Weakonomi¢s » banking

When The Next Too Big To Fail, Fails

The Weakonomist — Thu, 17 May 2012 14:21:10 +0000

One of the issues with the financial crisis was a government that wasn’t sure what to do with failing companies. When a company failed they could either let it go into bankruptcy or bail it out. Some were allowed to fail, and that created a panic that the system would lock up. So most were bailed out to preserve the integrity of the financial system. Whether that was the right choice is a matter of debate, but that’s what happened.

Financial regulation in 2010 sought to make this process a little easier if there was a next time. Agencies were given new powers they’re now getting around to figuring out how to use them.

One of the most powerful agencies is the FDIC, which insures the deposits of banks. If a bank runs out of cash to pay depositors, the FDIC comes in with fresh cash and takes over the bank. Their new system is a bit of corporate trickery, but I’m pretty sure you can keep up.

Most banks operate as holding companies. So a corporate entity owns a collective of businesses that look like one company to the customer. It’s the corporate entity the FDIC will take over. The individual businesses that aren’t broken will be allowed to continue to operate. This keeps the financial system intact. If those businesses need money, the FDIC is allowed to borrow funds from the Treasury.

Stockholders in the parent company will be given nothing. As per corporate law anyway, they should lose their money. Anyone that lent the bank money will exchange the debt for equity (ownership) in a new private company. Presumably, the new private company will include the functioning businesses, the sick businesses will be bankrupted.

This sounds relatively easy on paper, but in practice it could be a nightmare. In fact, some don’t think the FDIC could pull it off. Many expect it would be too hard and they’d just do another bailout. In the old style bailout the government will just lend the company the money directly and help them work through the issues. Stockholders will get hurt, but they may not be wiped out.

It is very complicated though. Stockholders in the failing company may fail themselves if the value of their stock goes to zero. A panic may still occur. But the goal of the new process is to keep the functional units functioning, therefore preserving the banking system. While the plan might not work, it’s better than not having a plan in place at all.

What regulators will have to keep in mind is that nothing ever goes to plan. The unexpected will occur and so they must be prepared to be flexible and adaptable. Hopefully, we’ll never need it.

Read: Avoiding the Next Big Bailout

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Three Really Dumb Ideas

The Weakonomist — Tue, 17 Apr 2012 14:03:42 +0000

Americans cut their own healthcare costs, and that’s a bad thing:
“Patients cut back on prescription drugs and doctor visits last year, a sign that many Americans are still struggling to pay for health care…” – NY Times

Stop right there. Is a reduction in prescriptions and doctor visits a bad thing? Healthcare spending is almost at crisis levels in the United States. And here you are telling me now that simply because we cut back that’s a sign people are struggling? It could mean that people are just tired of paying for drugs they may or may not need. Doctors are human, and therefore may make mistakes and prescribe stuff you don’t need. Worse, doctors are human, and some bad apples are willing to take kickbacks in order to fatten their wallet and prescribe you drugs you don’t need.

Cutting back on our healthcare spending doesn’t solve the problems of healthcare expenses, but to imply that a cutback means people are struggling to to pay for care implies two narrow views: One, that all care is good and worth it. Two, the cutbacks were only due to cost.

Bipartican policy is a good thing:
Just because everyone agrees it’s a good idea still doesn’t make it one. Obama’s painfully named Jumpstart Our Business Startups (JOBS) bill got through the House and Senate without much bickering. First of all, no one says “business startups”. That’s like saying “pizza pie”. It’s not wrong, but no one says is. But the bill is being picked apart left and right for essentially making it easier for scam artists to get money from morons. The best summary comes from Andrew Ross Sorkin. But who are we to judge who should invest in what? Stupid people can make mistakes and live and learn right? Well the entire investment industry is highly regulated to essentially protect the idiots. This takes some of that away.

But what’s even dumber is the portrayal of this bill as some kind of victory for Washington. Imagine Democrats and Republicans are two football teams who want to play but can’t agree on the rules, location, scoring, or even what kind of turf to play on. But this week they announced that whenever they have that figure out the team kicking off will be decided by a coin flip. Great victory. The only reason this thing passed was no large company or rich guy behind the scenes really cared enough to lobby against it. If you need further proof bipartisan policies aren’t necessarily a good thing: JOBS undoes some of the bureaucracy created by another bipartisan law: Sarbanes-Oxley. And the law passed in 1999 that allowed banks to become the huge things everyone hates now: bipartisan. (Interesting sidenote, the law that allowed banks to become behemoths was of course debated by our elected officials at the time. Why hasn’t this gotten more play? Granted, Congresspeeps make predictions all the time and occasionally get lucky, but still).

