Rolfe Winkler

China tightens rules on bank lending to curb inflation (Bradsher, NYT) Banks in China are chock full o’ excess reserves. Because their economy is growing, loan demand is healthy, so excess reserves are being lent out….multiplying the money supply and causing inflation. U.S. stocks are taking it on the chin because China is the world’s main economic driver at the moment…moves to cool it down, while totally prudent, are bad for stocks.

Georgia gives lenders more rope (Fitzpatrick, WSJ) Not such a good idea for the state topping the charts on bank failures…

BofA forecloses on home for which couple had paid cash (Marrero, St. Pete Times)

NJ Governor declares fiscal emergency, freezes spending (Sloan, CBS2) Wow, a Republican is  actually cutting spending instead of talking about cutting spending.

Me writing about the First Energy/Allegheny deal in the Times (Winkler, NYT) Scroll down the page to “Electric Synergy.”

Volcker rule gives Goldman stark choice (FT) This interview with Paul Volcker puts the lie to press arguments that Goldman will be the firm most impacted by his new “Volcker Rules” because it has the largest prop trading operation. All Goldman has to do is give up its bank charter, which it got in November ’08. The bank doesn’t have much in the way of deposits funding its business. The bank charter was just a gimmick to get access to cheap funding via the FDIC and to get access to the Fed as lender of last resort. And if the crisis comes roaring back, Goldman needn’t worry about failing. They’re still so big and interconnected, regulators wouldn’t let them go down…

Subpenny trading (CFA Institute letter) The latest abuse of the equity market?

Small banks hit snag as they try to raise cash (Sidel, WSJ) Trust preferreds remain a problem…

The President is right to target firm size if he wants to insure no financial firm can cause a system failure. Yet despite clear evidence that banks are already too big, Obama’s proposal won’t cut them down. It would only limit future growth by acquisition.

Specifics are being worked out, but what is clear is that Paul Volcker’s “size” proposal will limit future growth by acquisition only. It won’t force existing firms to shrink nor limit their ability to grow organically.

But if Obama wants to end the too-big-to-fail paradigm, if he wants to eliminate the possibility that one firm’s failure could cause a cascading financial collapse, he needs to engineer a system with more circuit breakers. Shrinking banks is crucial.

Like the power grid, the financial system is huge, dynamically complex and interconnected. A single point of failure can cause a cascading collapse. In 2003, some overgrown trees in Ohio were enough to cause a blackout that hit 55 million from Ontario to New York. In 2008, the failure of any one of a handful of financial firms could have plunged the economy into Depression.

True, size isn’t the only factor contributing to systemic risk. Yet despite thousands of bank failures during the savings and loan crisis, there was never a risk of systemic collapse because no bank was large enough to crash the system.

Another counter-argument is that gross balance sheet size isn’t by itself an indicator of risk. Certainly some balance sheets are riskier than others, but there remain 10 to 20 in the United States, of varying risk profiles, that are systemically dangerous.

Some argue that shrinking big banks would eliminate efficiencies. While size may have first order benefits, recent events show these are outweighed by second order bailout costs.

Nor do we need large banks to finance large deals. Big loans can be handled via syndication.

No doubt it would be tough to break up big banks, but we’ve done something similar before. Standard Oil and AT&T were split into Baby Oils and Baby Bells. Why not figure out a way to split too-big-to-fail financials into Baby Banks?

So, wow, the Obama administration has reacted very quickly — perhaps too quickly — post the Massachusetts Senate election. After proposing a tax on bank liabilities, Obama is taking an even tougher line, adopting recommendations from Paul Volcker that banks be limited in their size and scope.

Before getting to specifics, it’s worth noting how Geithner and Summers appear to have lost favor. In the preamble to the proposal, Obama mentions neither of them. And when he announced the plan he did so with Volcker and Bill Donaldson standing behind him…Geithner and Summers were off to the side. Could the duo be headed for the exit?

But back to the proposals themselves. Unfortunately they are very vague:

1. Limit the Scope – The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

In his prepared remarks, Obama called this first proposal the “Volcker Rule,”

2. Limit the Size – The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

These are good ideas, but until we see the details it’s hard to offer unconditional support.

The idea behind the first proposal is that since government insures bank liabilities, it must control bank assets. Bank liabilities are insured explicitly via deposit insurance and implicitly, for the biggest banks, via a general too-big-to-fail guarantee. Deposit insurance is the only one of those two that is defensible and its purpose is to protect the integrity of the payments system. Currently banks use this insurance to obtain cheap funding that supports risky side businesses, like proprietary trading.

But how will prop trading be defined? Will banks actually have to split up? Will they merely have to tweak their corporate structure?

As for the proposal regarding bank size, it doesn’t appear that there will be much to it. Banks won’t have to get smaller or even stop growing. Instead the new rules will just prevent bigger banks from making (any?) acquisitions. They’ll be able to continue growing organically. This probably isn’t enough to reduce systemic risk, unless other reforms can successfully reduce risk-taking. (Personally I think we should break up the banks into baby banks the way we busted AT&T into baby bells….so that none is so large as to be impossible to resolve in a crisis.)

