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NOTE TAG: Unlimited Insurance, Unlimited Risk

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Our next speaker is Mr. Doug French. As a former banker and then a man who got his master's in economics under Murray Rothbard, he knows where if he speaks about deposit insurance and related issues.

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Doug is a senior editor of Agora's laissez-faire book club, former president of the Mises Institute, a great donor to the Mises Institute, and it's great to have him here, Doug.

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and tell us all about deposit insurance.

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Thank you, Lew. It's wonderful to be back in New York. We were here two or three years ago and it's great to be in this wonderful city.

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It's especially wonderful to be down the street from, you know, Barneys and Ann Taylor and the NKY and Todd's.

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Some members of my family are going to be very happy about that and possibly do what Ben Bernanke wants us all to do with the smell of QE3 in the morning.

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I did want to make a mention about this book. You may have seen it propped up here,

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Re-Assessing the Presidency. If you do sign up as a member of the Mises Institute and support Our Great Cause,

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you get a copy of that for free. There's a few authors here today.

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Joe Salerno has a piece in there, Tom Woods, and so you may want to think about joining the Mises Institute today and get a great book and possibly a great keepsake to have them autograph it.

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So please think about that. This other book over here is a little something I wrote and you may not think I'm much of an author, but I had great help.

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Help. Murray Rothbard helped me with that book. It was my master's thesis and Hans

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Hoppe was on my thesis committee. So you can't get any better help than that. So whatever

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you think about me, think about, I tried to get, it had been wonderful to get Murray to

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co-author but it just didn't work out. So what I wanted to talk today about was TAG,

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which is maybe something you've heard about or haven't heard about. But the story of TAG

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The bank actually starts in 1934 with, I'm sure, a president that you're all very much

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revere, FDR, and after taking office and declaring a bank holiday, FDR told the nation in his

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first fireside chat, he said, after all, there is an element in the readjustment of our financial

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System, more important than currency, more important than gold, and that is the confidence

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of the people.

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Well, what FDR was telling Americans was to be confident in government force, to be confident

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in what Murray Rothbard called an inherent hoax, the smoke and mirrors term for unbacked

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Name of the Federal Government.

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Eight states had actually tried bank deposit insurance prior to the Great Depression and

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actually all eight funds failed.

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But that didn't stop the government from continually agitating for nationwide deposit insurance.

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There was actually 150 proposals for nationwide deposit insurance made into Congress.

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But the idea actually wasn't popular.

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In 1932, Herbert Hoover called guaranteeing bank deposits a lot of rot, adding that it

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would make the government responsible for the management of all the banks in the country.

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Big banks hated deposit insurance.

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It believed that it would only keep smaller, weaker competitors in business.

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And actually, FDR agreed with them.

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He told a press conference, the general underlying thought behind the use of the word guarantee

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with respect to bank deposits is that you guarantee bad banks as well as good banks

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and the minute the government starts to do that, the government runs into probable loss.

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FDR went on to say that the government's objective would have to be not putting a premium

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in the Future of Unsound Banking.

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Now, the banking panic that peaked

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in the first few weeks of March 1933,

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Roosevelt, in his first official act,

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he closed the banks on March 6th,

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said that the banks would be closed for four days,

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and then what did his administration have to do?

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Well, they had to quickly draft legislation

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to actually legalize the holiday

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and Resolve the Crisis.

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In other words, FDR had actually closed the banks without having the legal authority to

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do that.

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He didn't have the power to do it.

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The Emergency Banking Act wasn't completed until a few days later.

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At that time, presidential advisor Raymond Morley said, we know how much of banking depended

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upon make believe, believe or stated more conservatively the vital part of that public

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confidence had in assuring solvency.

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Now Murray Rothbard said it a little bit differently.

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He said the very idea of deposit insurance is a swindle.

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How does one insure an institution, fractional reserve banking, that is inherently insolvent,

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and which will fall apart whenever the public finally realizes and understands that it is

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in fact a swindle?

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Well, we didn't have nationwide deposit insurance until January 1st, 1934.

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And it started at what seems to be today a fairly nominal amount, it was $2,500.

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But when you adjust that in inflation, it was about $41,000 in today's money.

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And now in 35, that amount was doubled to $5,050, it was doubled again to $10,000.

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It went up in 66 to $15,000, $20,000 in 69, $40,000 in 74.

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And then in the middle of the S&L crisis in 1980, it was raised to $100,000.

