Could America Become Cyprus?

One of the problem with Cyprus is that its banking sector is just too big. GDP is variously reported as rangin from $20 billion to $23 billion, with total deposits being anywhere from 240% of GDP all the way up to 500%. What this means is that Cyprus just isn't big enough to bail out the financial sector.

So what about us? The 2012 GDP was estimated to be about $15.8 trillion. And deposits? A bit under $11 trillion, if this web site is to be trusted. So we're at roughly 70% of GDP.

We have a different problem, with too many deposits being concentrated among the top four banks. Here's a list of the top twenty.

Rank	Total Deposits	Bank Name
1	$1,246,327,000,000	JPMorgan Chase Bank
2	$1,117,622,296,000	Bank of America
3	$994,439,000,000	Wells Fargo Bank
4	$941,185,000,000	Citibank
5	$253,686,214,000	U.S. Bank
6	$239,447,000,000	The Bank of New York Mellon
7	$216,743,265,000	PNC Bank
8	$191,737,996,000	Capital One
9	$169,790,817,000	TD Bank
10	$168,552,949,000	State Street Bank and Trust Company
11	$136,567,968,000	Branch Banking and Trust Company
12	$133,278,697,000	SunTrust Bank
13	$127,864,714,000	HSBC Bank USA
14	$117,448,587,000	FIA Card Services
15	$96,588,183,000	Regions Bank
16	$93,278,271,000	Fifth Third Bank
17	$83,134,216,000	The Northern Trust Company
18	$80,349,888,000	RBS Citizens
19	$79,442,000,000	Charles Schwab Bank
20	$75,097,058,000	Union Bank

Each of JPMorgan and Bank of America have more than 10% of the total deposit base, and Wells Fargo and Citibank aren't far behind. Then there's a $700 billion drop down to U.S. Bank, and a tapering off from there.

To put this into perspective, if the roughly $4 trillion -- roughy 40% of all deposits -- held by the top four banks were transferred to banks no bigger than U.S. Bank, you would need at least sixteen of them, of four per bank.

More Reasons to Hate Big Banks

From the New York Times:

The nation’s biggest banks wrongfully foreclosed on more than 700 military members during the housing crisis and seized homes from roughly two dozen other borrowers who were current on their mortgage payments, findings that eclipse earlier estimates of the improper evictions. 

Bank of America, Citigroup, JPMorgan Chase and Wells Fargo uncovered the foreclosures while analyzing mortgages as part of a multibillion-dollar settlement deal with federal authorities, according to people with direct knowledge of the findings. In January, regulators ordered the banks to identify military members and other borrowers who were evicted in violation of federal law. 

... 

The banks uncovered about 20 borrowers who never missed a single mortgage payment, but lost their homes nonetheless. The properties, according to the people with direct knowledge of the findings, have since been sold.

The Exciting World of Bank Capital

Rarely do we agree with folk from the (Herbert) Hoover Institute, but we like what John Cochrane has to say in the Wall Street Journal:

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital. In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

And:

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do. Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. 

OK — we've got a quibble here. Those tech companies weren't financed through the sale of stock. Instead, issuing stock was a way for them to cash in. But Cochrane is correct that the impact of the tech bust was not wide felt, as people who had no money became paper billionaires and then people with no money. It may have sucked to own Pets.com, but they didn't leave a trail of unpaid creditors the way Lehman Brothers has. 

Back to the story:

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

....  

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Not only that, but the implicit guarantee behind the too-big-too-fail banks means they have artificially low borrowing costs, which encourages more borrowing. We now switch you to a Bloomberg article.

Lately, economists have tried to pin down exactly how much the [implicit government guarantese] lowers big banks’ borrowing costs. In one relatively thorough effort, two researchers -- Kenichi Ueda of the International Monetary Fund and Beatrice Weder di Mauro of the University of Mainz -- put the number at about 0.8 percentage point. The discount applies to all their liabilities, including bonds and customer deposits. 

Small as it might sound, 0.8 percentage point makes a big difference. Multiplied by the total liabilities of the 10 largest U.S. banks by assets, it amounts to a taxpayer subsidy of $83 billion a year. To put the figure in perspective, it’s tantamount to the government giving the banks about 3 cents of every tax dollar collected. 

