From KALLISTE@delphi.comThu Oct 10 11:44:36 1996
Date: Wed, 09 Oct 1996 19:54:31 -0500 (EST)
From: KALLISTE@delphi.com
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Subject: Here Come the Zombies
Here Come the Zombies
by J. Orlin Grabbe
Like to gamble with other people's money? Then
you need to start a bank. Because your government likes
to make bankers rich. Deposit insurance is one way.
Buckaroo Banker has $200,000. He takes half of
this--$100,000--and uses it as capital to start a bank. He
offers nice interest rates on deposits, and attracts $900,000
in deposits. So the bank now has a million dollars in
assets. Buckaroo takes the million dollars to Harrahs in
Reno and bets it all on Black at the routlette table. Also,
at the same spin of the wheel, he bets the $100,000 he still
has of his own money on Red.
And why not? Consider the advantages. If Red
comes up, the bank loses all one million dollars of its
assets. But repaying the $900,000 owed to depositors is
the government's problem: the government insured the
deposits. Meanwhile, Buckaroo's $100,000 bet on Red
has turned into $200,000. So he is as well off as before.
But if Black comes up, Buckeroo loses the
$100,000 bet on Red, but the one million dollar bet on
Black becomes two million. So Buckeroo pays back the
$900,000 he owes depositors, and walks away with $1.1
million.
That is, due to government deposit insurance,
Buckeroo has a fifty percent chance of ending up with the
$200,000 he started with, and a fifty percent chance of
increasing the $200,000 to $1.1 million. Personally, I
would say: Go for it, Buckeroo!
Consider the recent Savings & Loan crisis in the
United States. The S&L industry was the product of a
government effort to promote home ownership. S&Ls
were financial institutions constrained to take in short-
term deposits and invest the money in long-term
mortgages secured by residential property. The structure
of an S&L, borrowing very short-term and lending very
long-term, thus entailed a serious gamble on interest rates.
In the inflation of the late 1970s, market short-
term interest rates rose above locked-in, long-term
mortgage rates. This would have, at a minimum, required
S&Ls to pay more on their deposits than was received on
their loans. But the situation was even worse because
there were regulatory ceilings on interest rates, intended
to "protect" S&Ls from high funding costs. Ceilings
instead threatened to prevent the S&Ls from receiving
deposits altogether. S&Ls paid 5 1/4 to 5 1/2 percent on
small-denomination deposits, while market interest rates
(and inflation) had risen to more than double that level by
the end of the 70s. (Three-month Treasury bills averaged
10.04 percent in 1979 and 11.5 percent in 1980. The
change in the Consumer Price Index was 13.3 percent in
1979 and 12.5 percent in 1980.)
So savers removed deposits from S&Ls as well as
banks, and placed them in money market mutual funds,
which paid market interest rates. Money market mutual
funds, which grew in assets from less than $10 billion to
$188 billion between 1978 and 1981, lent savings back to
S&Ls and banks by purchasing from them large-
denomination certificates of deposit which were not
subject to interest rate ceilings. S&Ls were thus paying
more to their marginal depositors than they were receiving
on their portfolio of old mortgages. The value of their
mortgage portfolio, meanwhile, had fallen with the rise in
interest rates. "By 1980, before any deregulation had
taken place, the liabilities of the S&L industry exceeded
its assets by $110 billion. The industry was already
insolvent-its members owed more than they
owned-when Congress and the Carter administration
enacted the Depository Institutions Deregulation and
Monetary Control Act [DIDMCA] of 1980" (Catherine
England, "Lessons from the Savings and Loan Debacle,
Regulation, Summer 1992).
We arrive at the crucial juncture.
DIDMCA and the Garn-St. Germain Depository
Institutions Act of 1982 (GSGDIA) gave the S&Ls a free
call option. DIDMCA expanded federal deposit insurance
from $40,000 to $100,000 per account, even while it
phased out the interest rate ceilings S&Ls could pay on
small-denomination deposits. (S&L deposits were
insured by the Federal Savings and Loan Insurance
Corporation, or FSLIC.) GSGDIA then expanded the
range of allowable S&L investments.
