Is gold going to $6,300? Dylan Grice, an analyst with Societe Generale, says it’s possible, given the decline in central bank credibility. But investors need to keep one thing in mind: Gold is merely a vehicle to protect the purchasing power of money.

Gold is surging because investors see that the Federal Reserve — more concerned with deflation and unemployment than sound money — may be trapped in a never-ending cycle of monetary accommodation.

Ben Bernanke says he won’t monetize debt, but he already has. His Fed has bought $300 billion of Treasuries and is on pace to buy $1.45 trillion of government-backed mortgage debt all of which is being salted away indefinitely on the Fed’s balance sheet.

Why indefinitely? Because the Fed has no intention of unwinding its balance sheet so long as the economy is stressed. Witness comments this week from Bernanke, Fed Vice Chairman Don Kohn and San Francisco Fed President Janet Yellen all suggesting that the Fed’s “extended period” of low interest rates can be measured in years, not months. Today St. Louis Fed President James Bullard said rates aren’t going up till 2012.

So long as deficit spending continues, if the Fed wants to avoid deflation, it will be forced to monetize more debt.

[Elsewhere, capital controls are being erected in emerging economies like Brazil, Taiwan, and possibly Indonesia in order to keep speculative waters at bay. As Hong Kong's chief executive remarked last week, a dollar carry trade spawned by low rates threatens to inflate dangerous asset bubbles in emerging markets the same way low Japanese rates did in the '90s.]

Exploding debt throughout the developed world means other central banks face similar pressure.

(Click chart to enlarge in new window, reprinted with permission)

So confidence in paper currencies is waning.

Some people say it is absurd to buy gold; the metal has no intrinsic value. That may be. But is it any less absurd to hold paper? The best that can be said for paper is that if you lend or invest it, tomorrow someone will give you more paper in return. This is fine so long as its purchasing power is maintained. But it isn’t. A 2009 dollar is worth a 1914 nickel.

Eventually the value of all the paper you’ve accumulated goes to zero. The trick is to turn that paper into tangible assets with tangible value.

Gold may be volatile, but at least it maintains its real value:

(click chart to enlarge in new window, reprinted with permission)

Grice contends that the price of gold could reach $6,300 an ounce. He explains: “The U.S. owns nearly 263 million troy ounces of gold (the world’s biggest holder) while the Fed’s monetary base is $1.7 trillion. So the price of gold at which the U.S. dollar would be fully gold-backed is currently around $6,300. Gold is very cheap — at current prices, the USD is only 15 percent gold-backed.”

Absurd you say? It happened 30 years ago. President Nixon ended the Bretton Woods global monetary system and his compliant Fed Chairman Arthur Burns let inflation run wild. So by 1980 gold spiked to a level at which the dollar was “overbacked” according to Grice.

Did gold overshoot in 1980? Sure, but only because Paul Volcker was willing to hammer the economy to re-establish the Fed’s credibility. Today’s Fed has been very clear that it isn’t willing to put up with a recession of any kind in the service of sound money.

All of that said, investors should be careful. Grice’s chart shows that, over the long run, gold is likely to do no better than protect your purchasing power. An ounce of gold today buys a good men’s suit; in 100 years, it is likely to buy the same.

So gold won’t make you rich. But it may protect you from becoming poor.

Al de Molina’s tenure as CEO of GMAC was short and rocky, punctuated by bailouts and controversy over the morally hazardous tactics of subsidiary Ally Bank.

His strategy hasn’t worked and Ally’s anti-competitive behavior is hurting other banks. The new chief executive, Michael Carpenter, needs to restructure GMAC so that it is no longer dependent on a government lifeline.

GMAC has already received $12.5 billion of TARP money and recently asked for as much as $5.6 billion more. In addition, the FDIC has guaranteed $7.4 billion of debt.

Ally has also received another $7 billion in federally subsidized loans in the form of advances from the Federal Home Loan Bank of Pittsburgh. As a government-sponsored enterprise, the FHLB has access to cheap capital. It passes the savings on to member banks like Ally.

At the same time, Ally is marketing deposit accounts with interest rates among the highest in the nation. Insulated from risk, depositors couldn’t care less about Ally’s health. They’ve poured money into the bank over the past year, raising GMAC’s total deposits 57 percent, to $28.8 billion.

