The Obama Proposal for Bank Reform

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Well, we’ve taken a look at US President Barack Obama’s proposal for bank reform.

Not surprisingly, the plan involves trying to ‘unscramble the egg’ rather than throwing the whole thing out – including the pan – and starting again.

Obama’s plan has two goals. First to…

“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.”

And second…

“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.”

So far the market hasn’t liked it.

Since the ‘plan’ was announced last Thursday the Dow Jones Industrial Average has fallen 4%. As you can see from the chart below:

Dow Jones Industrial Average

 

Of course CommSec’s “Mr. Happy”, economist Craig James says not to worry:

“Fear has put its ugly head up again. I don’t think it’s going to be long-lasting this time. It’s a knee-jerk reaction to some proposed bank changes in the US and concerns in China. In Australia the overwhelming focus is the inflation figures. We’re looking for a fairly benign result, an increase of something like 0.7 or 0.8 of one per cent. That would be the sort of outcome the Reserve Bank wouldn’t be getting overly concerned about.”

Which rather reminds us of a cop stood at the scene of a traffic accident encouraging passersby to “move along, there’s nothing to see.”

We can expect to see plenty of similar claims from Australian mainstream commentators. They’ll tell you our banks won’t be affected by Obama’s plans because the ‘strong’ Aussie banks are different.

To conclude that Australian banks won’t be affected at all is somewhat naive. But look, we won’t jump the gun on that yet, we’ll wait for the so-called experts to put their foot in it first, then we’ll pillory them.

The problem with Obama’s plan is that it targets the effect but ignores the cause.

The real cause

Let me try and explain…

The two paragraphs that I’ve reprinted above, while they don’t go into specific detail, give you a clear outline of what the plan will involve.

It’s proposing to separate banking into ‘plain vanilla’ savings and loans banks on the one hand, and ‘fancy pants’ merchant or investment banks on the other.

The simple idea is that the ‘plain vanilla’ banks will take deposits from savers and lend out money to borrowers. While ‘fancy pants’ merchant banks will do, well, all the exciting stuff – finance hedge funds, manage investments, capital raisings, create and trade complex financial products…

And never the twain shall meet.

That, the claim seems to be, will result in a much stronger, safer and more responsible banking and financial system.

It may surprise you to learn that it’ll do nothing of the sort.

You see, what Obama and the mainstream commentators highlight as being the ’cause’ of the financial meltdown – “hedge fund or a private equity fund, or proprietary trading” – is actually the effect of the real cause of the meltdown.

They’ve got their causes and effects all mixed up.

Financial markets and banks didn’t collapse because of hedge funds, or private equity funds, or proprietary trading. The existence and actions of these groups is merely the consequence (or effect) of the real cause.

You can compare it to someone getting shot. Sure, it may have been the bullet that appeared to do all the damage, but it was the person who loaded the gun, aimed, and then pulled the trigger who should be blamed.

Like them or not, the banks were and still are, taking advantage of a distorted market. And it’s those distortions that are the real cause of the financial mess.

So, what are the distortions? Simply put it’s the fault of unsound money and government and regulatory manipulation. I know that may be a difficult concept to grasp considering all the blame has been shifted towards the ‘free market.’

Probably the funniest and most ironic aspect the last two years has been the way the mainstream press and economists have associated the idea of a ‘free market’ with the recent behaviour of the banking system.

That somehow the free market is responsible for 100-to-1 leverage. That the free market is the cause of super low interest rates. That the free market is responsible for banks taking excess risks. And that the free market is responsible for banks having to be bailed out by the government.

All of which is wrong.

The real truth is that you can draw a line back from those three problems – and any other you care to think of – all the way back to one of two causes: government and central bank manipulation.

Sure, the banks aren’t faultless. If you’ve read Money Morning for long enough you’ll know that we’re no fan of the banking system. But their actions are merely as a response to policies that originate with governments and central banks.

To explain what I mean, let’s take a brief look at three of the points I’ve highlighted above: excessive leverage, low interest rates, and excessive risk taking.

It’s all part of what I call a ‘Risk Shift.’

By that I mean, banks are encouraged to take risks due to a manipulated market. Like most risk takers they’ll push things as far as they can. Sometimes they’ll step over the line.

The problem is that the risk limit has been shifted. The banks went to the line, crossed over it and then found out they could push the barrier further back. So they did.

