The Bank Job: Part II

In the comments to The Bank Job, which by the way contains our first derivation (thanks Guy!), Dan was wondering, given the fractional reserve system, how do banks handle bank runs. He quite reasonably assumed that they took out insurance which is the smart way to handle high cost, low probability events. The following is my attempt to explain my understanding of the situation.

Your reasoning is quite correct. Insurance against this sort of thing would be prudent, and as long as you were talking about protecting against runs on individual banks, as opposed to the whole system, it could probably be written profitably. But your thinking suffers from a malady with which I am myself often afflicted. I haven’t quite nailed it down, but it’s something like the assumption, “if this is so obviously the way the world ought to work, it must be that way.”

Sadly, its not.

Banks have come up with a much better solution, from their point of view. In the event that they need more cash then they have, they have the Federal Reserve print it. It essentially comes out of all of our pockets through inflation. Now I’m about three books ahead of you in understanding this mess, so I’m no expert either, but here is roughly how it works. If a particular bank is in need of cash, due to withdrawals, they simply borrow it from other banks. If other banks don’t have it to spare, there is one Meta-bank. That bank is the Federal Reserve, which is tasked with being the lender of last resort. Since the FED, simply prints money it can lend all the banks need, completing the counterfeiting cycle by finally printing the cash we’ve all been pretending existed. Of course, as soon as people calm back down, and put their money back in the bank, this new money is considered excess reserves, promptly lent out, and ends up itself multiplied by ten.

Now in the event that a bank is technically bankrupt, that is its assets are less then its liabilities, as opposed to simply being short cash on hand, then it is taken over by the Federal Deposit Insurance Corporation or FDIC (a bank would be technically bankrupt if, for e.g., half the loans went bad, so now there are not enough loans supporting deposits). “A ha! So there is insurance.”

Well sort of. It works a lot like an insurance company, but is not insurance. Banks pay a premium of sorts, that is a fixed percentage of their deposit base. The difference between this and insurance is in the utter lack of even an attempt to avoid moral hazard. As Apos, could explain better than I, its important in any insurance contract that the insured retains some motivation to avoid the catastrophe being insured. For example with car insurance, not only would I hate to get in an accident, but I don’t even want to risk a speeding ticket, for fear that my premium will go through the roof. But with premiums depending only on the size of deposits, banks are encouraged to push risk to the limit to get their moneys worth. It would be like if my car insurance only depended on what the car cost… lets just stay I’d get places faster! If the FDIC insurance were instead allowed to be replaced with an insurance industry trying to earn a profit, risk in banking would be largely reduced, since lower risk would be reflected in higher profits, from lower premiums.

There is another important sense in which the FDIC is different from an insurance company. When the “premiums” are paid to the FDIC, they are deposited in the FDIC’s account at the Treasury. The government then spends the money and replaces it the IOU’s. I know I know sounds crazy! But here is it straight from the former FDIC Chairman William Isaac:

When I became Chairman of the FDIC in 1981, the FDIC’s financial statement showed a balance at the U.S. Treasury of some $11 billion. I decided it would be a real treat to see all of that money, so I placed a call to Treasury Secretary Don Regan:

Isaac: Don, I’d like to come over to look at the money.
Regan: What money?
Isaac: You know ... the $11 billion the FDIC has in the vault at Treasury.
Regan: Uh, well you see Bill, ah, that’s a bit of a problem.
Isaac: I know you’re busy. I don’t need to do it right away.
Regan: Well ... it’s not a question of timing ... I don’t know quite how to put this, but we don’t have the money.
Isaac: Right ... ha ha.
Regan: No, really. The banks have been paying money to the FDIC, the FDIC has been turning the money over to the Treasury, and the Treasury has been spending it on missiles, school lunches, water projects, and the like. The money's gone.
Isaac: But it says right here on this financial statement that we have over $11 billion at the Treasury.
Regan: In a sense, you do. You see, we owe that money to the FDIC, and we pay interest on it.
Isaac: I know this might sound pretty far-fetched, but what would happen if we should need a few billion to handle a bank failure?
Regan: That’s easy — we’d go right out and borrow it. You’d have the money in no time ... same day service most days.
Isaac: Let me see if I’ve got this straight. The money the banks thought they were storing up for the past half century — sort of saving it for a rainy day — is gone. If a storm begins brewing and we need the money, Treasury will have to borrow it. Is that about it?
Regan: Yep.
Isaac: Just one more thing, while I’ve got you. Why do we bother pretending there’s a fund?
Regan: I’m sorry, Bill, but the President’s on the other line. I’ll have to get back to you on that.