Let's try that one more time.

To put the figure in perspective, it’s tantamount to the government giving the banks about 3 cents of every tax dollar collected.  

The top five banks -- JPMorgan, Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc. - - account for $64 billion of the total subsidy, an amount roughly equal to their typical annual profits (see tables for data on individual banks). 

In other words, the banks occupying the commanding heights of the U.S. financial industry -- with almost $9 trillion in assets, more than half the size of the U.S. economy -- would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders. 

Let's do that one again, too.

In large part, the profits they report are essentially transfers from taxpayers to their shareholders. 

Enjoy that while you mull on the sequester.

Regulators can change the game by paring down the subsidy. One option is to make banks fund their activities with more equity from shareholders, a measure that would make them less likely to need bailouts (we recommend $1 of equity for each $5 of assets, far more than the 1-to-33 ratio that new global rules require). Another idea is to shock creditors out of complacency by making some of them take losses when banks run into trouble. 

Hold on — who is that magisterial "we" who recommends a 5:1 ratio?

It's the Bloomberg editors! Not Occupy Wall Street, not Michael Moore, but the editors of America's premier business magazine!

Hello! Is this thing on?

Now, there are a couple of ways out of this problem, which is good — because the banks are going to scream about implementing each one of them. With luck, they'll get hoarse.

First, and most directly would be to require banks to hold more capital. A second method would be to make debt less attractive. As discussed here, debt is deductible from taxes, while equity is not. This means there is a built-in tax preference for using debt (and getting all leveraged up.) Reducing (if not eliminating) the deductibility of debt would help level the playing the field, and make it less expensive for banks to add more capital.

For the third option, we turn to Kevin Drum at Mother Jones:

Split up the banks. If they're too big to fail, and everyone knows it, the only real answer is to make them small enough that they can fail. Creditors would then take care of all the rest.

Splitting up the banks would remove the implicit government guarantee associated with too-big-to-fail. The banks would be small enough to fail without jeopardizing the global financial system, and life would go on.

And that's what one senator proposed last year with the Safe, Accountable, Fair, and Efficient Banking Act of 2012.

Introduced by Senator Sherrod Brown on May 9, 2012, the following bill would place size and leverage limits on big banks.  Specifically it would:

• Impose a 10 percent cap on the share of U.S. deposits that any one bank could hold. This would eliminate loopholes in the existing federal deposit share cap
• Impose a 10 percent cap on the liabilities that any one financial company can take on, relative to the U.S. financial sector. Like the deposit concentration limit, this closes loopholes in existing law.
• Impose a limit on the non-deposit liabilities (including off-balance-sheet exposure) of a bank holding company of 2 percent of GDP.
• Impose a limit on the non-deposit liabilities (including off-balance-sheet exposure) of any non-bank financial institution of 3 percent of GDP.
• Codifies a 10 percent leverage limit for large bank holding companies and selected nonbank financial institutions into law. 

Under the measure, no bank holding company could exceed a size of $1.3 trillion in assets (at current GDP).  If enacted, Bank of America ($2.2 trillion as of 3/31/2012), JP Morgan Chase ($2.3 trillion),  Citigroup ($1.9 trillion), and Wells Fargo ($1.3 trillion) would all have to downsize.

Unfortunately, the bill was never referred out of sub-committee.

More on the Postal Savings System

We talked about it here. The Pacific Standard addresses it here.

What's Hedging, and How Did JPMorgan Lose $2 Billion by Doing It?

It's hedging, as in hedging a bet.

(Still yet another reminder that, at the end of the day, finance is mostly a fancy way of saying gambling.)

Some of the earliest (and most useful) hedges were in agriculture. A farmer would plant a crop in the spring, but wouldn't sell it until the fall. At that point, the price for his crop might be much higher (great news) or much lower (bad news) than he anticipated. The farmer, however, didn't want to speculate in commodities; he just wanted to sell his crop for a reasonable price.