When they reached the next barrier they found out they could go even further… and so they did. They shifted the risk ever further, and each time they were allowed to, not by the free market, but by government and central bank manipulation.

If it was left to a truly free market, the banks that crossed the line would have been punished. And those that didn’t cross the line would be disinclined to do so for fear of suffering the same consequences.

Sound money is the cure

Which brings us back to the concept of ‘sound money.’

You see, when you have a sound money system that is backed by gold – or is gold, the holders of the money (gold) know what it’s worth. They know that absent a massive discovery and recovery of a new gold resource the gold in their pocket is worth the same today as it was yesterday.

And that’s the most important aspect of a medium of exchange. There has to be faith in it. Faith that it will hold its value during the time that you’re holding it. Gold can do that because of its special qualities.

Paper money can’t hold its value because it has none of the same qualities of gold – apart from the ability to transport it easily. For instance, Wednesday’s consumer price index (CPI) number will illustrate this. You’ll find out the money in your pocket is worth less then that it was three months ago.

And about 90% less than it was forty years ago.

Here’s where the problems start. When you have unsound money, ie. a money system not backed or issued in gold, central banks and banks are able to do all sorts of funny things with your money.

When you’re using gold coins as the medium of exchange you know exactly what you have. However, when you’re using paper money you’re relying on the faith of the financial institution to have that paper money in their vaults.

But as you know, the amount of paper money isn’t the same as the amount of money on issue. The amount of notes and coins that have actually been minted and printed by the Reserve Bank of Australia (RBA) is only a fraction of the actual claims to money.

That’s all thanks to the fractional reserve banking system that allows banks to create money from thin air. Money that’s in excess of the notes and coins on issue. Think about it this way. When depositors put money into a savings account, the bank can use this as collateral to lend to borrowers.

The bank creates the money and places it in the borrower’s account which they then spend on building a house or buying a car. Yet the saver still has access to their savings. They can withdraw their savings and also spend it or invest somewhere else.

You deposit $100, the bank lends out $90 and keeps $10 in reserve. Yet you still have a claim on the full $100 which you can withdraw at any time. How is that possible when the bank has loaned it to a borrower?

It’s because at the tap of a button, the bank has just created the money to give to the borrower.

While the bank could theoretically do this under a gold backed currency it would be much harder to do so. If savers got wind that the bank was lending out all of your gold to someone else while still claiming it was holding the gold in the vault for you, it would create a ‘run’ on the bank.

Savers would demand their gold back. However, because the bank had been lending the gold to others it would not have all the savers’ gold in safe keeping and therefore would not be able to meet all the demands.

Under a sound money system a bank would be restrained from issuing excess credit. The bank would understand the risk of lending too much if it knew the consequence would be a run on the bank.

Of course there would be enough savers who would be happy to have their savings inaccessible for a period of time – a term deposit – so that they would know they can’t access their savings.

The bank would then be able to loan those savings in return for an interest cost knowing that the saver would not be able to make a claim on the savings until the term deposit had expired.

However, when you have a paper currency that has been forcibly instituted as the only legal tender by the government and the central bank, it creates the kind of problems you’ve seen in recent years.

The public grows accustomed to the paper money being sound because it’s ‘backed’ by the faith of the government and the central bank. You turn up to the bank and your money is there.

You can take it to the shops or exchange it with someone and they’ll accept it. Everything seems fine.

The problem is that because there is nothing apart from the ‘faith’ of the government backing the notes, the central bank and the banks are able to issue more notes and coins when they feel like it.

The result is inflation. The issuing of new notes and coins, and the expansion of credit by the banks, devalues the money already in existence.

Inflating the money supply

But that’s just the start of it. This helps to create the next phase where you have the excessive risk taking. Because the banks and savers and borrowers can see the effect of the increased supply of money – rising prices – they act to try and pre-empt the next rise in prices and asset values.

That causes them to take even bigger risks. Something we’re seeing in the Australian housing market now – “Quick, buy in now before it’s too late!”

The consequence for the banks is that there aren’t enough savers knocking on the door to deposit funds. So they need to get money from somewhere else.

That’s where complex financial instruments come in. By the way, having read the financial press in recent days you could be forgiven for thinking that all the risk taking happened after the US repealed the Glass-Steagall legislation that separated retail banks from merchant banks.

Of course this is incorrect. Mortgage backed securities for example have been around since the 1980s, long before the Glass-Steagall act was repealed in 1999 – check out the book Liar’s Poker for an insight into how that bubble started.