Once upon a time, there was indeed a segregated FDIC fund. During the Johnson Administration, someone had the bright idea to put the FDIC into the federal budget as a way to reduce the deficit. This was in the good old days when the FDIC always produced a surplus. Putting the FDIC on budget reduced the deficits being created by spending on the Great Society programs in tandem with the war in Vietnam.

The reality is that there is no FDIC fund. Anything the FDIC lays out to handle a bank failure must be borrowed by the Treasury, which adds to the federal deficit. The total amount of the current outlay is charged against the federal budget even if recoveries are expected in the future, as problem assets are collected by the FDIC. That’s the case whether the FDIC’s nominal balance at the Treasury is positive or negative.

(The above text is an excerpt from a document that used to be here, but has apparently been removed. One wonders if he was asked to remove it. A more charitable possibility is he just couldn't handle all the traffic. Luckily it was so funny I had saved it.)

So at the end of the day the FDIC also gets its funds from the Federal Reserve, or in other words from the rest of us through inflation.

Thoughts on Grad School

This is too good (true) to be missed: http://blog.penelopetrunk.com/2009/02/03/dont-try-to-dodge-the-recession-with-grad-school/#more-2071.

Part 2: http://philip.greenspun.com/careers/women-in-science

Interpreting the Second Amendment

My first post will be on an interesting linguistic interpretation issue that is having national reprecussions here in the U.S. This post will be summarizing issues with the second amendment that were brought up by Prof. Baron et. al. See the references below for more information.

The second amendment to the U.S. Constitution states:

A well regulated Militia, being necessary to the security of a free State, the right of the people to keep and bear Arms, shall not be infringed.

A modern English user will find the phrasing of this amendment quite clunky; in particular it seems like the phrase before the second comma (“A well regulated .... State,”) and after the comma (“, the right of the people... “) are two independent phrases that are just jammed together. For ease of discussion, let L1 refer to the first part and L2 refer to the second part.

Clearly the framers of the constitution were not English neophytes, thus this is not merely an “error” -- so what does it mean? We can view this at the grammatical and semantic level. From the grammatical point of view, L1 and L2 are grammatical independent. The question that mainly concerns us is whether the two phrases are semantically interdependent -- does the meaning of L1 affect the meaning of L2? There are two cases:

1) Semantically independent: L1 has no bearing on L2, it is merely “constitutional throat clearing” [Baron]. From this interpretation, we find that the 2nd amendment says that everyone should have the right to own a gun.
2) Semantically dependent: L1 impacts L2 in a if-then or cause-effect relationship. From this interpretation, it can be argued that the 2nd amendment only meant for state militia to have arms, and not everyone to have arms.

Clearly this grammatical difference has great import on national law! How do we decide which of these interpretations is correct? One way to do this is to try to understand the English of the founders. Prof. Baron does a great job of this in this article (from which most of this material is drawn).

To summarize some of his argument, English textbooks at the time discussed what is called the “absolute construction”, in which two phrases are grammatically independent and placed in a sentence. In particular he says:

“ In addition, grammarians from the 18th century down to the present affirm that the absolute construction invariable establishes a semantic dependence in a sentence.” [Baron]

I refer the reader to the post by Prof. Baron for more in depth examples.

The opposing argument, from an amicus brief filed by the opposing side, argues that L1 is merely providing context, but is not the *only* reason for protecting gun ownership. A great example from the brief is a passage in Article 3 of the Northwest Ordinance (written about the same time as the amendments):

“Religion, morality, and knowledge, being necessary to good government and the happiness of mankind, schools and the means of education shall forever be encouraged.“

Does this mean that schools should only be used for teaching religion, morality and knowledge?

Clearly, resolving this problem is not something that can be done easily. In this particular case, the Supreme Court viewed L1 as basically “constitutional throat clearing” [Baron] which does not affect the “meat” of the amendment.