Apps in store:
Do you have one of those QR code scanners on your smartphone? Maybe you use the JCPenney app when you’re at the store to pull up cool deals or get product info. Or maybe like me you want to see if those towels you wife has been eying at the department store are cheaper at online and scan the bar code. In theory these are all really good apps.

But in practice, no one gets reception in stores. In a time where wireless internet is almost ubiquitous, we still can’t check email in the bottom floor of a Nordstrom. It’s awesome to have all these apps available but my dear retailers, if you are going to offer one meant to be used in your store, you better role out some free WiFi and MAKE A MOTHER FREAKING MOBILE VERSION OF YOUR TERMS AND CONDITIONs PAGE! Why do you never see this anywhere?

Image: e-MagineArt.com

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Following Bond Through Casino Royale

The Weakonomist — Mon, 09 Apr 2012 14:23:37 +0000

Maybe I’m getting dumber, or older. Maybe that’s the same thing. But many modern action films are quite difficult to keep up with. They have so much action and move so quickly it can be hard to keep track of the plot. Over the last few years I’ve struggled with Star Trek, Transformers, and the two Daniel Craig era Bond films. Thankfully as they come on to TV (and my provider has given me a free DVR) I am now able to watch them many times over.

Casino Royale was a reboot of the James Bond franchise and started with Bond becoming a “double O” agent still young in his career. His first major assignment is to track down a mysterious organization that has infiltrated all aspects of business and government around the world and provides financing for terrorism.

The plot gets complicated quickly and it wasn’t until the 3rd or 4th time I watched it that I connected all the dots. I will not focus on every aspect of the storyline, as this is Weakonomics, I’m only focused on the parts that relate to money.

If you have not seen this film and do not want to be given spoilers STOP READING NOW! Just read Six Lessons James Bond’s Casino Royale Can Teach Us About Money instead. It’s fun and doesn’t have spoilers.

Bond’s investigation leads him to a guy who arranges acts of terrorism for money. The villain, Le Chiffre wants to blow up the prototype of a new commercial airplane (likely the fictional equivalent to the Airbus A380). As the company is strapped for resources blowing up the plane during a public showcase would make the stock tank (let’s ignore the fact the manufacturer probably has it insured). Le Chiffre has put up many millions in investments that make money if the stock prices fall. So, if the plane blows up and the stock tanks, the villain will have yacht-loads of money.

Bond’s boss, M, alludes to someone having placed similar bets before 9/11 – connecting the plot to real life events and implying Le Chiffre’s organization financed those attacks. This is also why the CIA is interested in him.

In typical fashion, Bond stops the explosion from happening. Seconds before disaster.

Le Chiffre’s investments go to nil. Now you would think that’s so sad for him but whatever. There’s just one problem. It wasn’t Le Chiffre’s money. He bet someone else’s money and those funds were supposed to go and finance some terrorism or war (presumably in Africa judging by the visitors to his hotel room). Le Chiffre is just a banker for the terrorists, and as a banker he bet money he didn’t have and lost it all. Notably: this movie was made in 2005, before the financial crisis. But it feels like it was made in 2009.

His organization will want that money back. The governments of the world hope that he will turn to them for asylum in exchange for information about the organization. In a last ditch effort to save his own skin, he organizes a high stakes poker game with a bunch of rich people with millions to lose. Le Chiffre is an excellent player and almost wins, which would allow him to continue his original transaction as banker. But Bond eventually bests him, and wins it all.

If this were anyone but Bond, Le Chiffre would have accepted an offer for asylum right then and there. But with Bond there’s always “the girl”. She’s kidnapped and Bond is captured trying to save her. They torture him to get the information needed to get Bond’s winnings but Le Chiffre’s own organization turns on him and puts a bullet in his head. They value secrecy and people they could trust. Even if Bond gave them the money, he clearly can’t be trusted with it.

And that pretty much sums up the main plot.

