We’ve heard this word a lot lately — usually with a negative connotation.  Fungible is used in economics usually to refer to money, although it may also be used to refer to any item that is freely exchangeable for an identical amount of the same product.  The $10 bill that I have is exchangeable for your $10 bill.  But it’s more subtle than that…

If we both put a $10 bill on the table, and mix them up, you can’t tell which one was mine or yours…assuming you didn’t memorize your serial number.  The point that is being made in today’s economy about “money being fungible” is usually used to beat-up on the banks and financial institutions that have received government assistance (did someone say “bailout”?).  A lot of folks are making a big deal about banks that are paying big year-end bonuses after receiving billions of dollars.  The banks are saying, hey, no taxpayer money was hurt in the making of these raises.

Well, here’s the thing…we can’t be sure.  The fact is that once a million goes into the coffers of the bank, you can’t tell one dollar from another.  If  two one-million-dollar deposits come in the front door, it’s impossible to tell which money was paid as a bonus, and which money paid the rent.

One of the principles of money as fungible is precisely the point here…you can’t tell if the money that was brought in the front door by the truckload is the same money going out the back door as bonuses.  If your local soup kitchen had a case of oranges donated, and you found a case of limes at the CEO’s house, could you tell where they came from?  Well, you could be sure that they weren’t the oranges that were donated.  Can you same the same thing about the $175 billion that went to AIG and the billions that went out in bonuses?  Nuff said.

UPDATE: If Bernard Madoff’s wife had no savings when they got married, worked for a firm that was a giant Ponzi scheme, and was paid a salary over 20 years by that $65 billion fraudulent company, then told the judge,
“Hey, $69 million of that money is mine — separate property — and should not be seized by the Feds to pay off all of those who lost their life savings”…

If you heard this story at a cocktail party, would you laugh at her or be sympathetic?  If you would laugh at her (il)logic, you understand that money is fungible.

There is a lot of talk these days about taxes…who will pay them, will they go up, by how much, etc.  A little perspective on how taxes affect people is in order.  What’s the difference between a progressive tax and a regressive tax?

We can spend a lot of time on definitions, but it’s easier to use a few examples:

Progressive tax:  As your income goes up, your tax rate goes up.  The idea is that you can afford to pay a higher tax rate if you make more money.  That’s why the bottom income tax rate is 0%, then 10%, then increases as you make more money.

Regressive tax:  Taxes such as gasoline taxes are regressive.  Most states, as well as the feds, tack on taxes to each gallon of gas.  Let’s say you pay $50 to fill up your gas tank (as I did yesterday).  About $10 of that was taxes.  Now, how much of that tax, in percentage terms, does that represent of your earnings?  If your neighbor makes $10/hour (about $20,000 per year), he just paid 1 hour’s work just for the taxes, or about 1/20 of a percent of his yearly earnings.  If your neighbor fills up once each week, with 2 weeks of vacation, he pays $500 per year  (50 weeks x $10) in gas taxes.  That’s 2.5% of his total income.  If you make $20/hour (about $40,000 a year), you paid the same amount, but you paid half as much in percentage terms as your neighbor, or about 1.25%.  Doesn’t seem fair, does it?  Whoa, there, you’re injecting some subjective judgment of fairness.  But ok.

This is why sales taxes and gas taxes are regressive…they hit the poor harder than they do the rich, in percentage terms.  Did you ever wonder why you don’t pay sales tax on bread, milk, cereal, and the like?  This is the local taxing authority trying to avoid a regressive sales tax and make the basic food group more affordable for the poor…you don’t pay tax to eat basics.  However, if you go to a restaurant and order a glass of milk, you will pay sales tax.  Why?  You can go to the grocery story and buy a gallon of milk for $2.50.  You might pay $2.50 for a glass of milk in the restaurant.  The city and the state say, hey, if you’re poor, don’t go out to dinner — buy your milk in the grocery store.  (OK, to be fair, the city and state really are saying that if you can afford to go out to dinner, rather than stay home, you can afford to pay tax on that transaction.)

