Monday, October 3, 2011


"The mother of all evils is speculation--leveraged debt."
Gordon Gekko (Wall Street 2: Money Never Sleeps)

Few cookies are sharper than John Hussman. The UMich PhD offers some great macro insight as well as one of the best frameworks for aggregate equity valuation that I've encountered. His weekly commentary is on my Must Read list.

However, some of his remarks/ideas in the policy arena leave me cold. For example, this week he reiterates a thought that he's discussed in the past related to troubled banks and their restructuring. He proposes that the liabilities of institutions facing insolvency should be divided into two buckets. One bucket would contain investor liabilities and one would contain depositor liabilities.

Dr J proposes that, when a bank faces insolvency, then what the bank owes to investors should head toward zero. So far, so good, as that is how capitalism is supposed to work. Investors must balance potential for gains (reward) against potential for loss (risk). Bad decisions means risk gets realized.

Of course, this is not how the system has worked over the past 2-3 yrs. Rather than going bust, investors have been bailed out under the auspices of 'too big to fail'.

However, Dr J proposes that the other bucket, the one full of depositor liabilities, goes into government receivership, and sold to new ownership, thereby 'protecting' the assets of depositors from the meltdown of deleveraging. John argues that this is necessary to protect the 'system' from meltdown. Depositors, he argues, should not have to think twice about where they deposit their funds, and they would be spared a "huge 'information problem'" that require consumers to have all the facts to avoid making bad depositing decisions.

But this is the same too-big-to-fail argument that the corporatists make. Dr J is merely couching it in a more populist slant.

Capitalism only works when buyers vet their purchasing decisions in their own best interests. This can only occur in financial services purchasing decisions if depositors face risk. Otherwise, we face a moral hazard problem as consumers turn off their brains and uncaringly place funds with inefficient operators. Depositors do this already because because they figure that the FDIC has their back in case of probs.

Moreover, Dr J fails to acknowledge that, like bondholders, depositors are creditors. Why should someone placing funds in a bank on deposit be treated differently than someone placing funds in the bonds that a bank sells?

John actually spells out the fundamental problem in the second paragraph of his 'Failure and Restructuring' section:

"The problem for banks, of course, is that they are leveraged, so even a drop of a few percent in their assets wipes out much of their own capital and threatens to make them insolvent." [emphasis mine]

Exactomundo. Leverage is the central problem. As long as the system maintains its current degree of leverage, then instability and crashes are the order of the day. Market forces want to delever this system. All interventionary actions, including Dr J's proposals, serve to keep leverage in the system artifically high.

The only way this occurs is to get government out of the way and let the 'equilibrium' that John waxes so poetically about actually come into being.

position in SPX

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