Financial Bandwidth – You're gonna need a bigger pipeline.

Tom Friedman has been quoting Roy Scheider's character in Jaws on first seeing the great white shark: “You're gonna need a bigger boat.” Friedman is talking about the size of the financial bail-out, the amount of money the Government is going to have to throw at the problems of our banks and other financial institutions to get them running again. I'm not sure I agree with Friedman on that claim, but I do know that if we restrict the leverage that those institutions can carry, we're going to need a lot more capital, and I don't know where that will come from.

Sec. Geithner says that the key to avoiding future meltdowns is “capital, capital, capital.” The Secretary's position bespeaks a sound, minimalist approach to regulation. The idea is that if financial institutions have a sufficient capital base, not only will they have a cushion with which to cover losses, but also, because they have so much capital at risk, they will take less risk with the money. As I said, this is sound thinking.

The problem with the Secretary's position is that excess leverage does not arise in a vacuum. Excess leverage arises when there is more cash to move than capital available to guaranty it. Think of Wall Street as a pipeline through which import dollars flow back into the American economy. An actual oil pipeline has to be big enough and strong enough to reliably carry oil from the well to the seaport. But size and strength are competing requirements: the thicker the walls of the pipe, the less its inner diameter and the less oil it can carry. Yes, the pipeline can be strengthened by adding thickness to the outside, but only if there is room in the system for a wider pipe. In many cases, it would appear to be easier to line the inside of the pipe without changing the shape of the pipeline than to accommodate an increased gross diameter. At least one can imagine how that might be the case.

The same principles apply to the financial “pipeline” that returns dollars to the US. If the economy returns to the level of pre-crash activity, the amount of petro- and sino-dollars that need to be recycled here will return to the volume that was being processed by our 30-1 pre-crash system, and those dollars will have to flow through the same pre-crash pipeline, because that's all there is right now. But the pipe will have been narrowed by increased capital requirements.

A bank that leverages at 30-to-1 can repatriate $300B if it has $10B in capital. A bank that leverages at 12-to-1 can accommodate only $120B. So where does the other $180B go? How does it get into the country? Some of it will doubtless become bank capital, probably against the better judgment of its owners. If putting $1B at risk enables a sovereign wealth fund to invest $11B with much less risk, and at a return greater than Treasuries even with the capital haircut, that's probably a risk worth taking. Sheik Alwaleed Bin Talal already owns a ton of Citibank, so he's already providing some capital for his country's' reinvestment. But that's at pre-crash levels. Maybe he'll need to buy more. And maybe he'll have to provide capital to other banks.

But is this what we want? Our banks being bought up by foreign investors, not because they think the banks are such good investments but because that's the only way they can get bonds to buy. Under that scenario, one would expect our trading partners to by-pass the investment banks entirely, setting up their own direct investment offices and not being bothered by capital requirements. Then who will need the banks?

The question that remains to be answered by events is whether a 12-1 banking system, strong as it may be, will have the capacity to service enough of the money coming home. Or will its role be supplanted by entities created for that purpose by trading partners who find our banks too puny for their needs.

Public-Private Investment Program - A good Start (Part I).

I like the Public-Private Investment Program. It effectively restores mark-to-model accounting by creating entities that will offer a mark-to-model price for banks' distressed assets. The banks are allowed to use mark-to-model accounting for such assets in seized up markets, but the rules are unclear, and no one would trust the banks' models anyway, so what would be the point? By creating entities with skin in the game, Messrs. Geithner and Bernanke and Ms. Bair have ingeniously allowed the banks to use mark-to-model accounting by getting someone credible to do the modeling. That's really very cool.

To understand how the PPIP fits into the "big picture," it’s important to understand why the credit markets don’t work now. And that starts with the trade deficit.

When we were not running a significant trade deficit, our banking system was essentially self-sustaining. Some part of the money we made found its way to banks, where it was recycled. And since the money we didn't save became money someone else earned, a part of that was also recycled, ad infinitum. At the end of the day, the money the economy needs was either printed by the government or recycled by savers.

But now that we are running a large trade deficit, much of the money we spend goes abroad to pay for things like oil and toys. This diversion of our money has two consequences: we need to borrow from abroad to finance things we would have financed ourselves, and foreigners have to lend to us to make the dollars they receive worth having. The recycling process continues, but with the money detoured through Dubai and Shanghai.

And New York. When there is no trade deficit, we deposit our money in our local banks. Yes, some money goes to Wall Street for investment, but we store a lot of it nearby where it can be relent to other Americans. Trade dollars do not come in through local bank deposits. They come in through money center (i.e., New York) banks and through the purchase of Wall Street securities that package loans created by banks and other lenders.

If you think of the flow of funds as a plumbing arrangement, the new setup has new pipes, and new pipes need to meet several requirements that there is no reason to believe they will meet without careful attention to their design.

Capacity. The first requirement of a pipe is that it have sufficient bandwidth to carry the water. There must be few bottlenecks in the inflow process. The entities involved must be able to operate on the scale required to process enormous volumes of money. This requirement does not exist in the non-trade-deficit scenario, where individual depositors make independent decisions and deposit their money in a wide array of banks which aggregate it into lendable pools. In the trade deficit world, the returning money is aggregated before it gets to New York; the depositors are large institutions and they want to deal with a small number of trusted large institutions. That's how we get the “too big to fail” problem.

Outflow filter. Even entities large enough to handle massive inflows of capital need a place to put the money they take in. I suspect that foreign investors returning trade deficit dollars through Wall Street are seeking, on average, greater safety than American investors would have sought if they were investing the money themselves. After all, people can speculate at home; a major attraction of investing here is (was?) safety. So we need to create securities with the right risk profile for the returning money. The problem is that American users of capital don't want or need capital with the risk characteristics that the foreign lenders are offering. Wall Street is thus charged with the job of restructuring investments to produce securities with the risk profile that foreign investors want. That process has problems, as shall see.

Leakage. Pipes can leak. The unprecedented increase in money flowing into the country through Wall Street has created opportunities for chicanery, temptations to corruption, and other ills that cause money to disappear. Liar loans, bear raids, naked shorting and credit default swaps, and corruptible ratings agencies all happen because new piping is vulnerable to corrosion. Regulation is a remedy, but remember that thickening the walls of a pipe may decrease its diameter, a metaphor that works very well for the effect of excess regulation of financial activity.

The current mess can be described as a case of the new plumbing springing a leak and foreign investors losing so much confidence in it that they have switched to an alternative inflow pipe – the U.S Treasury. The job facing our financial system, players and regulators alike, is to restore confidence in the private plumbing. The Treasury pipe just doesn't have the volume to handle the money our trading partners will need to invest if they are to continue to supply us with the oil we need and the toys we want. Obviously, reducing our demand for imports and increasing the world's demand for our exports will relieve the pressure, too, but that's a longer term project.