Beginning in the 19th century, the future markets allowed him to do so. A farmer growing corn, for example, could sell all of his crop for $2.00 a bushel -- in April, when he was just putting seed in the ground. As he would not be harvesting his crop until, say October, this kind of transaction is called a forward transaction, as performance of the contract -- both paying the cash and delivering the corn -- don't  happen in the here and now. And because this kind of forward contract is standardized and traded on an exchange, this forward is actually a future. (So all futures are forwards, but not all forwards are futures.)

In October, though, the price might be $3.00 or it might be $1.00. But the farmer doesn't care, as he established a sale price of $2.00 in April. In financial terms, he hedged market risk (the chance that the price of his commodity would move against him) by selling futures on his crop. 

The idea of hedging moved into securities, where it spawned one of the more popular and profitable trading strategies -- the long/short strategy. The investor reviews companies within a given industry and tries to identify two things -- the most over-priced stock (e.g., the one least likely to increase in price), as well as the most under-priced stock (e.g., the one most likely to increase in price). 

Retail investors typically only look for the latter. People would buy Apple, for example, thinking that Apple would increase in value. But the long/short strategy is both a safer and, potentially, more profitable trade. So the hedge fund (as mutual funds can't really engage in short-selling, only hedge -- hey, there's that word again! -- funds engage in this kind of trading) would buy Apple (the long part), and borrow shares of Research in Motion (which makes the ill-fated Blackberries) to short-sell. 

The hedge fund ends up winning in these three scenarios:

• AAPL goes up, and RIMM goes down.
• AAPL goes up, and RIMM goes up -- but not enough to offset the gains made with AAPL.
• AAPL goes down, but RIMM goes down even more.

The hedge fund loses in these two scenarios.

• AAPL goes up, but RIMM really takes off.
• AAPL goes down drastically, and RIMM only does down a little.

And the hedge fund gets creamed in one scenario:

• AAPL goes down and RIMM goes up.

The problem with this trading strategy is that when the bets go south, they really go south. Fundamentally, this bet is on the spread between AAPL and RIMM. If the spread increases -- for whatever reason -- the bet is a winner. But if the spread moves against you, you get killed. This is what did in Long Term Capital Management, back in the '90s. 

With our agricultural example -- which is a true hedge -- the farmer was able to get rid of all of the market risk associated with his investment (his crop). Financial hedging just can't do that. A perfect hedge in the financial world would mean both buying and selling an identical amount of the identical securities, which makes no sense economically. So in the financial world, investors always look for imperfect hedges, meaning something which reduces risk, but doesn't eliminate it. Everything will be fine except -- again -- when both the original long investment and the hedge go against you. 

So what did JPMorgan do? According to Bloomberg: 

A JPMorgan Chase & Co. (JPM) trader of derivatives linked to the financial health of corporations has amassed positions so large that he’s driving price moves in the $10 trillion market, traders outside the firm said. 

The trader is London-based Bruno Iksil, according to five counterparts at hedge funds and rival banks who requested anonymity because they’re not authorized to discuss the transactions. 

... 

The trader may have built a $100 billion position in contracts on Series 9 (IBOXUG09) of the Markit CDX North America Investment Grade Index, according to the people, who said they based their estimates on the trades and price movements they witnessed as well as their understanding of the size and structure of the markets. 

The positions, by the bank’s calculations, amount to tens of billions of dollars and were built with the knowledge of Iksil’s superiors, a person familiar with the firm’s view said. 

And it didn't turn out so well.

JPMorgan Chase, which emerged from the financial crisis as the nation’s biggest bank, disclosed on Thursday that it had lost more than $2 billion in trading, a surprising stumble that promises to escalate the debate over whether regulations need to rein in trading by banks. 

Jamie Dimon, the chief executive of JPMorgan, blamed “errors, sloppiness and bad judgment” for the loss, which stemmed from a hedging strategy that backfired. 

The trading in that hedge roiled markets a month ago, when rumors started circulating of a JPMorgan trader in London whose bets were so big that he was nicknamed “the London Whale” and “Voldemort,” after the Harry Potter villain. 

To be fair, this one incident doesn't really mean a lot to JPM, which made $19 billion last year. But it does support the argument for the Volcker rule, which limits how much money a bank can risk in the kind of proprietary trading JPMorgan engaged in. The bad news is that the Federal Reserve is delaying implementation of the Volcker  Rule for (at least) two more years, until 2014.