This doesn’t sit well with other banks that don’t benefit from so much government largess and can’t afford to pay the same rates. Last May, the American Bankers Association complained to the FDIC, which put the screws to Ally. The bank reduced its rates, but only a little. According to the Wall Street Journal, Ally now pays 2.1 times the national average for a one-year CD, down from 2.3 in May.

Ally’s financial condition, meanwhile, continues to deteriorate. Chris Whalen of Institutional Risk Analytics gives Ally an “F” grade, pointing to charge-offs that doubled in the third quarter.

Whalen also notes the growth of Ally’s securities portfolio. It is becoming less of a conventional lender and more of a bond hedge fund, he says. So why is the government is supporting it?

Ally’s funding is also life-support for ResCap, the subprime mortgage unit that helped sink GMAC in the first place. The more cash GMAC/Ally pours down the drain at ResCap, the less taxpayers are likely to get back.

Carpenter should cut his losses by cutting off ResCap. That would be a good start to restructuring GMAC.

But if GMAC can’t fund itself without the magical elixir of bailouts, deposit insurance and nation-leading CD rates, then for the sake of taxpayers, depositors and banks struggling on their own, it should be put out of its misery.

Rick Bookstaber announced on his blog yesterday that he will joining the SEC’s “Division of Risk, Strategy and Financial Innovation.”

This is a welcome development. Bookstaber is the author of A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.

He was part of an Oxford-style debate on that very subject at the Economist’s Buttonwood Gathering last month. I was lucky to be in the audience. Below is the video. (Here’s a link too…..go to “debate on financial innovation.”)

Watch it through just to see Jeremy Grantham. He was on fire. (His first comments being a third of the way in.) His rhetoric successfully flipped the audience from being 80:20 in favor of the proposition that “financial innovation boosts global growth” to a similar margin against.

It’s highly ironic that Myron Scholes was chosen to argue for the proposition. An inventor of the Black-Scholes options pricing model, he was also a partner at LTCM, the famous hedge fund firm that blew itself up mixing mathematical hubris with leverage.

Scholes’s life story should be a cautionary tale AGAINST the idea that financial innovation creates great wealth. Yet here he is, having learned nothing.

Not that it’s unexpected. Nothing encourages cognitive dissonance quite like the absence of consequences. Bailed out bankers on Wall Street who feel they’ve “earned” the bonuses they plan to pay themselves this year are just the latest example…

Do you think we should establish a government-backed insurance fund for big banks’ risky trading activities? Probably not. But that’s precisely what the administration and Congress agree should be done. Today Sheila Bair proposed her own variation on the theme. At first glance her idea sounds better, but it’s just as bad as the others.

From Alison Vekshin at Bloomberg:

Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

As I noted in my column yesterday, Barney Frank’s legislation would have taxpayers front money for systemic bailouts while large financial firms would be on the hook to pay the money back.

Of course that would never happen. Banks would never pay. Look how hard it’s been to get banks to replenish the Deposit Insurance Fund. Anyway, Sheila agrees that ex-post funding is a bad idea.

But pre-funding is an equally terrible idea. If there’s a fund somewhere that’s supposed to protect the system, that will codify TBTF and reinforce moral hazard. Not only will investors know some firms are TBTF, they’ll see there’s a pile of cash to protect them. This would put TBTF firms at an advantage in the marketplace.

Now, some would argue that it would penalize the firms because they’d have to pay capital into the fund. Perhaps in the short-term. But soon enough everyone will be content that the system is “safe,” people will be making money and Congress will tell the regulators to lay off.

This is not just a hypothetical. Look at our experience with the Deposit Insurance Fund. From 1996-2006, FDIC was prevented by statute from collecting insurance premiums. Congress, in its infinite wisdom, had determined the DIF didn’t need any more money because the system was firing on all cylinders.

The S&L crisis–which cost $150 billion to resolve–taught us the moral hazards of government insurance funds for bank creditors. Because their money iss guaranteed, depositors don’t care what kind of risky activities their bank are engaged in. They just go to the bank that offers the highest interest rate.

We’re reminded of this fact by GMAC today, whose subsidiary Ally Bank is able to attract billions in deposits by offering high interest rates. And read the Puget Sound Biz Journal’s article on WaMu. They were so desperate for funding amid a bank run last fall that they started offering 1-yr CDs at 5%.

