FDIC Fosters Moral Hazard Among Banks

What am I missing? Why do the majority of folks blindly accept the shenanigans of the federal government? Why is it advisable to bail out the failures and penalize the productive? Isn’t there a moral hazard lurking somewhere in this mix?

In a recent editorial, Peter Schiff reminded me of what my late friend Harry Browne, the former Libertarian Party candidate for president, used to say: “The government is great at breaking your leg, handing you a crutch, and then saying, ‘You see, without me, you couldn’t walk.'” That maxim is clearly illustrated by the financial industry regulatory reforms proposed recently by the Obama administration. (“Would you like a broken arm, or would you prefer a broken leg?”)

Every economic problem we face can be directly traced back to the federal government and the interfering laws that it continually passes. Remember the Resolution Trust Corp. back in the 1980s? It became “necessary” to bail out the savings and loan industry because so many of the S&Ls gambled wildly with their depositors’ money. Sound familiar? How could the S&Ls of the 1980s and the too-big-to-fail banks of the ’00s make such horrible business decisions? Were/Are the management teams just stupid or are they also incompetent?

Consider this: We’ve had a record number of bank failures just this year. As of June 19, 2009, the FDIC has closed 40 banks at a net cost of over $11.5 billion. Are you worried? Why not? Oh, your account is insured. By whom? So when the management of the bank that controls your deposits makes stupid business decisions, you don’t care? The FDIC will bail out your account. Not only that, the “insured” amount was increased from a “mere” $100,000 per account to $250,000 this year (this extra coverage expires at the end of 2013 and reverts back to the $100,000 figure in 2014 as currently scheduled). Do you see a slight problem here?

Just for giggles, suppose there were no FDIC and your deposits at any bank or S&L were simply not insured. Would you then perhaps have a slightly different outlook as to the safety of your money? Would you perhaps behave somewhat differently when selecting a bank in which to deposit your funds? Why? Do you now see that the FDIC is a federal government-sponsored insurance scheme to protect you from greedy and stupid bankers? Or do you perhaps see that the FDIC actually facilitates excessive risk-taking on the part of the bankers, since they have nothing to loose? Do you suppose there might be a slight moral hazard hiding somewhere in this mix? If the bank did not have the FDIC insuring your deposit and that same bank had to compete in the open, free market for your deposit account, would you suppose that the bank management might behave in a slightly more conservative manner? Wouldn’t you behave in a slightly more conservative manner when selecting a bank?

Now consider the actions of the too-big-to-fail companies, be they banks, insurance companies, Freddie and Fannie, or even automobile manufacturing companies. What’s to restrain the management of those companies? If they mess up, the government will protect them. And as we’ve all observed, the very folks that made the stupid and reckless business decisions will still get their multimillion-dollar bonuses. Would you be willing to make a wild guess that maybe there is a slight moral hazard hiding somewhere in this scheme?

What about the business management that continues to make prudent decisions and continues to operate profitably? What is their incentive? How are they rewarded? The same federal government that bails out the too-big-to-fail companies totally ignores the hardworking, successful managements of the smaller businesses. Actually, it’s even worse than that. The companies and individuals that are successful now get penalized, because their tax dollars are used to bail out the unsuccessful. They get to subsidize the failures. Isn’t that a wonderful reward for doing a good job?

So I again ask what am I missing? Am I the only person (or only one of the very few) concerned? When I/we comment about these obvious inequities, does anyone pay attention? Does anyone question the wisdom of the federal government’s decisions? Based on the feedback I’ve received from the congressmen and -women who claim to “represent” me, they certainly don’t care. Aside from the folks who attended the various Tea Parties on April 15, the rest of the folks don’t seem to care. What am I missing?

One of the factors that caused me to write this white paper is the incredible discussion of so-called “green shoots” from our eminent Fed head “Helicopter” Ben Bernanke and the observation of the recovery light at the end of the tunnel that now seem to be so visible to the mainstream media. As Ronald Reagan used to say, the media know a great deal that just isn’t true.

There has been a tremendous recent effort to create “transparency” in and from government. Using that as a diversionary tactic, the public’s attention is now away from the facts. While perception is important and can mask facts for a period of time, it cannot avoid ultimate economic laws of nature. In this case, the public’s attention is being diverted from the undeniable facts that we are nowhere near the bottom of this economic downturn. Banks are still hiding toxic waste in their off-balance sheet accounts. These virtually worthless assets are not just going to disappear with no one noticing. Sooner or later, these near-worthless assets must be accounted for. The so-called bank stress tests were a joke. The intent was just to give the public the perception that the worst is over.

It isn’t. We have at least one more major leg-down in our economic future. And I believe that leg will take us to a Dow of 5,000 and perhaps as low as 3,000. Yes, the Dow may continue upward to 10,000 from its current level of 8,500, but then it will head down once again. All we have to do is look at Japan 1989-present and our own economy from 1929-1932. Oh, yes, it can happen again! Absolutely nothing has been done to prevent a repeat of this history. In fact, what has already been done by the federal government interference with our markets almost assuredly guarantees that it will happen once again.

What is it that will happen? A depression. Why? Because too many government interferences have occurred over the decades since the last depression. Perhaps it might be helpful to first define the difference between a recession and a depression — at least by my definitions of the terms.

