Checking My Understanding
What with crises and all, I thought I should refresh my basic grasp of the issues by perusing an economics textbook. Chapter 13 of Macroeconomics by Paul Krugman and Robin Wells concerns the monetary system. It includes the following “check your understanding” question:
A con man has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme?
Having read the chapter, the correct answer is that modern banking regulations involve capital requirements that don’t let you do this. Having watched the past six months unfold, the real answer seems to be “not very well!”
32 Responses to “Checking My Understanding”
Register
RSSLogin
Topic Cloud
ArchivesBlog RollAbout Matt YglesiasContact Me
Donate
October 16th, 2008 at 12:45 pm
Matt, I believe the bank failures are not solely the result of default on a bunch of bad loans (particularly subprime). My understanding is that the proliferations of Credit Default Swaps (for which there are no capitalization requirements that most other insurance instruments carry) allowed the banks to become dangerously over-leveraged.
October 16th, 2008 at 12:51 pm
With Evan’s comment in mind, I suppose one could expand Krugman and Wells’ description to include additional material about “reducing the risk” by such manuevers as reselling the interest on the loans as securities and creating “default swaps” to “compensate” for the absence of any actual capital. The outcome, however, would remain exactly the same.
October 16th, 2008 at 12:56 pm
How would modern bank regulation frustrate his scheme?
Ooh! Ooh! Professor Krugman! I’ve got it!
The modern Republican regulatory system would be to allow 1000 other con men, also with no capital of their own but with Applied Financial Wizardry degrees from many famous colleges and universities, to create and sell Ponzi loan guarantees and Ponzi default swaps to their heart’s content, to “securitize” the first con man’s risky loans. The system would then encourage the guys who hold onto Joe Schmoe’s monthly paychecks and Christmas club accounts, and who supply the capital to the company that provides Joe Schmoe’s job, to buy lots of these pieces of Wizard Scrip, so that when the whole scheme collapses, 300 million Joe Schmoes have no option left but to bail out the last wannabe-wizard suckers holding onto the paper at the top of the pyramid, while the guys who dumped it earlier take their money and run.
This is called the “distribution of risk”.
October 16th, 2008 at 12:59 pm
Not to be too on(or off)-topic or anything, but the con-man scenario has been happening along those lines in the Check Your Understanding questioning in China, where there have been scandals about this–with people trying to chase higher returns by deliberately investing in such schemes…
October 16th, 2008 at 1:29 pm
I’m going to go dig through my Mankiw Macroeconomics book and see if I can’t find a similarly insightful problem =P.
October 16th, 2008 at 1:40 pm
Bingo. All the talk about regulation misses the Fed. The Fed was created to insure the quality of bank assets. If the banking system is collapsing why doesn’t it occur to more people that the Federal Reserve failed. (The investment banks were under the powers, if you want to call them that, of the SEC not the Fed)
When people think of the Fed they think pretty much about how they control interest rates. Well they don’t control interest rates directly, but that’s another story. Their main job is to make sure their membe banks are sound. They have failed spectacularly in their primary task.
Everyone has finally caught on to the shadow banking system but that system was not seperate from the traditional banking system. It was funded and for the most part operated by the traditional banks.
There is not a chance that there will be real reform until it becomes conventional wisdom that Greenspan was the worst central banker of all time. Well John Law was the worst but that was too long ago to be relevant.
October 16th, 2008 at 1:41 pm
I don’t think all that many of the current lending is to real estate developers (although such loans may become more problematic pretty soon). Loans to very aggressive real estate development undertakings were common, especially in the Southwest, during the S&L fiasco of the 80s/early 90s. To the Krugman/Wells scenario it’s important to add that the shady banker can also use the FDIC deposit insurance promise to pursue deposits aggressively (which also happened in the S&L thing) — hence the FDIC regulates insured entities.
An interesting, though perhaps wonkishly dry (as is bank regulation and oversight), online document is the history of the FDIC, written by the organization’s historians. Links are available at http://www.fdic.gov/bank/analytical/index.html
October 16th, 2008 at 1:43 pm
The FDIC has far more to do regarding bank oversight and safety and soundness than does the Fed, contrary to rapier above.
October 16th, 2008 at 1:47 pm
So are Paulson and Bernanke economists pretending to be politians or politians pretending to be enconomists??
October 16th, 2008 at 1:49 pm
Comment 1 nails it.
It was not banking, as you describe, that failed.
Writing insurance, without adequate loss reserves and capital, is the real reason for this crisis.
This insurance scam was legalized fraud. Calling insurance as CDS does not change the nature of the product.
October 16th, 2008 at 2:46 pm
I think in a free market he’d be unable to execute his scheme. Where would he get the money to lend out? Nobody would give it to him.
However in a more regulated market, for example where depositors accounts were insured by the government, he might be able to get people to deposit money by paying attractive interest rates.
So this is really a story about the INTERACTION between government guarantees and regulation. You can’t have one without the other.
