Friday, January 15, 2010

Why is this profit different from all other profits?

Let's look at bank profits.  As usual, we have to split this out between commercial banks and investment banks.

First, commercial banks.  The crowds gather with their pitchforks this week to express outrage at the profits earned by banks on the backs of the taxpayers.  What's new?  If you think bank profits haven't always depended on the support of taxpayers, you don't understand how the system works.

We The People place our money in banks.  Since the Depression (you know the Depression, as in "this is the worst financial crisis since the Depression",) when too many banks failed, we've had the FDIC.  FDIC "solved" the problem that banks fundamentally mis-match their assets and liabilities.  They borrow short (that is, take deposits from customers who can demand their cash at any time,) and lend long (that is, write mortgages and other loans that are longer dated assets.)  The existence of this mis-match creates the potential for bank runs: More depositors want their cash back than the bank can actually pay.  A run does not require that loans default.  A run only requires more people want their cash than the bank has cash.  FDIC insurance protects that risk.

In the "olden days" customers cared what their banks did with the deposits.
With FDIC, depositors stopped caring.  Shareholders cared.  Shareholders very quickly figured out that they needed to maximize the value of the protections provided by FDIC, (especially since it is only relatively recently that FDIC charged different premiums for different risks!  Imagine if car insurance had one price.  We'd all drive more recklessly, I can guarantee it!)  So, with FDIC the banking system moved the concern over asset liability mis-matching from the depositors in any particular bank, over to the taxpayers as a whole, we provided the ultimate source of funding for FDIC.

So, this brings me back to the hoopla over J. P. Morgan and others this morning.  Nothing changed in the "system" recently.  All we're seeing is the difference between ex ante and ex post.  We the taxpayers have always provided extraordinarily large disaster insurance to the banks that allowed them to earn their profits, only now we're "outraged" tha we had to pay off on their claims.  If we didn't want to pay claims, we shouldn't have been in the insurance business!

But investment banks are different, right?  Not really.  J. P. Morgan has been a commercial bank for a very long time.  As you may recall, Goldman and Morgan Stanley only became banks in the height of the recent crisis.  Why did they become commercial banks?  They needed access to the various subsidies that banks receive, both from the Fed and via commercial deposits.

Why then?  We the public pulled the subsidies we had usually provided them!  Investment banks funded their activities with equity just like commercial banks (well, maybe not quite as much equity as commercial banks, but that's really splitting hairs,) but instead of deposits, investment banks had corporate debt, ranging from overnight loans to long term debt.  They used debt to finance their assets, and they tried to match their assets and liabilities.

The problem strikes when the buyers of the debt think the investment bank gets too risky, they stop providing capital.  Isn't that novel!  Those lenders actually monitor what the borrower does with the money!  So, when things look dicey, they stop lending to the investment bank.  That's brilliant!  But, what about those loans?  Here I explained that owning bonds has risks similar to writing insurance policies, only worse.  And here I explain why bond investors often deceive themselves about risk.  Because all these loans to the investment banks were owned by the taxpayers (generally speaking, our money market funds, mutual funds, pension plans, etc.) we were subsidizing the investment banks too.

So, as outraged as you and President Obama might be, let's show some outrage at the folks who decided subsidizing banks and abdicating all responsibility for thinking about the risks we take with our money was a good place to start!

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