Now suppose you are an insolvent, or "zombie,"
thrift. You know you are insolvent, or are heading in that
direction, but the regulators don't know it yet-not until
their next audit, which may be a while, because you are
not the only institution with problems, and they have a lot
of work on their hands. So what you do is, first, get new
money by offering higher than normal interest rates on
large deposits. Ordinarily, doing this would scare people
away. They would assume you were paying higher than
normal interest rates because you were in trouble, and
hence other depositors were demanding a risk premium.
But in this case people aren't scared away, because the
deposits are federally insured. The federal insurance takes
away the market discipline. Money fund managers
spreading deposits nationwide will gladly accept the
higher interest rates: they don't have to worry about credit
risk.
Then, with the new money in hand, you can
engage in risky investments or speculations. Anything
that might give you a chance of making up your deficit, or
making a windfall, before the auditors show up. If the
gamble succeeds, you walk away a winner. If the value of
your assets rises above the value of your liabilities, your
call option is "in the money"-it pays off. But if your
gamble doesn't succeed, you are no worse off than before:
Your call option expires out of the money, and your S&L
is still broke. The deficits on your balance sheet are
passed along to the FSLIC. Such was one of the many
games played during the remainder of the 1980s.
The key to the whole scenario is, of course, the
eagerness of government to blow taxpayer funds on banks
and bank depositors. The problem is not limited to the
U.S. It's worldwide. According to the Bank for
International Settlements:
"Sovereign borrowers and
private lenders must
understand that incautious
behaviour on their part will
not necessarily be made
good with public money."
(*Annual Report*, Basle,
1996)
But the Elysee palace and banks like Credit
Lyonnais apparently haven't gotten the message. Credit
Lyonnais expects a lot more state aid. As anticipated in
"Credit Lyonnais and L.F. Rothschild Ready to Topple,"
the bank announced a small profit--of French franc 67
million (FF 67 million) for the past six months. This
"profit" was obtained after the bank received FF 3.9
billion in taxpayer funds from the French government.
Translation: Credit Lyonnais had a FF 3.833 billion loss
in the past six months.
Credit Lyonnais also said it would need "an
injection of at least $1.54 billion to $1.74 billion" to meet
the government's goal of privatization (Washington Post,
Oct. 5, 1996). What does this mean? Well, it means the
French government wants to get rid of this bottomless pit,
and sell it to private investors. But investors are not about
to buy something that has a negative net worth. (Would
you pay someone fifty dollars to take over their $1000
debt obligation?) So the government will have to add
capital to the bank to give it at least a zero net worth. And
the bank is saying that $1.54 billion to $1.74 billion will
do the job. This is somewhat smaller than the $2 billion
in the red I reported in my previous post on the subject.
But I am confident that my numbers are at least as
accurate as theirs.
The French newspaper *Liberation* asked "Should
this Bank Be Saved?", and estimated the total taxpayer
cost of past and future bailouts to come to about $29
billion. This is includes about $17 billion in losses that
will eventually materialize from the transfer of bad loans
to the Consortium des Realisations.
Credit Lyonnais has had a long free ride. It took
in loads of money laundering deposits from the Cali cartel
and other sources. Then its managers invested in risky,
prestige projects like MGM and the Chunnel project (the
tunnel between England and France under the English
channel).
Credit Lyonnais used to be one of the largest
banks in the world, based on assets. Based on capital, its
negative net worth of about $2 billion now makes it one
of the world's smallest. (Nine of the world's top ten
banks, based on reported assets, are Japanese. The other
one is a German bank, Deutsche, which has about $500
billion in assets, and ranks 7th.)
Credit Lyonnais is now a Zombie. It only comes
out at night, wearing dark glasses to protect its delicate
eyes from muted street lights, in search of other people's
money and the neighborhood Roulette table.
October 9, 1996
Web Page: http://www.aci.net/kalliste/