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And that's the way it's been until, of course, the recent market meltdown in 2008, and the

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deposit insurance limit was raised to $250,000.

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But that's not all.

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Also in 2008, the FDIC instituted a program called TAG, Transaction Account Guarantee

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Program.

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And what TAG does is provide unlimited coverage for non-interest-bearing transaction accounts.

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These are typically checking and payroll accounts for corporations and municipalities and possibly

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large personal accounts.

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Now according to Wall Street Journal last month, taxpayers are standing behind 1.3 trillion

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dollars in tag deposits.

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And interestingly enough, the vast majority of these tag deposits are held by the top

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five banks.

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While the Fed has been stomping down interest rates to zero, and as of yesterday it appears

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Bankers, they are going to do that until the end of time.

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Banks are paying but a few basis points to interest-bearing accounts, so you're not

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giving up much to actually just take zero interest and get unlimited FDIC insurance.

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Jim Grant wrote in his latest, Grant's Interest Rate Observer, he wrote, zero percent interest

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Business rates and blanket FDIC insurance of bank deposits reconfigured what used to

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be a market in short-dated IOUs of the private sector, today's money market is increasingly

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a market of short-dated IOUs of the public sector.

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He went on to write, when a given claim yields nothing, the prudent investor will roll treasury

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Bills or, functionally the equivalent same thing, layup deposits at too big to fail banks.

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Now it's clearly where corporate cash is going.

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The American Banker reports that the percentage of corporate cash held in bank accounts stood

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at 51% in May.

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That's marking the highest level since they started doing the survey seven years ago.

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This year's percentage compares to 43% a year earlier and 23% in 2006.

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77% of the companies surveyed said they didn't care about yield, they cared only about safety,

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and only 2% were interested in yield.

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FDIC reports that actually non-interest bearing deposits for the top five banks have swelled

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over 100% since TAG was put into place in 2008.

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And by the way, if you're wondering about the FDIC Deposit Insurance Fund, it currently

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stands at $22.7 billion.

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That sounds like a lot of money, but it is backstopping $7.1 trillion in deposit.

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That is 30 basis points, basis points being a hundredth of a percent.

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The Problem Bank List website actually put this rather colorfully.

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They wrote, this is the equivalent of trying to protect yourself with an umbrella in the

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middle of a cat three hurricane.

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The collapse of one of the two big to fail banks would immediately require the FDIC to

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to seek financial assistance from the United States Treasury, and of course, during the

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last financial crisis, the FDIC was, nobody else was able to secure a loan, but the FDIC

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was able to secure a line of credit from the Treasury for $500 billion, just in case the

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need should arise.

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One might guess that the need will arise.

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The TAG is scheduled to actually to expire at the end of this year, like so many other

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government intrusions.

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It was put in place actually in 2008 with the idea it was temporary.

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You remember, but it was worried they weren't going to be able to get their cash out of

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their ATMs.

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I mean, what would we do?

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So they put this in place.

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Let's do this until the financial storm passes.

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And then it would sunset at the end of two years actually in 2010.

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But actually in 2010, the Dodd-Frank bill extended TAG for another two years until the

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end of this year, so this is again an issue.

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Back then, FDIC Sheriff Sheila Baer said, it is necessary to extend the TAG program

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because the lingering effects of the financial crisis that emerged in 2008 in large, systemically

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Many important banks have now spread to institutions of all sizes, particularly in regions suffering

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from ongoing economic weakness.

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Allowing the TAG program to expire in this environment could cause a number of community

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banks under stress to experience deposit withdrawals from their large transaction accounts and

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would risk needless liquidity failures.

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This reflects the continuing legacy of too big to fail and the different liquidity pressures

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our community banks experience as a result. Keep that in your mind, community banks.

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Now, here we are two years later. The bankers still do not want to give this up. Frank Keating,

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he just wrote a letter to the editor, to the Wall Street Journal, and he claimed that taking

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The takeaway tag would increase uncertainty in an economy whose path is anything but certain.

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He says the goal of the program was to maintain liquidity for financial institutions.

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He said depositors remain nervous for a number of reasons.

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The fiscal cliff, problems in Europe, the economy has slowed and who knows what all

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and this program should stay in place.

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But of course he doesn't want to make it permanent.

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He just wants a temporary extension of another two years.

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He writes a tag and a bailout because the banks have paid deposit premiums on these

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deposits.

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Of course, we might remind Mr. Keating that there are only 30 basis points worth of these

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premiums that stand behind their coverage.

