WASHINGTON — Tired of the government bailing out banks? Get ready for this: officials may soon ask banks to bail out the government.

Is this a real plan?  Or just the dog chasing its tail?

Just wait ”til I get it!

Bailout is a term debased through overuse.  Aside from its aura of undeserved relief, it tends to connote gift – or grant in a government context – rather than lending or simple liquidity. 

Senior regulators say they are seriously considering a plan to have the nation’s healthy banks lend billions of dollars to rescue the insurance fund that protects bank depositors.

That distinction – writeoff dressed up as Potemkin-village debt and pre-refund gap loan – lies at the heart of why it’s being floated. 

That would enable the fund, which is rapidly running out of money because of a wave of bank failures, to continue to rescue the sickest banks.

Liquidity problems?  Financially under water?

Not that the government is running out of money – for better or worse, we can always print more [Suppressing the hideous shudder accompanying that sentence – Ed.] – but that the FDIC insurance fund, a pot under particular control, might run dry. 

Since January the Federal Deposit Insurance Corporation (FDIC) has seized 94 failing banks, causing a rapid decline in the deposit insurance fund.  Despite a special assessment [Capital charge – Ed.] imposed on banks a few months ago to keep the fund afloat, its cash balance now stands at about $10 billion, a third of its size at the start of the year. (Another $32 billion has been set aside for failures that officials expect to occur in the coming months.)

Unlike the FHA, which as we saw is explicitly Treasury-backed, FDIC clings to its autonomy. 

From the NYT: Sheila C. Bair, head of the FDIC, would prefer not to tap a line of credit from the Treasury.

The FDIC, which oversees the fund, is said to be reluctant to use its authority to borrow from the Treasury.

If the FDIC’s fund runs out, that would send the FDIC director running to Treasury to ask for an increase in her allowance.

The fund, which stands behind $4.8 trillion in insured deposits, could be wiped out by the failure of a single large bank, although the deposit insurance corporation could always seek a taxpayer bailout by borrowing from the Treasury to stay afloat.

Like the GSEs, Fannie Mae and Freddie Mac.  Like FHA. 

Wonder what entity’s next?

Under the law, the FDIC would not need permission from the Treasury to tap into a credit line of up to $100 billion. But such a step is said to be unpalatable to Sheila C. Bair, the agency chairwoman whose relations with the Treasury secretary, Timothy F. Geithner, have been strained.

Are we seriously hearing that personal pique may drive our banking policy?

You must have misheard

“Sheila Bair would take bamboo shoots under her nails before going to Tim Geithner and the Treasury for help,” said Camden R. Fine, president of the Independent Community Bankers. “She’d do just about anything before going there.”

Warning of bamboo shoots under the nails: Camden R. Fine

Previously I posted about the turf battle now playing out among Federal banking regulators:

In many ways our current banking regulation operates like the Articles of Confederation, where each regulator is akin to a sovereign state that can safely ignore what the others are doing, and may certainly ignore the dictates of any purported central regulator.  Now what Mr. Geithner wants is to force through a new federal financial Constitution that makes the Federal Reserve the truly national supra-regulator:

The administration’s proposal would give the Fed broad discretion to supervise any major U.S. financial company and would also create a “financial services oversight council” to coordinate policy and help resolve disputes among regulators.

One ring to rule them all, one ring to bind them.

One conference table to seat them all …

How power would be balanced between the Fed and this entity has emerged as a flash point, one that administration officials debated.

Signs point to political trouble

According to the story inspiring that post, Ms. Bair is angling for more FDIC power and her elevation into equality with Mr. Geithner of Treasury.  Asking him for an advance on the funds under her control undermines both her policy logic and her political leverage.

Instead of asking someone with power over you, why not ask those over whom you have power?  Maybe they’ll pass the hat!

Borrowing from the industry is allowed under an obscure provision of a 1991 law adopted during the savings and loan crisis. The lending banks would receive bonds from the government at an interest rate that would be set by the Treasury secretary –

The premise, therefore, is that this is real debt – just an advance.  But here comes the stinger:

What stinger?

– and ultimately would be paid by the rest of the industry.

“Paid by the rest of the industry” = “tax on their profits.”

Translated into money-speak, which bankers understand, I regulate you, so lend me some money that I’ll pay back by taxing you.

Or even simpler, gimme some money.

Pound notes, bad checks, loose change, anything!

The bonds would be listed as an asset on the books of the banks.

Yes, we are.

The plan, strongly supported by bankers and their lobbyists, would be a major reversal of fortune.

Some bankers, some lobbyists.

Bankers and their lobbyists like the idea because it is more attractive than the alternatives: yet another across-the-board emergency assessment on them, or tapping an existing $100 billion credit line to the Treasury.

It’s all going around in circles anyhow; the question is whether the government (meaning us taxpayers) or the banks (meaning their shareholders) pays the bill.

Bankers worry that a special assessment of $5 billion to $10 billion over the next six months [A] would crimp their profits and [B] could push a handful of banks into deeper financial trouble or even receivership.

Risk A (profit-crimping) shouldn’t occur if the loan is a good loan, and if it’s counted as Tier 1 regulatory capital subject to nominal capital charge – all of which factors are within Treasury’s control, if not the FDIC’s. 

Please can I have some money?

Risk B (submerging marginal banks) is subsumed in Risk A – if the loans are good, and counted as good capital, why does that change the lending bank’s health or liquidity?