And think about what’s being insured here. Trading. In derivatives, stocks, bonds, forex, commodities …. all of it with leverage. Trading + leverage = high risk!

Despite the moral hazards of deposit insurance, we insure commercial banks because the functions they provide (managing the payment system, turning savings into loans) are important to society. In the fullness of time, I have my doubts that even this makes sense. But arguments supporting it are at least defensible.

This new scheme that Bair is proposing would insure investment banks, and all the risky trading activities they engage in.

Again, we’re acting to protect the needs of TBTF banks rather than protecting the needs of society. What we should be doing is getting trading activities out of the banks to begin with.

The repeal of Glass Steagall essentially put the Wall Street Bull inside the China Shop we call the commercial banking system. We’re surprised when he trashes the place every few years?

But instead of kicking him to the curb, we’re expending all this effort putting the China in bubble wrap…..which in the long-run is no match for the Bull….

Stopping by the Value Investor Congress today….still getting over the Bears’ ATROCIOUS loss last night….

MUST READ: How Moody’s sold its ratings — and sold out investors (McClatchy) Great stuff from Kevin Hall.

Sorry, no jobs. This is California (Reuters) 12.2% unemployment rate in the Golden State.

With privilege comes…? (PIMCO) Downward pressure on the dollar to continue, but will it be a rout?

FDIC failed to limit commercial real estate loans (Bloomberg) Regulators had plenty of power to corral the bubble. They just didn’t use it.

Goldman, can you spare a dime (Frank Rich) Obama is modeling himself on the wrong Roosevelt. We need Teddy, not Franklin…

Everything you know about China is wrong (Newsweek) I think economic power is shifting from West to East. But it’s going to be a very bumpy ride. China’s got LOTS of its own problems. And the author doesn’t even mention they may be inflating a dangerous credit bubble…

Man tries to euthanize dog, dog’s owner tries to euthanize man (postandcourier.com)

Human jumbo-tron…

By Peter Thal Larsen and Rolfe Winkler

LONDON/NEW YORK, Oct 5 (Reuters) - Of all the reforms proposed by global financial regulators over the past 12 months, none looks as appealingly straightforward as the leverage ratio. What could be simpler than linking the total amount of assets a bank can hold to the amount of capital it has to absorb losses it makes on them?

Alas, such a task is more difficult than it appears. There is little international agreement about how to calculate banks’ assets or capital, let alone what the ratio between the two should be.

A few years ago, even the idea of such a simple measure seemed hopelessly out of date. Banks were busy building sophisticated computer models to measure the risks they faced. They were allowed to tweak the amount of capital they held against assets depending on how risky the computer thought those assets to be. Then those models failed.

Now bank regulators want a blunt measure that will cap banks’ expansion, regardless of what their models say. Despite the complexities, they are right to try.

Still, finding a consistent way to measure banks’ assets is a daunting challenge. For instance, U.S. accounting rules allow banks to report their net derivatives exposure. International Financial Reporting Standards used by most European banks don’t. Take Deutsche Bank: At the end of 2008 its gross derivatives book accounted for nearly half its total assets of 2.2 trillion euros. Using IFRS, Deutsche’s leverage ratio is 1.3 percent but under U.S. GAAP it’s 4.2 percent.

(Click on chart to enlarge in new window)

Regulators agree that any calculation of leverage should adjust for these differences to discourage regulatory arbitrage. But barring an unlikely shift to global accounting standards, this will undermine the leverage ratio’s simplicity, which is central to its appeal.

Measuring capital is also a thorny issue. U.S. regulators believe that only tangible equity — cash raised from shareholders or retained through earnings — should count as capital. That is sensible: Only this capital occupies the true first loss position. Without it, investors higher up the capital structure tend to panic and run for the exits when losses mount.

But the emphasis on tangible equity has gone down badly with European banks, which have historically stuffed preferred shares and other forms of hybrid capital into their capital structures. If these are excluded from capital measures, European banks will have to find tens of billions of additional equity — or shrink their balance sheets even further. Another objection is that U.S. banks are currently allowed to count deferred tax assets as capital, even though these are worthless if the institution cannot make a profit.