The other way to limit the amount of money in play, and the one which we strongly prefer, is to limit the amount of leverage banks can use. Banks hate this idea as much as, if not more than, Volcker Rule, because both are serious restraints on the banks' ability to make money.

This is true. But the federal government will always be called on to clean up financial crises, so it's more than fair for them to limit the amount of harm that banks can do to themselves. This, oddly, is how the federal government hedges its risk.

Congress Kills No Birds with Two Stones

Kevin Drum notes that the Senate (but not the House) has passed legislation to save the Post Office. As we discussed here, the Post Office is fighting a losing battle against e-mail, so much so that first-class mail now makes up less than 30% of all mail delivered. (The rest -- mostly catalogs and the like -- is sent via standard mail.)


The USPS had suggested a series of sensible changes -- ending Saturday delivery, relaxing delivery times (40% of first-class mail is delivered within one day), and closing a bunch of post offices and postal centers.


We also noted that much of the current "crisis" is fake, as the USPS was forced by (the Republican-controlled) Congress to pre-fund 75 years worth of its employee benefits within a 10-year window. That helped turn the USPS' $1 billion surplus in 2006 into a $5 billion deficit in 2007.


So how did the Senate do? Kevin Drum summarizes (and we editorialize):

Allows USPS to recoup more than $11 billion that it had overpaid into one of its pension funds.	About time.
Provides early retirement incentives for nearly 100,000 USPS workers.	Good one.
Restructures payments to a health benefits fund for future retirees.	Probably a good thing.
Frees up USPS to offer a broader range of services like delivering beer and wine for retailers.	Okay – but we could do more.
Creates a USPS chief innovation officer.	Absolutely pointless.
Halts the immediate closing of up to 252 mail-processing centers and 3,700 post offices.	Not good.
Forces USPS to preserve overnight delivery of mail sent to nearby communities.	More not good.
Forbids USPS from closing a rural post office unless the next-nearest location is no more than 10 miles away.	Still  more not good.
Places a one-year moratorium on closing rural post offices and then requires the mail agency to take rural issues into special consideration.	Oh, Christ.
Prevents USPS from cutting Saturday delivery for two years, until the agency can prove such a cut is needed as a "last resort."	Seriously?
Transitions from door-to-door delivery to curbside delivery in some areas, such as suburban neighborhoods.	Meh.
Strengthens the appeals process for customers opposed to closing a post office.	Bleh.
Caps bonuses and pay for USPS executives.	Pointless.
Forces USPS to wait until after Election Day to close postal facilities in states that permit voting by mail.	Apparently, these states don’t have mailboxes.
Permits USPS to co-locate post offices in government-owned buildings.	Good.

So, Kevin, what do you think?

There's nothing in there about allowing the postal service to increase postal rates. 

This is crazy. 

Take a look at countries around the world that have smaller volumes of mail than us: they all charge higher postage rates. They have to. And as volumes keep declining in America, we're going to need higher rates here too. Right now, a first-class equivalent stamp runs 75¢ in Germany, 72¢ in Britain, 82¢ in France, 98¢ in Switzerland, 97¢ in Belgium, and 63¢ in the Netherlands. There's no way that we can stay at 45¢ as volumes decline and pretend that somehow everything will be hunky-dory. 

Agreed.

And the Senate also failed to consider resurrecting the United States Postal Savings System, which was shut down during the patchouli-scented days of 1967, when we all thought the banking system was safe. Not only would the United States Postal Savings System provide another revenue stream, it would require virtually no start-up costs -- the USPS already engages on certain small-scale financial transactions (money orders) and the post offices themselves are already built and fully staffed.

A revived Unites States Postal System would also provide crucial financial services to a population which increasingly can't afford to use banks. An April 2011 study by the Pew Charitable Trust found 16.4% of all Mississippians didn't have a bank. And it's about to get a lot worse.

The New York Times reports that:

An increasing number of the nation’s large banks — U.S. Bank, Regions Financial and Wells Fargo among them — are aggressively courting low-income customers ... with alternative products that can carry high fees. They are rapidly expanding these offerings partly because the products were largely untouched by recent financial regulations, and also to recoup the billions in lost income from recent limits on debit and credit card fees. 

