walls, as though the pranksters were hidden nearby: "Okay, okay, come on out guys! What's the catch? Tell me what the joke is!"

Since there is no way to predict the outcome of the investigations underway, and there is little reason for those of us who are not LIBOR experts to suddenly learn a bunch about what it is and how it works, our net investment thesis is something between short everything having to do with banks and governments and I don't care and I am going to ignore the whole thing. You could make a case that random and capricious prosecution of impolite behavior (certainly Barclay's attempted "manipulation" of LIBOR at least qualifies as impoliteness) indicates that those in the know among regulators of the financial industry are short the banks and intend for other investors to sell out at the bottom.

It could be foolish to expect that LIBOR will last much longer. Do we need a benchmark rate built on the assumption of a free handout of information?

Eliot Spitzer writes in Larry Kudlow Says the Libor Conspiracy Has No Victims. That’s Grotesquely Wrong (sorry, I misplaced the URL) that there is massive harm done in this case. People are quite astute at perceiving damage to themselves done by others. Some are astoundingly good at it, spotting eleven out of every three cases of negligence or inconvenience that occur. The remedy will be an unexpected consequence:  LIBOR will go away, and we all--Spitzer, you, me, and all the other people who have mortgages and car loans--will have to rely on much fuzzier (and more expensive) estimates of short-term borrowing costs.

On Stranded Capital

There are significant differences between what the current economy feels like, especially as reported by the media, and its underlying strengths and weaknesses.

The cause of the current malaise is the necessary adjustment period after a boom. The current recession was not caused by the financial crisis of 2008. The financial crisis was driven by the boom of 2003 to 2006. During the boom years, optimism for increasing housing prices caused people to spend and invest more than they otherwise would have. As a result, they stranded their capital on a deserted island.

When you over-invest, you take a risk of stranding your capital in an unproductive place. A classic example of an investment is a house: You need a house, so buying one might be a good investment, as it may reduce your costs of housing yourself over rent. Suppose that you are so impressed by the good returns on your first house that you buy a second one. Whether this second investment pays off depends on the external market. If no one wants to buy your second house from you, then all the money you poured into it is stranded until such future time as the market comes back and decides once again that it wants to buy your house. In the meantime, all of that money is tied up in concrete, wood, nails, flooring, roofing, electrical cabling, appliances, and all of the labor that was required to put those items into the shape of a house. You can do nothing with that money because it has been converted into goods. It is stranded. Presuming that the rental market too is down along with the housing market, the house is a stranded investment, providing no payback.

If the entire economy contains a significant amount of stranded capital, then the economy will show the same signs of stress that the owner of the second house is under. Of course, this example is extremely close to what actually did happen in the mid-2000s, and our current situation continues to reflect stranded capital sitting in houses that are not returning any value to their owners or society.

The solution to the current recession is then quite clear: Wait long enough for there to be enough people that those houses can be useful and occupied, or long enough that the capital that was stranded is small compared to the new capital generated by all of the country's other useful pursuits. Any other attempted solution potentially ignores the fundamental problem of the stranded capital, and therefore will not repair the problem.

What's Wrong with Banks

Nearly every Yahoo! Finance article has dozens of reader comments castigating bankers for the damage they have done to the U.S. economy. If this is the common wisdom, and the common wisdom is wrong, then what is the truth?

Theoretically, debit cards save consumers money by reducing their costs of holding cash. At least, this is what the bankers associations believe. But in order to feed their top and bottom lines, over the years bankers got themselves addicted to two kinds of fees: those they would levy on customers who were "bad", which is to say, those who overdrew their accounts; and fees charged to the merchant at the point of sale. Now that the U.S. has regulations curtailing both types of fees, the banks are finding themselves short of many billions of dollars of fees. So they have tried to make up the missing revenue through other fees. Bank of America, for example, is famous for saying that it would levy a $5 monthly fee on debit card users, only to rescind its plans when popular outrage made it clear that the fee would cost them too many accounts.

Let's start counting up the mistakes.

First, a debit card is not an asset, for most customers. Unlike paper cash, which provides a clear signal when it is being expended, debit cards make it much more difficult for the customer to track the drain on their bank balance. It makes overspending much easier. This benefits the merchant, because they can sell more goods, and it benefits the bank, which collects higher fees on the transaction, and which gets a small probability of collecting a penalty fee in the event the customer's account is overdrawn. The banker's theory that a debit card saves money for the customer makes the incorrect assumption that the customer's spending will be the same as when the same customer uses cash. Academic studies show that even savvy credit card holders spend more money when using a credit card than they do when using cash.