It looks a little clumsy, putting out a plan this short on detail. That said, it seems to mark a clean break with the ridiculous policy that somehow protecting the banks protects America.

The real test for Obama’s leadership, by the way, will probably come if a substantive plan like this passes. Forcing banks to make big changes to their balance sheets will surely crimp the economy in the short-run as it makes it more difficult for banks to extend credit.

That’s not a bad thing. Either we do it proactively in order to contain risk, or we let the system blow itself up again. The latter course will lead to more credit destruction of course. But asking people to voluntarily subject to economic pain will be tough. Hopefully Obama sticks to his guns.

Paul Volcker’s speech to the Economic Club of NY last week (pdf) was generally reported as the latest example of the former Fed Chairman calling for more substantive financial system reform. He did repeat those points, but the focus of his speech was about the importance of the Fed maintaining its regulatory and supervisory authority over the banking system. At a certain point, this seems the stuff of absurdist theater. If the Fed never intends to use its regulatory authority, why insist the authority be maintained?

The problem with his speech is that while he acknowledges the Fed is badly staffed — mostly with economists/mathematicians, few from business/banking — he doesn’t address the clear failure on the part of the FOMC to 1) grapple with bubbles nor 2) to get serious about sensible reforms. He bemoans “reform light,” but that is precisely what the Fed is delivering.

Volcker wants tougher rules for derivatives trading, yet Pat Parkinson — the man Bernanke appointed as the Fed’s top bank regulator — has long favored a hands-off approach to derivatives. Volcker argues proprietary trading and other risky activities should be spun-off from commercial banks. It makes no sense for such risky activities to be backstopped by the financial system safety net — deposit insurance and last resort lending from the Fed. Yet Bernanke has done nothing to indicate he’ll separate the two.

Volcker is correct that the Fed should play a vital role in regulating the banking system. But this assumes the guys in charge actually use their regulatory power. Bernanke hasn’t done so. Instead he adopted his predecessor’s deregulatory zeal and penchant for bailing out the system.

Continuing the pattern of the last 25 years, the next financial market emergency is likely to be more disruptive than the last. The Fed has already lost so much credibility that when the next one hits, it’s not hard to envision it being neutered.

Consumer protection agency in doubt (Paletta, WSJ) Chris Dodd appears willing to trade the CFPA in exchange for Republican support of his financial reform bill.

Manhattan apt rents drop 9.4% in Q4 (Gittelsohn, Bloomberg) Great stimulus for the NY economy.

Volcker calls for support in fighting bank lobby on reforms (Harper, Bloomberg) Looking to get a copy of this speech to post later today.

Can online comments affect your credit? Yup. (Sandberg, SF Chronicle) More an oddity than a trend, but interesting nonetheless.

CBO: Fannie/Freddie cost government $291 billion in ’09 (Golobay, HW) The full report from CBO is here. CBO estimates the total cost of subsidizing Fan/Fred will only be $99 billion more through the end of 2019. Meanwhile most of the housing stock in the U.S. will end up on the government’s balance sheet.

JP Morgan loan losses overshadow higher profit (Comlay, Reuters) The bank reported earnings that beat analyst estimates, but the reasons for the beat — lower taxes and lower bonus accruals in JPM’s investment bank — are considered “low quality” because they aren’t sustainable sources of profit. And lower bonus accruals may sound good from a populist point of view, but they don’t really help anyone other than bank shareholders who get to retain the earnings.

Monologue wars (Gawker) Late night hasn’t been this interesting in years. The 10@10 segment with Jimmy Kimmel on Leno is gold. In related news, Conan’s show is for sale on Craigslist.

Roger Ebert vs. Rush Limbaugh (SunTimes)

The Exorcist (imgur)

Windpipe transplant renews Belgian’s life (AP) A Belgian woman has a working windpipe after surgeons implanted the trachea from a dead man into her arm, where it grew new blood vessels before being transplanted into her throat.

For the next time you’re playing H-O-R-S-E. And the handshake at 0:18 is possibly more impressive than the shot….

If you’ve been surfing the economics blogosphere recently, you’ve likely seen charts of various economic indicators pointing towards a recession. Forthwith, my (growing) collection. Lots more of these out there. If you’ve got one to add, send it our way:

YoY change in unemployment, by month. From the NYT:

Credit Card Trends, (via the NYT, hat tip Mish):

Manufacturing sentiment. The Philadelphia Fed’s general economic index:

Money Supply (using the “M Prime” calculation of the Von Mises Institute, again thanks to Mish). Check out that link for a full explanation of the M Prime money supply calculation. Fascinating read.

Housing Starts and Completions (hat tip CR):

The Philly Fed’s calculation of states with increasing activity. Thanks to CR.