Banks say that they are offering a valuable service for customers who might not otherwise have access to traditional banking and that they can offer these products at competitive prices. The Consumer Financial Protection Bureau, a new federal agency, said it was examining whether banks ran afoul of consumer protection laws in the marketing of these products. 

In the push for these customers, banks often have an advantage over payday loan companies and other storefront lenders because, even though banks are regulated, they typically are not subject to interest rate limits on payday loans and other alternative products.

For example:

When David Wegner went looking for a checking account in January, he was peppered with offers for low-end financial products, including a prepaid debit card with numerous fees, a short-term emergency loan with steep charges, money wire services and check-cashing options. 

“I may as well have gone to a payday lender,” said Mr. Wegner, a 36-year-old nursing assistant in Minneapolis, who ended up choosing a local branch of U.S. Bank and avoided the payday lenders, pawnshops and check cashers lining his neighborhood. 

Along with a checking account, he selected a $1,000 short-term loan to help pay for his cystic fibrosis medications. The loan cost him $100 in fees, and that will escalate if it goes unpaid. 

And it gets worse:

 Lenders are also joining the prepaid card market. In 2009, consumers held about $29 billion in prepaid cards, according to the Mercator Advisory Group, a payments industry research group. By the end of 2013, the market is expected to reach $90 billion. A big lure for banks is that prepaid cards are not restricted by Dodd-Frank financial regulation law. That exemption means that banks are able to charge high fees when a consumer swipes a prepaid card. 

The companies distributing the cards have drawn criticism for not clearly disclosing fees that can include a charge to activate the card, load money on it and even to call customer service. Customers with a “convenient cash” prepaid card from U.S. Bank, for example, pay a $3 fee to enroll, a $3 monthly maintenance fee, $3 to visit a bank teller and $15 dollars to replace a lost card. 

Capital One charges prepaid card users $1.95 for using an A.T.M. more than once a month, while Wells Fargo charges $1 to speak to a customer service agent more than twice a month.

Banks are evil. The Post Office is not. For more on why the United States Postal Savings System is a good idea, check out our earlier post here.

What the Bain Gang Can Teach Us about Corporate Tax Reform

We need to kill the business interest deduction.

As we noted in our discussion about eliminating the mortgage interest deduction, interest has historically been tax deductible. In fact, it wasn't until 1986 that personal interest was not deductible -- thank you, astonishing growth in credit cards and personal debt -- though the mortgage interest deduction was preserved. 

But it's now time to think about whether business interest should be deductible at all, and one of the best arguments against it is courtesy of private equity concerns like Bain Capital.

First, though, how awesome is that picture.

Private equity is a bit of a catch-all term that includes things like venture capital (to get a company off the ground and running), mezzanine capital (providing additional capital to an existing company), and leverage buy-outs (see Gordon Gekko). 

When Romney has been talking about creating jobs, he's been talking about venture capital. When people talk about the companies killed by Bain Capital, they're talking about leveraged buy-outs.

In its simplest form, a leverage buy-out is a like a mortgage, where you use the asset you want to buy to secure the financing necessary to make the purchase. Josh Kosman explains to Mike Konzal:

JK: The whole industry started in the mid-to-late 1970s. The original leveraged buyout firms saw that there were no laws against companies taking out loans to finance their own sales, like a mortgage. So when a private equity firms buys a company and puts 20 percent down, and the company puts down 80 percent, the company is responsible for repaying that.

Now the tax angle is that the company can take the interest it pays on its loans off of taxes. That reduces the tax rate of companies after they are acquired in LBOs by about half. Banks, also realizing this tax effect, were willing to finance these deals. At the time, you could also depreciate the assets of the company you were buying — that’s not true today.

They saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same.

MK: So the business model is based on a capital structure and tax arbitrage?

JK: Yes. It’s a transfer of wealth as well. It’s taking the wealth of the company and transferring it to the private equity firm, as long as it can pay down its debt.  It think it is real - the very early firms targeted industries in predictable industries with reliable cash flows in which they by and large could handle this debt. As more went into this industry, it became very hard to speak to the original model. Now firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered.