If you don’t understand what happened with the girl keep reading. Vesper is the love interest. She works for Her Majesty’s Treasury and provides public funds to finance Bond’s entry to the poker tournament. She also provides the account number to transfer the Treasury’s money back to the government. Bond has the password, which he gives to the escrow agent after Vesper provides the account. Later, Bond gets a call from his boss asking when the money will be transferred back. Vesper has betrayed him* and transferred the money to another account. She had a boyfriend who supposedly (see the second film) had been kidnapped by Le Chiffre’s organization and held hostage. So she delivered that money back to the organization and Bond tried to stop her. I can’t remember if they got it or not, it’s not important though. Vesper, who did love James, dies.

So, hopefully this helps with the plot. The movie is great and with this knowledge it’s a lot easier to follow.

*Quantom of Solace, the second film, ties up the loose end with Mathis. He was guy who Bond originally thought betrayed him earlier.

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What Would It Take To Kill The Penny?

The Weakonomist — Tue, 03 Apr 2012 13:49:09 +0000

Canada just decided to kill their penny, which is more or less worth the same as our penny. The cost of producing them is just too high. They cost 60% more than they’re worth in Canada. Coins are a throwback to the days when the coin was literally worth its weight in the metal it was made from. But in more modern times they became a means of transaction, with their worth equal to how much gold it could buy. A penny in the 1800s bought a penny’s worth of gold. That is how value was established. In modern times there is no underlying value. A penny is worth as much as a penny. This is the nature of most money in the world.

And the penny just isn’t worth much anymore. Canada’s ending of penny production has stirred up a regular conversation in the US about whether or not to kill ours. It’s just as expensive to produce as the Canadian penny and Obama’s budget for 2013 includes provisions for changing the makeup of the penny to make it cheaper to produce again. It’s previously been an issue to melt down coins when the are worth more as raw material. This video makes the full case for killing the penny quite well:

Not only are pennies a drag, but as the video points out they are already refused in many areas of the economy. But does that mean we’ll be killing the penny? Don’t bet a 1943 Copper Wheat Penny on it happening soon. I wouldn’t even bet a 1912 D Wheat Penny. There are a lot of considerations that would have to be addressed.

The biggest problem with killing the penny is the fact that we buy things that require pennies all the time. If you pay cash, you’ll probably get pennies back. If you left your card at home and don’t want change you probably need to have some pennies on you. This is due to the pricing system in the US (“Only $19.99”) and a sales tax system that adds cost on top of the list price. In Canada, and in other countries, retailers are encouraged to round to the nearest nickel to adjust their pricing. In the US, we’d need that as well as a simplified sales tax system that either builds the cost into the price or adds everything easily at the point of sale. An example:

Buying a shirt for $14.99 with a 7.5% sales tax costs $16.11. A cash transaction would require pennies. So move the price $14.95. But with sales tax that would be still be $16.07. Still need pennies. So stores would need to simplify pricing or round up. There’s a cost to rounding up to consumers that isn’t insignificant over the course of multiple transactions.

And think about the cost for the nearest currency to the penny. The nickel. The nickel costs more than the penny to produce, significantly more. More nickels would be needed to pick up the slack. That’s going to increase the burden on the government. It’s not until you get to the dime that you start to see any real efficiency in coinage.

But the problem persists that pennies are difficult to use today. They are accepted wherever most cash registers are available, but that’s about it. And there is a cost for dealing with them. As inflation continues to drive down the value of 1 cent, it becomes a greater problem figuring out the value the penny adds to society. Don’t expect to see the penny get cut in the US anytime soon. It would likely take some kind of crisis like a shortage of metal or massive government austerity to bring it down in the next decade or so. It isn’t out of the question though for people who grew up barely knowing what a checkbook was to see it sent to pasture in their lifetimes.

Image: eurleif

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Weak Links: Less Roads, Less Traffic?

weakonom — Fri, 23 Mar 2012 14:21:09 +0000

Why I gave up my six-figure salary and quit Bay Street: Bay Street is in Toronto and is Canada’s version of Wall Street. You can’t expect much a difference between the two countries, but this author provides a well written explanation of his time in finance and why he, and others, left.

