I'm Only Happy When It Rains...

On On the Media, Adam Davidson describes the difficulty of explaining anything financial on the Planet Money podcast. And this has to be a concern to all of us for a simple reason: we (the tax payers) got totally looted this time around, and if we can't even understand the arguments about how to fix the problem, Congress isn't going to "fix" the systemic problems in our financial system in a manner that works out well for us. Simply put, if we can't understand it, we're going to get looted again.

So what do we do when we find explanations like this? Friedman is arguing that people buying homes at of market were acting rationally, the bankers weren't acting irresponsibly due to their paychecks, and that regulation, not deregulation caused the crisis. His arguments are more nuanced than I am describing; I am phrasing them a bit more bluntly to draw out how ludicrous they are. Mike Konczal takes apart point three here.

But can we even understand what they are arguing about? What are these capital minima, and why do we care?*

Rainy Day Funds

As part of our personal finances, we maintain "rainy day" money - that is, money that just sits in a boring old FDIC insured bank account for the sole purpose of having money on hand if something bad happens, like I lose my job or the car gets hit by a meteorite.

Now we have a friend, let's call him Joe. Joe has a good job that pays a lot of money, and Joe has expensive taste. He pays for his car, mansion, caviar, champaign, and Armani suits using credit cards, mortgages, car payments, etc. In other words, Joe has a ton of debt, but he also has strong cash flow coming in to pay that debt. He swears he has the situation "under control".

Joe has a rainy day fund too! But...his rainy day fund is only $5000. We keep telling Joe "that's too low". What if something happens?

Unfortunately Joe's high paying job was in banking, and he was laid off last year. The $5000 of rainy day money wasn't even close to being able to absorb the avalanche of debt he was faced with. In fact, it got a lot worse; since his house went down in value, he can't sell his house to make back the money he owes on the mortgage. Clearly $5000 wasn't enough.

Rainy Day Funds for Banks

You can think of reserve capital as rainy day funds for banks. Every time a bank makes a loan, they are required to put a little bit more money into the rainy day fund, just in case the loan goes bad. The Friedman and Konczal are arguing about what effect the government minimums on the rainy day fund had.

Konczal's argument is an important one to understand, and it is basically this:

• If banks are going to have the minimum rainy day funds the law will allow, then banks are trying to live on the edge, and the law has to assume that bankers are crazy.
• If banks are going to have larger rainy day funds than the law will allow, then you can't blame the law for being "too lenient" because the bankers are choosing their own (larger) rainy day funds and thus it is the banks own decision that is right or wrong.

In other words, you can't claim that banks are grown-ups who can manage their own finances and then blame the law when banks fail.

This begs a question: why wouldn't banks set up larger rainy day funds to avoid failing? The answer is that banks profitability is measured relative to their rainy day fund - that is, relative to their capital base. Thus the closer to the edge a bank runs, the more relatively profitable it is as a business.

I would argue that there is also assymetric risk (something that deserves its own post). Basically if the bank is more profitable, the bankers might get higher pay, their stock options might be worth more, they might get a bigger bonus pool. But if the bank fails completely, once the bank is bankrupt, life doesn't get worse for the bankers if it is more bankrupt. If the bank fails gently (is insolvent by $1) the result is the same for the bankers as if the bank completely implodes and needs a huge taxpayer bailout.**

One more thought: while I think Konczal is right to point out the flaws in Friedman's logic regarding regulation, I consider the capital requirements (rainy day arguments) a little bit silly; the rainy day requirements that would have been necessary to keep a bank functional in the face of the crisis at hand now would have been so high that anyone suggesting them would have laughed the idea out of congress or the boardroom. The requirements would have been too large for banks to function at all.

The heart of the problem isn't banks having inadequate reserves for a crisis, the heart of the problem is the banks making an astounding number of loans that will never be paid off. It's the equivalent of Joe buying the state of Florida on his bankers salary; no amount of rainy day savings is going to protect against that.

* Regarding whether bankers who made money by doing deals regardless of whether they failed may have had incentive to do stupid things, and the mentality of home buyers in 2006, I'll leave that to you to judge - human nature is what it is.

** That result under Bush and Obama appears to be that the bankers get to keep their jobs, which is astounding.