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And besides, he says, hey, it's been successful.

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It has supported lending at no cost to the taxpayer, but in fact really there's been

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no lending at all during this post-crisis era.

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Scott Shea, he's the chairman of Signature Bank here in New York City, and he says the

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deposits of too-big-to-fail banks are already essentially covered, so it would be unfair

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to take TAG away from other lenders.

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Jeff Gerhart, Chairman of the Independent Bankers, says, tag deposits anchor broader

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banking relationships and support local lending.

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Local lending, really, 40% of the bank deposits in the entire country are held by four banks

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and they're not local.

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78% of the deposits are held by the largest 1% of banks, let's say the largest 70 banks

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that are out there.

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And by the way, if banks aren't lending, what are they doing?

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Well, derivatives.

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That's the latest growth industry in the banking business.

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And when it comes to derivatives exposure, the top 1% of banks have 99.999% of the derivatives

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exposure.

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That total derivatives exposure, according to the last FDIC quarterly report, was $225

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trillion.

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So what are these big banks doing?

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If they're not lending money, there's no one to lend to.

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Well, during testimony before Congress, JP Morgan's CEO, Jamie Dimond, specifically

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stated that the bank's deposits had swelled by more than $400 billion in recent years,

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putting pressure on the bank to seek higher returns.

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Bank analyst Chris Whalen, who by the way spoke for the Mises Institute here two or

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He makes the point in a recent investment letter of his that the growth of J.P. Morgan's

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non-interest-bearing deposits supported by TAG almost perfectly tracks the period when

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the Treasury of the Bank increased its rogue speculative activity as something you may have

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read about, specifically the size and risk profile of the lending trading operation of

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of Bruno Ixkill and the J.P. Morgan CIO Office seems to have increased at the same time that

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the supply of excess funds due to TAG at J.P. Morgan was peaking, essentially from 2010

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till today.

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Wayland figures that TAG accounts for 200 billion of J.P. Morgan's deposit base or

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about 10% of total assets.

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So that additional cash provided a big incentive for Morgan management to add increased risk

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because remember after all JP Morgan Chase needs to make, can keep assets and equity

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returns at a growing rate.

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And if you have increased assets through increased deposits, then you need to take more risk

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to keep up that return.

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Diamond told Congress that his bank was unable

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to deploy these increased deposits via lending.

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There just wasn't enough loan demand.

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So the liquidity instead was invested in corporate bonds

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via the Chief Investment Office.

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Whalen says insiders actually at J.P. Morgan have told him

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that his suspicions that there was a connection

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between the increase in TAG deposits and the speculative trading activities of the office

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in London is actually true.

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They've actually confirmed that conversation with him.

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Now, according to the New York Times, this spring, JP Morgan had 30% of its portfolio

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invested in securities that are backed by the federal government, either agencies or

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treasuries.

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Now, this was a shift from the end of 2010 when actually their portfolio was 42% of governments

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and agencies.

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Now, by comparison, Bank of America had 87% of its bond portfolio in government securities.

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So clearly, J.P. Morgan was taking more risk in the corporate bond area.

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The Times speculates that J.P. Morgan may have wanted to be a little more ambitious

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and earn more returns with its hedging program, and of course the hedging program is made

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through the heavy use of derivatives, price of these derivatives being linked to the value

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of corporate bonds.

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And this is a quote from the New York Times, while the bank made both bullish and bearish

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with these instruments it appears that the trading strategy started losing a

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lot of money when the market turned against corporate bonds toward the end of

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March. Now J.P. Morgan's troubles or J.P. Morgan's problem with what to do with

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the excess tag funds was actually mentioned by Thomas Limke. He's a

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general counsel and executive vice president for Legg Mason and he was

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I was speaking on behalf of the Investment Company Institute, who is, by the way, against

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the extension of TAG.

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He wrote, we understand that some are calling for Congress to extend this unlimited insurance

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program beyond its statutory expiration date.

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ICI strongly opposes any such extension.

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We view the program as having the potential to dislocate markets and increase systemic

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take risk in times of market stress by creating an unlimited taxpayer support backstop for

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these transaction accounts.

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Historically, the risks posed by deposit insurance programs have been mitigated by capping that

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amount of the depositor's account that is insured.

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Now in banking, everything starts with funding.

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Funding creates the need for earning assets.