Remove the highways, fix the traffic problem: One of the most interesting reads in 2012 so far. John Norquist championed the destruction of some highways in Milwaukee while the mayor and actually saw an improvement in traffic. New Urbanism is the name of the idea and it calls for better city planning that reduces congestion. The best way to sum it up is that by proper planning of roads, people won’t have an incentive to live far out of town and commute in for things they need. If you work in the city, live in the city. We are likely to see this in some form or another in increasingly greater amounts all over the country as the cost of commuting continues to rise. Most traffic issues are “solved” by adding supply to support the increased demand. What would happy to demand if supply was taken away? I’d like to see how they would do DC though.

Castro might have known Kennedy was going to get shot: Conspiracy theorists rejoice. A great conspiracy about Fidel Castro knowing JFK was going to get shot. The only downside is if this story is true, most of the cover-up conspiracies likely wouldn’t be.

Generally speaking, everything makes you fat: Extensive article showing that calories alone can’t account for the reason everyone is so fat. It’s the quality of what is put into our body. The whole article reads like an endorsement for organic food, and it will give the overweight among us an excuse for not jogging tomorrow. Mommy’s eating when she was pregnant made me fat.

Men, just thinking about talking to women makes you dumber: This would explain while I fumble through my words every time I need to talk to my wife about something. Points scored for The Weakonomist (if The Sheconomist is reading)!

Number cruncher’s life in charts: I didn’t build this, but I feel a good connection to the charts. Especially aligning the supposed same data from different sources.

Are you a ginger? You can take the pain: Red heads feel less pain than everyone else. Are they more genetically advanced? Will they rule the world? Thank a ginger today.

Divorce: the downside to living longer: Til death do us part used to mean 60 years. Now 90 isn’t crazy. The rate of divorce of people over 50 has doubled over the last 20 years. When the kids are gone, it usually meant you were about to die. Now it means you have to decide if you want to spend another 50 years with the other parent. Many are thinking, not. Via @pkedrosky

More People Interested in Part-Time Retirement: Count me as one of them. Weakonomics started because at the time I was bored working just 40 hours a week. I work more now, but I can’t imagine full blown retirement. Not yet at least.

Tricks retailers use to carve out extra profits: Candy bars have been shrinking, but the prices for them haven’t. That’s good for bellies, and retailers. This is just one of a number of ways retailers are playing games with price tags these days.

Once again, I entered a post into the Carnival of Personal Finance. Once again, I was editor’s choice. Click through to see what it was.

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A Banker, Executive, & Attorney Walk into a Bar…

The Weakonomist — Wed, 14 Mar 2012 13:15:04 +0000

The financial crisis left a sour taste in our mouths for bankers. The term “banksters” became popular again. Executives got a bad reputation again thanks to bailouts, bonuses, and boneheadedness. The public is even coming around to the idea that politicians played a part in causing the crisis, but of course we already hated them. Before the financial crisis though, who did everyone hate?

I’ll give you a hint:

Q. What’s the difference between a dead dog in the road and a dead lawyer in the road?
A. There are skid marks in front of the dog.
A client who felt his legal bill was too high asked his lawyer to itemize costs. The statement included this item:
“Was walking down the street and saw you on the other side. Walked to the corner to cross at the light, crossed the street and walked quickly to catch up with you. Got close and saw it wasn’t you. — $50.00.”
Q. What do you have when a lawyer is buried up to his neck in sand?
A. Not enough sand.
Q. What’s the difference between a lawyer and a vulture?
A. Lawyers accumulate frequent flyer points.

Those times are gone though. Lawyers are looked upon more favorably, at least in comparison to banksters. But wait, there are all kinds of lawyers out there. And the financial industry employs some of them. Did they play a role in the crisis? I’m glad you asked.

Attorneys in the financial industry take on all kinds of roles, but one of the more important ones is in deal making. If one company wants to buy another company, they hire bankers to broker the transaction. But they also hire lawyers to handle all the legal work going into the buyout.

Notable financial writer Andrew Ross Sorkin summed it up perfectly:
“Chief executives and bankers may make easy punching bags these days, but for every bad decision they make, there is often a lawyer who approves it — and most likely charges over $1,000 an hour for that brilliant advice.”

Corporate attorneys are no more darlings than any other player in banking. In the deal making world almost everyone has a vested interest in making sure the deal gets done. The bankers usually charge a fee that’s a percentage of the transaction. The sellers want to cash out. The buyers want their business. And the lawyers want to charge a bunch of fees to handle the paperwork.