By the way, here’s the political reason:

And any new borrowing from the Treasury would be construed as a taxpayer bailout that could open the industry to a political reaction, resulting in a wave of restrictions like fresh limits on executive pay.

What, like the industry’s already so popular?

Isn’t the political backlash risk not against the already-reviled banks but against the Administration?

Any populist furor could be avoided, the thinking goes, if the government borrows instead from the banks.

Just fantastic, double optics: two reasons, both optical rather than substantive.

I see right through your facades

“Borrowing from healthy banks, instead of the Treasury, has the advantage of keeping this in the family,” said Karen M. Thomas, executive vice president of government relations at the Independent Community Bankers of America, a trade group representing about 5,000 banks.

In case you’re wondering, the ICBA group is the little-banks-receiving-relief not the big-banks-providing-liquidity.  In short, completely not disinterested.

“It is much better for perceptions than having the fund borrow from somewhere else.”

Never mind that it’s worse for reality.

Ultimately, officials say, the deposit insurance corporation could settle on a plan that replenishes the insurance fund by doing some of both: [C] Borrowing from healthy banks to shore up the shorter-term liquidity needs of the fund –

Option C is justifiable – if it’s good debt, that is – and feasible with powers already available to the regulators, or at least to Treasury. 

– and [D] imposing a special fee on banks to increase the longer-term capital level of the fund.

Except that you can’t tax profits if you’re making losses, and if you tax a weak sector, you weaken the sector. 

Officials say that the FDIC will issue a proposed plan next week to begin to restore the financial health of the ailing fund.

There is no consensus among the five board members, consisting of Ms. Bair, two other FDIC officials, and the heads of the Office of Thrift Supervision and the Office of the Comptroller of the Currency. Others may propose novel ways to replenish the fund, for example, by asking the banks to prepay the premiums that they were planning to make next year.

When in danger or in doubt, run in circles, scream and shout.

I’ll get it this time!

Send post as PDF to

Some weeks back, the first banks not only repaid their TARP advances (some of which they took under intense pressure to accede) but also bought back their warrants, for cash.  You’d think that seeing banks get out of hock and giving our deficit-ballooning government free cash would be a good thing, but some folks at the Huffington Post found in this a source of outrage that the banks were getting away too cheap.  They want either that the banks pay the computed Black-Scholes valuation, without adjustment, or that the warrants be put up for public auction.  As I mentioned yesterday, I have personal experience with mandatory government negotiations regarding asset values, and my experience suggests the government did well then and is doing well now.

Yes, I’ll negotiate

Fifteen years ago, in the face of what it called a national housing emergency, the Federal government breached its contractual agreements with owners of affordable housing properties.  Instead of allowing them to go market when contractually agreed, the government abrogated that right, taking it in an eminent-domain-style expropriation (which so personally offended me I sued the Federal government), and offering eminent-domain-style compensation via a statute known as LIHPRHA.  Our company represented dozens of owners going through the negotiated valuation-and-compensation.  After a few years, the government suspended the program, restoring owners’ right to go market, because incessant criticisms from some policy advocates about owner overcompensation had convinced Congress owners were bluffing.  In fact, with the benefit of hindsight, the government got a great bargain in the lion’s share of the cases.

We did?  Good for us!

The Treasury Department refuses to comment on negotiations until two days after they are completed, giving the public and outside investors no say in the process.  

For goodness’ sakes, it’s a negotiation.  Do the fans get to listen in on the quarterback’s huddle?

Okay, Black-Scholes on two, break!

Recently, a group of House Democrats began an effort to end the practice and introduced legislation to require the Treasury to hold public auctions.

That is a choice.  One I would not recommend, because as I said before:

My guess is that at least eight of the ten banks buy back their own warrants via appraiser-aided negotiations with Treasury. Letting them go to the auction would be too hairy when compared with a known strike price that could be closed at the table there and then.

An auction is a crapshoot.  Either party could do better than the baseline; either party could do worse.  A negotiated settlement will have a much lower band of error.

But the more general flaw with the Treasury process is a simple lack of transparency. A public auction would “avoid congressional scrutiny and immunize banks and Treasury from any accusations of there being some sort of sweetheart deal,” said Wilson.

Do I have to be immunized against criticism?

Here again, I believe the Huffington Post has stapled the professor’s comments onto an editorial conclusion it had pre-baked.  Sure, the public auction reduces suspicion of sweetheart deals, but it wouldn’t silence the Monday-morning warrant buyers, since if it went badly for Treasury, they could howl that any fool should have taken what was offered.

In fact, we’re likely to find out:

In several instances the banks have been more transparent about the transactions than the Treasury Department. The BB&T transaction has yet to appear on the Treasury report even though the deal was struck on July 17, as the bank announced. The bank hasn’t yet paid for the warrants, so Treasury won’t comment on it.

Treasury’s doing the right thing.  Transparency’s a good thing when either (a) those observing can offer valuable advice to those who are acting, or (b) those observing are a necessary check to keep honest those who are acting.  Here there’s no suggestion of impropriety – which is the usual justification for transparency.  Rather, the critics (or at least, the singular critic of the Huffington Post) simply doubts that Treasury’s competent, and wants to watch the brain surgery so see for itself.  But the observer’s not especially competent to comment, so what’s the point of real-time transparency?

Does transparency really help here?