The entire argument that we’re having regarding “95% of the taxpayers won’t pay one dime more in taxes” is all about progressive taxation.  The idea that the rich can more afford higher taxes than the poor is what it’s all about.  What they’re really arguing about is not “can” the rich pay more, but “is it fair” for the rich to pay more.

This blog is not about that “fairness” argument.  It’s about definitions.

While out today doing our part for the economy (our slang for spending at the mall), the wife and I passed the local coal-fired power plant and got into a discussion about Cap and Trade.  It occurred to me that most of us have heard of it in the media, but may not know what it is.  Here goes:

The idea behind Cap and Trade is that we “cap” the amount of CO2 that companies may emit into the atmosphere, and then we allow them to “trade” with others for permits to exceed their caps.  Pretty straight-forward idea.  But you know what they say about economists and “all other things being equal”.  So there are (un)intended consequences.  Let’s talk about the economics.

Assumption 1:  The government sets an initial price of $10 per ton of CO2.
Assumption 2:  The government sets a “cap” of 100 tons per day on each of 2 power plants for year 1.
Assumption 3:  Each plant emits 120 tons per day today.
Assumption 4:  The government reduces the “cap” for each plant by 10 tons per day for year 2.
Assumption 5:  There are 10 electric customers for each power plant (just to keep the math simple).

Now, let’s examine what happens to revenues, taxes, and, most of all, your money.

Day 1:  Board meetings at both power plants.  Boards wonder how they are going to meet the caps.
Day 2:  Each company “trades” $200 to the government for the right to emit the extra 20 tons per day.

Now the government has $400, the companies are lighter by $200 each.  What do you do if you’re one of the companies?  Well, first thing is you raise your rates to your customers by $20 each (to cover the increased cost of generating electricity).  You don’t have any competition, so you go to the State Public Utilities Commission and add the new “cost” into your rate base.  Voila, your costs are now passed on to the customer.

Meanwhile, customers raise the prices of their goods to cover the increase in their costs.  Hint:  this is called inflation, and we’ve just witnessed one way for it to start.

Now, let’s say one of the power plants reduces its emissions down to the 100 ton per day level.  Wow, they don’t have to pay for any additional “trade” permits.  So they’ve saved $200, right?

Not so fast.  How did the plant reduce its emissions?  Did it build a new smokestack that removes CO2?  Did it cut back on a shift or two of workers, thereby reducing its emissions?  Each of these choices have costs.  Building a new smokestack for, say, $600, would increase costs now by that amount, but in year 4 and in the future would keep their costs from going up by $200.  But someone has to pay that $600.  Guess who?  There are only 2 choices:  the stockholders or the customers.  Someone has to pay.  And what happens in the out years (years 4-10) when the government reduces the allowed “cap” on emissions by, say, 20 tons per year?  You and the board of directors better get cracking on a way to pay for it.  Oh, wait, you really don’t have to worry about it…you get to pass the costs on to your customers.  Don’t worry, be happy.

Moral of the story:  Cap and Trade is a tax…period.  You can’t call it anything else.  If the government mandates it, and it increases costs, then it’s a tax.

YOUR TAXES WILL GO UP WITH CAP AND TRADE.  And the cost of living will go up…remember, inflation.  If you’re okay with that, then you should support C&T.  Just remember…as costs go up, economic activity will be reduced by some amount.  So we’ll get lower growth, or no growth, or a new recession, or a continuation of a current recession, plus inflation, if we implement Cap and Trade.

Oh yeah…what about the $400 the government received in year one, plus all that extra money in the following years?  You think they’ll give it back to us as tax credits?  Doubt it…I suspect spending will go up.  But those tax credits could happen.

