"Saving Capitalist Banking from Itself"

In addition to his weekly newsletter, John Mauldin¹ occasionally e-mails articles written by others as part of his "Outside the Box" series. Today's "Outside the Box" e-mail included a couple of good ones (both of which can be read in full here). To keep this post from getting too long, I'll post an excerpt from the second one in a separate post. The graphic above comes from the first, "Saving Capitalist Banking from Itself", by PIMCO Managing Director Paul McCulley². McCulley starts with a recap of the basics of fractional reserve banking and continues with a description of the shadow banking system. The excerpt below is from the "bottom line" part of his essay:

The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week.

And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF).

The formula? Take a small dollop of the Treasury's free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press. That's the formula for the TALF, to provide leverage, with no recourse after a haircut, to restart the securitization markets.

The same formula applies for the P-PIF, with the addition of FDIC stop out loss protection for dodgy bank assets that private sector players might buy. With such goodies, such players, it is hoped, will be able to pay a sufficiently high price for those assets to avoid bankrupting the seller bank.

Unfortunately, Secretary Geithner hasn't laid out the precise parameters of how to mix these three ingredients, which is driving the markets up the wall. But make no mistake, these are the ingredients, along with continued direct capital infusions into banks where necessary.

¹JohnMauldin@InvestorsInsight.com

²You may recall McCulley's name from a previous post where we excerpted one of his essays, "Breaking the Paradox of Deleveraging".

Breaking the Paradox of Deleveraging

This essay by Paul McCulley, the head of PIMCO's money market desk, is worth reading: "The Paradox of Deleveraging Will be Broken". Below are a few excerpts.

[T]he genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund – with the possible exception of a money market fund – could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity [...]

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”

[...]

I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey. But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.” Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

Fortunately, the sovereign is currently able to borrow money for thirty years at about 3.7%.