Debit cards were introduced as massive trickery in which retailers and banks colluded to induce consumers to overspend while shopping. They reduce time at the register, but by disconnecting the customer's budget sense during the payment process, they cause the customer to lose hundreds and thousands of dollars per year in spending that is unnecessary.

If you have $100 in your wallet and are about to buy an item that costs $40, if you have to use two of the five 20s in your wallet, you might decide to cancel the transaction and not buy at all. If you use a check, you might still compare the amount you are writing on the check with the cash in your wallet, but you will also think "I still have $100 in my wallet," making it feel like you aren't spending of your cash. If you use a debit card, you might not even notice that the total is $40. Hence it is very easy to let the transaction go through, because it barely feels like you are spending money at all.

A number of banking services that evolved between 1995 and 2010 are based on psychological tricks of this type. Customers believe they are rational, and are not. The banks get their services and fee structures approved because everyone, including regulators, assume that customers are rational, and they are not. The services are perhaps designed by the bank with full knowledge of the irrational behavior of customers, or perhaps it is just that some of them get lucky when they try random services, and they keep the profitable combinations, which just happen to have unpleasant side effects on customers.

Now, when I say irrational, I don't mean customers who act against their own best interest, or who are random or perverse. I mean that they act in ways that are chronicled in the psychology literature, things like helping their friends to do worse than they do on critical tests. Also, by not doing arithmetic when considering whether a purchase is in their budget. That's hardly a case of insanity or not. It is simply that rounding off numbers and doing the arithmetic in your head is much harder when using debit cards than it is when using cash. It isn't the bank's "fault" that you don't do this arithmetic. It just happens to be the beneficiary of your laziness.

You could also say that cash is like an automatic computer, because the supply of bills remaining in your wallet always matches the amount of money you have left (!!).

So if the bankers are evil, it is because they have marketeers that use the same tricks that Neiman Marcus, Saks, Wal-Mart, Nordstrom's, Sears, Dollar Tree, Kohl's, Bon Ton, Abercrombie, Safeway, Kroger, and thousands of other retailers and hucksters use to take your money and make you overspend your budget every day.

I've picked on debit cards here, but you can probably make the same case for other financial products, especially mortgages, that permit the customer to make a mistake.

You could go further, and discover that the existence of conservative banks doesn't help, because there will be banks that play at the margins. If the conservative bank turns down a mortgage applicant for a loan, but the bank of marginal behavior offers the same applicant a loan, who is the hero and who is the victim? Many, many community activists at one time or another, and perhaps now, would have castigated the conservative bank for failing to agree to the loan, and praised the marginal player. Where were these activists in the era of 100% loan-to-value? Shouldn't they have been out there trying to stop individuals and families from taking these loans from overly generous banks?

The same thinking applies to all risk-based banking products. Risky bankers ruin it for those with better values. Aggressive and marginal consumers are either taken advantage of by the bank, or taking advantage of the bank (and I don't see that you can make a definite case that one is more true than the other), and they ruin it for the rest of the customers who don't partake of the foolish banks nor present such banks with unusual risks.

Historically, banks have exploded over and over. The system tends to be unstable, with each success at systematizing any part of the process, reducing costs, and making things normal instead causing instabilities that tend to make the industry implode and sometimes take the economy with it. Government regulation has been tried repeatedly, but since this is just another attempt at systematization, it isn't clear that regulation will prevent the problem.

Since I try to write an objective blog, not a normative one, I will not prescribe a "fix" to the banking system or to specific elements, like debit cards. My task, as I see it, is to discover the hidden truths that self-interest and conventional thinking tend to obscure. Hence, my only recommendation is to be very open-minded about future events. Regulation of debit cards could result in their disappearance entirely, or in enormous shrinkage of their distribution. And maybe that would be a good thing for people, who cannot afford a payment mechanism that makes overspending so much easier than cash.

Bank Lending: Policy Makers Squeezed Tight?

The prescription to cure an economy that choked on too much credit is simple: Less credit. Unfortunately for officials, this is a very unpopular medicine, since it reduces economic activity by reducing leverage among lenders, reducing lending, and propping up medium-term interest rates that affect purchases of durable goods. If you want a bank to increase its capital relative to assets, then assets must shrink, since capital will only be generated over time through earnings. Fewer assets, less lending, fewer lenders who are open to lending.