In fact, there’s good evidence the process is working well, only the Huffington Post is too blind to see it:

JPMorgan Chase & Co. has reportedly asked the Treasury to hold a public auction, unhappy with Treasury’s offer.

The JPMorgan case is telling. Since Treasury has so far set the bar so low for the warrant repurchases, banks that are just now entering negotiations don’t want to pay more than the nice deal the last guy got.

That is utterly ridiculous.  If the bar is low, JPMorgan would jump at it.  That JPMorgan wants to go to an auction suggests the price isn’t too low. 

In fact, the poster’s statement is completely nonsensical.  To get the other party to raise its offer, you don’t announce publicly that you want an auction, you use the multiple internal steps already set forth in the process, which (from my previous post) include:

Step 2. I’ll tell you what I think it’s worth.

Step 3. We bargain … quietly.

Step 4. We invite two guys driving through the rear-view mirror, to value it.

Step 5. The two guys pick a Delphic oracle.

Step 6. We puree the results

If JPMorgan (and its advisor) and Treasury (and its advisors) have reached an impasse despite these multiple resolution steps, that’s very, very powerful evidence Treasury isn’t being a lapdog on pricing.

Let’s discuss this

In fact, the situation’s asymmetric in several other ways, all of which imply that Treasury has grounds to get premium values, not discounts:

1. Fractional interests are always worth more to the controlling party than to an outsider.  Without getting lost into the valuation theory of appropriate discounts for illiquidity, large-bloc size, fractionality, and lack of control, we can certainly apply common sense.  If I already own most of something, and you own a small part of the something, it’s worth a bit more to me to consolidate your minority interest into my majority piece, resulting in an indivisible whole.  I don’t have to worry about reporting and tracking the fractional position; I don’t have to concern myself with possible fiduciary-duty or prudent-man documentary standards (not that I’m unethical, just that I don’t have to write down all the whys and wherefores).  I’m free and both my optionality and my internal efficiency increase.

2. Treasury will play the game more times than any individual bank.  If these bargains are a game, the game is one each bank plays only once.  Treasury will play it ten times or more.  The multi-player party has a grater willingness to play hardball in some cases, as an experiment, because the knowledge gained in any single experiment can be applied multiple times.  Each individual bank gains nothing from the experiment and has no particular loyalty to the overall cause of banking.

3. Banks will pay a premium to escape.  The banks never wanted to be here, remember?  They gain substantial non-economic value from escaping.  No more regulators crawling through every administrative orifice.  No more dividend and compensation limitations that are acting as competitive disadvantages relative to other non-TARP banks.  No more ongoing hostile press.  No more having to consume valuable executive time dealing with the government.  No more worrying about how any given business decision may look in the press.

Banks will pay a premium to flee.  In fact, one bank fairly clearly did:

Yes, the Goldman Sachs that Rolling Stone reporter Matt Taibbi recently described as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

“Yes, Goldman Sachs, may I entangle you?”

Wilson speculated that Goldman Sachs decided to pay fair price to avoid more of the bad press that’s been coming its way the last several months. The bank paid $1.1 billion for its warrants, which Wilson estimates have a fair market value of $1.12 billion based on Tuesday’s closing price on shares of Goldman Sachs.

Have you ever bought a house?  Did you ever offer the Ask?  If you did, I can tell you why you did it – you felt that if you didn’t, the opportunity would run away.  In fact, Goldman originally offered much less than the Ask:

The investment giant initially offered to pay $650 million, sources familiar with the negotiations said.

Goldman Sachs said Wednesday that it had paid $1.1 billion to buy back the ownership stakes it had handed over to the government when it received a federal bailout package last year, acceding to Treasury Department demands for a higher price on the securities.

If my mental arithmetic is on target, the price Goldman initially offered is probably in line with the discounts from calculated valuation agreed in the other bank buyouts.  But then Goldman caved, and fairly rapidly, suggesting (at least to my way of thinking) that Goldman paid a big premium for exiting swiftly.

I’m in a hurry to escape

Goldman could afford to pay it out, too, considering that it pulled down a $3.4 billion profit in the last quarter and the taxpayer gave it billions by funneling money through AIG to Goldman.

[That 'funneling money through AIG to Goldman' crack has been floating around the internet for some time.  I think it's a calumny but it's not worth trying to explode. – Ed.]

But if the only way the public has of getting full price is to put the history of the bank on the cover of a magazine, then most banks are likely to get better deals.

Isn’t that another way of saying that the price includes a ’shakedown premium’ for not being unfairly vilified?

Don’t go there

Selling the warrants at auction would put an end to the game. There’s still time, noted the oversight panel, chaired by Harvard Prof. Elizabeth Warren, stating that “the process is still at an early enough stage that the maximum benefit for the taxpayer could be realized if the open market process is enacted now.”

Maybe it could.  Maybe not. 

Treasury shows no signs of changing on its own. Rep. Mary Jo Kilroy (D-Ohio) hopes she can force it to with her House bill.

Looking out for the tapayer: Kilroy was here

“Other investors would want to get a return on their investment,” she said. “There’s no reason taxpayers shouldn’t.”

Actually, I think they did.

We won?

Send post as PDF to

Are we taxpayers winning?

A month ago, Treasury first cleared ten banks to repay their TARP funding, creating rules to sell its glass financial menagerie:

Submitted for your consideration, as discussed in this Wall Street Journal article, is a gargantuan Federal government that, for one good reason or another, now finds itself holding warrants in a series of financial institutions that it has forcibly recapitalized.