PS.  There are several other alternate universes here.  What if the states don’t allow the power plants to pass the “Cap and Trade” costs on to their customers in the form of increase rates?  That money then either comes directly and solely from stockholders (in the form of reduced dividends), or the company goes out of business.  And remember unintended consequences?  What happens to granny when you reduce the dividend?  The price of the stock goes down, and the owners (stockholders) lose investment income as well as the value of the stock.

And in case you say, “too bad for the stockholders”, remember:  your 401(k) might hold some of those utility stocks.  So your retirement is in jeopardy.

Well, don’t worry.  All things aren’t equal.  Your tax increase may vary.

One of the crazier regulations that must be changed before the economy will come out of recession is mark-to-market (m2m). What is it?  In its simplest form, it means that financial institutions (and others) must evaluate and reprice assets daily or monthly, based on what those assets are worth right now.  It’s like saying, hey, what can I get for this gold coin today?

Let’s talk about how mark-to-market works for a bank.  Banks loan money (well, they used to).  When they make a loan, the value of that loan becomes an asset on the bank’s books.  Say Big Bank loans you $100,000 to buy a new truck for your business.  Big Bank then has an asset that is worth a hundred grand on its books.  If you are credit worthy (meaning the bank thinks you’ll pay the loan back), Big Bank can sell your loan to Bigger Bank for what it’s worth today, less the time value of money (look it up — I’ll post on it later).  Assume that your loan is at 10% for 5 years.  At simple interest, you’ll pay $150,000 back.  So the bank might sell your loan for $130,000, figuring the $30,000 profit now is better than $50,000 profit in 5 years.

Well, the fly in the ointment is the economy.  If things go bad in the economy, you might get behind in your payments.  Does that mean you won’t pay off the loan?  Not necessarily.  How does a bank calculate how much of a risk you really are?  They can’t, really, predict any one firm’s failure.  But by having a large pool of loans, they can calculate the statistics of how much of their loan portfolio will go bad over the years.

Let’s get back to you and your $100,000 loan.  Let’s say there is a general downturn in the economy, and truck drivers are defaulting on their loans.  Let’s say that 20% of truck loans go bad.  Now, the bank and the accountants will try to guess how much your loan is worth today, based on statistics and SWAGs.  The key is, the bank and the accountants are supposed to reprice their assets regularly.  So let’s say next month they write down the value of your loan by 20%, or $20,000.  Remember in the earlier post when I talked about bad loans being subtracted from a bank’s capital?  Well, this “markdown” gets subtracted from capital, too.

The economy might be going through a rough patch, but let’s say you’re a conservative bidnez-man, and you have a couple of hundred grand in the bank, in cash, just in case you need it to pay off your loan.  Well, the bank is still going to mark the value of your loan down to what the market price is that day — regardless of your cash position or other factors.  Silly, right?  Well there are times when mark-to-market is a good thing (think crude oil, or gold, or corn).  But when you’re talking about a 5-year loan, especially on hard goods (those that last a long time), a lot of things can happen over that 5-year period that are bad for the economy in general, but that don’t necessarily affect your ability to pay back your note.

Think of your house and your 30-year mortgage.  The fact that your house loses $20,000 in value this year doesn’t really mean much to you if you plan on staying in it for 25 more years.  The ups and downs will average out.

But banks can’t take into consideration the fact that your loan is a long-term one, and that you have money in the back to cover it in case you get hit by your own truck.  They are required to mark that loan to market price.  So you see how this mark-to-market can wipe out a bank’s capital, even when all borrowers are paying their loans?  It’s madness to follow m-2-m in this type of situation.

Mark-to-market is causing banks to lose capital.  That’s one of the reasons banks aren’t loaning money.  If we let banks carry loans for full price, less the interest, why, we’d shore the banks up overnight and new loans would start flowing.  But as long as we have m2m around, banks won’t loan us any money.  They will be too busy writing down loans with one hand, and asking for more bailout money with the other.

There are a lot of times when m2m is sound policy.  Now is not one of them in the banking business.