October 16th, 2008 at 3:04 pm
I seemed to remember something about a Krugman textbook being available online…
This page has links to a whole bunch of chapters, as well as lecture notes:
http://www.pkarchive.org/theory/13.html
October 16th, 2008 at 3:28 pm
Actually… The problem is still correct. What regulations prevent the con man from doing is escaping the bank collapse without losing any of his own capital (since he needs to inject a sizable equity stake on top of the debt he uses to fund the loans). And indeed, the shareholders and bondholders (who technically don’t inject equity, but still are investing directly in the business and are the next group wiped out by a failure) in U.S. banks have been shafted over the past 6 months or so. They’ve lost hundreds of billions. Since the con men (or capital holders) did not escape unharmed, the banking regulations did their job.
Now, the reason the reality does not seem to precisely match this problem is because Krugman’s question ignores agency issues by making the con man both the equity owner and the manager. In our reality, where the two roles are separate, a shifty manager can carry excess risk to get an option-like payoff just like the con man from the problem, unless the shareholders exercise unrealistic levels of oversight or insist on a better incentive package that makes the manager an equity partner.
Still, even in those circumstances, it can’t save the company from good ol’ fashioned short-sightedness. Lehman Brothers was famous for how much of the company was owned by employees, and how much of the bonuses were paid out in stock. Dick Fuld suffered alongside every investor in that company, but it didn’t make him any better of a risk manager.
October 16th, 2008 at 4:57 pm
I saw that movie
It was called The Producers. Zero Mostel was a laugh riot in it.
I forget how it ended.
October 16th, 2008 at 8:40 pm
That’s a stylized version of Charles Keating’s story, right?
October 16th, 2008 at 10:37 pm
Evan is right and it illustrates exactly why this problem describes the situation precisely correctly.
It was because loans would require reserve set-asides that the CDS market was created and why it flourished. This was one of several mechanisms for regulated banks to avoid the reserve requirements and take risks beyond what they were allowed to take. They also moved the risks off balance sheet to special investment vehicles.
Normally, because of the reserve requirements, regulated banks could not have become leveraged to the extent that they were and still are.
The problem is that the bank regulators all over the world (with the exception of Spain) knew that the banks were getting highly leveraged using CDS and SIV structures and other accounting subterfuges and yet failed to enforce the reserve requirements.
The problem is not lack of regulation but lack of enforcement of existing regulation. Obama cites both lack of regulation and failure to supervise as the cause of this crisis and he is right but it is much more the latter than the former. The conservatives then come back and attack the lack of regulation argument and ignore the lack of supervision argument.
October 17th, 2008 at 7:01 am
He’s not a con man, he’s an entrepreneur with a cash flow situation.
October 20th, 2008 at 6:52 pm
Daan Kervick is exactly right about the Ponzi scheme nature of the Credit Default Swaps, and until it becomes conventional wisdom that these un-backed CDSs are purely instruments of fraud, in the same way that kited checks are purely instruments of fraud, we will not be able to clean up our financial systems.
A relevant question is this: What is the least unit of fraud (LUF) in the CDS scandal? That is, when does a CDS become not a valid instrument but a fraudulent instrument? I would contend that, as soon as someone issues a CDS without having in his own hot little hands the assets to make it good, he is defrauding the buyer of the CDS. He can’t rectify the fraud by buying a second offsetting CDS from a second issuer, because he can’t know for sure that the second issuer can make good on the second CDS. Nor can he rectify the fraud by selling the first CDS to a third party, because he can’t know for sure that the third party can make good on the CDS.
Ponzi schemes work, for a while. So does check kiting, for a while. Ultimately, like the CDS fraud scheme, they collapse, leaving someone holding the bad assets. All are fraud from beginning to end.
Spread the meme: Un-backed CDSs are instruments of fraud.
December 12th, 2008 at 7:56 am
Hi!
My name is Jessika!
January 17th, 2009 at 10:28 am
laptop battery
laptop batteries
February 8th, 2009 at 10:43 pm
laptop battery
March 1st, 2009 at 7:42 pm
cialis
I bookmarked this site. Thank you for good job!
March 13th, 2009 at 12:07 am
Excellent site. It was pleasant to me.
March 16th, 2009 at 10:48 pm
sry i just know how to write my name in arabic
) anyway however my english not that good but i think i get the point. thanks
March 16th, 2009 at 10:50 pm
sry i just know how to write my name in arabic
) anyway however my english is very poor but maybe i understand what you talk about. thanks
March 22nd, 2009 at 6:34 am
tramadol
If you have to do it, you might as well do it right
March 22nd, 2009 at 10:39 am
buy viagra online
Excellent site. It was pleasant to me.
April 3rd, 2009 at 4:28 am
I want to say – thank you for this!
cheap brand pfizer viagra
April 9th, 2009 at 8:26 am
I bookmarked this site, Thank you for good job! viagra
April 9th, 2009 at 8:59 am
My fellow on Facebook shared this link and I’m not dissapointed at all that I came to your blog.
April 14th, 2009 at 9:39 am
Great site, Good info
viagra
April 19th, 2009 at 3:11 am
make money online http://www.makemoney321.com http://www.makemoney321.com