Even if these problems can be overcome, the leverage ratio is not foolproof. After all, U.S. regulators have long imposed a 4 percent leverage ratio on banks. But this did not include off-balance sheet assets. More recently, Swiss regulators introduced a leverage ratio for UBS and Credit Suisse that explicitly excludes the banks’ Swiss loan books from their asset calculations. Some bankers argue that, because the ratio does not adjust for balance sheet risks, it may even encourage banks to load up on risky assets.

Placing an appropriate cap on the expansion of banks’ balance sheets is crucial to the future of banking regulation. If it’s too loose, banks may rush into another crisis. If it’s not applied consistently, banks will arbitrage differences between regimes. Some will argue that if it’s too tight, banks will constrict lending or will dump safe assets in favour of risky ones.

But this misses the point. The leverage ratio is not designed to replace risk-based measures of capital: it is a safety net in case those measures fail. Despite the difficulties involved, regulators should not be deterred from introducing it.

(e-mail: peter.thal.larsen at thomsonreuters.com; rolfe.winkler at thomsonreuters.com)

Wells Fargo fires exec over Malibu house scandal (Reuters)

Warren: “Until we have a credible liquidation threat, we don’t have capitalism in America” (HuffPo) Yeah, we need better resolution authority for big financials, but we should break up banks so that they aren’t large enough to pose a systemic risk in the first place. By the way, for all the folks out there that think the government “made money” when Goldman bought back TARP warrants at a small profit, Warren reminds us that they still have $13 billion of your money that was passed through AIG.

Citigroup explores bid to pare U.S. stake (WSJ) Speaking of the canard that we’re “making money” on the bailout, it’s unfortunate this piece ends by noting that taxpayers are up $9.8 billion on their Citi stock. The reason the equity has positive value is because the rest of the capital structure is being supported by taxpayers. And the ultimate cost of that support is likely to be significant.

Johns Hopkins student kills intruder with samurai sword (Baltimore Sun) Quentin Tarantino eat your heart out.

Study faults Bush’s reliance on daily intelligence brief (WaPo)

The Devil’s Dictionary, Financial Edition (WSJ)

Kids send Marcus the lamb to slaughter (Reuters) They voted 13-1

Comedian Eddie Izzard runs 43 marathons in 51 days (BBC)

11 Craziest Kim-Jong-Il moments (11points.com)

I’ve seen the between-the-legs volley before…but never one this good.

A week ago, I wrote about Paul Volcker’s call for money market funds to stop using the $1 NAV. In conditioning investors to believe their principal isn’t at risk, money funds can be very dangerous, systemically-speaking. When the buck gets broken …

1. Investors panic: Their money was supposed to be safe.
2. Since the fund has promised to redeem them at $1 per share, instead of at the day’s market value, investors have an incentive to get out as quickly as possible. The quicker they redeem, the more likely they are to get all their money back. It’s a bank run.

According to a report in today’s WSJ, Deutsche Bank is now launching a money fund with a floating share price:

Unlike conventional money-market funds, the proposed DWS Variable NAV Money Fund will allow its net asset value, or NAV, to fluctuate rather than trying to maintain a stable $1 share price. The fund will require a $1 million minimum investment, a regulatory filing said.

The idea of floating money-market NAVs has been hotly debated. In the wake of the Reserve Management Co.’s Reserve Primary Fund falling below $1 last fall, regulators have searched for ways to make the $3.6 trillion money-fund industry more stable ….

Many in the fund industry are opposed to the idea of floating money-market NAVs, saying the move would essentially destroy the money-fund business.

They think it could destroy the business because if the NAV floats, then it’s not possible to market the funds as “cash equivalents.” Suddenly they’re just another bond fund, albeit an ultra-short/relatively safe one.

If you want the nitty gritty on why the $1 NAV is so crucial to the marketing of money funds, take a look at the March report of the Investment Company Institute’s working group on money funds, in particular section 8, pages 107-111. In a nutshell, allowing money funds to use amortized cost accounting, i.e. NOT marking their assets to market, provides for many tax, operational, legal and liquidity conveniences that an ultra-short bond fund doesn’t.*

More money market funds should follow this example. Hopefully the Obama administration pushes them in that direction when it releases its report on money market fund reforms September 15th.

