Kelly Campbell, Government Bailouts and Pure Arbitrage

The other day I was so smitten with Kelly Campbell's discussion of mortgages, I investigated his other great advice.  In particular, he gives three reasons CDs stink.  I wish I could say this got me thinking, but it didn't.  I only observed that his three reasons are all the same: Certificate of deposit rates are low, you barely earn anything and they might rise in the future.

That doesn't mean they stink.  So, I went looking for a good example of a CD.  That's when I found the arbitrage.  For this, I owe Kelly thanks.

You and I own Ally Bank (f/k/a GMAC.)  Ally has great commercials.  The Feds took over when the financing arm of the old General Motors went bust.  We both own it as taxpayers, re-branded as Ally.  Unfortunately, I happen to own ever so slightly more due to an investment through my old employer.  I say ever so slightly because the equity owners were diluted so massively by the government bailout.

As owners, we should all be pleased that Ally has filed for an IPO.  Let's hope the bankers do a great job selling the stock.  But, I'm a little concerned about how Ally funds itself.

Ally offers the usual line-up of deposit products to attract cash.  Remember, banks make money by attracting deposits from savers and lending to borrowers, taking a spread.  Potentially uniquely, Ally attracts deposits by offering five year CDs with an early termination penalty of two months interest.  So, Ally will take your FDIC guaranteed deposit of $250,000, and pay you (today) 2.37% interest, fixed for five years.  However, you can close the account any time you please, only forgoing two months' interest.  That's free money.

What's the problem?  Ally may look like it has a chunk of stable, longer term deposits, when in fact it doesn't.  It has deposits that could be long term, but probably aren't, from people smarter than me who have been engaged in this transaction for a long time.  When short term rates rise, these deposits flee.

So, as Ally shareholders, what should we do?  I for one have just opened my account.  I'll get my too high, riskless return on my cash...and maybe contribute slightly to the fiction of Ally's strong balance sheet, ever so slightly improving the IPO price!

Of course he saw it coming...

I'm am completely sick of hearing he saw it coming...nothing about this individual in particular bothers me, but we hear this refrain all too frequently after outlier events.  Making proclamations that unlikely disasters will happen is easy because, well, talk is cheap.

Making piles of money (John Paulson, anyone?) doesn't even prove the point, but it's a step in the right direction.  At least he placed the bet.  Betting that disasters will happen when the bets are cheap takes skill to price, luck to get right, and errors don't come cheap.

The problem remains, however.  If we're talking about rare events, we can't see enough to differentiate luck from skill.  How long do we need to watch an investor to see if he can accurately predict one in fifty year events?  In financial markets, were correlations run very high, the answer, sadly, is a long, long time.

Where does that leave the academic in the SEC?  Sadly, I suspect ignored, with no authority, and a somewhat bigger audience than I have...but he won't be as entertaining!

Hey Buddy, I'll Swap You Some Prop

The plan to rein in the beaten down banks makes no sense.  As a seven year old, I had a poster on my bedroom wall from some ancient paper mill, printed on very nice 100% rag paper that said:

Rags make paper,
Paper makes money,
Money makes banks,
Banks make loans,
Loans make beggars,
Beggars make rags...

I think that was my first understanding of a ponzi scheme, however mis-guided.  A bank is a state sanctioned ponzi scheme.  I'm only half kidding.  Banks collect deposits based on a promise to pay their customers cash when the customer come looking for the cash.  The bank doesn't hold the cash.  The bank lends the cash.  If they're lucky, they lend it to someone who deposits it back with them. 

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.

Monday morning quarterbacking Geithner

I tend to NOT second guess either the Secretary of the Treasury or the Chairman of the Fed.  Generally speaking, I am comfortable that these individuals make decisions with substantially different information than you and I have, especially at the time they make the decisions.  Monday morning quarter-backing is way too easy.

In the latest flap over AIG and Geithner's actions while at the NY Fed, I don't think he deserves the abuse.  This is what I think happened at the time, and those who heard me ranting about this can confirm!

AIG needed huge amounts of cash quickly.  And, basically every other financial institution needed cash quickly too.  The problem: The Fed had neither a mechanism to get cash to everyone, nor a good way to determine who got how much of the cash to be distributed.

So, Congress said okay to bailing out AIG.  Geithner and his colleagues obviously knew AIG would immediately pay all the cash out the back door anyway, that's why it needed cash...AIG owed lots of counterparties HUGE payments!

Finally, I would imagine Geithner and Co didn't think too hard about which counterparties should get paid by AIG, or which banks should benefit from the AIG bailout.  They simply concluded making good on AIG's counterparty payments would at least pay off of the banks and institutions that were smart enough to hedge themselves in the first place.

Simply put: AIG became a money pump for the Fed because they had no other tool that quickly at their disposal.  They used it to pump cash to the least undeserving of the financial istitutions.

Why did he hide it?  That's obvious too!  If he had been transparent at the time, the backlash we're seeing today would have hit very hard.  AIG wouldn't have been bailed out, (I don't have a view to express on this...at the moment!) but more importantly, there would have been no mechanism to force liquidity through the system.