Ten big banks earlier this month paid back were cleared to pay back $68 billion in federal government aid. Those firms were: J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley, BB&T, U.S. Bancorp, American Express Co., Capital One Financial Corp., Bank of New York Mellon Corp., Northern Trust Corp. and State Street Corp.

At the time, I speculated:

Conclusion: negotiate, negotiate, then bid?

When the ten banks paid back their TARP money, they knew that it would trigger the buyback or resale of treasury warrants. Sight unseen, I can guarantee that every such bank would like to see those warrants extinguished, and will have already planned its entire tactics, up through and including a potential auction of the warrants.

My guess is that at least eight of the ten banks buy back their own warrants via appraiser-aided negotiations with Treasury. Letting them go to the auction would be too hairy when compared with a known strike price that could be closed at the table there and then.

Knowing this, I expect Treasury’s advisors to be shrewd and to drive fairly tough bargains.

And not a groat more!

Did we?  It depends who you ask, and let’s start with some shrill Monday-morning warrant buyers over at the Huffington Post, whose title leaves no doubt where they stand: Ignoring Watchdog Report, Treasury Gives Three Major Banks Sweetheart Deals:

Less than two weeks after a congressional watchdog called attention to backroom deals in which the Treasury Department repurchased stock warrants from bailed-out banks at well below market value, three more such transactions have now been reported. The big loser: The U.S. taxpayer.

It was easier in the old days of smoke-filled rooms

Before we can call the taxpayers ‘losers,’ it’s as well to remember that any bank that has repaid its TARP has cost taxpayers nothing, and in fact we made money on the interim TARP dividends. 

[Also, don't forget that many banks, Goldman Sachs among them, took the TARP under extreme duress, and were not happy about having to do so. – Ed.]

The warrants are additional consideration, so here’s the equation:

            What we put in                                      What we got out

+ Capital advanced                                 + Capital repaid

+ Risk of losing capital                           + Dividends (at five percent annually)

                                                            + Value of the warrants

Although the risk of losing capital is significant, for the repaying banks, we haven’t lost any money.  Even the five percent dividends look decent in this interest rate environment, with sovereign rates close to zero.  So the warrants are ‘playing with house money,’ and what causes the Huffington posters to fulminate is that we sold them back to the issuing banks at a price the post, in its wisdom, believes to be below what we could have gotten had we auctioned them:

The Congressional Oversight Panel reported earlier last month that in 11 transactions with small banks, taxpayers walked away with about 66% of what they could have gotten.

That’s why Monday-morning quarterbacks are never wrong: they can never be disproved.  Who knows what the auction would have fetched?

Who knows what I would have done, if I’d done something different from what I did do?

Before we go completely ga-ga on this subject, we need to understand precisely what the warrants are, as outlined in a more balanced Washington Post view on the subject:

Many major banks that received federal aid are seeking to exit the Troubled Assets Relief Program. To completely sever ties with the program, the companies must also buy back these ownership stakes, known as stock warrants, which were given to the government in exchange for aid.

[Snip]

Stock warrants give their owner the right to buy a company’s stock after a set period of time at a predetermined price. The Goldman warrants allow the holder to buy 12.2 million shares at $122.90 apiece 10 years from now.

[Snip]

But the long-term nature of the warrants makes them difficult to value because no one knows what the stock price will be after a decade.

A lot can change in ten years

Between now and a decade from now lies inflation and uncertainty.  Future dollars will be worth less than present dollars – quite possibly, much less – and the alternate uses of capital in that interval could be quite high-yielding. 

At a hearing on the warrant repurchase program in the House on Wednesday, Herbert Allison Jr., a senior Treasury official, insisted that the sweet deals the banks got were needed to aid the liquidity of the smaller institutions.

I absolutely doubt that’s what Mr. Allison said, but leave that be.

But now, in three out of the four newly-reported transactions, all with much bigger institutions, the deals have only gotten worse. The transactions returned between 54% and 65% of what the taxpayers could have gotten on the open market, according to one estimate.

How many birds in the bush is a bird in the hand worth?

Do you think the answer’s two?  Bueller?  Anyone?

BB&T agreed to buy back its warrants for $67 million, as reported in a July 17 press release. On July 8, the Treasury sold warrants back to State Street Corporation for $60 million. On July 15, Treasury gave up warrants to U.S. Bancorp for $139 million. The latter two transactions are listed by the Treasury in its transactions report for the period ending July 17.

“We are very pleased to have completed the repurchase of the warrant, effectively concluding U.S. Bancorp’s participation in the Capital Purchase Program,” said Richard K. Davis, chairman, president and chief executive officer of U.S. Bancorp, when announcing the deal.

As well they should be. The warrants that USB bought from the taxpayer for $139 million had a fair market value of $260 million, says an academic who has closely tracked the bailout and the warrant repurchase program.  Linus Wilson is an assistant professor of finance at the University of Louisiana at Lafayette’s B. I. Moody III College of Business and he uses essentially the same methodology to calculate fair market value that the Congressional Oversight Panel used — the Black-Scholes and Merton option pricing models.

A man who did his own math: Linus Wilson

At issue isn’t the method of valuation, but rather the assumptions used to make the calculations.

According to Wilson’s calculations, the State Street warrants, which paid the taxpayer $60 million, should have brought in $92 million at fair market value. And the value of BB&T’s warrants was $114 million, meaning the Treasury left $47 million on the table.