MK: The most common argument for why Bain Capital and other private equity firms benefit the economy is that they are pursuing profits. They aren’t in the business of directly “creating jobs” or “benefitting society,” but those effects occur indirectly through the firms making as much money as they can.

But even here, “profits” — how they exist, where they come from, and how they are timed — have a crucial legal and regulatory function. A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code. Can you talk more about this?

JK: That sounds about right. If you took away this deduction, you’d still have takeovers, but you’d have a lot less leverage and the buyer would be forced to really improve the company in order to make profits. I think that would be a great thing.

If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can’t handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It’s very hard for companies to take that hit twice. 

So leveraged buy-outs aren't about turnaround artists, people who take failing companies, re-organize  them and get them back on track. Instead, it's financial engineering, just taking advantage of the tax code. As James Surowiecki at the New Yorker notes,

The rewards can be extraordinary: when Romney was at Bain, it supposedly earned eighty-eight per cent a year for its investors. But piles of debt also increase the risk that companies will go bust.

And:

[B]etween 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

And the business interest deduction is exploited by other industries as well, most notably investment banking. When a bank raises money by selling more equity, it faces a couple of problems. The first is that the previous group of shareholders are generally not happy, as the percentage of their ownership of the bank has gone down. Secondly, when the bank pays dividends, those dividends are not tax deductible, which makes the company less profitable. 

Raising capital by issuing debt solves both those problems. Each shareholder's stake remains the same, and the disbursements to the bond holders get written off the taxes. This led to some of the banks, most notably Lehman Brothers, becoming grossly over-leveraged, by some estimates up to 44:1. This made Lehman Brothers a very profitable company when times were good, but almost insured that it would get pummeled in the (inevitable) event of an economic downturn.

But what does the leverage really mean? Let's walk though an example, using a somewhat higher leverage ratio of 50:1. 

At that ratio, you could put up $2 but would have $100 in purchasing power, with the remaining money being supplied by a bank. If you invested that in stock, and the stock's value went to $101, you'd have a return of 50% -- you initially put up $2, but now have $3. 

But leverage works the other way as well. If the value of the stock drops by 1% -- form $100 to $99 -- you've lost 50% of your equity. And if the stock drops another dollar, your finished. 

(For the sake of comparison, the Federal Reserve limits the leverage you can use to buy stock to 2:1 through Reg T. (although that ratio can increase to 3:1 once the purchase has settled. Still, not so bad.)

The business interest deduction certainly made sense some time ago, but the financial wizards have turned it into a real hazard. Getting rid of this tax break would't prevent leveraged buy-outs or raising capital through debt, but it would re-focus these efforts on making sure the companies themselves did well. Private equity firms, banks and other corporations would have more "skin in the game," and the tax disadvantage of raising capital through equity would disappear.

It's also worth remembering that, despite the crowing about corporate taxes, the percentage of pre-tax corporate income used to pay taxes has fallen dramatically over the last 50 years:

From Kevin Drum and the Federal Reserve of St. Louis.

And corporate tax as a percentage of all US tax revenue has fallen harder.

See page 68 of this 2010 Senate Committee on Finance report. And thank you,  Felix Salmon.

So if we're trying to get the deficit back under control, we should be looking seriously at making corporations pay their fair share as well. Eliminating the business interest deduction would be one step down that path. 

Banks are Evil: Special "Citibank Must Die a Thousand Deaths, Its Wives and Children Scattered to the Corners of the Earth, Its Orchards Burned and Its Fields Plowed with Salt" Edition

... or Return of the Float.

Back in the old days, banks needed a float for check deposits. The float was the time it took your bank to process your check, send it to another bank, and actually get the cash (OK, a wire) to post to your account. If memory serves, local checks typically took three days, and out-of-state took five.

This meant that the banks ended up with several days where they got the use of your money for free.

Technology improved, check clearing went digital and now the float has been reduced to about a day.

But getting money for free is something banks really, really like, and Citibank came up with an ingenious way to do it in the mortgage field. As Felix Salmon reports:

Most salaried Americans ... get paid every two weeks. Which means, to all intents and purposes, that you need to be able to make one mortgage payments out of every two paychecks.