Do you know what an “unfunded mandate” is?  As used between government agencies, it means that one part of government requires another governmental entity (or individual taxpayers) to obey rules and regulations, but provides no funds for doing so.  Here’s an example:

The states that border the Great Lakes are required by the Federal Government to make sure that water runoff doesn’t pollute the Great Lakes.  On a practical level, local governments must comply with federal and state laws to make sure that all the salt, sand, and other junk put down on roads during the winter doesn’t all end up in Lake Michigan (or one of the other lakes).  It usually sounds like a noble goal.  So how do you pay for it?

Local governments come up with all kinds of different fees to create holding ponds for water runoff so that pollutants can be removed before the water ends up in the lake.  But neither the Feds nor the States provide funds for this.  So, local governments impose taxes (they are usually called fees, but they are a tax, period).

One of the reasons that some states are in financial difficulty during recessions is that they must maintain this spending level on unfunded mandates even while property tax revenue may be going down (because property values are headed south).

Another example of an unfunded mandate is also an example of judicial activism.  Someone sues your city because they are not doing enough to clean up the water that’s runoff.  The court agrees, and orders your city to clean up the water even further.  Does the court give the money to the city?  Nope.

So the next time you say, “Someone should do something about that!”, be careful what you wish for.  Government can tax YOU to make sure something is done about it — whether you contribute to the problem or not.

I can tell you the moment the banking “crisis” of the 1980’s started.  Todd Conover was Comptroller of the Currency (the head of National Bank Examiners, for one thing; part of the Treasury Dept).  Mr Conover caused the crisis by making a statement during a speech at the American Bankers Assn meeting in Dallas.  He was the cause; now a little background.

When banks go into business, they draw up papers to propose a new bank, gather together investors that will provide the initial capital for the bank, and submit these papers to the Office of the Comptroller of the Currency (OCC) hoping to get a bank charter.  That bank charter is the government’s permission to go into business as a bank, and it’s also a promise to insure deposits up to the FDIC limit.

After a bank gets its charter, it is then subject to regular examinations by OCC.  This usually means a team of lawyers and accountants come in to examine the business of the bank, review loans, and generally make sure that they bank is being run according to OCC rules (no redlining, for instance).  One of the things that bank examiners do is look at loans to see if the are “performing” — which means, is the borrower paying back the loan according to the terms of the loan.

If examiners determine that a loan is “non-performing”, it is then “classified”.  I’m over-simplifying here, but basically, if the examiners don’t think a loan will be paid back, they put it on the “classified” list, and, most importantly, the amount of that loan is deducted from the amount of capital that the bank has.  As you read in a previous post, if enough loans are classified, a bank’s capital can be wiped out, and the bank goes under.

During the heady real estate go-go days in Texas in the early 1980’s, banks would loan money to developers and speculators to buy up commercial land.  Everyone had an expectation that land prices would go up (sound familiar to home prices will always go up?).  So bankers would loan money “interest only”.  A borrower would make only interest payments on the land, expecting to sell it in 6 months or a year, and pay off the original loan, plus the interest, and keep the rest as profit.  Works great — as long as prices go up.  Developers could come up with the interest payments to keep the loans current.  As long as they only had to pay interest, then they could pay off the loans when they sold the property.  Mighty high leverage, that.

There was a lot of fraud going on back then.  I read about a banker who bribed real estate appraisers to increase the value of the land each time it changed hands.  Sometimes the land would change hands 4 times in a day.  (The banker and the appraisers went to jail.)

All good real estate bubbles must burst, and Conover was just the prick that was needed to pop this bubble.  He announced at the ABA meeting that, from that moment forward, his bank examiners would classify (mark as bad) any loan in which the borrower didn’t have the cash flow to pay back the loan.  He didn’t mean “pay the interest” — he meant pay off the loan.  Now, you had a lot of real estate developers who were paper-rich and cash-poor (they had a lot of assets, but not much cash).  As I said, they could scratch up the interest payment on a $1 million piece of raw land, but they didn’t have the money to pay a regular mortgage on it.  (Think of this as if you agreed to pay your mortgage interest-only.  6% on a $300,000 house is only $18,000 a year, or $1,500 a month, whereas a “normal” payment would be closer to $2,500 a month.)