Judging from his home page, Professor Wilson is certainly qualified to do the calculations, and some interesting byplay about whether the pricing was right suggests he’s genuinely interested in the truth, not (unlike the Huffington Post) in scoring cheap rhetorical points.

A Treasury official said in a statement to the Huffington Post that the process it uses to determine the price of the warrants is fair: “The warrants for common stock held by Treasury do not trade on any market and therefore do not have observable market prices. Their values can only be estimated.”

Valuing financial assets that are not going to be traded always involves an element of uncertainty. 

Maybe I’m worth it, maybe I’m not

Conversely, the act of selling them changes reality permanently, so that if you go to the auction and are disappointed, you have no way of going back and taking the negotiated offer.

“Treasury follows a comprehensive approach to estimating these values, which involves using a variety of inputs including a set of well-known financial models. These models will include, but will not be limited to, binomial and Black-Scholes option-pricing models, and are widely used in financial markets to value options and warrants.”

This is what Professor Wilson did:

The specific flaw in the Treasury methodology, business professor Wilson told the Huffington Post, is that it doesn’t give enough weight to the bank’s stock price in its calculation. “Treasury starts out with a very low price [that it offers in negotiations].  Banks come back with an even lower price.”

While I have every confidence that Professor Wilson knows what he’s talking about, the quote attributed to him here doesn’t buttress the sentence that preceded it.  Obviously current price means something, but as we know, stock prices fluctuate, so without reading Professor Wilson’s analysis in depth, I can’t evaluate how much difference current stock price makes in a Black-Scholes forward projection. 

Meanwhile, Treasury brought into its estimations several other data sources unavailable to the good professor:

“Treasury also relies on indications from market participants as to what they would be willing to pay for the warrants.”

That’s sound.  In real life, my for-profit company provides independent valuations of complex real estate financial interests.  We build detailed financial models (discounted cash flow, which is to real estate interests what Black-Scholes is to options), populate them with the most defensible and evenhanded assumptions, and derive a value.  Then, when we have that value, whenever possible we go find people who might be buyers of whatever unique asset we are valuing, describe it (anonymously, of course) and ask, “how much would you pay for this asset?”

How much would you pay for all this?

But wait!

There’s more!

We do this because a sequence of reasonable assumptions can sometimes derive an unreasonable conclusion, whereas a market-maker in the money store will bring a holistic assessment of what the object is worth – and after all, that’s the real definition of value, what price will be paid by an independent party dealing at arm’s-length.

We’re dealing at arm’s-length

“We obtain quotes from three separate market participants who regularly invest in or trade similar securities.”

Not just one quote, but three.  Excellent confirmation if you can obtain it.

If we three agree, you gonna disagree?

“We also retain outside managers to provide full, independent valuations.”

These experts, one presumes, will have been drawn from the banking and valuation sectors.

“Together, these various methods constitute a robust process for estimating value and protecting the taxpayers’ interests.”

In point of fact, they do – when one needs to estimate, one gets a better answer by using multiple categorically distinctive approaches and then comparing the results.  So the Huffington Post, by not only relying on a single estimate (and if I were the author, I’d be cringing at the hyperventilated overclaims being made using my report as sole evidence) but also ignoring the ancillary procedural evidence, all of it relevant, whips itself into a lather.

Ignoring evidence? I’m not ignoring evidence!

“Banks get a very good deal,” said Wilson.  “Taxpayers would be better served if the Treasury took an optimistic view of the warrants’ value and moved most of them to auction.”

Perhaps; perhaps not.  I have direct personal experience suggesting that a tortuous internal negotiation can be a good result for the government, much better than allowing the market to work.

The best road isn’t always a straight line

[Continued tomorrow in Part 2.]

Send post as PDF to

Genoese admiral Andrea Doria, by Sebastian Piombo

[A similar meltdown] happened a hundred years ago, in the Panic of 1907 – which lead directly to the creation of our Federal Reserve Banks, as testified by New York Fed CEO Tim Geithner to Congress on April 3, 2008:

Geithner getting a grip on financial history

[Geithner's testimony – Ed.] Congress created the Federal Reserve after the Panic of 1907 with broad authority and a range of instrument … in recognition of the need for a public institution to perform the role of lender of last resort.  When the Federal Reserve was founded, there was no deposit insurance, so the willingness of individuals and businesses to hold deposits at a particular bank depended wholly on their degree of trust that the bank would be able to promptly furnish them with the money they had deposited—whenever they might request it.

As the country debates Secretary Geithner’s aggregator bank proposal, it may be comforting – or not! – to discover that such a concept originated at least half a millennium ago, in Genoa, as reported by a diverting article in the Economist:

Genoa’s Banco di San Giorgio building

An Italian archive yields its treasures

If European banking was invented anywhere, it was probably in Genoa in the 12th century, spurred on by the revival of trade in the Mediterranean. That, at least, is the case convincingly put forward at a website devoted to the history of the bank of San Giorgio. The site was formally launched at the end of 2008 at the conclusion of a 25-year study of Genoa’s early economic history in the voluminous and carefully preserved state archive. The prize possessions are documents from the 12th century describing financial instruments that are commonplace today.

