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- Illicit Interest Arbitrage -
-The Second Greatest Story Ever Told, Chapters 10 - 11 -
- The Discount Rate/Interest Rate Spread -
- Borrowing Short to Lend Long -
- Anticipation and Accommodation Bills
Illicit Interest
Arbitrage
There was nothing sinister about the appearance of
the Discount House, as a precursor of the bank. Nor was there anything
suspicious about the bill of the goldsmith, as a precursor of the bank note. Fraud
came later, as the story of the bill of exchange unfolded, and illicit
interest arbitrage and the practice of borrowing short to lend long appeared
and spread.
The villain of the piece is the Acceptance House, as
we shall see, another (and this time quite sinister) precursor of the bank. The
Acceptance House conspired with impostors in order to put fictitious bills of
exchange into circulation. As long as these fictitious bills remained in the
public domain, with due diligence, the fraud could be exposed. But soon
enough some banks joined the conspiracy and started sheltering the fictitious
bills in their portfolio of assets. For the Acceptance House and the
conspiring banks this was a lucrative business. It allowed them to pocket the
spread between the higher interest rate and the lower discount rate, to which
they were not entitled. They wanted to profit but without taking risks. Not
only did they take no risks, neither did they provide a service to society that
might have justified the profit. The business of selling fictitious bills
against buying bonds is called illicit interest arbitrage. It means
borrowing funds in the bill market at the lower discount rate and peddle them
in the bond market at the higher interest rate. The arbitrage is illicit, as
we shall see it in full details later. It is a case of extortion. It is
fraudulent as it is involves misrepresentation and non-disclosure. The scheme
of illicit interest arbitrage would collapse if transparence
of business transaction were maintained and safeguarded. Now I return to The
Second Greatest Story Ever Told.
Chapter
Ten
in which the gentle reader learns why the miller and the baker were
blacklisted at the Discount House
One day the manager of the Discount House
noticed that a bid/asked spread appeared in the trading of the
miller-on-baker bills. Buyers consistently bid a lower price than that asked
by the sellers of these bills. Normally, there was no spread in bill trading.
A bill with two good signatures could be bought and sold back-to-back, often
at the same price. This is explained by the fact that the bill was an
appreciating asset. Its value increased daily as the date of maturity
approached. A bid/asked spread, whenever it appeared, suggested trouble. It
indicated that there were too many of that particular bill around,
discouraging buyers.
The manager of the Discount House suspended
the trading of the miller-on-baker bills, waiting for the situation to clear
itself. Soon it turned out that the miller had conspired with the baker in
putting bills into circulation supposedly representing flour on the move to
the bread-consuming public. In fact, however, there was no flour and there
was no movement. There was only grain sitting in the miller's bins, held back
by the miller in hope for an increase in the grain price. The miller and the
baker were speculating that the poor harvest could create a shortage causing
higher prices in the grain market, from which they wanted to benefit. They
were trying to finance their speculation by drawing miller-on-baker bills
representing the grain withheld from consumption, sitting in the miller's
bins.
The speculation ended in a fiasco. The
miller's and baker's expectation of much higher grain prices didn't
materialize. They 'rolled over' their credit, that is, they paid the maturing
bill by drawing another on the same grain holdings. This was a very serious
violation of the statutes of the bill market, because the limitation of 91
days on the maturity of bills was absolute. Under no circumstances must the
bill on the same goods be redrawn.
In the meantime, the bill market grew less
accommodating. As the fraudulent miller-on-baker bills were in addition to
the regular ones supporting the supply of the consumer with bread (that is,
on merchandise that did indeed move) a bid/asked spread appeared. When the
Discount House suspended trading the miller-on-baker bills, the conspirators
were squeezed. In order to extricate themselves from their situation they
threw their grain on the market. The forced sale of such an abnormal quantity
of grain temporarily depressed the price. The conspirators wound up their
ill-fated speculation with a huge loss. In the end, they defaulted on some of
their bills at maturity.
Default by merchants on their bills was
exceedingly rare. Even loss of cargo at sea was no occasion for default. A
bill drawn on merchandise in the bottom of vessels had to be accompanied by
insurance certificates showing that the merchandise at sea had been insured
to the extent of the full face value of the bill. In case of loss at sea the
insurer would pay the bill at maturity.
If a merchant defaulted for reasons of
personal financial tangles, then he could never again hope to discount a bill
in his life. Nor could his sons. Their name was to remain on the blacklist
for several generations. Being cut off from the bill market meant that the
lifeline of the merchant was severed, as it were, his trading capital was
confiscated. The merchant found himself out of business. This was exactly the
fate awaiting the miller and his accomplice, the baker.
