Thursday, February 28, 2019

Hamilton and His Bank

The visionary Founding Father, Alexander Hamilton (1757-1804), was a highly controversial figure in his day. Although from quite low origins in the Leeward Islands of the Caribbean, he was sponsored to be sent to attend King’s College (now Columbia) in New York. He got caught up in the political fervor of Revolutionary War and in 1776 he joined to fight, then shortly organized a 60 man Artillery Company of whom he was elected captain. They participated in the battles of White Plains and Trenton and in 1777 at the Battle of Princeton. He was recommended to George Washington and served him as his closest Aide to Camp, as Lieutenant General for four years until he insisted on the chance to lead his own troops. He participated in the decisive battle of Yorktown in 1781 that saw the surrender of the British and the eventual end of the Revolutionary War.

He served in the Continental Congress and as an Assemblyman in the New York legislature prior to Constitutional government. In 1784 he established the Bank of New York along with Aaron Burr, his eventual killer in a duel in 1804; that bank continues today as New York Mellon Bank (BNY Mellon). He served as delegate to the Constitutional Convention, as well as writing the majority of the Federalist papers along with Madison that championed its ratification.

In 1791 he was appointed Secretary of Treasury in Washington’s administration under the new Constitution. He was an advocate of what would later be termed the American System, most closely associated to Senator Henry Clay (John Quincy Adams and Abraham Lincoln, as well).  The platform of the American System included protective tariffs, national bank and internal improvements. His “Report on Manufactures” to Congress in 1791 recommended active measures to promote business ventures along with a protective tariff, a nationalist economic program.  

He pressed for an America that was meant to assimilate the business elites into its governance. Their participation was essential to good government. The Bank would be the vehicle to do this for one by holding the deposits of the U.S. Treasury. As such he advanced high tariffs to promote American industry and actually the Whiskey Tax to pay for the military to fight western Indian Wars (1791-1795).

For many, including the Federalist, there was great distrust of direct democracy that can easily descend into mob rule and disorder. Our Constitution is designed for government NOT to work well, since it is thought a government that governs least governs best. It’s divided into three branches; the legislative branch bifurcated into Senate, originally meant to be elected by state legislatures and the House. And virtually from the beginning the Judiciary, designed to check the other two branches, was filled by Federalists, appointed by President Adams, the party most suspicious of governing competence of the common man.

Agrarian America opposed the idea of Hamilton’s schemes. Part of the controversy was fact that a Federal bank was not part of the enumerated powers (Article 1, Section 8) set forth in the Constitution. From the beginning of the Republic there was debate over the idea these Enumerated Powers and the concluding section called the Necessary and Proper clause:

 “To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Powers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof.”

The debate continues to this day between the Constitution as a Living Document as opposed to one interpreted towards the Original Intentions of the Founders.

Agrarians had little use for these suspect artifices called banks. Banks were devices which “covetous” persons enriched themselves at the expense of the honest and diligent. Many efforts were made to ban banking completely. Governor of Kentucky in 1819 proposed a Constitutional ban on banking. Texas in 1845 prohibited banking absolutely. Iowa and Arkansas in 1846 prohibited the same. Free banking had led to abuses with suspect bank notes and many farmers left stuck with worthless bank paper.
An idea that echoes today’s Libertarians can be heard in William Gouge’s thoughts, “The business of lending [printing] money is no part of the duty of any government, either Federal or State.” And several periods in American history there was no Central bank with government currency. The policy of a national currency has great advantages but as has been seen in our recent history to harbor terrible risks.

There were many still, who saw state charted banks as a boon with its circulating paper. Many state banks had been chartered in the first decades of the Republic. Upon the closing of the First U.S. Bank in 1811 these state banks began to accelerate bank note lending, lacking the restraint provided by the Federal Bank. The amount of the bank notes rose from $28 million to $68 million between 1811 and 1816. It must be noted this is during the War 1812 where war time demands always strain the resources economies. That reckless interim prompted Congress to charter the Second U.S. Bank in 1816. As a depository of the U.S. Treasury it would accept specie, Fed bank notes and state bank notes redeemable on demand as payment of taxes. A significant segment of polity opposed the bank and the debate would arise again in 1832 for re-charter. President Jackson was incontrovertibly opposed to the U.S. Bank and vetoed the re-charter. The bank would cease to be a depository of the U.S. Treasury in 1833.