And that in turn raises an intriguing possibility: if you take half of your mortgage payment out of every paycheck, you’re going to end up making 13 mortgage payments a year. Which will pay down your mortgage faster, and could save you thousands of dollars. 

Enter the ever-helpful Citibank, with a product which does just that. It’s called The BiWeekly Advantage Plan®, and it’s essentially an automated mortgage payment, of half your monthly mortgage payment, which comes out of your account every two weeks. Easy.

Except that:

 Payments are remitted to your mortgage company monthly.

As Felix notes:

The payments are made in arrears, of course. You make your half-payment, and then wait two weeks, and you make your second half-payment, and then the two are bundled up and sent off to the mortgage company (which in nearly all cases is CitiMortgage itself) as a single monthly payment.

Which means that for roughly half the year, Citibank is sitting on an amount of money equal to half your mortgage payment. That money has left your account: it’s not yours any more, and Citi can do with it as it pleases. And Citi gets the float from all that money until it gets around to sending it off to pay off the mortgage.

Basically, Citi is getting a big advantage from you making half your mortgage payment two weeks early.

It gets better. Citibank actually charges you to lend them money for free.

There is a one-time non-refundable enrollment fee of $375 and a transaction fee of $1.50 for each draft [or $39 a year]. 

Pure friggin' evil. It's their best idea since:

Saving the Post Office through Financial Reform-ish

We wouldn't normally take the time to solve a problem which has largely been fixed, or that wasn’t that big of a problem in the first place, but the situation with the United States Postal Service is an opportunity to sneak in a little financial reform, and all in a historically appropriate manner.

In late 2011, much to do was made of the postal service’s financial condition. They were $8.5 billion dollars in the red, and Republicans were raising the usual cry for privatization (and further paring down union membership). The causes cited were generally high labor costs – some 80% of its budget – and the replacement of snail mail with e-mail.

From Chicagomag.com

We’re pretty sure no one got rich working at the post office, but it is undeniable that e-mail is proving to be a worthy substitute for regular mail in most cases.

But there is an additional reason for the postal service’s financial woes; namely, the Postal Accountability and Enhancement Act of 2006. Despite its non-threatening title, this law created a burden for the postal service which no other entity of the government -- or the private sector – faces. The postal service is now required to pre-fund 75 years of its employee benefits within a ten-year period.

We note in passing that Republicans, at that time, controlled the White House, the Senate and the House of Representatives. Coincidentally, there are more than a half million union members working at the post office – 47,000 with the National Postal Mail Handlers Union, 220,000 with the American Postal Workers Union, and 300,000 with the National Association of Letter Carriers.

The effect was drastic.

From Chicagomag.com

The USPS went from running a surplus in 2006 to running a $5 billion deficit in one year – despite seeing its revenue grow by $3.2 billion. The deficit is entirely due to the increase in expenses, which shot up $8.2 billion, or 11%.

So while we do need to junk this atrocious law, demand for the postal service’s, um, services, will continue to slacken, and adjustments must be made.

The USPS has done an admirable job at this, suggesting a slew of reasonable cut-backs, namely relaxing delivery times – right now, 40% of all first-class mail is delivered within one day – and eliminating Saturday deliveries; shuttering half of the 487 mail processing centers around the country and closing 3,700 of the nation’s 32,000 post offices; and eliminating about 100,000 of its 653,000 jobs.

We’re not happy at the loss of union jobs, and we’re concerned about how the closing of post offices will affect rural customers, who are not as well served by the internet as those in urban areas. To help the friendly folk at the post office, we’d like to propose that the United States Postal Service … get in the banking game.

Actually, the USPS is already in the banking game, as it sells money orders – $1.10 gets you a money order up to $500, and $1.55 gets you one up to $1000. And, until 1967, the USPS ran its own bank – the United States Postal Savings System. Citizens who were concerned about the financial health of banks (and their ethically dubious business practices) had an easy-to-use alternative. At its peak in 1947, the Postal Savings System held $3.4 billion in deposits, or $32.8 billion in 2010 dollars. This would have made them the 37^th biggest bank in America.