It seems clear that the unambiguous interpretation of laws is, if not impossible, highly improbable. Readers add their own interpretations and biases, and we must recognize that and provide a means for the continual reinterpretation of historical documents.

As a side note, I think this case argues for the political need for research in liberal arts and sciences. When we interpret legal documents it is not just the words we must understand, but rather the context in which they were written. Language is a powerful tool, yet it is inherently a convention -- meaning of words and phrases are agreed upon by the users of language; and thus language can, and does, change as society changes. In order to understand a legal document, one must also understand the writers and the society they lived in.

And finally, take a look at the post by Prof. Baron for a much more in depth look at this issue: The Web of Language

Moral Hazard: The Gift That Keeps On Giving

I love the concept of karma - the idea that you do an action and the consequence depends on your action. It is just so clean. Systems that employ karma as the guiding principle for how they operate work so well! We do use this idea in various aspects of our society: We create laws such that people who harm others are punished. People who make productive contributions in their job can look forward to better earnings. People who drive carefully get better auto insurance rates.

However, when it comes to the karmic balance of our economy... well I’m not sure it exits anymore. The recent bailouts have tossed out this relationship of action and its consequences. The bailouts repulse me in many ways: first of all the govt is taking ownership in private enterprises, secondly the companies that are being bailed out have very little probability of producing any returns greater than or equal to zero, thirdly the govt doesn’t have the money!

As much as these reasons upset me, the one thing that scares me is the amount of moral hazard* now prevalent in our economy. The idea that if you make bad decisions you will suffer for it, is no longer true! Because of the bailouts, especially of the auto industry, we have removed karma as our guiding principle. What incentives do people or companies have now to manage their risk and to make good decisions? We have created a system that allows for companies to make terrible decisions without them worrying about the consequences. Rather, we have created a system where the consequences of actions have changed, and incentives are altered.

Suppose you have a situation where two events are possible. You can make a lot of money say $X with 60% probability and you can loose a lot of money say –$X with a 40% probability. Suppose, now, the situation has changed (as in the case of the bailouts). The probabilities and the amounts are the same, but what you will experience is changed. Instead of experiencing –$X profit you will end up with $0 and the government as your new owner. How will this influence your decisions?

I am not claiming that in all situations and all companies will make more risky decisions because they might feel like the government will bail them out. In depends on how –$X relates to ‘$0 and the government as the new owner’. Maybe having the government as your new owner is worse. If all other companies in your industry are functioning well and don’t need to be bailed out, but you do, then maybe it is far worse to have the government as your owner. But if all other companies in your industry are being bailout out... what kind of decisions are you going to make?

Since I am an Actuary, I love making predictions based on trends. So, here is my prediction: Many more companies will make bad decisions based on their new found security of the bailouts (at least in the short term future). Of course these companies will probably make rational decisions based on their risk analysis, but people will see them as being greedy and unreliable. And greed is bad right? So maybe we will venture off again on our quest to find the magic pill to get rid of it. And reliable? I wonder why companies don’t like to make decisions that will be similar to suicide, even though they would be doing it for the good of society. Oh well, atleast it will give us some ammunition in our fight against "Corporate America". And THIS can most definitely help the Democrats to usher in a new era of socialism.


*Moral hazard is the change in the behavior of people and organizations when their share of loss is reduced.

Adventures in Photon Land or Massive Communication Gap

Ok it’s time for a light-hearted anecdote (but it is still faithful to VERITAS).