An etching of San Giorgio, from the seventeenth century

With its rival Venice, Genoa was a principal trading and shipping hub, and being the closest large port to the Pillars of Hercules and the Atlantic, Genoa was far better placed to lead the global expansion spurred in the mid-fifteenth-century by improvements in shipbuilding and celestial navigation.  No surprise, then, that a hub of commerce was also a hub of finance – America’s first financial capital, Boston, similarly paired money and venture with the China trade, before giving way to New York City.

The first recorded public bond is dated January 1150 when the municipality raised 400 lire by granting to investors the tax revenue raised from stallholders in the marketplace.

This is exactly analogous to the Redevelopment Areas (RDAs) used today by California municipalities to finance public infrastructure – or, in a slightly different way, to the repayment of Sao Paulo’s slum upgrading infrastructure costs by levying a surtax on water and then financing the stream via an IDB loan.

Municipal infrastructure, financed via a surtax on water: Jardim Iporanga, Sao Paulo, Brazil

The term was 29 years, and the loans were described as compere—or purchases—to evade the church’s usury laws.

Presenting a loan as a purchase-and-repurchase is exactly the dodge used today in Islamic finance: 

For financial markets, and particularly for home ownership in an urbanized world, the wheel of commerce is the loan — debt finance, renting money on an agreed basis for a stipulated time. Without it capital is sluggish, and when capital is sluggish, so is the economy.  

Amazing scholarship: Fernand Braudel’s marvelous The Wheels of Commerce

Islam lacks the financial wheel because of some words Mohammed is said to have uttered on his deathbed. As reported in the Wall Street Journal:

The barrier that Islamic financial modernizers are trying to overcome is the Quranic prohibition on receiving or paying interest: “Allah permitted trading and forbade interest.”  While ignored by many secular Muslims and the conventional banks that operate in most Muslim nations today, this ban has long denied the benefits of modern banking to strict believers — contributing, some say, to the Muslim world’s relative decline after interest-based bonds and loans powered the West’s Industrial Revolution.

For the Indians, travois were good enough — nobody had competitive advantage, and everybody got around, albeit inefficiently — until the Europeans arrived with the wheel, whereupon travois technology became instantly obsolete. In roughly the same way, Islam’s heartland in Arabia is being confronted with an import arising from outside, in this case Malaysia:

Six years ago, a Malaysian bank asked 80 financial institutions in the Persian Gulf for help in selling a corporate bond that complied with Islamic prohibitions on interest.

The corporate bond is a work-around — an object reverse-engineered around an obstacle, in this case the Quranic prohibition — to achieve the same results indirectly as if the obstacle were absent.

For legal purposes, that’s a straight line

This multi-century parallel tells us something about global finance and Islamic finance:

The good news is that Islam has developed a workaround past religious prohibitions on ‘usury.’

The bad news is that Islamic finance has 800 years of catching up to do.

The better news is that the catching-up can occur very quickly, if Muslims want it to.

Meanwhile, back in the early Renaissance:

In the 13th century tradable government bonds were issued in Genoa, paying 7% interest. In the 14th century the first sinking funds were organised in Genoa; and, 100 years later, the first lottery. Giuseppe Felloni, a Genovese historian and numismatist, has written a commentary on this impressive list of historical firsts in a 91-page pamphlet, “Genoa and the History of Finance: A Series of Firsts?” A fuller account and the pamphlet itself (.pdf) can be found on Mr Felloni’s website.

Written in Italian and a proudly grandiloquent English

According to Felloni, the bank as financial institution was invented in Genoa:

By the 15th century Genoa’s finances were in such a parlous state that in 1407 the municipality established a private bank to consolidate its debts and called it the Bank of Saint George.

What is a bank, anyhow?  And why did people invent it?

When commerce was in barter, one had no need for banks, merely for strongboxes. 

1880 strongbox

Today’s modern equivalent is the safety deposit box – a place to keep items of value, be they monetary or otherwise. 

Lot of strange things in those boxes

When wealth turned into money, money requires investment (”Money is like muck; not good unless it be spread” – Francis Bacon, 1625), which requires a money store.  Because it’s difficult to bind the sovereign, banking emerges as the alternative to taxation and confiscation.

Commercial moneylenders already operated alongside the bond market (they were known as banchieri) but the Bank of Saint George was the first institution in Genoa that could be called a bank.

General ledger from the Banco di San Giorgio, 1453

It also operated as a giro bank and it stayed in business for 400 years. It was not the first in Europe; a giro bank in Barcelona beat them to it by six years.

Banking was essential because Genoa was both wealthy and a huge trading port.  The Renaissance was fueled with capital – ships were a vast undertaking, both to develop and to outfit for a long and risky voyage to the East or West Indies.  As Felloni quotes (page 14):

A powerful master is Sir Money.

Born with honors in the Indies.

Where everybody befriends

It arrives in Spain to die.

And then is buried in Genoa.

El Rey Felipe II of Spain:

The richest man in Christendom, but he went bankrupt

To be an entrepreneur, one needed to raise money.  To be a capital provider, one needed to invest money, and it needed to be on deposit with someone.  Whoever held the deposits had to remain solvent throughout the deposit period.  According to Felloni, the Genoese invented the bank as a recapitalization strategy:

By the 15th century Genoa’s finances were in such a parlous state that in 1407 the municipality established a private bank to consolidate its debts and called it the Bank of Saint George.

In other words, the municipality of Genoa was the ‘bad bank’ whose debts were consolidated and then (presumably) recapitalized by the rich Genoese merchants, so they had a source of ongoing liquidity. 