Speculation in
Agricultural Commodities
It is important to understand that there is nothing
wrong per se with speculating in agricultural commodities. As long as
the speculator is using his own funds, or
legitimately borrowed money for this purpose, no one has the right to
criticize him. But the miller and the baker in our story tried to use the
bill market for the purpose of financing speculative stores. This is
definitely wrong. The bill market is strictly for merchandise that moves,
moreover, move it must fast enough to reach the cash-paying consumer in less
than 91 days. It is fraudulent to represent that the merchandise held back
for speculative purposes moves since, in fact, its movement has just been
arrested.
Most tradesmen are sensible people realizing that,
while speculation in agricultural commodities is a legitimate business, it
must be financed properly. The speculator has no right to shift his risks
onto the shoulder of society. For this is exactly what is involved in
drawing bills on merchandise sitting in speculative stores waiting for a
price-rise. The bill market, as we well-know, is a clearing system. It
can only work if each bill faithfully represents the underlying transaction,
and if the merchandise is moving as specified on the face of the bill. Accordingly,
each bill is scrutinized by the market not only in regards of the credit
standing of the drawer and the acceptor, and every subsequent endorser, but
also in regards of the transaction represented on its face. Dubious bills, or
bills which appear to be over-abundant, are rejected.
The miller and the baker did not try to defraud any
particular individual. In drawing bills under false pretenses
they tried to defraud the general public. They pretended that the underlying
merchandise was moving and would reach the ultimate consumer in 91 days when,
in fact, they were responsible for arresting the flow of goods. In doing so
they were not merely hoping for speculative profits. They were also trying to
shift the risks from their shoulders to the public at large. They wanted to
pocket the difference between the higher interest rate and the lower discount
rate. They would justify this as profits for shouldering risks. But they passed
their risks on to the public. It is clear that they were not entitled to
those profits.
The conspiracy of the miller and baker is an example
of what we shall call illicit interest arbitrage. More generally, the term
refers to arbitrage from the bill to the bond market. As interest rates are
generally higher than the discount rate, the temptation is constantly present
for tradesmen with ready access to the bill market to use bills for
illegitimate purposes, such as selling them to invest the proceeds in bonds. Illicit
interest arbitrage is a crime against the general public, the same as the
crime of forging public documents. Indeed, the bill of exchange is a public
document, and false statements on its face must be treated as fraud. (Note
that arbitrage in the opposite direction, from the
bond to the bill market is not illegitimate. Such action is profitable in the
rare and abnormal case when interest rates are pushed below the discount
rate. For this reason, it is called 'natural interest arbitrage'.)
The market tends to expose illicit interest
arbitrage, as it exposed the conspiracy of the miller and the baker. But in
so far as the conspiracy remains unexposed, the public at large is victimized
in the form of higher prices.
Anticipation
Bills
Chapter
Eleven
in which the gentle reader learns how the miller and the baker went on the
warpath to strike back by establishing the Acceptance House.
Many years have gone by, but they couldn't
remove the bitterness of the miller and the baker over their humiliating
failure. They felt that in being blacklisted at the Discount House they have
been unjustly victimized. They thought that they were the 'misunderstood
innovators'. They were plotting to take a revenge. Their
opportunity came when the manager of the Discount House died, leaving his
business to the elder of his two sons. The other son, known by the nickname
Prodigal, did not inherit any part of his father's business nor, apparently,
his acumen and integrity. The miller and the baker moved to befriend him.
"Your inheritance is more valuable than
you realize, if you had eyes to see your fortune", the baker said to
Prodigal. "Your name is spelled in gold. Let me show you how you can pan
it. You should start a business of your own." But Prodigal pleaded
poverty; he has already spent his patrimony. He could not put up the capital.
"Never mind capital", retorted the miller. "We shall teach you
a new creative way to start a business with no capital."
The young man may have been prodigal but he
was not stupid. "Why don't you start your own business if you know how
to do it without capital?" he asked. The baker explained, sotto voce,
that you need a name with high recognition value to do that. Prodigal was the
scion of a merchant family that has been in business for over two hundred
years, the last fifty of which in discounting. It had an impeccable name and
enjoyed the respect and admiration of everybody. "You contribute your
name, and we contribute the expertise", the baker cajoled him. "You
don't even have to work if you don't want to. We give you 50 percent of the
profits. My friend, the miller and I will be satisfied with 25 percent
each."
