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Here Come the Zombies

by J. Orlin Grabbe

Like to gamble with other people's money? Then you need to start a bank. Because your government likes to make bankers rich. Deposit insurance is one way.

Buckaroo Banker has $200,000. He takes half of this--$100,000--and uses it as capital to start a bank. He offers nice interest rates on deposits, and attracts $900,000 in deposits. So the bank now has a million dollars in assets. Buckaroo takes the million dollars to Harrahs in Reno and bets it all on Black at the routlette table. Also, at the same spin of the wheel, he bets the $100,000 he still has of his own money on Red.

And why not? Consider the advantages. If Red comes up, the bank loses all one million dollars of its assets. But repaying the $900,000 owed to depositors is the government's problem: the government insured the deposits. Meanwhile, Buckaroo's $100,000 bet on Red has turned into $200,000. So he is as well off as before.

But if Black comes up, Buckeroo loses the $100,000 bet on Red, but the one million dollar bet on Black becomes two million. So Buckeroo pays back the $900,000 he owes depositors, and walks away with $1.1 million.

That is, due to government deposit insurance, Buckeroo has a fifty percent chance of ending up with the $200,000 he started with, and a fifty percent chance of increasing the $200,000 to $1.1 million. Personally, I would say: Go for it, Buckeroo!

Consider the recent Savings & Loan crisis in the United States. The S&L industry was the product of a government effort to promote home ownership. S&Ls were financial institutions constrained to take in short- term deposits and invest the money in long-term mortgages secured by residential property. The structure of an S&L, borrowing very short-term and lending very long-term, thus entailed a serious gamble on interest rates.

In the inflation of the late 1970s, market short- term interest rates rose above locked-in, long-term mortgage rates. This would have, at a minimum, required S&Ls to pay more on their deposits than was received on their loans. But the situation was even worse because there were regulatory ceilings on interest rates, intended to "protect" S&Ls from high funding costs. Ceilings instead threatened to prevent the S&Ls from receiving deposits altogether. S&Ls paid 5 1/4 to 5 1/2 percent on small-denomination deposits, while market interest rates (and inflation) had risen to more than double that level by the end of the 70s. (Three-month Treasury bills averaged 10.04 percent in 1979 and 11.5 percent in 1980. The change in the Consumer Price Index was 13.3 percent in 1979 and 12.5 percent in 1980.)

So savers removed deposits from S&Ls as well as banks, and placed them in money market mutual funds, which paid market interest rates. Money market mutual funds, which grew in assets from less than $10 billion to $188 billion between 1978 and 1981, lent savings back to S&Ls and banks by purchasing from them large- denomination certificates of deposit which were not subject to interest rate ceilings. S&Ls were thus paying more to their marginal depositors than they were receiving on their portfolio of old mortgages. The value of their mortgage portfolio, meanwhile, had fallen with the rise in interest rates. "By 1980, before any deregulation had taken place, the liabilities of the S&L industry exceeded its assets by $110 billion. The industry was already insolvent-its members owed more than they owned-when Congress and the Carter administration enacted the Depository Institutions Deregulation and Monetary Control Act [DIDMCA] of 1980" (Catherine England, "Lessons from the Savings and Loan Debacle, Regulation, Summer 1992).

We arrive at the crucial juncture.

DIDMCA and the Garn-St. Germain Depository Institutions Act of 1982 (GSGDIA) gave the S&Ls a free call option. DIDMCA expanded federal deposit insurance from $40,000 to $100,000 per account, even while it phased out the interest rate ceilings S&Ls could pay on small-denomination deposits. (S&L deposits were insured by the Federal Savings and Loan Insurance Corporation, or FSLIC.) GSGDIA then expanded the range of allowable S&L investments.

Now suppose you are an insolvent, or "zombie," thrift. You know you are insolvent, or are heading in that direction, but the regulators don't know it yet-not until their next audit, which may be a while, because you are not the only institution with problems, and they have a lot of work on their hands. So what you do is, first, get new money by offering higher than normal interest rates on large deposits. Ordinarily, doing this would scare people away. They would assume you were paying higher than normal interest rates because you were in trouble, and hence other depositors were demanding a risk premium. But in this case people aren't scared away, because the deposits are federally insured. The federal insurance takes away the market discipline. Money fund managers spreading deposits nationwide will gladly accept the higher interest rates: they don't have to worry about credit risk.

Then, with the new money in hand, you can engage in risky investments or speculations. Anything that might give you a chance of making up your deficit, or making a windfall, before the auditors show up. If the gamble succeeds, you walk away a winner. If the value of your assets rises above the value of your liabilities, your call option is "in the money"-it pays off. But if your gamble doesn't succeed, you are no worse off than before: Your call option expires out of the money, and your S&L is still broke. The deficits on your balance sheet are passed along to the FSLIC. Such was one of the many games played during the remainder of the 1980s.

The key to the whole scenario is, of course, the eagerness of government to blow taxpayer funds on banks and bank depositors. The problem is not limited to the U.S. It's worldwide. According to the Bank for International Settlements:

"Sovereign borrowers and private lenders must understand that incautious behaviour on their part will not necessarily be made good with public money." (Annual Report, Basle, 1996)

But the Elysee palace and banks like Credit Lyonnais apparently haven't gotten the message. Credit Lyonnais expects a lot more state aid. As anticipated in "Credit Lyonnais and L.F. Rothschild Ready to Topple," the bank announced a small profit--of French franc 67 million (FF 67 million) for the past six months. This "profit" was obtained after the bank received FF 3.9 billion in taxpayer funds from the French government. Translation: Credit Lyonnais had a FF 3.833 billion loss in the past six months.

Credit Lyonnais also said it would need "an injection of at least $1.54 billion to $1.74 billion" to meet the government's goal of privatization (Washington Post, Oct. 5, 1996). What does this mean? Well, it means the French government wants to get rid of this bottomless pit, and sell it to private investors. But investors are not about to buy something that has a negative net worth. (Would you pay someone fifty dollars to take over their $1000 debt obligation?) So the government will have to add capital to the bank to give it at least a zero net worth. And the bank is saying that $1.54 billion to $1.74 billion will do the job. This is somewhat smaller than the $2 billion in the red I reported in my previous post on the subject. But I am confident that my numbers are at least as accurate as theirs.

The French newspaper Liberation asked "Should this Bank Be Saved?", and estimated the total taxpayer cost of past and future bailouts to come to about $29 billion. This is includes about $17 billion in losses that will eventually materialize from the transfer of bad loans to the Consortium des Realisations.

Credit Lyonnais has had a long free ride. It took in loads of money laundering deposits from the Cali cartel and other sources. Then its managers invested in risky, prestige projects like MGM and the Chunnel project (the tunnel between England and France under the English channel).

Credit Lyonnais used to be one of the largest banks in the world, based on assets. Based on capital, its negative net worth of about $2 billion now makes it one of the world's smallest. (Nine of the world's top ten banks, based on reported assets, are Japanese. The other one is a German bank, Deutsche, which has about $500 billion in assets, and ranks 7th.)

Credit Lyonnais is now a Zombie. It only comes out at night, wearing dark glasses to protect its delicate eyes from muted street lights, in search of other people's money and the neighborhood Roulette table.

October 9, 1996
Web Page: http://www.aci.net/kalliste/