Business cycles frequently become what are referred to as overheated economic cycles. (Note that every one of these so-called overheated situations is a direct result of government monetary interference with what otherwise would be free market behavior.) So a so-called cooling-off period of adjustment then takes place to correct the malinvestments that were made during these periods of irrational exuberance (thanks, Alan). These adjustments happen rather quickly, and then the recession is finished. You’ve heard it called the “V” recession because we tend to enter quickly but then we tend to also recover quickly. Today, the mainstream is talking of a “W” recovery, meaning a double in-and-out recession. But recessions usually take place rather quickly and are then finished. In a depression, structural changes to the economy actually occur and then it takes years to readjust. Can you say Japan? The new version of the resulting economy is a major change from the prior economy. Old bubbles are never reinflated, but new bubbles are ultimately formed. Note that our federal government is trying to reinflate the last bubble, meaning a return to a consumer-led economy. It simply won’t happen. We’ll waste a tremendous amount of taxpayer money and it will all be for naught.

Ultimately, a new bubble will be created. In the past decade, we’ve enjoyed the Greenspan dot-com bubble followed by the real estate bubble. Now we are starting to form what I see as a bond bubble. In the process, everything in the path of this “recovery” is being socialized: banks, insurance companies, mortgage lenders, even automobile companies. Yet to come will probably include national health care. If you think private health care is expensive, wait until you see how much “free” health care costs. But this is what I mean by “structural” changes. It’s new territory for most of the participants.

What do you think will be the end result: inflation or deflation? I think we’re in for both deflation and inflation — in that order. Short-term deflation, but longer-term inflation. So I’d invest to protect myself against inflation. That means precious metals, energy, and commodities such as foods and water. Period. For the foreseeable future. Speculations would be in the area of biotech, nanotech, and stem-cell-tech.

I also hope that my comments are just being realistic — not doom and gloom. I admit my emotional reactions may be affecting my opinions. I hope not. But I’d rather be overprepared than underprepared or unprepared.

Considering that the value of our dollar is being actively destroyed by our government, how will you protect yourself and your family from further destruction of the dollar? Are you aware that the dollar is now worth 4% of what it was worth when the Federal Reserve was created with the charter mandate to provide a stable dollar? What did I just say? Are you happy with 4 cents of purchasing power left for your hard-earned 100-cent dollar? Don’t take my word for it — it’s on the Bureau of Labor Statistics (BLS) Web site. My recommendation includes making investments in areas that are not dollar denominated. As such, you can expect to benefit from a currency hedge as well as from the performance of the investment itself. Today, all currencies are fiat, so this becomes a relatively moot consideration — see my next comment below.

Still another area to consider is foreign exchange. Consider Swiss francs and Chinese renminbi (yuan) for starters. Also consider the Brazilian real, due to the country’s incredible discovery of offshore oil. The real would be a speculation, while the franc and yuan are slam-dunks. Norway’s kroner is also a consideration, due to the country’s oil economy. I’d stay away from the Canadian loonie simply because Canada’s economy is so closely tied to the US’.

I believe we are in a depression, not just a recession. By that, I mean we’re in for major structural changes, not just a clearing of some malinvestments that got out of hand in recent years. The Dow could go as high as 10,000 before the next drop, but there will be another drop. As I said, I expect the Dow to go as low at 5,000 and possibly 3,000. I know how that sounds, but that is what the markets are telling me. While we will then recover, it will be a long, drawn-out recovery. Years, not months. This is not the muddle-through recession that so many expect. I’m guessing we’ll remain in this morass for at least five years, if we’re lucky. We could go the way of Japan, which hasn’t recovered yet after two decades! The more Washington interferes with the markets, the more severe the problems then become and the longer the recovery period. As Bill Bonner is fond of saying, we’ll see “a corrective force equal and opposite to the deception and delusion that preceded it.” And of course, we could just be headed into outright and total socialism, so all this attempted planning could just be for naught.

But back to my original question: What am I missing? What do you know that I seem to be overlooking? Why am I not in agreement with all the mainstream economists and government officials such as “Helicopter” Ben Bernanke and Timothy tax cheat-in-charge-of-the-IRS Geithner? Why is it OK for the U.S. government to “fire” all the profitable Chrysler dealerships because they donated to the Republicans while keeping the unprofitable Chrysler dealerships because they supported the Democrats? Why is it OK to medically insure the 47 million uninsured at the expense of the folks that actually pay the premiums? Why is it OK to bail out AIG because it insured Goldman Sachs? Why is it OK to “gift” a major ownership of General Motors to the UAW simply because the union supported the Obama election campaign? Why is it OK to stiff the Chrysler and GM bondholders who, by USA contract law, have first right to the assets of the corporations in case of a bankruptcy? Why is it OK to simply ignore and override centuries-old corporate law? Why is it OK to issue presidential edicts that circumvent corporate and civil law? Why? What am I missing? Why?

There is much, much more to be said on this topic. However, what I’ve already written is probably more than enough for the moment. By the way, were I a registered broker or financial adviser, the securities rules and regulations would prohibit me from telling you the above. So don’t be too hard on your current financial adviser. The government would suspend his/her license for telling you the truth.

Tex Norton

July 10, 2009

The Daily Reckoning