Hamilton, a Federalist, saw the bank as essential to the new Nation. The monied elites would have a stake in the new Republic. For that matter the majority of the delegates of the Constitutional Convention held debt, deeply discounted, of the revolutionary States of the Confederation. The prevailing wisdom held that these debts incurred during the Revolutionary War would never be honored. Hamilton and many others, representing business and mercantile interests, who were promoting the new Constitution desired to see these redeemed in full. Madison only wanted the original holders to be reimbursed in full, the speculators only partially.   Hamilton and his party would see that they would be repaid in full. This helped to create a foundation for promoting business interests; America would become a patron of the Industrial Revolution. 
Agrarian interests were very skeptical of what would become the standard financial lexicon of the Industrial Revolution.  The change Hamilton was pushing was an economy of obligations, contracts, negotiable instruments and other invisible artifices as opposed to the agrarian idea of direct exchange with money for a good between two honest men without these artifices. Corporations were held to be suspect associations of men that allowed them to act immorally; that is act in a way they wouldn’t individually. First Bank of U.S. was one of these artificial corporations.

We live in Hamilton’s America not Jefferson’s. Under his purview he set up the contentious U.S. Bank (also known as the First Bank of the United States) in 1791 situated in Philadelphia with several branches throughout the country shortly thereafter (Boston, New York, Baltimore, Charleston, Washington, Savannah and New Orleans). The bank was capitalized with $10,000,000. This bank imitated the Bank of England’s partnership of moneyed interests and the crown’s interest. The U.S. government was to contribute $2 million to the bank. This was done by sleight of hand. Government commissioners sold $2 million government securities in Amsterdam then deposited the drafts into the First Bank of the United States as the government capital contribution. Then the U.S. Treasury borrowed $2 million from the U.S. Bank to take up the $ 2 million in drafts, so a large claim of specie wouldn’t be presented to the fledgling bank. The reminder of the $8,000,000 was contributed by private interests of the country. $ 2 million in specie was to have backed the bank, but in fact no more than $400,000 was collected. Later this amount was to grow but the reality was the bank was lacking specie to back the bank. All to the good since the bank was run properly and no run was made on the bank.

This was a Fractional Reserve bank, established with a fraction of total deposits backed by specie. In this case ideally at 4 to 1, deposit to specie ratio, it was similar to the Bank of England.  Fractional Reserve Banking became the dominant type of banking in the industrial world. The TBFT (Too Big to Fail) banks like Citibank, JpMorganChase or Wells Fargo currently have capital ratios higher than 10 to 1. That is only $1 backing $10. These fractional reserve banks are subject to collapse. Thus Big Government with the complicity of duped taxpayers is called on to bail them out from time to time to prevent economic chaos. Despite the fact that they could have bailed themselves out as they had done prior to the Federal Reserve Bank was established in 1913. The biggest disaster related to this fractional reserve banking was the Great Depreciation, in which the banking system collapsed like an accordion.  Federal Reserve Bank, established in 1913 to allay these disasters, stood on the sidelines. There were thousands of bank failures; Iowa had 1200 alone in the 1930’s.   

Banking, fractional reserve banking that is, began with an immoral scam. Once banks fulfilled the purpose of a safe storage and prevention from loss for your valuables, gold, silver or jewels; then banks provided the convenience of a bank note that represented your value in safe keeping.  That was so much easier than carrying that bar of gold around and safer too. But then banks realized particular customers hadn’t bothered to redeem their bank note for specie for a lengthy period. An unscrupulous banker hatched the idea to lend at discount the same specie. Another bank note is originated on the same store of specie and bank makes more profit. The bank note is used to pay someone else, with the assumption that it’s redeemable in specie. If ever those two show up at the same time…oops! Let me get back to you about that gold, says the banker… It’s around here somewhere, I think. The Founding Fathers realized this too:

“Every dollar of a bank bill [note] that is issued beyond the quantity of gold and silver in the vaults represents nothing and is therefore a cheat upon somebody,” John Adams, 2nd President of U.S., said in 1809. This view might be one reason he and Thomas Jefferson had a dim view of Hamilton and his fractional reserve bank.