By comparison, Citibank and Wells Fargo each have roughly $800 billion in deposits, and Bank of America and JPMorganChaseManhattanChemicalBankManufacturersHanoverBankOne have over a trillion dollars in deposits. The fifth biggest bank, U.S. Bank, has a mere $200 billion.

There are several great reasons why getting the Postal Savings System up and going again would be a good thing.

#1.  A lot of people can’t afford banks. A Pew Charitable Trust survey found that many households in the old Confederacy – figure that – don’t have checking accounts.

From the WashingtonPost

And both the FDIC and Pew suggest that about a third of all people who closed a bank account did so due to high account fees. 


#2.  Banks don’t want small customers. Felix Salmon at Reuters reports:

All four of the big banks have a standard checking account with a monthly fee which is waived once you keep a monthly balance of more than $1,500. At Wells Fargo, that fee is $5. At Citi, it’s $10. At Chase, it’s $12. And at BofA, it’s also $12, rising to $17 if you use your debit card.

Oddly, Felix is in a good position to judge these matters, as he was on the board of the Lower East Side Federal Credit Union. They, too, have a checking account fee – but it’s:

$3 a month, for people carrying a balance of less than $75 — essentially, a way to discourage people from keeping bank accounts open and unused with no money on deposit.

#3.  Banks are evil. The Pew study found that:

• the median length of bank disclosures for key checking account policies and fee information was 111 pages;

• overdraft fees will cost American consumers an estimated $38 billion in 2011—an all-time high; [and]

• banks can maximize the number of times an account “goes negative” by reordering deposits and withdrawals to reduce the account balance as quickly as possible.

In addition, the Pew Charitable Trust reviewed how Wells Fargo treated one of its customers, Veronica Gutierrez, to extort more money from her.

Here are Gutierrez' charges in chronological order.

From the Pew Charitable Trusts

And here is how Wells Fargo maximized the penalties they could impose on her. 

From the Pew Charitable Trusts

Yup, the quadrupled their revenue.

#4.            Reducing balances held at the makes them less profitable. This is a feature, not a bug. The fewer deposits a bank has, the less it can lend out. And the less it can lend out, the less profit it makes. With less profit, the bank has less money to go to PAC and lobbyists. Maybe then we wouldn’t have a fiasco where the most qualified person to head up the Consumer Financial Regulatory Bureau – Elizabeth Warren – wasn’t even nominated, and the second choice – former Ohio attorney general Richard Cordray – couldn’t get an up-or-down vote.

#5.            It’s cheap funding for the federal government. Okay, $32.8 billion isn’t a lot of money when compared to a $3.83 trillion budget, but it’s something. But that number would explode if state and local governments were required to place their accounts there, instead of holding them at banks. See, also, #4.

#6.            It would be dirt cheap to do. Some of the biggest costs of banking are building and maintaining its branch offices, and payroll for tellers and the like. With the Postal Savings System, these costs would be … $0. The buildings are already in place, and the employees are already there. To be fair, some costs would be involved in things like setting up an on-line banking facility, but these would be minimal in comparison to the benefit of having 28,000 branch offices up and ready to go on Day One.

By comparison, Bank of America had 5,856 branches in 2010.

*                                   *                                   *

Now that we’ve come up with extra revenue for the postal service, we need to take some of it away.

Last year, there were 3.7 billion pounds of first-class mail – and an additional 9.3 billion pounds of standard mail (the kind mass-market advertisers use). We don’t know what percentage of that 9.3 billion is made up of catalogs, but we’d venture to say it’s substantial.

And wasteful. Our highly unscientific polling suggests that most catalogs get thrown away with barely a glance between their pages. At a minimum, there should be a Do Not Mail registry which operates like the Do Not Call registry, giving people the opportunity to opt out of receiving catalogs in the mail. This would result in lost revenue for the postal service, although some portion of that could be made up by increasing the rates applicable to standard mail.


Unfortunately, reducing the amount of junk mail will mean fewer mail carriers and processors. But maintaining those jobs just to drive around and deliver a billion (or two, or three) pounds of stuff no one wants just doesn't make sense.