Most bankers back then didn’t really care about the cash-flow of the borrower, because the value of the property (collateral) was always rising, and the bank figured they could sell it to pay off the loan if the speculator investor defaulted on the loan.

So when Conover said at lunch that his folks would start looking at the cash-flow of the borrowers, instead of just the value of the collateral, bankers looked around the room at each other, and there was a collective “Rut-roh” moment.  Bank VP’s flew out of that room to call their banks and try to figure out a way to shore up those “interest only” loans that were stinking up propping up the bank’s books.

All good things come to an end — and real estate bubbles burst.  From that moment forward banks went out of business left-and-right, and investors couldn’t pay off their interest payments, let alone sell the property for what they had borrowed.

Moral of the story — the bankers should have looked more closely at the borrowers, and examiners should have looked at the financial position of the borrowers.  I’m not advocating more regulation per se; but if you want FDIC insurance on your deposits, you have to abide by the rules.  Conover did no one any favors by changing the rules so radically and so fast.  It’s my opinion that if he had announced that it would be phased in over a year or so the banking crisis would not have been as severe…but that’s 20/20 hindsight and my opinion only.

This is a historical lesson about how bankers (indeed, the free market) will work within the rules and come up with a way to game the system.  The current crisis seems to be caused by regulators forcing bankers to loan money for homes to folks who couldn’t afford the house and/or were otherwise poor credit risks.  This one was caused by the regulators — not caught by them.  In the current debate, the regulators (Dodd, Frank etc) should be the ones who do the jail time.  After all, the bankers would have said “no” to the borrowers if they government hadn’t pressured them to make these dumb loans.

How do I know they were dumb?  That’s easy — if you have to set up a government program to buy loans from the bank, the loans shouldn’t have been made in the first place.  The market should determine who gets the money, not the politicians.

Here endeth the lesson.

I’m no personal fan of bank bailouts, but I thought that I might try to explain why some banks are making the case that they are “too big to fail”.  There are a couple of things going on in the banking system today that we’ve seen in the past; why should bailouts be undertaken today?

First, the largest problem of all now is the danger of large banks failing.  Why is this a danger?  If we want the economy to keep moving, loans to small businesses and individuals must be available.  If banks won’t (or can’t) lend money, everything grinds to a halt.

Banks are required to keep reserves on hand to cover folks who want to come in and cash checks (demand deposits) or take money out of their savings accounts to buy Christmas gifts.  (How many of you even HAVE  a savings account?)  During good times, this means that a bank can loan more money than they have on hand – called creating money.  It works like this.  If the reserve ratio is 10%, it means that the bank must keep 10% of all capital, loans and deposits on hand in the bank (I’m oversimplifying, but for our discussion, it won’t matter).  If a bank has $1 million in capital, it means it can loan out $10 million.  With $10 million in loans, the 10% reserve ratio is satisfied if $1 million is “in the bank”.

Let’s assume that a bank has $1 million in capital, and it makes 10 loans, each for $1 million.  The chance of all of the loans going bad at once are usually pretty slim, unless the bank makes all of the loans in one industry and that industry goes bad (think of the real estate and oil business busts in Texas in the mid-80’s).

So what happens if one of those loans goes bad?  If the bank has to write-off one of those million-dollar loans, it can be in trouble.  Why?  Because the Feds (the Comptroller of the Currency, actually the national Bank Examiners) require banks to write off bad loans against capital.  It’s an accounting issue, but it sure as hell can sink a bank fast.  Why?  If that bad million-dollar loan is written off against capital, the bank would have none left.  See the problem?  If the bank only has $1 million in capital, and one loan goes bad, the loss is written off against the capital – and now we have no capital left in the bank.  And you wondered why banks give away toasters to get deposits?  HA!  They do it so that they have more reserves, so they can grow, but mostly to protect themselves against a capital shortage!