—–

*also check out footnote 25 on page 27 (ht Felix)

Warren Buffett is back as the nation’s financial conscience, publishing an op-ed in yesterday’s NYT lamenting the dangers of too much monetary and fiscal stimulus. As regular readers of this blog are aware, that’s a message with which I wholeheartedly agree. My problem with Buffett’s piece is that he makes a good argument and then totally undercuts it in his conclusion:

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

This have-your-cake-and-eat-it-too approach is typically what we get from Paul Krugman: Yeah, debt is a problem and has to be dealt with long-term, but in the meantime we should jack up deficit spending in order to boost growth. To paraphrase St. Augustine, make us fiscally and monetarily prudent, just not yet. Ben Bernanke said something of that sort in a speech. He was trying to be funny.

The problem, it seems to me, is that rising GDP and employment—i.e. “recovery”—is not compatible with de-leveraging, which is what Buffett is talking about.

When consumers try to cut debt and boost savings, the economy goes into a deflationary spiral that Keynesians argue must be counteracted with fiscal and monetary stimulus.*

Consumers de-lever, government re-levers.

Private consumption and government spending now drive something like 80% of GDP. It can’t keep rising unless consumers, the government or both continue borrowing huge sums.

The goldilocks economy Buffett describes, in which we can have “recovery” without increasing debt, is a fantasy.

My point is that in order to reduce debt we have to endure some sort of deflationary recession. The alternative is to spend and print perpetually, which Buffett points out is the worse option.

What Buffett should have said? Suck it up folks, we’ve no choice but to learn to live with less.

——

P.s.: I think Buffett actually knows this, but being asset-rich, he’s boxed in. Deflation hammers the value of all non-cash assets, so he has to support monetary/fiscal stimulus in order to preserve his own and his shareholders’ wealth.  Hence the opening of the piece, which lauds the “wisdom, courage and decisiveness” of the Bush and Obama administrations in the face of collapse, and the end of the piece, which says their emergency measures continue to be necessary. He maligns the effects of stimulus, but he’s stuck supporting it.

*The “Paradox of Thrift” this is called, a particularly problematic economic theory used to justify heavy government borrowing.

(send links, pics, vids to optionarmageddon at gmail)

U.S. raids Colonial bank office in Florida, serving “TARP-related” warrants (Reuters)  Cheers for kicking butt and taking names.  As the special inspector general for TARP, Neil Barofsky has broad authority, including subpoena power and the right to carry a handgun.  This profile in the WSJ quotes critics that say he’s got too much Eliot in him, Ness or Spitzer, “over-stepping” his bounds or other such nonsense.  With the vast legal apparatus that rich banksters are able to hide behind, we need a guy who’s not afraid to offend delicate sensibilities.

Hot Waitress Economic Index (NY Mag)

Wall Street profits from trades with Fed (FT)  Makes a great point.  Too bad there aren’t any numbers here. But then the Fed won’t make that possible; it won’t let anyone audit its books.

Boom and Bust will be with us for some time (FT, via Kedrosky)  The former SocGen strategy duo (Montier recently left) take on the adaptive markets hypothesis.  Keeping economists honest!

Cops: Wife, three other women torture husband (Chicago Breaking News)  “Torture” is probably too strong a word.  Then again…

10 years ago, an omen no one saw (NYT)

Trump cuts price on Park Ave. penthouse by 40% (NY Post)  WSJ also had a good page 1 story this morning on the problems at the high end of the housing market.  So much for the top of the market being the last to decline and the first to recover…

Japanese couple turns down free trip to Rome, says would be waste of Italian taxpayers’ money (abc.net.au)

Barney’s illegitimate child? (imgur)  I can’t believe I never noticed the resemblance.

Cosmoplitan (incredimazing)

There were five bank failures tonight.  Two of meaningful size, but none in Georgia!

We’re still waiting on two big fish, however, Guaranty and Corus.  In an SEC filing today, Corus said it was “critically undercapitalized” with Tier 1 Capital of $157 million.  They also admitted is was “highly unlikely” they’d be able to raise capital, so FDIC seizure is a matter of when, not if.  Next Friday may be the day. (ht CR)

And we have a new addition to the Bank Death Watch list: Colonial BancGroup, which late today expressed doubt it can continue as a going concern.  With $26.4 billion of assets and $24.6 billion of deposits as of March 31st, it’s larger than Corus and Guaranty put together.