In fact, they didn’t stop there.  Author Felloni claims the following Genoese firsts:

First public bank (Banco di San Giorgio)

Government bonds

Public debt

Public debt reforms

Repayment of public debt and sinking funds

Discount of public debt coupons (TARP, anyone?)

Felloni thinks the Genoese got there first

Double entry and public accountancy

Lottery and selection to public office

Clearinghouse

Protection of financial capital

Aided in part by its mastery of finance, Genoa boomed, vying with Venice for Mediterranean supremacy.

Genoa, 1720, prosperous and independent

As Harry Lime put it in The Third Man:

The cuckoo clock … Goodbye, Holly

Don’t be so gloomy. After all it’s not that awful. Like the fella says, in Italy for 30 years under the Borgias they had warfare, terror, murder, and bloodshed, but they produced Michelangelo, Leonardo da Vinci, and the Renaissance. In Switzerland they had brotherly love – they had 500 years of democracy and peace, and what did that produce? The cuckoo clock.

Meanwhile, back in Italy, the Renaissance flowered:

The oldest bank still in business is Italian, however. Monte dei Paschi di Siena was founded by the municipality in 1472 to give loans to the poor at better rates than those offered by the moneylenders: a business model that has persisted for half a millennium.

Banking in Siena …

Banking, charity, and affordable housing – tied together since the inception of banking. 

… since 1472

Send post as PDF to

My dear, your being down is in the nature of things

“I don’t want downs!” shrieked Lucy.  “I want only ups!  I want to go from an up to an upper up!”

So it is with investors and risk; we’re delighted to take the ups – we even congratulate ourselves on our sagacity and daring – but we become apoplectic at the downs.

Does the word begin with F?

So, it seems, are the editors of the New York Times, who have authored a nothing-but-upper-ups editorial

If you have a 401(k) retirement plan at work, you don’t need us to tell you that you’ve taken a hit in the past year. The really bad news is that the damage to your retirement security is likely worse than what the numbers say on your statement.

Many Americans didn’t have enough savings coming into the downturn.

Okay, stipulating that to be true arguendo, whose fault is it that they don’t?

And employers are increasingly cutting back or suspending their 401(k) match.  FedEx, Eastman Kodak, Motorola, General Motors and Ford, among others, have announced such moves.

There’s also no guarantee that today’s battered 401(k)’s will rebound powerfully.

There’s no guarantee of anything.

People close to retirement don’t have time for a do-over.

Lest those reading the editorial not be themselves close to retirement, the Times wants you to feel afraid too:

I fear the wrath of Times

Even for those still far from retirement, there’s no telling how stocks will perform in the future.

That’s always been the case.  You could have invested your 401(k) in bonds or treasuries.  Or you could have a defined-benefit plan (which was the old model) – but then you face the risk, as my grandfather had it, that your company will go bust before you retire.  He worked for over two decades at the Saturday Evening Post, and built up a very nice pension.  Unfortunately, the Post went under, and with it his pension.  From that financial implosion and several others we enacted legislation – ERISA, the Employee Retirement Income Security Act –to safeguard pension money from plunder or corporate collapse, and then enacted 401(k) because it was a better investment alternative for individuals. 

Here’s Wikipedia’s summary of the history:

In 1978, Congress amended the Internal Revenue Code by adding section 401(k), whereby employees are not taxed on income they choose to receive as deferred compensation rather than direct compensation.  By 1984 there were 17,303 companies offering 401(k) plans.  In 1998, Congress passed legislation that allowed employers to have all employees contribute a certain amount into a 401(k) plan unless the employee expressly elects not to contribute.  By 2003, there were 438,000 companies with 401(k) plans.

Originally intended for executives, the section 401(k) plan proved popular with workers at all levels because it:

Had higher yearly contribution limits than the IRA

Usually came with a company match

Provided greater flexibility than the IRA, often providing loans

If applicable, offered the employer’s stock as an investment choice.

It is, in short, a better mousetrap.

Is that my retirement cheese?

The danger of the 401(k) plan is if the contributions are not diversified, particularly if the company had strongly encouraged its workers to invest their plans in their employer itself. Congress inserted trust law fiduciary liability upon employers who did not prudently diversify plan assets.

Today 401(k)’s are the retirement savings vehicle of choice, because they incentivize savings, are easy to administer, give employers a reliable expenditure stream, and give recipients wide choice in their investment strategy. 

Most people, quite rationally, put their 401(k)’s into equities.  Which go down, as the Times bemoans, but also up:

I want only upper ups!

They could post impressive gains, especially in the near term, from their current low levels. But they could also struggle. The last 25 years was a time of low inflation rates and low interest rates, which boosted stock prices. Going forward, inflation and interest rates have nowhere to go but up, which would be bad for stocks.

This is populist nonsense.  In general, inflation is the young’s revenge on the old for their over-spending.  As the world’s foremost consulting housing financial theorists, Sherlock Holmes, put it:

“If revenge is a dish best served cold,” said Holmes, “then inflation is a dish long marinated.  Inflation is the young’s revenge on their elders for over-spending.  In fact” – he twirled his fingers and the image appeared – “we may express it as a law.”

“Fortunately or otherwise,” Holmes said with a thin smile, “once money was invented, inflation came along with it.  As opposed to pure barter, where commodities and services are exchanged directly – money is always an abstract representation of a unit of value.”