Bankers (good ones, anyway) watch capital levels like parents watch 2-years-olds in candy stores.  If loans start to go bad, you need to get deposits in fast (at least before the next bank exam or the next accounting reporting period).

How does this apply to the current crisis?  Exact same principle, simply more zeros in the capital needs than in the example above.  If Citibank has $5 billion in capital, and they have loaned out $50 billion, they are damned sure watching their loan portfolios.  As home loans start to go bad, Citi will have to start writing off some of those loans.  Pretty soon – technical insolvency.   The fly in the ointment today is that Citi doesn’t really know what its maximum exposure is.  We’ve all heard that banks can’t figure out how much some of their derivatives are worth.  Well, if they are on the books as worth $10 billion, and they’re written down by half, that’s $5 billion against your capital.  If that’s all the capital you have, you’re done (in the eyes of the Feds).

The bank won’t cease to function; you can still cash a check and use your credit card.  But the Feds will force you to either raise more capital or be acquired by another bank with more capital.  If the country is in a credit crunch, as it is today, who the heck is going to buy more Citibank stock (which is the quickest way to get more capital into the bank – sell stock)?  That’s what the banks are asking for – money from the government to apply to capital.  That’s why the government is getting stock as part of the transaction – it’s a clean accounting method to get more capital into the bank.

Well now – what happens if we give Citi (and others – I’m not picking on Citi, just using them as an example) $5 billion in capital?  Well, first off, we had better be damn sure they’ve written off all of their bad loans.  If we give them $5 billion, and they write off another $5 billion in loan losses in December, they’re just going to come back and ask for more (this is what happened at AIG).  So the Feds are trying to make sure all of the bad news is already known.  Trouble is – how can we know?

Your tax dollars are being used to prop up banks that the Feds consider to be “too big to fail”.  What’s the alternative?  Well, in the mid-1980’s we let a bunch of banks fail.  95% of them were so small that their customers went to other banks and got money.  There were a lot of large Texas banks that failed (RepublicBank, for instance), and it hurt the local economy, but there was no systemic threat to the overall banking system.

In some minds, Citi is too big to fail.  And so are many others.  It’s not that we couldn’t survive a Citi failure – we could – it’s that Citi’s failure could cause a domino effect to other large banks.

Right now, the banks are hunkering down, not loaning money to preserve capital.  This is precisely the wrong thing if we want the economy to grow.  So giving capital infusions to these large banks should allow them to start loaning money again – if all of the bad news is out there.  How do we know?  We don’t.  And that’s why the Feds had better be sure they’re propping up these tin-cup-holding banks and not just putting money in that will be lost in another 60 or 90 days.

Now you know why I’m not a great fan of bailouts – the bankers at Citi have an incentive to say “all is well –we’ve told you all of the bad news” in order to get the money.  And the money is needed so fast that the Feds can’t get in there and do a review of the books to see.  So it’s “trust me” from Citi (and the others).  When was the last time you felt comfortable when someone said “trust me”?  Especially with $25 billion of your tax dollars.

I’ve been asked to blog here on basic economics and business concepts.  The goal is to focus on current topics and give an explanation of the underlying definitions.  For example, the fact that the Federal Reserve and the US Government are going to “bail out” several industries should give us pause to consider:

1.  Why do banks need money when they have all of ours already on deposit?
2.  What is a “bail-out”, exactly?
3.  As the Feds give money to these companies, where does that money come from?
4.  Will inflation follow (and why should we worry about inflation now)?

You get the idea.  I like it, and I’ll try to blog as events happen.

I have an Economics degree and have been in the business world for 30 years.  Not too much is happening now that we haven’t already seen in my lifetime.  I’ll try to put some of the current smart (and dumb) ideas into historical perspective.  Mostly I want to provide some clarity on the subjects that CNN, MSNBC, and the like are being hysterical about.