AMERICAN.COM

Banking is and always has been a risky business. A Venetian senator in 1584 claimed that there had been 103 banks established in the history of the city, of which 96 had failed.

Can you improve things by punishing bankers for their inevitable mistakes?

In 14th-century Barcelona, the law provided that any banker who failed would be publicly disgraced by the town crier and then kept on a diet of bread and water until his creditors were paid. (Luckily the Dodd-Frank Act didn’t think of this idea.)

However, this did not seem enough punishment, for in 1321 Barcelona added the penalty of being beheaded if the banker’s obligations were not settled, and indeed in 1360 one Francesh Castello, a hapless failed banker, was beheaded in front of his bank!

Apparently even this wasn’t enough: in 1438 Barcelona simply made private banking illegal.

So whatever are our problems with the riskiness of banking, we can be assured that such problems are of long standing.

(These and other adventures in the history of banking are instructively discussed in Bernard Shull and Gerald Hanweck’s 2001 book Bank Mergers in a Deregulated Environment, although you wouldn’t guess it from the title!)

Which are the most profitable banks in America? Not the private banks, but the government banks—namely the 12 Federal Reserve Banks.

In 2011, the 7,357 U.S. banks made an aggregate net profit of $119 billion. Only 12 Federal Reserve Banks made $77 billion.

The private banks made a combined return on equity of 7.8%.  The Federal Reserve Banks’ combined return on equity was about 144%.

The private banks had leverage (total assets divided by equity) of about 9 times. The Federal Reserve Banks were leveraged 54 times.

The banking system as a whole must be understood to contain these two parts: private banks and Federal Reserve Banks. Quite a contrast between the parts! This is summarized in the table below for the year-end 2011:

Distinguished economist Greg Mankiw has just written on his blog that his formula for setting the federal funds rate “recommended a deeply negative federal funds rate during the recent severe recession.” He continues, “Of course, that is impossible.” No, it isn’t. Negative interest rates are perfectly possible, as most recently shown by the sale of short-term German government bills for negative yields. We don’t seem to be able to rid economics of the myth that interest rates cannot go below zero.

The Federal Reserve is not willing to try them, however, although it has tried many other things. I speculate that this is because the Fed prefers to pursue credit allocation to mortgages through expanding its own balance sheet, in order to try to prop up house prices.

The notoriously bankrupt MF Global’s assets apparently will cover about 82 cents on the dollar of its obligations to customers. The de facto bankrupt Social Security’s assets will cover about 83 cents on the dollar of its obligations to beneficiaries. Jon Corzine, meet Social Security!

We have had a good deal of financial agonizing of late about whether problems with the U.S. government’s debt limit might mean a loss of status for Treasury debt so that we would no longer have a “risk-free [interest] rate.” Well, not having one is not much of a problem, because there never was a risk-free rate, or a risk-free anything else—including government debt.

Lending money to a sovereign power, which might just choose not to pay you back, has occasioned many a lender’s loss. An essential distinction is that the debt is that of the government, not of the country. Consider the bonds of Czarist Russia or the Confederate States of America.

Sovereign debt was never risk free, and financial history is replete with defaults by governments on their debt. Carmen M. Reinhart and Kenneth Rogoff (This Time Is Different) chronicle 250 such defaults since 1800. The notion that sovereign debt is “risk-free” should be considered primarily a marketing slogan for borrowing governments and bond salesmen.

European banks are staring at potentially huge losses on sovereign debt in their portfolios. This reflects a long history and much precedent: one key purpose of banks going back at least to the founding of the Bank of England in 1694 was to lend money to the government in exchange for getting charter privileges.

Reflecting this, it is commonplace to find regulatory policies and bank capital requirements written to encourage banks to hold a lot of government debt. In the United States, this was extended by regulatory policies to encourage banks to hold large quantities of the government-sponsored debt of Fannie Mae and Freddie Mac, and also of their preferred stock, in order to promote housing. These policies exacerbated the hyper-leveraging of the housing finance sector.

An irony is that the banks themselves represent indirect government debt, since their most stable funding sources are deposits guaranteed by the governments.

The lack of a risk-free anything forces us to contemplate a difficult truth. The financial universe, like the physical universe, is Einsteinian, not Newtonian. There is no absolute frame of reference. There are only many financial things, all moving with respect to each other, with constantly changing exchange rates between them, all subject to various risks and to guessable, but unknowable, uncertainties.

President Obama to middle classers: I want you to pay more into Social Security and give you a return of -50 percent—or perhaps -100 percent!

But Andrew, it seems to me that it doesn’t make sense unless you’re raising the tax without raising the payout.

Andrew, isn’t the key point that he wants to raise the tax base, but not to raise the benefits base. So, hello, all you middle classers: You are going to pay more Social Security tax, but get no increase in retirement benefits in exchange. Therefore it is clear that this Social Security strategy represents not a nice government savings account, but a welfare program. Isn’t that what the president and the other members of his party don’t want to say?

Instructive excerpts from articles on banking, international debt, and the real estate market:

Gone is that hysteria of financial terror. There is a return of reason.

The Federal Reserve System, by buying government bonds, has launched a more aggressive policy of credit expansion. The time for excessive caution is past. There is greater danger now that the banks will loosen up too slowly.

Reserve policy may be shaped by a desire to stimulate confidence via the stock market.

We have become more or less hardened to the threat in various countries of default on international debt payments.

This is going to be a bad year for residential mortgages.

Lenders are wary. The air is full of reports of foreclosures on houses, and about inability to renew mortgages. Mortgage companies generally say about the last thing they want to do is to foreclose on a mortgaged home. On the other hand, it is undeniable that large numbers of householders, finding that the second mortgage has discounted any possible appreciation in values and loaded them with impossible payments, are giving up.