Later in the 1830’s John Quincy Adams identified suspension of redemption by banks with counterfeiting (the “let me look for your gold, I know, it’s right around here somewhere” response).

Banks were disinclined to promote redemption of paper to specie. It was far easier to loan a bank note and then postpone redemption to specie. In a classic case of the golden rule where the gold makes the rules, banking law came to accommodate this chicanery.  In fact before the American Civil War state legislatures began to see the benefit of banks delaying or even refusing to redeem its bank notes in specie. Specie, gold and silver, which had always been considered real money, was always in short supply. Ordinarily paper money possessed value only when it had the prospect of being redeemed by gold or silver. But more often than not the bank had issued far more bank notes than actual specie on hand. Honest redemption, paper for specie, will cause the accordion to collapse, the banks would caution.

Paper money, as many advantages as it possesses, can be frightfully abused. Bank notes can indeed be passed hither and yon. And in fact fractional banks (paper money backed by a fraction of specie) can create money. The bank would loan a sum represented by a bank note (or bank check) and this note  could be re-deposited or deposited to another bank or given to someone else as payment. In 19th century America that discounted check might not even be presented back to the originating bank. Nice for the bank, which would earn interest on the loan and never have to face redemption. Better than counterfeiting. As a result unregulated banking led to massive expansive of bank notes and acted as currency. One egregious example back at the beginning of banking, in March 1808 The Farmers Exchange Bank of Gloucester, Rhode Island had $22,514 bank notes circulating with promise of redemption in gold or silver and $380.50 of specie on hand. Unscrupulous bankers might have more than one bank in which they would write bank notes on the other. Nothing more than sophisticated kiting.

At the foundation, banks were expected to stand ready to redeem the bank note for specie, generally gold. Many times they failed to do so.

Incidentally, Revolutionary War state governments had shamelessly abused the issue of bills of credit. Since there was little to finance the Revolutionary War, states began to issue I.O.Us or bills of credit, actually a Fiat Currency. The abuse led the Constitution to prohibit States issuance of Bills of Credit (Article 1, Section 10). And many thought banks charted by the states and issuing bank notes were virtually the same mechanism prohibited by the Constitution; people preferred the circulation of paper, however.

If you didn’t know, the Union Government in the Civil War did much the same with its Greenbacks. Of course Confederate money once again a fiat currency was far worse and was known to be worth little more than paper, even before they lost the war. 

The First Bank of U.S. was America’s first central bank and acted to regulate the currency. This in itself caused hostility from the public. The bank insisted on redemption of specie from bank notes written on state banks and transferred gold balances to the bank in Philadelphia. The criticism of the South and the West was that it drained gold from the branches to pay to demands on the Eastern banks. America exported agricultural products, much of it cotton. The South produced the bulk of the exports that the North borrowed on. And thus the South paid for the imports. And so it was thought that it was the North’s buyers and bankers that took the South’s profit, adding insult with North’s advocacy of the tariff. Nonetheless, without the gold that the Federal bank transferred from South and West to the East imports would have largely ceased.

I conclude by re-emphasizing that Hamilton, so accomplished and visionary, prompted an idea of a Central Bank remarkably controversial for the predominately agrarian society. It regulated banking by insisting redemption of specie from the state banks’ notes, something hated by the banking sector in general. It rankled Southern and Western regions by transferring gold balances from branches to the central bank in Philadelphia. The bank only dealt with state banks ready to redeem their bank notes in currency, a restraining policy on private banks that profited by floating its bank notes. Absent a bank, farmers with good reputation could often obtain credit from monied individuals within the community; this is how credit demands were fulfilled in the agrarian society without banks.  Admittedly, this would undoubtedly make it far harder for less established agrarians to obtain credit.

Hamilton’s vision was for a prosperous, industrializing America guided by business elites. His vision would be mostly realized. Jefferson’s Republic of yeoman farmers not at all, but his ideas live on in Conservative and especially Libertarian thinking. 