If you are a public official, the last thing you want to be associated with is reduced lending. Hence our current official set of matched lies: "It is the banks who are refusing to lend" versus "You'd better increase your capital ratio." Calling it hypocrisy would be exact, but then some readers find that to be a loaded term, implying more criticism than is intended.

The key point is understanding how all of the players are influenced. While the economy is in bad shape, banks will be hit with blame from officials for not lending while being given incentives to do exactly the opposite. There is a gap between the genuine true and the printed and perceived words in the press. Bank lending will not increase until the real conditions, not words, are there to support it.

~ ~ ~

On the other side of the coin are consumers. If they don't want to borrow, they won't. Right now the prudent action for consumers is to pay down debt and build up savings. Eventually, government encouragement to spend and fail to save will arrive, but don't expect an increase in consumer lending until the mood of frugality has passed.

Bank Bailout Cost Decreases Again

I reported on the rapidly diminishing estimates of TARP costs last month. Today, AP reported ("Lower bailout estimate assumes higher stock prices") that the total cost to taxpayers has decreased again, to $105.4 billion, according to the The Treasury Department. The White House and Treasury maintain different estimates.

Other estimates:
Congressional Budget Office, March 2010, $109 billion

Commentators Exceed LATimes Columnist

Put this in the "measurements of quality" category. David Lazarus is a syndicated LA Times financial columnist. A recent 4/25/10 column on bank reform legislation made reference to "puppies and kittens." I went looking for other telltales, and found Bank of America yanks Countrywide Financial customers' credit lines.

What's interesting is that reader comments show more sobriety than the columnist's original prose. For example, KathyA says:

"Mr. Lazarus, you seem to want it both ways. In the past, you have (rightly) raked banks over the coals, especially Countrywide (now Bank of America), for risky financial decisions in mortgage lending. You can't expect to be taken seriously when you now criticize these same institutions for making fiscally conservative financial decisions."

Lazarus' complaint is that Bank of America has declined to renew home equity lines at the five-year mark, as the contracts issued by Countrywide permitted. His reaction, over the bank's failure to provide an explanation, seems puzzling. At least, until you draw an analogy of the bank as bartender and home owner as alcoholic. The alcoholic doesn't like being cut off, even if, or perhaps especially if, the reason for severing the drug supply is rational.

In summary, the problem, the way Lazarus has described it, is that Countrywide was a good co-dependent, and Bank of America is not behaving right as a co-dependent properly should.

Snicker snack!

TARP Will Cost How Much?

In the beginning, TARP was announced and it would cost $700 billion.

Then banks began repaying, and the cost was lowered to $341 billion in August 2009.

Then some warrants and preferred stock, and the cost was reannounced at $117 billion.

April 23rd, TARP losses were re-estimated to be as low as $85 billion.

At this pace, the U.S. Government will soon be announcing profits from TARP.

7 Illinois Banks Shut

The Federal Deposit Insurance Corp. took over seven banks Friday April 23, all in Illiniois, with four in Chicago. That brings the total number of closures in Illinois to 32 since the start of 2007. Georgia still leads the death count, with 38 failed banks since 2007.

The closures on Friday, in Chicago, with assets shown in millions:

New Century Bank, $485.6M
Citizens Bank&Trust Company, $77.3M
Broadway Bank, $1,200.0
M Lincoln Park Savings Bank, $199.9M

Elsewhere in Illinois:

Amcore Bank of Rockford, $3,800.0M
Peotone Bank and Trust Company, $130.2M
Wheatland Bank of Naperville, $437.2M

Bank failures remain concentrated in four states: California, Florida, Georgia, and Illinois. Minnesota is a distant fifth. Total closures by state, for January 2007 to date:

State Total
AL 4
AR 1
AZ 6
CA 26
CO 3
FL 25
GA 38
IA 1
ID 1
IL 32
IN 1
KS 4
KY 1
LA 1
MA 1
MD 3
MI 6
MN 11
MO 6
NC 2
NE 1
NJ 2
NM 1
NV 7
NY 3
OH 4
OK 1
OR 4
PA 2
SC 1
SD 1
TX 8
UT 5
VA 1
WA 8
WI 1
WV 1
WY 1

Total for all states, January 1, 2007 through April 23, 2010: 225 banks failed.

To get your own copy of the list of failed banks, in a CSV file suitable for analysis in your favorite spreadsheet software application, go to http://www.fdic.gov/bank/individual/failed/banklist.html.