But all sorts of conflicts of interest can arise that could screw one party or another. The legal team should play a role in identifying those interests. According to Sorkin’s article (linked below), they aren’t.

But maybe that doesn’t mean lawyers aren’t hated. The general public likely considers them a “banker”. “Banker” being a generic term in this sense. But I doubt lawyers are noticing. And no one is occupying Wachtell, Lipton, Rosen, & Katz to remind them either. No one has heard of any of these firms, and likely never will.

The new financial regulation might have some new rules for attorneys in this business. But even if there is no one is talking about their role in the crisis. Maybe they will now.

Read: Conflicted, and Often Getting a Pass via @EveryayFinance

Image: andygee1

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Pay Me To Borrow Money, From You

The Weakonomist — Mon, 06 Feb 2012 15:43:13 +0000

That’s what the US Department of Treasury may be telling investors in the near future. What that effectively means is that the rate the US pays to borrow money would be negative. Investors would be paying the US for the privilege to lend to them? How can this happen in a world where our debt was downgraded just last fall? Interest rates on US debt have done nothing but fall since the downgrade. An astute reader can see that this is counter-intuitive, after-all if your credit score fell from 750 to 700 you couldn’t expect to get the same rate on a loan could you? Could you?

Maybe you could. Because interest rates aren’t just driven on the likelihood of default, they are also dependent on the market. And while the US went from being “near perfect” to “perfect-ish”, the global bond market has been in turmoil. This means that the US is still considered the safest place in the world to park your money, and so rates have fallen. Just as a person with a 700 credit score today can get a better loan rate than someone with 750 a couple of years ago.

Rates have gotten so low they’ve actually been at zero percent recently and traded at a negative yield in the secondary market. The US Treasury may soon offer some short term Treasury bills with what’s called a negative coupon. When investors submit bids for the bills they might offer $101 for a bill worth $100. Under normal circumstances they might bid $99. In 4 weeks the US would give them $100 back in either circumstance. When investors are allowed to bid $101 for the a $100 bill, that is a negative return, or negative interest rate. The idea of investors paying for the privilege to lend money to the US is so weird the Treasury systems will have to be updated just to make it possible. But this is something that has already been happening in the secondary market for these bills and so by updating their systems, the Treasury would either have to borrow less or could perhaps consider taking the proceeds and putting it towards our national debt.

Negative interest rates are not common, but you can effectively see them all around you. Think about your checking account. When you deposit money into a bank you are loaning it to them. They will pay you a small rate (if at all) for allowing them to borrow it. But then the bank slaps you with a couple of fees every month and even if you are getting interest the fees more than offset it. So you’re paying the bank for the privilege to lend them your money. Banks don’t see it this way because of all their overhead, but essentially that’s what you got.

Does it make you kind of wish banks would just get rid of fees and charge a negative interest rate? Part of me feels that way. Ditch all the fees, just charge 1% per year based on some kind of average balance. But that will never fly because each account has a basic fixed cost. If it costs $100 a year (it’s actually more) to keep a checking account going and they need $20k in balances to make that back then they aren’t going to charge wealthier customers for their business. They wouldn’t need to because they could make the money back elsewhere. People with balances below that line will just cost the bank money. So you’d end up with a segregated population that is divided by the people who pay for the privilege to lend the bank money and have access to their cash, and the people that are paid to have the same access.

Banks know that middle and lower-income demographics won’t respond well to that, so instead you have the al la cart menu fees which, while annoying, have the appearance of being fairer. Plus no consumer is going to park $50k in a place that pays -1%. So while the Treasury is looking forward to indulge in a little negative interest rate territory don’t expect to see it show up on your banking documents for a long time.

Read: Treasury may let investors pay to lend to U.S. government (Reuters)

Negative Bill Auction Yields Would Avoid ‘Grab-a-Thon’ (Bloomberg)

Image: SqueakyMarmot

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What Created The Rise Of Finance?

The Weakonomist — Fri, 27 Jan 2012 14:43:59 +0000

Does this statement disturb you?