Thursday, February 7, 2019

Panic of 2008 Explained

The 2008 Panic is little understood. We know there was evidence of a sharp downtown. Real estate prices plunged. The stock market collapsed. Investment banking firms on Wall Street failed. Large automobile manufacturers were in peril. Where did the Panic arise? Was there good reason for the financial sector to Panic?

The real Panic occurred in a dimly known and complex, unregulated financial sector, now known as Shadow Banking. Shadow Banking was populated by derivative securities whose value was derived from other sources, much of which was from residential real estate mortgages. 

In fall of 2008 we were informed that the gears of the financial world had locked up. Without immediate intervention a cataclysmic financial event was about to transpire. Absent massive governmental intervention we’d re-live the financial collapse of the Great Depression of the 1930’s. A frenzied colossal demand on the public treasury is made by the Bush administration. Was this just a play to fleece the taxpayers by Wall Street banksters?  

There were many factors contributing to the crisis.  One element was stated governmental policy under the Community Reinvestment Act to increase the number and percentage of citizens, especially minorities, owning a home. A large part of the problem originated when Banks had begun offloading their mortgage loans to Structured Investment Vehicles (SIV). In mid-2007 there were 36 of these non-bank financial institutions, usually situated off shore, totaling $400 billion in assets that gathered large groups of mortgages then spun off derivative securities backed by these mortgages, often subprime mortgages.

The commercial banks (ones that most people maintain their checking and savings accounts) needn’t be so careful about their borrowers, now. Banks would originate mortgages, bundle them then ship them to the SIVs which put them into tranches from prime to sub-prime. They would create residential mortgage backed securities (RBMS). These were acquired by Wall Street investment bankers like Morgan Stanley, Goldman Sachs, Lehman Brothers, Bear Stearns, etc. The last two of these went down in flames in 2008. The other two were secretly supported by the Federal Reserve with unlimited access to the Federal Reserve’s funds in 2009 to keep them afloat; the support amounted to $ trillions in short term borrowings at zero interest.

Housing prices that had seemed set to rise forever surprisingly began to decline. Housing never goes down, right? The first indication for me was the real estate for-sale signs that proudly read, “New Price”. Very interesting to announce a new price; it literally doesn’t tell you much. Is that a lower price or higher price that’s being announced? This forces you to guess that it’s probably a lower price, but makes you wonder why they are being so cute about it. Housing prices went as low as $90, $45 or even $20 thousand (that one was next door) in my community. Who knew? Not many. Maybe the mortgage lenders at the banks originating the lousy sub-prime loans knew, but they didn’t really.* Housing never goes down, right?

Part of the real estate mortgage bubble were teaser loans, no down payment, no principal payments, low interest ARM (adjustable rate mortgage) with balloon payment in 3 years which planned to show equity by the time refinance was due, as house prices continue to rise…oops! Housing prices stopped rising in 2007. People were faced with much higher payments after the initial enticing (ARM) mortgages expired and the need to refinance arrived. They couldn’t even sell the house for the amount of the mortgage, likely to be nearly, if not all of the original amount of the house value, now reduced. How did this torpedo the Wall Street Investment Bankers, the Fanny Mae and Freddie Mac mortgagors, and AIG Insurance?

These investment bankers were the casino gamblers of investment world. In the past Wall Street bankers lived off of fees for underwriting IPO’s (Initial Public [stock] Offerings) or issuance of stock or corporate bonds. They obtained fees for arranging mergers and acquisitions, as well. They did well.

Then the Smartest Guys in the Room (investment bankers) started buying asset backed securities (ABS) and Residential Mortgage Backed Securities (RMBS) using them as collateral and letting large corporate depositors say $500 million to stash money overnight. The RMBS is used as collateral for the party that deposits the cash. The investment bank pays a rate of interest on the cash that is less than the rate earned on ABS. These exchanges are called repos. The investment bank holding the ABS gives the Corporation the ABS as collateral, and the investment bank takes corporate cash, as a deposit. The investment bank makes additional profits when loaning out the cash in short terms loans.
The size of these exchanges is guessed to have been as big as or bigger than the commercial banking sector. In the $ trillions. This was the unregulated Shadow Banking world that the regulators Federal Reserve and FDIC were oblivious to.