#65

• Failed Bank:  First State Bank of Altus, Altus OK
• Acquiring Bank: Herring Bank, Amarillo TX
• Vitals: At 6/19/09, assets of $103.4m, deposits of $98.2m
• DIF Damage: $25.2m

#66

• Failed Bank:  Integrity Bank, Jupiter FL
• Acquiring Bank: Stonegate Bank, Ft. Lauderdale FL
• Vitals: At 6/5/09, assets of $119m, deposits of $102m
• DIF Damage: $46m

#67

• Failed Bank:  People’s Community Bank, West Chester OH
• Acquiring Bank: First Financial Bank NA, Hamilton OH
• Vitals: At 3/31/09, assets of $705.8m, deposits of $598.2m
• DIF Damage: $129.5m

#68

• Failed Bank:  First Bankamericano, Elizabeth NJ
• Acquiring Bank: Crown Bank, Brick NJ
• Vitals: At 7/16/09, assets of $166m, deposits of $157m
• DIF Damage: $15m

#69

• Failed Bank:  Mutual Bank, Harvey IL
• Acquiring Bank: United Central Bank, Garland TX
• Vitals: At 7/16/09, assets of $1.6b, deposits of $1.6b
• DIF Damage: $696m

The subsidy for the auto sector cloaked as an environmental program has already run through its budget.  (WaPo):

“The program started only six days ago, giving vouchers to consumers who trade in their gas-guzzling cars for more fuel-efficient models. But the unexpectedly brisk response made federal transportation officials increasingly fearful Thursday that they would exhaust their [$1 billion of] allocated funds….”

Dealers are in the press touting the program’s “success.”  Of course it’s successful for them, they get to clear their inventory.  But the program represents a net cost to society: the money borrowed to fund it plus interest.  Since, at the rate we’re going, the debt will have to be rolled over in perpetuity, we’re talking a lot of interest.

By the way, I suspect CfC is a net negative for the environment too.  The MPG requirements—anything below 18 MPG traded in for anything over 22 MPG qualifies for the tax credit—are silly.  And the energy consumed to produce the new cars offsets any savings from a few extra MPG.

The Obama administration wants to suspend the program because it has promised to corral the deficit.  But congressmen want to keep funneling cash to the dealers in their district, a portion of which will no doubt end up in campaign coffers.  They are even talking to the administration about recycling TARP funds.

How much money are we willing to spend subsidizing the auto industry?  Already GM and Chrysler have received tens of billions that are never coming back.  Now Congress wants to spend $1 billion more per week?  Where does the spending insanity stop?

Please Mr. President, make it go away.

(Cartoon from The Economist, click to enlarge)

NEW YORK, July 29 (Reuters) – The sound money set remains concerned that the Federal Reserve’s emergency actions to corral collapse could ignite hyperinflation.  In particular, they point to the explosion of excess reserves inside the banking system, which they call dry tinder just waiting for the spark of recovery.  Bill Dudley, president of the Federal Reserve Bank of New York, says this isn’t an issue because the Fed now pays interest on excess reserves.  It’s a good argument, but only in the short run.

To liquefy the banking system, the Fed drastically expanded its balance sheet, which, as you can see in the chart to the right, has led to an explosion of excess reserves at banks.

(Click chart to enlarge in new window)

For decades they never rose above $10 billion. Now they’re above $700 billion. To understand why this level of excess reserves has some worried about hyperinflation, it helps to understand what they are.

The Fed requires banks to keep a certain level of assets in reserve against deposits, either cash in the vault or reserves held at the Fed.  Reserves held over this required amount are referred to as “excess” reserves which banks are free to lend out.

When banks lend money into the economy, the money borrowed typically ends up as a deposit in another bank.  Say I borrow to buy a house; the mortgage I get from the bank is money I give to the seller, who then deposits the cash in his own bank.

Lent money turns into a new deposit, which turns into more lent money, which turns into another deposit, and so on.  As the supply of money multiplies, you get inflation.  If it multiplies too quickly, you get hyperinflation. The multiplication of money that might come from banks lending out over $700 billion of excess reserves is the stuff of inflationary nightmares.

But banks aren’t lending it out.  Why not?  As Dudley points out in his speech, it’s because the Fed is now paying them an interest rate.