In 1950, finance and insurance in the United States accounted for 2.8% of GDP, according to US Department of Commerce estimates. By 1960, that share had grown to 3.8% of GDP, and reached 6% of GDP in 1990. Today, it is 8.4% of GDP, and it is not shrinking. The Wall Street Journal’s Justin Lahart reports that the 2010 share was higher than the previous peak share in 2006.

It’s certainly not surprising is it? It makes perfect sense considering the rise of banking and Wall Street over the last generation or so. This blog has said before that this rise also lead to greater levels of compensation, and thus drew talent that may have otherwise focused on other areas (like science or education). This probably further grew the industry’s share of the economy. And when people read these kinds of comments about the rise of Wall Street it is worrisome that they always think this is a bad thing.

Consider the following. Your grandparents likely retired on a pension and collected social security and hardly ever needed to save for retirement. In 1950 the average person lived to be 68 years old. Retirement didn’t last very long, if at all. In 2009, we were living to be 78, and we all know this number is only going to rise with time. That’s an extra decade of living expenses. How is that being paid for? Pensions have had to invest considerably more money in order to deal with the burden of people living longer. Reforms here and there occasionally soften the blow for them, but the burden is still much higher than it used to be. Pensions now invest in riskier securities, and get better returns too. Wall Street’s role was to facilitate the transactions that enabled these pensions to survive just a little bit longer and pay the retirements of all these people. And to say nothing of the rising insurance needs of the aging population. Those premiums are invested too. When a new demand is born, an industry grows.

When you consider that baby boomers are just now retiring the rise of Wall Street makes even more sense. These were the first group of people that may have to sustain their retirement with personal savings and investments. 401(k)s became very popular in the 1980s and of course still are; IRAs too. Now people were taking their retirement into their own hands. This gave rise to the mutual fund industry and now you have a bulging population entering the prime of their careers and saving for their own retirement. Again, an industry grew to service this demand.

Just as everyone was taking responsibility for their own retirements, the internet was about to start growing too. With the internet, people were able to take their own financial management to a new level. Soon, people would be able to buy and sell stocks within a few minutes, and then seconds through online brokerages. Once again, an industry rose to meet this demand.

Further still, consider the globalization that has occurred. More so than ever before, we are engaging in huge levels of trade, moving trillions of dollars to Moscow, Beijing, Tokyo, London, Singapore, Dubai, and Rio. This movement happens at the speed of light and the infrastructure to enable it was built and managed by the finance industry.

The rise of Wall Street shouldn’t be concerning at all. Given the changing demographics and economy, it makes perfect sense. And what of the greed and the financial crisis? Unfortunately, finance is not a stable industry. The financial crisis had a lot of causes, and Wall Street was certainly part of that. Together with a poor incentive structure, they again rose to meet a demand. This is a case of the industry getting ahead of itself.

No one should be surprised nor concerned that the industry continues to be a large part of the economy. Our lives are more financially complicated. The financial crisis is a perfect example of the growing pains. It’s impossible for this industry to grow and meet demand without making mistakes. Everyone made mistakes. I’m no apologist for the criminal, greedy, and immoral acts in any industry. But the rise of finance as a share of GDP is merely a reactionary metric of the way the world has changed.

Image: Jan Tik

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Cosa Nostra è la Mia Banca

The Weakonomist — Thu, 12 Jan 2012 14:49:18 +0000

Times are rough in a number of European countries. Much like in 2008 here in the US, credit markets are tightening across the pond. But, whereas things froze overnight here, there things are just tight; like your pants usually are in January. And like the US the banks are cutting back on lending and only extending loans to the most credit-worthy customers. The difference between the crises is the banks are in danger from owning too much European debt, and in the US it was too much bad housing debt.

And where does that leave all the people who need loans and can’t get them? In Italy at least, they have the Mafia. Mafia is a generic term for many organized crime syndicates around the world, but Cosa Nostra refers to the families that are still very prevalent in the Italian economy. Their operations are sizable, enough so that if the crime were shut down completely over night the economy would likely fall into a depression. And in the absence of lending from traditional banks they’re breaking into new territory.

And it’s not like loan sharks either handing out a few bills in back alleys either. They’ve gotten a lot more sophisticated. Considering how intertwined Italy is with the Mafia it stands to reason they’ve got people in law, government, and banking. They have the resources to do actual due diligence on their loans. They’re doing real banking. I doubt they take deposits, but I’m sure they hold collateral.