The second mortgage is the curse of the own-your-own home program.

It is to remedy this precarious situation and to facilitate future financing that President Hoover has proposed the idea of a national system of Federal Home Loan Banks. A bitter fight is being conducted in Washington and all over the country. The Mortgage Bankers Association and the big insurance companies are opposing it. The American Bankers Association appears to be cold to it. The National Association of Real Estate Boards, small insurance companies, and the National League of Building and Loan Associations are avidly for it.

It will encourage members to loan freely, doing away with the second mortgage bane. It should be in operation in time to afford much relief to frozen small mortgages and so contribute to the general improvement of the whole home-building finance field. Opponents, indeed, say it will lead to inflation and over-building.

It is very much to be doubted that the world will take undue alarm over any probable deepening of the present crisis in Germany.

From The Magazine of Wall Street, March 19, 1932 (ellipses not shown).

Ordinary Americans are being taxed so that foreign investors in the debt securities of the insolvent Fannie Mae and Freddie Mac can get all their interest and get their principal paid off at par.

In this context, here are some intriguing excerpts from former Secretary of the Treasury Henry Paulson’s book, On the Brink (emphasis added and ellipses deleted):

“I had told Dave to reach out to international investors, approaching finance ministers and central bankers. ‘Make sure they understand what we’re doing,’ I instructed him. ‘Make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.’”

“Treasury had been getting nervous calls from officials of foreign countries that were invested heavily with Fannie and Freddie. Foreign investors held more than $1 trillion of debt issues or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. They had bought these securities in the belief that the GSEs were backed by the U.S. government. They wanted to know if the U.S. would stand behind this implicit guarantee.”

“I flew to China for the Olympics on August 7 [2008]. Among the many financial leaders I spoke to were my old friends Zhou Xiaochuan, the head of the central bank of China, and Wang Qishan, vice premier in charge of China’s financial and economic affairs. It was important to relay what was going on to the Chinese who owned hundreds of billions of dollars of GSE debt. They had trusted our assurances and held on to this paper at a crucial time. ‘I always said we’d live up to our obligations,’ I reminded Wang.”

Now where do you suppose the secretary of the Treasury got the authority to commit U.S. taxpayers to bailing out the Chinese bondholders?

Image by Bernhard Suter.

Sitting on the sidelines, looking back after the fact, how clear the patterns may seem. Not so to those who must make decisions subject to great uncertainty while in the midst of a financial panic, blindsided by surprises and the unexpected. Consider the following quotations from former Treasury Secretary Henry Paulson’s striking memoir of the crisis, On the Brink.

Paulson had been at the head of one of the greatest financial firms. As secretary of the Treasury of the dominant country in the world’s financial system, he was at the center of a unique international network of communication and information.

And yet:

“I misread the cause, and the scale, of the coming disaster. Notably absent from my presentation was any mention of problems in housing or mortgages.”

“I had never thought I’d have to use the emergency powers Congress had given me.”

“The crisis … came from an area we hadn’t expected-housing-and the damage it caused was much deeper and much longer lasting than any of us could have imagined.”

“Now, I hadn’t seen the Russian financial crisis coming-none of us had.”

“In August 2006 … the economic outlook was strong.”

“In the summer [2007] I’d asked Bob Steel to begin developing solutions for our mortgage problems, though at the time we didn’t realize how far-reaching those problems would become.”

“All of this led me in late April 2007 to say … that subprime mortgage problems were ‘largely contained.’ I repeated that line of thinking publicly for another couple months. Today, of course, I could kick myself. We were just plain wrong.”

“Noted Herb Allison … ‘We used to think we knew a lot more about these assets.’”

“Just about everyone lived at the Treasury … to try to solve problems that kept getting bigger than we had anticipated.”

“General Electric … was having problems selling commercial paper. This stunned me.”

“I never expected to hear those troubles spreading like this to the corporate world.”

“Lehman’s UK bankruptcy administrator, Pricewaterhouse-Coopers, had frozen the firm’s assets in the UK. This was completely unexpected.”

“In a celebratory mood, Pelosi, Reid, Dodd, Frank, Schumer, and I walked together to Statuary Hall to announce the [TARP] deal. Perhaps I should have foreseen the problems ahead.”

“We got hit with a surprise when the Wachovia deal with Citi was suddenly thrown into doubt.”

“AIG was again bleeding. It astonished me.”

“Chairman of Standard Chartered Bank… asked in a low voice about Citigroup and GE. ‘Are either of those two going down?’ This jolted me.”

“I expected the program to be politically unpopular, but the intensity of the backlash astonished me.”

“AIG would need a massive equity investment. I was shocked and dismayed.”

“I began to seriously doubt that our asset-buying program could work. This pained me, as I had sincerely promoted the purchases to Congress and the public … I dropped a bomb when I informed them we had decided against buying illiquid assets.”

“I headed over to the Oval Office to tell the president that Citigroup was teetering on the brink of failure. ‘I though the programs we put in place had stabilized the banks,’ he said, visibly shocked. ‘I did, too, Mr. President.’”

“I had been falsely reassured by the fact that the markets had supported the bank [Citigroup] for so long.”

“Ken Lewis called to tell me that Merrill Lynch’s fourth-quarter losses were way out of line with what he or anyone had expected.”

“‘Hank, it is worse than any of us imagined,’ Lloyd [Blankfein] said.”

And so, says Mr. Paulson:

“We had no choice but to fly by the seat of our pants, making it up as we went along.”