Before last October, banks lent out all their excess reserves.  After all, excess cash in the vault earns the bank no profit.  But then Congress gave Ben Bernanke the power to pay interest on excess reserves, which means banks now can earn a return by keeping them on deposit at the Fed. Money that could be lent isn’t, inflation remains a potential threat, not a kinetic one.

But there’s a catch. When the economy recovers banks won’t any longer want to keep their excess reserves on deposit at the Fed, not unless the Fed is willing to pay a much higher interest rate.

Walker Todd of the American Institute of Economic Research argues that “the economy won’t be able to handle the high interest rates the Fed will be forced to charge in order to keep excess reserves immobilized in its vault.”

The Fed argues it has other tools to shrink its balance sheet when the time is right. For one, its emergency lending facilities are priced high enough such that banks will stop drawing on them when the economy recovers. But even after its lending facilities are wound down the Fed acknowledges the level of excess reserves will still be huge. To keep them immobilized will require substantially higher rates.

But raising rates will cause asset prices to plummet. Weak balance sheets will collapse and the financial crisis could return in full force. This is the conundrum the Fed faces.

Guaranty Financial Group, the holding company that controls Guaranty Bank, noted in an SEC filing that due to new writedowns, there’s no hope they’ll be able to raise capital to comply with a recent Cease & Desist order. (ht frog)

Previously I wrote a column describing Guaranty’s potential application for open bank assistance, and why it would be a mistake for FDIC to accept it.  They know they’d get rejected at this point so they’re not even going to bother applying.

The writedowns included a $1.45 billion impairment for non-agency MBS as well as a $107 million goodwill impairment.  To put those figures in perspective, they had about $15 billion of assets as of last November.*

The Company believes that recent write downs foreclosed the possibility of applying for open bank assistance. Our primary stockholders have not affirmed their willingness to commit to a capital infusion in support of such an application…..In light of these developments, the Company believes that it is probable that it will not be able to continue as a going concern.

Based on these adjustments, the Bank’s core capital ratio stood at negative 5.78% as of March 31, 2009. The Bank’s total risk based capital ratio as of March 31, 2009 stood at negative 5.52%. Both of these ratios result in the Bank being considered critically under-capitalized under regulatory prompt corrective action standards.

Say bye-bye.

BTW, we’re also keeping an eye on Corus.  FDIC says they may be seized as soon as August 6th.  (Since when does FDIC make comments about when they’re likely to seize a bank??)

————-

*Their books are so messy, they haven’t been able to file a 10-q or 10-k since then.  Their assets were likely well below $15 billion when they took this writedown.

From Reuters:  S&P tweaks CMBS model, reverses week-old downgrades

Standard & Poor’s on Tuesday reversed some controversial downgrades of widely watched commercial mortgage-backed securities in a highly unusual response to investor ire.In a rare and dramatic reversal from just a week ago, S&P upgraded the bonds to the top AAA rating. The move reinstates their coveted eligibility under a Federal Reserve lending program that is behind a strong rally for the $700 billion market.

Among upgrades, S&P raised ratings on the A2, A3 and A-AB classes in Goldman Sach’s 2007-GG10 transaction, considered a benchmark for CMBS, back to AAA from BBB-minus.

The key issue is in the second paragraph, where the article notes that to be eligible for TALF financing from the Fed, CMBS have to be rated AAA from at least two of the big credit rating agencies.

So who is (are) the market participant(s) that prompted S&P to “clarify” its approach?  Is it the Fed?  On the one hand, the Fed doesn’t want to get stuck with crappy collateral on its balance sheet.  On the other hand, it wants to shovel as much money out the door as possible in order to bail out the shadow banking system to boost “liquidity.”

But the Fed can’t have it both ways.  Lately, according to Moody’s, commercial real estate prices are falling quite spectacularly:  Off 16% in the last two months (I plan to blog on this tomorrow).

So in order to get money out the door, the Fed has had to bend its own rules and accept junky collateral.  But it needs “independent” raters like S&P to cover its tracks by inflating credit ratings.  It’s not like anyone’s going to get wise.  The Fed doesn’t use regular accounting rules nor are its books audited, so burying losses ain’t so tough.

Taxpayers are the ultimate losers.  TALF loans are non-recourse.  Which means if the collateral goes bad, the public eats most of the losses.

Of course banks themselves might be pressuring S&P.  They need buoyant ratings in order to sell paper to gullible, and lazy, portfolio managers who want to chase yield.