Is Money in the Bank Really Safe?

Interview With William Black

William Black reassures listeners on why their money is safe in the banks, and talks at length about Credit Default Swaps and why AIG went bankrupt.

Douglas Goldstein: I'm very excited to have, on The Goldstein on Gelt Show, Professor William Black. He is the author of a fascinating book called The Best Way to Rob a Bank Is to Own One. It's a pleasure to have you here, William Black.

William Black: Thank you. It's a delight to be here.

Douglas Goldstein: When people in financial shows joke about robbing a bank, I think listeners get a little bit nervous. Should people be worried about their bank deposits?

William Black: No, because bank deposits are insured and that's one of the reasons they are insured. One of the leading risks historically has been the guy who controls the bank. It's a whole lot easier to turn off the alarms and they know the combinations. In seriousness, the way you steal from banks big time is with accounting.

Douglas Goldstein: Let's go back to the part about insurance. You're referring to the FDIC, the Federal Deposit Insurance Cooperation, which protects people today for up to $250,000 per account, right?

William Black: In the U.S.

Douglas Goldstein: In the U.S.

Why Are OECD Countries Introducing Depositing Insurance?

William Black: One of the important changes over the last 25 years has been the spread of depositing insurance to essentially all OECD nations.

Douglas Goldstein: That's interesting. Is it part of what they have to do or is it just a tradition?

William Black: No, and it's actually neither. At the same time that many economists were warning against depositing insurance, there's been an enormous move throughout developed nations to adopt depositing insurance. They have also made the move to increase the amount covered by the insurance.

Douglas Goldstein: Back in 2008, people believed that the FDIC couldn't have been able to bail out the banks. Was that just a scare tactic in the media or was there actually something to that?

William Black: There was nothing to that because the FDIC is backed by the full faith and credit of the United States of America. It doesn't matter how much is in the insurance fund. In the savings and loan debacle of the 1980s for example, we were insuring an industry that had over $1 trillion in liabilities and as a low point, this is liquidity. Now, it's supposed to be a net worth number. We were down to $500 million, so we were running on fumes.

There was still no nationalized run because everyone knew that the Treasury was good for the money. Of course politically, if some congressman tried to pass a law saying, "No, let's stiff the American people on that," the half life of his political career would be measured in nanoseconds.

Douglas Goldstein: Is it really true insurance? The banks are not paying a market level premium in order to take coverage. It's really just a backstop that the government puts up and says, "No matter what you guys do, we're going to come in and protect you."

William Black: It's not actuarially-sound insurance but there are, in many countries, efforts to make some degree of risk-based pricing. It's not completely distinct.

What About Risk?

Douglas Goldstein: Why wouldn't countries actually make risk-based pricing so it's a real insurance? That way, banks actually pay for the insurance that they're getting.

William Black: They wouldn't know what price to charge because one of the great secrets of banking is that people are quite pathetic in evaluating risk. This is why we have these kinds of crisis in advance. Or to phrase it the other way, the entire arc, from the standing point of the CEO, is to make it appear that the bank has a trivial risk, while in fact taking extreme risks. Or, to quote George Akerlof, the Nobel laureate in economics, to loot a bank.

Douglas Goldstein: All right. I can actually talk about this all day because I have a lot of thoughts on it, but let's go back to what normal people would care about. You say that people should not worry because their money is safe in the bank. I'm putting those words directly on our guest today, Professor Bill Black, who wrote the book, The Best Way To Rob A Bank Is To Own One.

Now, what did you mean by saying that the money that has been taken from banks is actuarially?

William Black: Let me be precise. I said if you're insured and your money is within the insurance limit, you're not going to lose.

Douglas Goldstein: So right up to the amount that they're covered, they should feel safe?

William Black: Right. In terms of insurance, one of the clear differences in the crisis for example, was AIG. AIG was the leading seller of Credit Default Swaps. It's typically referred to these things as if they were insurance, but they were of course not insurance. There were no reserves or regulation, and you didn't need to have an insurable interest. In other words, we typically don't let you buy fire insurance on your neighbor's home, because maybe that would create some pretty bad incentives.

Douglas Goldstein: All right.

William Black: With Credit Default Swaps, hypothetically, a thousand of us could buy fire insurance on your neighbor's home. That really screws up the actuarial type of thing, right? It's no longer the risk that a particular home will burn down; it's now the risk that that home will burn down times a thousand.

What's a Credit Default Swap?

Douglas Goldstein: Please define what a Credit Default Swap is because it's not something that individual investors normally buy. These are usually used by institutions.