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After all, this is fractionalized banking. You don't collect deposits and then let them

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sit there and guard them so that people, when they come back for their money, it'll be there.

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Banks do something with this money and hope not everybody comes back at once for their

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dough. So the Fed's zero interest rate policy actually has banks under margin rate pressure.

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A flood of funding encouraged by this FDIC's emergency TAG insurance causes bank management

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to make even more risk for more yield.

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As Mr. Whalen says, quote, we see too big to fail zombie banks doing even more stupid

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things than is normal and customary, unquote.

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TAG has plenty of adherents and supporters on Capitol Hill.

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Senate Banking Committee Chairman is Tim Rogers, and he actually is a Democrat from the great

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state of South Dakota.

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He wrote a letter supporting extension of TAG.

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That's hardly surprising since Citicorp's banking operations are actually operated in

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that state, or at least chartered in that state.

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Johnson is easily one of the most friendly members in the Senate when it comes to pandering

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to the too-big-to-fail banks.

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And it should be noted that the too-big-to-fail banks benefit disproportionately from TAG.

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For every $1 of TAG funding that goes into small banks, $4 will go to large banks.

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Indeed, when small banks may have had a funding advantage actually before the crisis, today

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large banks have the upper hand in terms of funding, in part because of the FDIC's TAG

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program.

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Indeed, the proportion of TAG eligible deposits held by the largest bank, as I said earlier,

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has almost doubled.

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At the end of the first quarter of this year, more than 75% of the $1.3 trillion in TAG

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Deposits were held with banks of over a hundred billion in deposits.

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Less than four percent of the amount was held by small community banks with assets of less

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than one billion.

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So far from supporting economic growth, as supporters of TAG suggest, and far from supporting

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In these poor community banks that's mentioned by Sheila Baer and others, the FDIC insurance

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for TAG eligible deposits actually spurs the growth in too big to fail banks and it actually

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spurs unsafe and unsound banking practices by these same banks.

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In the case of JPMorgan, the result was of the nearly 10% increase in their total assets.

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and this flight to quality, if you will, encouraged by TAG, was a significant increase in the risk-taking at that bank.

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The need to degenerate returns on the flood of funding pouring into J.P. Morgan actually resulted in a breakdown of their internal systems

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and controls leading to a significant financial, which I believe was $5 billion or such,

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and Reputational Loss, one of the biggest banks in the country.

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Now, a similar increase in this non-interest-bearing deposits has occurred at Wells Fargo Bank.

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And what Wells has done with this increase in funding is an increase to almost 40% market share in the new mortgage origination sector.

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and that's an incredible market share that has been encouraged by the fact that they

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have a vast funding advantage with the FDIC TAG program over their smaller competitors.

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Now as Whalen writes the half point rate differential between Wells Fargo and the other mortgage

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lenders implies that this giant bank is actually taking a loss on its new residential production

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and over time.

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But what Wells can do as they originate these mortgages is quickly sell them off and make

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a quick gain on sale and that's really what they're after.

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Now the American Bankers Association or the Independent Community Bankers Association

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may cry for an extension of TAG to stimulate economic growth or jobs, but TAG is simply

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Money is actually another act of government intervention in the United States economy,

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that under the guise of protecting small banks and the banking public.

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But actually the winners are the large banks.

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Small banks and the publics are net losers.

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Now in a wonderful book, Money, Bank Credit, Economic Cycles, Jesus Soto's wonderful book,

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He wrote, the various systems and agencies designed to insure created deposits in many

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western countries tend to produce an effect which is the exact opposite of that intended

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when they are established.

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These deposit guarantee funds encourage less prudent and responsible policies in private

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banking since they give citizens the false assurance that their deposits are guaranteed

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and thus that they need not take the effort to study and question the trust they place

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in each institution.

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These funds also convince bankers that ultimately their behavior cannot harm their direct customers

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very seriously.

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In not quite 80 years, U.S. deposit insurance coverage has gone from an inflation-injusted

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$41,000 now to unlimited.

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So it's no wonder that the financial system, while magnitudes larger, has grown many times

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more unstable.

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William Seidman, he was the chairman of the FDIC during the S&L crisis.

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He wrote, a deposit insurance system is like a nuclear power plant.

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If you build it without safety precautions, you know it's going to blow you off the face

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of the earth.

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And even if you do, you can't be sure it won't.

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A return to sound banking would mean doing away with the swindle of deposit insurance

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entirely.

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Otherwise, that financial nuclear explosion could happen anytime.