Meaning that the value of money is what you can buy with it.  So inflation, if it comes back – which it will, with a vengeance – devalues debt instruments, increases the value of commodities and equities.  Stock will come back when inflation does – probably before.

It wasn’t supposed to be this way. Over the last several decades, businesses and government used matching contributions and tax breaks to encourage the proliferation of 401(k)’s. They lauded them as a way to harness the market to create wealth and increasingly viewed them as replacements for traditional corporate pensions.

Well, they were.  Indeed, they encouraged people to save, tax-free.  Remembe the Times bewailing that Americans didn’t save enough?  It wasn’t for lack of incentives or vehicles.  Nothing could have been easier that to put away more of one’s paycheck.

My company uses 401(k)’s.  We believe in them; we fund a match. 

In 1983, 62% of workers with retirement coverage had a traditional pension only, while a mere 12% had 401(k)’s. Today, approximately 20% have a traditional pension and about two-thirds have only 401(k)’s.

Because they’re better.  Because defined-benefit is a different fool’s game.  Because there ain’t no such thing as a free risk premium. 

The shift to 401(k)’s also shifted investing risks and responsibilities from employers to employees, but as long as participants generally made money and recovered losses quickly, the risks seemed reasonable.

Seemed?  I know not seemed.  The risks were reasonable.  Investing in a 401(k) didn’t compel you to put your money into equities.  Most companies offered a range of funds, from heavily debt-oriented to mostly equities.  So each investor could decide where he or she wanted to be on the risk curve.\

Don’t say you didn’t have choices

Choices within choices

Now many Americans are inevitably having second thoughts.

Would it be too cynical to say they are now having first thoughts?

Perhaps you should have thought through your actions first?

So far, the cumulative wipe-out of household retirement savings totals about $2 trillion, and no one believes that the downturn is anywhere near over. As a result, participants in 401(k)’s are in greater danger than ever of coming up short in retirement.

Yes, let no one doubt that the global de-leveraging will hit everybody – that’s the definition of a financial pandemic – among them the soon-to-be-retirees of my boomer generation, who always spent as if there would be no tomorrow.

That grim reality calls for an expanded approach by policy makers to retirement issues.

I’m from the Department of Post-Mortem Investments and I’m here to expand my approach

Well, does it? 

Traditionally — and correctly — an important focus has been on lower-income Americans who lack the means to save and tend to work for employers who do not offer retirement plans.

Yes, and one could argue that they are the only part of the spectrum with whom government should concern itself.  Caveat emptor applies to all of us.

During the campaign, President Obama supported a better savers’ tax credit to encourage savings among lower-income Americans.

Fine, although this has nothing to do with the Times’ editorial thesis, that we need to reform how savings are invested and what options people should be allowed in investing their retirement savings.

He also supported universal IRA’s, which would make a 401(k)-like account available to all workers. Those good ideas should be pursued.

Can you hear the approaching but … ?

There are also good ideas for improving 401(k)’s that deserve attention, such as helping people manage their retirement withdrawals so that the money lasts a lifetime.

More should be made of this throwaway comment. 

Money, though conceptually simple, is in its deployment and management fiendishly complex.  Financial literacy doesn’t mean merely understanding how a mortgage loan works or how to balance your checkbook (at least in theory, or via input into Quicken or the like).  We’ve seen that savings precedes borrowing, that buying a home requires consulting help and asks you whom do you trust, and creates opportunities for complex fraud.

“A woman’s handshake is not legally binding.”

Doesn’t the reverse hold as well? 

If the home is people’s largest financial asset, aren’t their retirement savings the second largest?  When vastly wealthy people gave Bernie Madoff their investment money, relying on otherguy due diligence, we clucked at their naivete.  When my grandfather’s savings were wiped out, we patched the funding hole with ERISA.  In turn, he pulled up his socks and got a job at Newsweek, worked a few years longer than he had planned, and go through. 

The wipeout in 401(k)’s has made it clear that it is not enough to get more people to save more. There needs to be a better way to reasonably ensure that a lifetime of savings can’t be undone by forces beyond one’s control.

Like Lucy Van Pelt, the Times wants no downs, only ups and upper ups.

I can’t help those who deny reality

The Center for Retirement Research at Boston College, a leader in retirement policy, is advocating a new savings account — in addition to Social Security and 401(k)’s — that would enable risks to be shared among workers, retirees and the government.

Whoa!

You mean I can share my downs but not my ups?

[The proposal does not leap to the eyes from a quick peek at the CRR’s web site; any reader who can find the reference is invited to email me. – Ed.]

To insulate retirees from the consequences of their overspending, the Times would like to parcel out their risks to:

1. Current workers, who are already paying for employees’ retirement through their Social Security payments.  I don’t know anybody under the age of forty who sees Social Security as anything other than a contemporaneous transfer of taxes from themselves to their parents’ and grandparents’ generation.

2. The government, which is just us in another guise.

Got it?  The pain will be shared among retirees, current workers, and current workers.  Two out of three of these are innocent. 

Two of the three of us are apoplectic

To insulate people of my generation who overspent, they would tax those who didn’t – the young, who will already bear the burden as we dig our way out of this little mess – either directly (probably by taking a payroll deduction at source and funneling into retirees’ accountants – that’ll be popular), or indirectly (by taxing all of us).

“Don’t tax you and don’t tax me, tax that man behind the tree.”

– Senator Russell Long

Send post as PDF to