Again, the creation of mortgage backed securities wasn’t the cause, it was the effect. Banks needed to get access to more cash so they could provide more mortgages to take advantage of the demand for housing that was being created by an increase in credit.

Not surprisingly, the merchant banks came to the party offering to bundle the regional banks’ mortgages into a package which could then be sold off to investors – pension funds, fund managers, etc.

As the idea caught on, more and more banks got into it. And because these mortgages would slide straight off their books into the hands of investors, the banks became less concerned about the ability of borrowers to repay the loans.

On top of that, strong arm tactics by the US government to virtually force banks to lend to those with lower credit ratings – mainly minorities – made the problem even worse.

But again, lending to minorities wasn’t the cause of the meltdown, it was the effect of the government interference.

Finally, the great ponzi scheme collapsed, because those that borrowed were unable to repay, and those that saved were unwilling to invest in those ‘assets’. And then it was realised that not only were investors investing directly in these ‘assets’ but investors were also investing in instruments based on those assets.

The excessive credit, excess leverage, and excess risk taking met its doom.

The free market would have sent the banks broke

But none of it was down to the free market. Certainly there were market forces involved. But it was market forces distorted by government and central bank manipulation. In a free market the banks would have been allowed to go bust.

And those banks that didn’t take part in excessive risk taking and leverage would have been rewarded by attracting new customers looking for a safer bank. A free market most certainly would not have bailed out the banks, and it most certainly would not have allowed them to carry on their same old tricks.

To think that somehow the problems that caused the financial meltdown have been solved or will be solved by more regulation and government manipulation is extreme naivety.

It will do no such thing. We can’t be sure that Obama’s plans will make things worse than they were, but they certainly will not make things any better.

Limiting the scope and the size of banks and their activity does no more than attempt to fix something that’s already been broken a thousand times.

We can see right now that the repeal of Glass-Steagall act in 1999 is being used as the scapegoat to blame everything on the free market. As if there was a linear connection.

There isn’t.

Make no mistake, relying on the ‘brains trusts’ of politicians and bankers to solve a problem to an event that they didn’t foresee happening will only succeed in ensuring the same problem reoccurs in the near future.

Cheers.
Kris.

 

60-Second Market Round Up
by Shae Smith

On Friday, the S&P/ASX 200 was down 102 points (2.10%) in the first 15 minutes of trading. The index settled slightly up and traded sideways for the rest of the day, finishing at 4,750.60, ending the day down 1.59%.

Again the Australian market has opened down this morning. But it will be a quiet trading day, as many people have aren’t working today in the lead up to Australia day.

The Dow Jones Industrial Average took another beating on Friday, losing 2.09% or 216 points to close at 10,172.98. The Dow has lost 5.1% over the past three trading days.

Investor’s nerves are being tested in the States at the moment. President Barak Obama’s banking restrictions continued the massive sell-off of the major American banks on Friday and people are starting to question if Ben Bernanke, the current chairman of the US Federal Reserve Bank, should be nominated again for the top job. His term expires on the 31st January. Read more about the US market here.

On Friday, in the UK, the FTSE was down 0.60%, closing to 5,302.99. The Footsie was down 2.8% overall for last week. The poor earnings for banks and the ‘Obama news’ has continued to unsettle investors in the UK.

The Nikkei was down 277 points (2.56%) to close at 10,590.55.

The price of spot gold in Australian dollars is trading at $1,213.55 while in US Dollars it is trading at $1,092.60. The price of silver in Aussie dollars is $18.89 and in US Dollars it is $17.01.

The Aussie dollar versus the US dollar is trading at USD$0.9032, and against the Japanese Yen JPY81.46

Crude Oil closed at USD$74.54

For the biggest movers on the market yesterday click here…

Kris Sayce

Kris Sayce

Publisher and Investment Director at Money Morning Australia

Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the editor of Tactical Wealth — where he reveals ‘special situations’ he’s discovered in the markets. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It’s where he shares investment insight, commentary and ideas that he can’t always fit into his regular Money Morning essays.

Kris Sayce is the Publisher and Investment Director of Australia’s biggest circulation daily financial email, Money Morning Australia.

Kris is a fully accredited advisor in shares, options, warrants and foreign-exchange investments.