My lab notebook is filled with sighs (“Oh God, why me ??”), curses (*$%& you too, detector! [sorry mom, but trust me it’s appropriate !] ) and monologues to my future self (“Get out here while you are still sane”). Of course there is the requisite amount of bad data, empty pages, and specifications of equipment that never meet specs, but these are for another post. Let’s go back now to that part about me-talking-to-my-future self. The most recent of these conversations started about two years ago. My past self had written down very clearly “Dearest Radzie, please don’t ever touch the allignment laser – it’s a bitch. She will not bother you, if you don’t bother her”. For those of you who don’t know about my experiment (which is everyone but me), the alignment laser is a bright red laser used to correctly position the million optics (lenses, prisms and such) in my experiment, because I can’t see the actual photons that traverse these dangerous terrain. Simply put, I use the alignment laser to visualize my photons’ adventures. Remember that this note was about two years ago. Of course 3 months after I had written that, I promptly removed(!!) the alignment laser (I hope my advisor is not reading this blog – he’d know what an idiot I am and that I write to myself, which somehow seems worse than talking to yourself even though it is just another form of communication – hmmm. Note to future self: think about why this is so). Why did I remove the alignment laser? Because it was in my way- duh! So first instance of future self not listening to past self (bad bad future-self). Let’s start keeping scores: Future Self = -1. Past Self = +1. Yes, I penalize people for not listening to me and reward those who do. Roughly a day after I removed the laser, my then-future-self but now-past-self wrote another note “ Yeah gurl, remember that note about the alignment laser – yeah very very true. Don’t ever touch that again. TRUST ME - Its really a bitch!”. Now this time, my past-self did one step better – she tried to etch into my memory the pain involved in realigning the alignment laser. She didn’t do a very good job. I promptly took it down three months later and had to tearfully realign it two weeks after that. Score: Future Self =-2. Past Self = +2. This kept happening. Fast forward to now: you’ll know what transpired in between from the latest scores - Future Self =-5 and Past Self = +5. Notes to future self are now covered in curse words, some in ALL-CAPS and some were just empty pages (an example of my past-self trying the silent treatment on the future-self – “I don’t even wanna talk to you anymore”). The last of these misadventures happened yesterday. As I was wondering how I could improve communications between these different time zones, I finally figured out why we (i.e., my past self and my future self) have such a massive communication gap. No - its not really a memory thing – I always remember the warnings and have slight forebodings of the pain involved. It is not a language problem either - I have known and will know the meaning of “DON’T”. The vile vicious virulent villain is the middle man – the present self! AKA: yours truly, ME (oh man, it sucks to be the bad guy)! The minute the thought to move the alignment laser enters my head, I start playing with the laser’s knobs (physicists like to touch knobs – to see how sensitive they are [that’s what she said!]). Of course, when things are aligned and you are turning knobs just a wee-bit, everything seems under control. The middle (wo)man gets confident. I start thinking, “oh my past self aligned optics like a little girl (the expressions somehow seems less punchy than throwing-like-a-girl, or hitting-like-a-girl. Nevertheless, it is meant to communicate the same sort of disdain). This must have looked hard to her. Haha! Look at me now – I am the queen of optics…and this is my humble subject. My wish is its command”. Then of course in my vain red-queenly manner I proceed to “chop off the optic’s head” and almost immediately conjure to disappear from the scene leaving nothing behind but a I-told-you-so past self and a very disappointed what-have-I-done future self. The problem is ME. Or YOU - if the me we are talking about is you.

We’ll turn to the moral of the story (the Duchess would have wanted this anyways) to explain the last line: turns out neuropsychology says that this miscommunication is a well known phenomenon. We all work very hard, sacrifice our youth building something that we think we would value when we turn older. Be it pulling all-nighters in college, becoming stressed-out lawyers and consultants or renouncing the castle to elope with a knight (OMG, that is so 2008!) When you get there – you aren’t any happier! Why? Because the future self isn’t really your past self. You have changed. Turns out the best way to judge whether you will be happy in a particular career, lifestyle, country is to poll multiple people doing what you want to do in the future. The chances are you will side with the majority when you get there. Only now – you can save yourself from the pain involved in getting there - if it turns out that there is not the never-never-land you were hoping for! The key is not to ask questions like “oh, are you happy you did this?”, because most people cannot be objective about their life-changing decisions, but questions about their day-to-day life and then trying to picture yourself in their shoes. I know what you are thinking “but I am not them. I am different. Smarter, perhaps prettier, but definitely better”. That’s also a known phenomenon. It’s called the middle man - you or, in-my-case, me!

Ps: Now you probably realize why I am taking so long to do my PhD. Not only do I keep doing the same things over and over again (“hey, that’s how you become an expert !”), but there are voices in my head – all competing for attention and shown in different colors. That or I have severe ADD. I don’t know – lets go ride bikes.

PPs: This post is dedicated to Alice (the one in wonderland) and Lewis Carroll. I just finished rereading it. Note to future self (both mine and yours): “It’s brilliant . Reread it in about 5 years!” :).