All of this business by the investment banks is highly leveraged 20 to 30 times. So the money that’s really backing all this gambling is a fraction of the amount that’s being invested. It’s something like your standard two income family making something like $100k annual income together, deciding to borrow to buy a $3 million dollar home. No danger there? Somebody loses job or gets ill or divorce or any interruption in income will see them losing their house. And so, a hiccup and Wall Street banksters went into the crapper.  

On April 2, 2006, New Century Financial Corporation, a sub-prime mortgage originator files for bankruptcy and becomes a sign things are not all well in the mortgage sector. Many other indications of a downturn in the housing market begin to make themselves known to investors and the market suddenly came to realization that the collateral (these RMBS and ABS) that the Wall Street banksters possess may not be as safe as advertised. By the way, the Federal Reserve Bank wasn’t even looking at the housing market prior to the Panic.

Before the Panic, the investment bank’s collateral, the derivative security, was taken at face value; a $1,000 security would be sufficient collateral for $1,000 in cash. Then as in a run on commercial banks in the past, the investors began to demand more collateral for the same amount of cash deposited. And the crazy part of the panic, the investor began to demand the extra collateral for ALL securities, safe or suspect. Since these securities were so complex, nobody really understood them. Investors began to question them all, even the quality tranches. This is typical of a bank run. All banks suffer the run since the depositor knows nothing of the current financial health of their bank, even a sound one. It’s not just the bank in trouble that faces the panic; they all suffer a run. This is where the financial sector began to freeze up.

Wall Street Banksters were so leveraged they didn’t have the cushion to sustain the shock of a run. Bear Stearns was the first to topple in March 2008. It was bought by Morgan Stanley, which kicked in $1 billion along with a $29 billion loan from the Fed Reserve. Morgan Stanley bought them at $2 a share. Shares had been quoted at $172   January 2007.

What’s more, realizing in part just how risky these derivative securities were, the parties to these transactions thought they covered themselves by purchasing Credit Default Swaps. AIG offered these by the hundreds of $ billions. Investment bankers would find out later just how worthless they were. 

Then this same type of run was made on Lehman Brothers and there was no one to catch it. With their collapse the inter-bank transactions with these repo arrangements froze. That was onset of the Panic. Bush administration and the Federal Reserve were running around like their hair was on fire, not really understanding the cause. But doing everything they could to provide liquidity to the banking system.

The Great Depression in contrast saw the Federal Reserve stand on the sidelines as banks failed by the thousands, a key one was New York Bank of the United States. This saw the collapse of the money supply and financial disaster.

A case where complete collapse was averted was the Panic of 1907, taking place prior to the Federal Reserve Bank being established in 1913. The establishment of the Federal Reserve Bank was setup to prevent these panics. We’ll see shortly how well they performed.

The 1907 Panic saw a sharp downturn in the stock market of nearly 25%, several banks failed and others encountered runs. This is the situation where ALL financial institutions, solvent or no, became suspect and were subject to panicked withdrawals by depositors. Fortunately, the banker J. P. Morgan intervened to summon assistance from other bankers and provide liquidity in the financial system. Something the Federal Reserve failed to provide some 20 years later, whose failure led to the Great Depression. The voting public didn’t want the financial elites like J. P. Morgan bailing out the economy so the Federal Reserve Bank was instituted in 1913. Of course they failed miserably in 1930s to stem systematic bank failure.

The same cooperative assistance between Wall Street bankers could have been contemplated in 2008 but Wall Street knows they have the taxpayers and Federal Reserve to pull their chestnuts out of the fire. The elite 1% are far more clever about pillaging the public treasury than the public. The arcane financial instruments that Wall Street investment bankers had devised backfired on them and the Goldman Sachs bankers within the Presidential administrations knew when their cohorts in Wall Street were in need of relief.
As stated previously, a significant portion of the 2008 Financial Crisis can be laid on the stated governmental policy by the Community Reinvestment Act to address the lack of minority homeownership. There were presumed racial biases keeping minorities from getting a leg up into owning their own home. The government begins to promote mortgage loans to lower income earners and minorities. Lending standards were degraded. But the commercial banks offload these mortgages to the SIV, as earlier stated. These mortgages are grouped and sold in tranches with assigned risk ratings. The more risky loans with blemishes like recent late pays or low credit ratings or high loan to value ratios or even bankruptcy are placed in the lowest rated tranches.