William Black: Credit Default Swaps are not something you should buy yourself.

Douglas Goldstein: Don't try this at home.

William Black: Don't try this at home. This is a really good way to lose a lot of money and that's why AIG went bankrupt and had to be bailed out by the United States treasury. With Credit Default Swaps, you figure out the risk of something, which we call “an underline”. In the crisis, it had the acronym “Collateralized Debt Obligations” or CDOs. These things were 80% of the typical CDO, and it was raided Triple A even though the average down grade on them during the crisis was 20 credit grades. Triple A is the best you can get and this stuff was really much closer to the phrase the industry used - “toxic waste”. Single C means it's on the doorstep of default or already there, and no normal person should be buying that kind of stuff. It is way below the cutoff line for what are called “junk bots”.

So you're saying, "I'm going to protect you from having any loss by selling you this CDS policy, Credit Defaults Swap. If it goes bad, something akin to insurance, I, AIG, promise I will pay you for the loss in value on that Triple A CDO." These Triple A CDOs, depending on the time period, often lost 60% or more of their market value. That'd be a really big hit.

Here's the remarkable thing: when you sell the supposed insurance - you're AIG - you don't have to put aside any, I mean zero reserves for losses, even though you're taking on the risk of that loss. You pay the guy in charge a bonus immediately, when he sells the CDS "protection." Now that means he's going to walk away with an immense amount of money and he maximizes the amount of money that he gets, his bonus, by selling more. The way you sell a whole lot more of something in finance is to underprice, which brings you back to that concept you asked me about - actuarial.

In other words, you charge a whole lot less than the actual risks. People flood into AIG's doors to buy this underpriced CDS protection, because AIG had a Triple A for a while during all of this. They must be safe.

AIG, for a time, actually lost its rating. Eventually, it had a Triple A rating, so what could go wrong, right? You are buying something, the underline CDO that was Triple A, and you belted and suspended it with this complete unconditional protection against loss from AIG, also Triple A. The guy selling it knows that the more he underprices it, the richer he becomes. AIG can't even figure it out because it's supposedly financially illiterate. That maybe it should not have to pay people bonuses until 10 years later, nor does it have any claw-back provision to get the money back if it turns out the guy who's running this kind of deal.

The guy running their CDS unit actually made more money than their CEO. AIG CEO was very, highly compensated, so he walked away very rich and the people of the United States got to bail out AIG, which in turn bailed out.

Douglas Goldstein: Although AIG did eventually pay them back, right?

William Black: Sort of. Would you do a bail-out of AIG of your private sector?

Douglas Goldstein: I don't think the public sector should be involved in any of this, quite frankly.

William Black: That's the point, right?

What Should Be The Government's Role In Risk?

Douglas Goldstein: These are risks that the government shouldn't be involved in, and the people who want to risk their money should feel free to blow it however they want. I don't think the government should be there cleaning up the mess because it's complicated enough for the professionals who don't understand it. It's also complicated for government regulators who can't control it. Without having transparency and understanding, the government really shouldn't be involved with taxpayers' money. In the end, I understood that the AIG deal, which was terrible in the very end, did pay back the money that they got from the U.S. government.

William Black: Yes, but this is the finance show. That doesn't cut it, right?

Douglas Goldstein: That in the end it worked out okay.

William Black: Yes, that's not how we do things in finance.

Douglas Goldstein: Sure.

William Black: AIG was the largest insurance company in the world, and so a whole lot of things were going to blow up. This is in the context of having the largest run in world history occur within three hours of the bankruptcy filing of Lehman Brothers. That scandal took down every money market mutual fund in America within about three days with a run totaling over a hundred billion dollars. This is a run, not by you and me and the people listening, but by massive corporations and in particular banks.

The Fed and Treasury were wondering whether they should bail out AIG or whether they were going to have this whole row of dominoes take the world, not just the United States, down into something far worse than the Great Depression.

You tell me what you would have actually done as Treasury secretary. I tell you, the Washington phrase, "Where you sit is where you stand," has a lot of truth.

Douglas Goldstein: I know that there's a lot of truth in what you're saying. Unfortunately, we're just about out of time now. In the last few seconds, tell us how people can follow you and follow your work.

William Black: They can see the TED Talk, talking about the crisis. They can visit New Economic Perspectives, which is the blog of the University Missouri Kansas City Economic Department. The blog also has a lot of stuff on elite fraud and corruption.

Douglas Goldstein: Okay, we will put links to that at the show notes of today's show, as well as to your book at the show notes today at GoldsteinonGelt.com. Bill Black, thanks so much for your time.

William Black: Thank you.