Kris has close to twenty years’ experience in analysing stocks. He began his career in the biggest wasp’s nest in the financial world — the city of London — as a finance broker back in 1995.

It’s there where he got his ‘baptism of fire’ into the financial markets, specialising in small-cap stock analysis on London’s Alternative Investment Market. This covered everything from Kazakhstani gold miners to toy train companies.

After moving to Australia, Kris spent several years at a leading Australian wealth-management company. However he began to realise the finance and brokerage industry was more interested in lining its own pockets with fat fees, commissions and perks —rather than genuinely helping out the private investors they were supposed to be ‘working’ for.

So in 2005 Kris started writing for Port Phillip Publishing — a company which was more attuned to his investment outlook.

Initially he began writing for the Daily Reckoning Australia— but eventually, took over Money Morning. It’s now read by over 55,000 subscribers each day.

Kris will take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money! Whether you agree with him or not, you’ll find his common-sense, thought-provoking arguments well worth a read.

To have his investment insights delivered straight to your inbox each day, take out a free subscription to Money Morning here.

Kris is also the editor of Tactical Wealth — where he reveals ‘special situations’ he’s discovered in the markets that you could profit from. If you’d like to learn about the latest opportunity Kris has uncovered, take a 30-day trial of Tactical Wealth here.

 

Official websites and financial e-letters Kris writes for:

(You can find a list of recent investment articles written by Kris at the bottom of this page.)

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25 Responses to “The Obama Proposal for Bank Reform”

  1. GB

    It seems i was wrong and china will boom forever – the WA chamber of commerce “… predicts business and consumer spending will match and even surpass levels from immediately before the global financial crisis within months” and “The local impacts of the global economic slowdown will soon be a distant memory as WA enters the new decade…”

    he said: “within months” – does that mean that interest rates will also be back at 10% within months??

    http://au.news.yahoo.com/thewest/business/a/-/business/6720211/forecasts-put-wa-back-in-boom-business/

  2. cb

    Liar, liar, the chief warmist’s pants are on fire!!!
    It looks like the IPCC’s Chairman himself will be forced to resign before too long, but guess who is in the headline video shots with him? You have to see it to believe it:
    http://www.youtube.com/watch?v=CVhhYyCsvBM&feature=player_embedded#

  3. Ciao

    The key question for both Krys and several of the readers are:

    1. Could there have been sound money without a Gold standard?

    2. Could there have been a real estate bubble and services economy without a funny money facilitated current account deficit?

    I contend yes to the first question if debt service costs and rents become measured as part of the CPI basket after the current bubble has burst. The CPI basket itself must in future be acknowledeged as being constantly subject to manipulation and attack by inflationists and consequently there must be an Austrian minded oversight of money supply excess; one that is not the instrument of rate adjustment but the reserve power that calls severe trade weighted & money supply imbalances and adds such penalty rates required to redress them.

    2. My answer is no here, for all the current account deficit countries. There is no point of difference for Australia’s recent “hold” effected on the real estate bubble because the funny money is still very much in play (at least until recent days or as reflected by speculators in past months interest rate swaps) for a country that has exploited both a carry trade & a sovereign guarantee of bank funding that has not been available to any other major economy (don’t count NZ because they too are on Australian 4 pillar balance sheets courtesy of their branch offices). So that means the bubble will pop here even louder than it has in the US, UK, and the PIIGS the second the AUD dives (and that could be any day now).

  4. cb

    Ciao – You may be right, but your proposal would have the disadvantage of remaining more susceptible to manipulation and obfuscation than a simple gold standard, which would be straightforward and much more easily monitored. Alas, wherever money is to be made, there will be a Madoff, and the risk of excess printing of paper, even under a gold standard, is ever present. This is what Nixon did, and a few other presidents before him, until the US outright defaulted by refusing to settle their trade imbalance in gold, and instead formally abolished the gold standard.

    So, I am not quite sure what to say. Under whatever standard, including a gold standard, if those entrusted with the safeguarding of the nation’s earnings and savings purchasing power decide to be crooks, then that is what they are going to be, and the good people will be the ones to suffer. My personal conclusion from this would be that the only way one could protect oneself against such risks would be to keep the cash portion of one’s savings in actual, physical metal.

  5. cb

    Wow, the tide seems to be really turning, when even The Age is publishing an opinion piece like this:
    http://www.theage.com.au/opinion/politics/be-alert-but-wary-on-climate-claims-20100126-mw7z.html

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