The Bank-Job: A real-life thriller

This is one of those things that you'd like to assume is an urban legend; one of those little facts about the world that as the potential to totally blow your mind. I haven't been this astounded that the world works this way since I found out peoples wages aren't indexed to inflation. This is the story of how banks, quite legally, counterfeit money and charge you interest on it. Hey, it’s a great job if you can get it…

Imagine a small town out west somewhere that has been living peacefully without a bank all these years. When the bank comes to town they are all happy to have a place that will protect there money AND pay them to do it! Life is hard out here and they’re a little suspicious of a free lunch, but after word gets out that you don’t have to sit through a sermon everyone piles in and is happy to be rid of Jimbob. (Jimbob owns the gun shop and used to charge a small rent to let people keep their savings in his safe.)

Let’s see what happens to the money after the bank gets a hold of it. We’ll follow the $100 that Tom deposits. Well, Tom comes in with his money and they assure him it will be safe in their big fancy vault. They show him the 10 inch thick doors and the absurdly large wheel you use to open the door. Then they tell him he can come and get his money whenever he wants, or he could just spend it with these here checks. Tom likes the sound of that and hands over his hard earned dough. As soon as Tom turns around the bank carefully places $10 of his money in the vault, and throws the other $90 in the “For Loan” pile. You see banks operate under what they call a “Fractional Reserve System”, as Jimmy Stewart famously explained in “It’s a Wonderful Life”, the bank keeps some fraction of the deposits on hand incase you as for it, in this case 10%, and loans the rest out.






Now the bank makes a $90 loan to little Billy and charges him 8% interest. They give 1% to Tom and keep the rest for all their hard work right? Well, yes, but what Jimmy didn’t explain is what the late, great Paul Harvey would call The Rest of the Story:

Now Billy spends the $90 of a new bike for his paper route. Then Sam, who owns the bike shop, deposits it in his new fangled account. At which point the banker carefully puts $9 in the vault and throws the other 81 in the “For Loan” pile. Did you catch what just happened there?








Now, where before the there was 100 dollars, there is promise of 190 dollars! They claim both Tom and Sam can come get their money whenever they want and the bank is earning 8% interest in 171 dollars! Of course that 81 dollar loan is spent as well and finds its way back to the bank who keeps a portion of it in the safe and loans the rest out at 8%. This process goes on with the money always finding its way back to the bank to be re-loaned. After awhile the situation might look like this:






















And this process continues until eventually, inevitably, Toms entire real $100 is consumed as “reserves” to support $1000 in deposits and $900 in loans on which the bank is earning 8% interest. $900 x 8% = $72. 1% of this they pay to depositors, leaving $63 for the bank! That’s a 63% return for all the money the town puts in the bank!

More importantly there is now 1000 dollars in deposits that the bank claims you can come and get whenever you want. And the problem isn’t just that the money is loaned out “to support your community” as is claimed in “It’s a Wonderful Life”, it’s that 900, of the 1000 dollars does not even exist!

Talk about false advertising! Is there any other business allowed to exist, that is so premised upon a lie? It is an impossibility that your money can be both in your account at your disposal, AND loaned to someone else. It’s a scheme that would make Ponzi blush, but like all good marks were blinded by the promise of something for nothing.

An ode to PERSONAL RESPONSIBILITY

Inspired (read outraged) by a heated discussion on how "we" need to remove coke and candy dispensing vending machines and ban (sic!) people from bringing cookies to distribute at work, all for the "goodness" of "everybody's" health, I cried out words like "individualism", "America'" and "self-control". "Most advanced nations in Europe are this way - they have removed vending machines", came the reply. I realized the winds are changing. As I feebly said, " are you proposing to ban coke as well, coke - only one of the greatest company ever ?", an image of a heroine walking away into the dusk flashed in my head. I barely got a glimpse of her - she was handsome, she held her face high and walked tall. She was looking back as she slipped away - her hair flowing, almost blending with her fleeting chiffons. It hit me then that no one knows her anymore, no one wants her any more - SHE: my subconscious rendering of PERSONAL RESPONSIBILITY was "high-maintenance". And all I wanted to do was to at the least bid her a proper adieu:

Ah there she goes
a beauty so quaint
a stride so proud
now a mirage quite faint

Her words thundered with strength
her cadence echoed of courage
A brave maiden once she
but now feeble with age

In spring she stood alone
towering over masses
not afraid to reach above
or be burned to ashes

They envied her stature
her glance her stance her goal
but what they wanted most
was her very soul

Quiet was the day
hardly a wind there was
but there they came in broad daylight
to smother her for all she was

Her breath was pure fire
her hair pure rage
oh what a fight she put up
A honor-drenched barrage

A storm she conquered
but then came a waft she could barely feel
little-by-little they wore her
her fate this wind would seal

Now she walks away
her time gone she says
with a glimmer of past glory
and an aura of heroic ways


ps: I have never written a poem (not a decent one anyways) so it surprised the hell out of me when these words came gushing out in about 10 minutes after the discussion. Talk about mundane inspirations and sensitive subjects ! This can't be healthy - I am a physicist - I am not supposed to be creative. Comments welcome !!

Worst since the Great Depression!

Some times people use words to fool us. (Gasp!!) I know, I know, old news right. How about this one: Sometimes people use true statements to lie to us. One form of this is making a comparison between two things that are on a vastly different scale, to imply that they are on the same scale. Like saying Bill gates is the richest guy since John D Rockefeller who was the richest person EVER! It might be technically true, but old John D. could buy Bill Gates about 6 or 7 times over. In fact to equal the inflation adjust fortune of John D. Rockefeller, you’d have to add together the fortunes of the 13 richest people in America today.

You see the statement is technically true, but it doesn’t really convey the proper scale. The form of this linguistic abuse that’s been bothering me most it the constant refrain by politicians and talking heads that “it hasn't been this bad since the great depression." By many measures it’s a true statement, but it conveys a lie. Our current economic situation is not even in the same league as the great depression. Have you seen any breadlines?

The graph below is courtesy of Barry Ritholtz at The Big Picture. It’s a great blog that every now and again features a graph that really lives up to its namesake.

I won’t even comment on the graph. It speaks for itself. Next time you hear this statement, ask yourself what they are really trying to convince you of.

A sudden, terrifying realization swept over me this morning!

A prime virtue of Liberty is that by not interfering in peoples triumphs and failures, capital naturally flows to those who know how to use it. With each bad decision people become less able to affect the rest of us.

In our current system the Bailout short-circuits this mechanism. If you cross some unseen and undefined line and become too big (or too well connected) to fail, you are paid for your losses by the rest of us. So now there are two classes of people. In one group, the mega-well-connected, you keep your gains but pass off your losses. In another, the rest of us, you keep you gains, and your losses, and their losses.

Bailout is the evil bastard child of Capitalism and Socialism that is far worse, and unjust, then both. It is far worse than any tax hike or universal healthcare option and must be opposed as such. Bailout’s true power to destroy comes from its tendency to dress up in its father cloths. Because this bastard child is allowed to present itself in Capitalism’s name, the only “rational” choice left is Socialism.

This is a threat to your liberty and must be opposed. It will not be enough to complain to your friends and relatives. Something must be done. It will not be enough to write your congressman, because your congressman has been bought for a pittance. The list of campaign contributors before bailout (here and here) is -- Surprise! -- a veritable who’s who of bailout recipients! After Bailout, these very companies are dealing a percentage of the handout back to the very congressmen who gave it to them in the first place!

So I urge you to do two things: First, write you Congressman and Senators. Let them know that you are not happy with the bailout not just because it is inherently unjust, but because you see the bigger implications mentioned above. Also let them know that you know who really butters their bread by looking up their campaign contributions here. Second, I don’t think the above will be enough to make sure this never happens again, so please comment below on your thoughts on how we as citizens can resist.

In closing, allow me to note the haunting similarities between our situation and Arthurian legend. We capitalists stand like Arthur ready to walk down the length of the spear to kill this monster; this child that was created through deception by a vengeful mother for the express purpose of ridding the world of the father. Like Mordred this child will wipe its father from this earth for a thousand years if it’s not put down early and without mercy. Let us not walk down that spear. Let us lift our head from the shortsightedness of battle and recognize this evil for what it is before it is too late.