Obama Wants to Eat the Regulators' Cake

As I described last week, loan demand is down, which is good for the economy in the long run. The FDIC and Federal Reserve are encouraging banks to lend prudently and hold large capital reserves. Today's remarks show that the Executive Branch is not comfortable with that course of action, however, as the President called for banks to step up lending to small business. Is a titanic struggle in the offing?

Hardly. Bank of America and Wells Fargo pledged $5 billion and $4 billion respectively in increased lending to small business customers. These amounts, which will seem large to the public's ear when played as sound bites, are small relative to the discretion the banks have, as viewed by their regulators. In other words, it is all a show: The President gets to sound like he is beating up big banks again, and the banks get to show that they are complying with the President's request. Since the FDIC is happy, you should be happy too.

It is just another day in the scapegoating business for those holding blame bags chock-a-block with hot air and invective.

Hysteria a Sure Contrary Indicator

It is always useful to observe the other market participants. Not so much to see what they are doing so you can copy them, but to observe emotional overreactions that are telltales. Today Henry Blodget declared that Bank of America's (BAC) repayment of TARP funds was a bad thing.

If he weren't so hysterical about it, he might have been able to make a case. In this situation, however, the overreaction would seem to be good indicator that people are against the bank for reasons that are more emotional than logical, but that it is otherwise on the right track (65% chance). So paying back TARP is a good thing for BAC and its investors. The future course for the stock is up.

Let's suppose BAC were to obey Blodget and not repay TARP. Then it would be subject to further negative publicity, could possibly fail to find a CEO in a timely fashion (40% chance), and would likely be constrained in its business and employment practices that are either self-imposed out of fear (90%) or by the Government directly (30%), or both. It would also be the convenient scapegoat for bank-haters.

If BAC pays back TARP, it both violates the expectations of those who expect BAC to fail or to fail to pay back TARP and elevates the bank's status. If your conception of BAC is that it can't do those things, then suddenly you have cognitive dissonance. Hence the histrionics.

Now, whether it is a good and proper thing to hate banks is not the subject of this post. There may be societal value to having a goat to heap your scorn upon, or not. The point here is that the telltale says to buy BAC shares.

True Frugality/Prosperity Too Bitter for U.S. Leaders?

One of the essential elements of the business cycle is that it instructs market participants. When times are too good, immoderate behavior is rapidly rewarded, but soon after is then rapidly punished in the subsequent collapse. When times are bad, those who stored resources against bad times pick up bargains and benefit from their careful attention to economic reality.

The financial crisis of 2007 to 2009 is firmly rooted in overextension of credit to non-worthy borrowers. Clearly the lesson to be learned was "stop lending to poor credit risks; stop lending aggressively." As painful as a recession is, it really does reinforce the message that people must engage in economic behavior that is tied to reality. Unlike bubble behavior, in which people make investment decisions that are unsupported by economic fundamentals.

The collective decisions of consumers and businesses drive the economy. Each individual misallocation of resources hurts the long-term economy, even if in the short run it "feels good" or would seem to increase the velocity of money. When money is scarcer, the quality of these individual decisions rises. That is what generates recoveries.

If you have a recovery that is based on the millions of tiny gains that arise from good resource allocation decisions, then it is a sound one. If your recovery is based on a command-driven push to increase lending in order to restore some measurement of economic activity to a former level, then you are in danger of undermining your own long-term prosperity. Economic lessons in frugality are expensive; they hurt. We should not throw away the benefits of those hard-won lessons.

Are banks presently lending enough? It is a poor question. Better: Are banks meeting the existing demand for loans at prices that repay them for their risk? My sense is that commercial banks are lending appropriately, and if loans outstanding are dropping, it isn't their fault. Demand for loans is low and will stay low while consumers and businesses make prudent decisions based on the hard lessons they just learned.

This concept, that loan demand is dropping and is a good thing seems to be hard to grasp. Some people assume that loan levels are just set by the banks, and currently banks are being mean or trying to inhibit a recovery by failing to lend. This is echoed in the words selected by the interviewer in this video story at Tech Ticker. Mike Shedlock and Peter Atwater make the case that banks are reserving for current risks based on their customers' assessments of economic prospects, and that the building of non-loan assets is a reasonable use for their liquidity and has good historical precedent.

Conclusion: Profits are good now because of the steep yield curve, but consumers are laying a good foundation for a recovery through their credit decisions. There is a risk that this prudence could be short-circuited by governmental action, though my guess (95%) is that lobbying efforts for windfall taxes on banks, and other measures to force new risky lending, will not succeed.