Part of the financial slump Freddie Mac and Fannie Mae, the giant residential mortage GSOs, that accepted much of this trash, with their tiny to nonexistent capital balances, doomed them to go under. In 2008 they held an estimated $2 trillion sub-prime loans (what a euphemism! Really risky or suspect is more accurate characterization). For example nine years after their massive bailout the 2017 Freddie Mac financial statements showed a negative ($312) million in equity. They were bailed out to the tune of $300 billion, one source reports. It’s certainly not beyond the realm of imagination with their nonexistent capital balances, the US taxpayer will bail them out again sometime in the future.
The “smartest guys in the room” thought safeguarded themselves from risk by insuring themselves with Credit Default Swaps: Insurance against failure for these risky RMBS and ABS items. Under CEO Martin Sullivan’s guidance AIG (American International Group) issued $ hundreds of billions of these CDS guarantees, never figuring they would have to pay. They were right they didn’t; U.S. tax payers did with $180 billion in bailout money. We’re told they it has been paid back some years later…small consolation.

As an aside to give a picture the size of $180 billion, it’s sufficient to construct a hundred auto plants or skyscrapers. All to the insurance industry. And $300 billion to Fannie Mae and Freddie Mac, who bought $ billions of these sub-prime loans, to the mortgage finance industry. The level of the malfeasance of the finance and investment sectors was astounding!                                                                                                                                                                                                                                            ***
The 2008 panic was accompanied by a great deal of hysteria, especially by the Bush administration, which along with the Federal Reserve was largely clueless themselves. The Bush administration was throwing money around by the hundreds of billions, $700 billion in the TARP (Troubled Asset Relief Program). This was an unfocused program that spread money around to financial institutions including $10 billion each to investment bankers Goldman Sachs and Morgan Stanley. In actuality they found use to expend $431 billion of the appropriated $700.

The Federal Reserve was completely oblivious of the workings of this massive Shadow banking market prior to the 2008 Panic, with its bundled mortgages and corporate paper in SIV’s and repo exchanges. No accurate estimate can be made of the size of this Shadow banking sector was; some estimate it was as large as the known, regulated banking sector itself. For that matter they remained ignorant of the impending collapse in the overinflated housing market.

The Federal Reserve began a nearly decade’s long Zero Interest Policy, by setting its loans at 0.0% in attempts to put liquidity into the banking sector. This included a massive purchase of $ trillions of these suspect RMBS. Even now in 2019 the Fed’s balance sheet is bloated with $3.7 trillion of bonds and RMBS. This was a unheard of policy whose consequences have yet to been determined. So far steady but not spectacular economic growth for past 10 years.

The crux of the Panic was the unexpected decline in the residential real estate mortgage sector; panicky corporate depositors demanded more collateral as question was raised about the safety of the derivative securities like RMBS used for collateral by the Wall Street investment bankers. This is quite similar to a run on a commercial bank and highly leveraged investment bankers couldn’t ante up. The huge Shadow banking sector had frozen up; the fallout from that would be unknown. No one wanted to repeat the Great Depression. The Bush ($700 billion appropriated) and the Obama administrations ($800 billion) spread money about with abandon in hopes the collapse would be stayed.  

The Panic of 2008 differed fundamentally from the Great Depression that originally saw the Crash of the Stock Market in 1929. The Great Depression eventually saw the collapse of the commercial banking system that led to widespread bank failures in the thousands (9,000 approx.). The Federal Reserve, newly established in 1913, making a monumental miscalculation, neglected to stymie the increasing cascade of bank failures. In 2008 the numbers of commercial banks actually failing were few; runs on these commercial banks were nonexistent, as a result of deposit insurance.

*There was an isolated voice in WaMu (largest savings bank at the time), warning of a housing bubble. He was ignored. The company, guilty of purveying suspect residential mortgages, many with little or no documentation, tanked in September 2008, subject to massive runs and  rejection of their mortgages for securitization. But he was only one of the few. Such luminaries as Warren Buffet, Alan Greenspan and Ben Bernanke failed to see the impact of a declining housing market.