Putting aside the fact they are a criminal organization capable of doing terrible things to delinquent borrowers, the Cosa Nostra are likely providing a valuable resources to struggling Italians. In a time of crisis, they’ve got the money, and are willing to take the risk, on lending to otherwise risky borrowers. If no one else is willing to risk their funds, these guys apparently will.

I can imagine some economists are dripping at the thought of learning more about what is going on in the country. Mob banking is likely the best example of a free market. Admittedly, I’m curious too. What kinds of interest rates to they charge? Do they have different types of loans? What percentage of the loan portfolio is 90 days late (a standard measure of a borrower about to go under)? How cruel are they actually about collection? Even if they are operating outside of the law, if they bang up people too much for not paying, no one will want to borrow from them. Free market indeed.

What will be the most interesting observation over the next few years will be to see how big of a role the Cosa Nostra play in Italian banking and the economy altogether. If things continue to get worse, will they step up their efforts further? Have the mob already effectively bailed out the country? If the economy stabilizes will their lending efforts decline or will they step up efforts in light of competition from legitimate banks?

Read: Mafia now “Italy’s No.1 bank” as crisis bites-report (Reuters)

Photo: TaxBrackets via Flickr

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Flyover States and MFing Global

The Weakonomist — Thu, 15 Dec 2011 15:21:04 +0000

There are some elements of finance that even I struggle with. For example, how can you draw a line from a wheat farmer in Nebraska to a bankrupt brokerage in New-York City? Maybe that connection is easy, but why is the farmer’s money missing just because the farmer’s brokerage company went bankrupt? And why are the funds belonging to the wheat farmer in Saskatchewan just fine?

If a bank goes under then technically speaking a customer’s assets should be just fine. Maybe the bank no longer has the resources to manage your money, but your money should still be find, be it investments or cash. These assets would be transferred to another institution.

But with dedicated brokerages there are some different rules (mind you these rules may apply elsewhere too). Brokers can engage in their own financial transactions and MF Global had done just that. They bought European debt. You know how that went. So they lost a bunch of money. But part of the deal with their bets on debt requires posting collateral (because they borrowed money to buy the debt). That collateral can come from customer funds. So if you are a farmer and post collateral to make trades in wheat futures, MF Global can use your collateral as their own. One would question the logic behind this, and many have. This is why there are limits on how much of this can be done, and it is against the law to use Canadian funds to do it.

American and British funds are fair game, which is why the Nebraskan wheat farmer can’t seem to get his money back. That money is missing because even with the rules on posting collateral as collateral, MF Global may have simply broken the rules to make its own trades. So why is MF Global in such a mess? If you aren’t following there are two problems. The first is they made bad bets with their own money, the second is they may have broken the rules with posting customer money as collateral for those bets. If you want to know more about this read up on the Shadow banking system, repurchase agreements, and rehypothecation.

Now all you east coast and west coast people who don’t work on Wall Street may wonder why some wheat farmers have anything to do with a broker you’ve never even heard of. Look at it this way, imagine you averaged $75,000 a year in income over the last 10 years. But some years you made $15k and other years $150k. You had absolutely no control over what it would be. If someone offered you the chance to guarantee your income in advance for a small fee, would you take it?

Of course you would. Essentially this is one service a broker like MF Global offers. Farmers take advantage of it to smooth out the price of their product. Everything from corn to pork can be as volatile in price as a stock, so farmers don’t want to stress about how much their wheat will be worth once it’s grown. They use brokers like MF Global to engage in contracts that lock in prices ahead of time. MF Global takes a small fee, and may also collect collateral if prices aren’t paid up front. This is the collateral that ends up getting used in the rehypothecation (you haven’t looked it up yet?).

I hope people in the middle-states aren’t offended by my headline, but it helps draw attention to the idea that the global economy is truly global. A small town farmer’s money very easily got tied up in the European debt crisis and with a firm that is doing no favors for Wall Street’s reputation for recklessness.

MF Global’s bankruptcy is the largest since Lehman Brothers back in 2008. Thankfully this seems to be an isolated incident and not a domino. Hopefully new rules will be put in place to prevent such reckless behavior, should it be determined rules would have actually prevented this.

Image: mrpbps

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