The offer was too good to turn it down. The
'enterprise' was called the Acceptance House. It would take business turned
down at the Discount House. It would endorse - or to use the resurrected
word, 'accept' - any bill presented to it, provided that two conditions were
met. (1) The bill should have an air of demure respectability in referring to
some goods about to be shipped. For this reason it was called an anticipation
bill. (2) The face value of the bill should be posted as a collateral
security in the form of mortgages on real estate or bonds. The Acceptance
House was entitled to liquidate the collateral in case of a default by the
drawer of the bill, but would return it upon payment of the bill in full at
maturity. In addition, the Acceptance House stood ready to roll over the
credit facility indefinitely upon advance mutual agreement.
Now the operators of the Acceptance House were
in the position to bilk the general public out of its funds by taking
advantage of the positive spread between the interest and discount rates. In
effect, they were selling bills and buying bonds with the proceeds, pocketing
the difference, while taking no risk at all. At any rate, that's what they
thought.
Accommodation
Bills
The essence of the bill of exchange is that salable goods are moving to a place where there is a
ready demand and market for them. The reason for making it payable at a later
date is to allow for shipping and ultimate disposal, including the time
needed for garnering the proceeds of the sale. The act of acceptance makes
the bill of exchange immediately negotiable or convertible into cash through
discounting. The bill had the advantage of 'paying itself'. The goods on
which the bill was drawn, being certain of a market, are
the guarantee to the bill's holder that "he is not holding the
bag" containing nothing. The anticipation bill, promoted by the
Acceptance House, was very different. The underlying goods did not move, and
there was only a vague understanding that they eventually might. The sale of
merchandise to the ultimate cash-paying consumer by the maturity date could
no longer be taken for granted. On the contrary: it was a foregone conclusion
that the anticipation bill would have to be redrawn and redrawn again, at the
end of each 91-day period. That redrawing bills was a dubious practice was
already pointed out by Adam Smith. Even worse was the practice of drawing
accommodation bills. These were bills drawn on fictitious goods shipped to
fictitious vendors. But the impeccable name of the Acceptance House made them
as good as cash, regardless of the fraud involved in
drawing them.
Debauching
Accounting Standards
Banking has grown out of two separate roots: the
business of the goldsmith, and that of the Acceptance House. The latter is
the bad guy. Here is a conspiracy between the borrower and the Acceptance
House with ready access to the bill market. Once the fraudulent anticipation
and accommodation bills are removed from the bill markets and given shelter
in the portfolio of the bank, then whatever
possibility for the detection of the fraud had existed before was lost. The
practice of shortchanging the public could be
perpetuated.
The banks could create something out of nothing only
through the fraud of accepting anticipation and accommodation, disregarding
the fact that these bills were no longer self-liquidating. The banks could
not care less how the borrowers would eventually get the money to repay the
loan. In case of a default the bank would liquidate the collateral and
satisfy itself from the proceeds.
The banks were in fact usurping and monopolizing
social circulating capital. They could get away with it by virtue of the government
patent exempting banks from the rigors of bank examinations and from the
strict application of accounting standards. The banks could carry their
assets at arbitrary values. They said it was their business and nobody
else's.
Before the government exempted the banks from the
provisions of contract law, strict accounting standards had been in force
reflecting the desire to protect the public from the consequences of
conspiracy such as (1) declaring bankruptcy fraudulently (by representing
assets at artificially low values) or, its more common counterpart,
(2) window-dressing the balance sheet fraudulently in an effort to stave off
a run on the bank (by representing assets at artificially high
values). Honest accounting demands that the bank carry assets either at
historical cost or at market value, whichever is lower. The government
patent protecting the banks has resulted in permitting the banks to carry
assets either historical cost or at market value, whichever is higher.
Non-disclosure or misrepresentation of the true state of affairs is, of
course, a crime against the public interest. But the banks were protected
against prosecution by the patent the government has given them.
The profession of chartered accountants and bank examiners
ought to stand guard over the integrity of balance sheets and the quality of
assets of the banking industry. But it has long since departed from this
ideal. Accounting codes and norms have been changed in order to suit the
interest of the government, as opposed to the interest of the public. The
government has become an accomplice in the fraud and a party to the
conspiracy against the public. The government, in betraying its sacred
mission of standing guard over the public interest, is motivated by its
consuming passion to have its own debt monetized through the banking system.
Neither the government, nor the banks, nor the
accounting profession will be able to escape responsibility for compromising
accounting standards and for corrupting the profession of accountants and
bank examiners, when the day of reckoning finally dawns. The present exercise
of a witch-hunt to charge producers with accounting crimes is hypocritical in
the extreme. The government should come clean of its own accounting crimes first.
The Two
Categories of Bank Assets
Illicit interest arbitrage in modern setting
manifests itself through certain practices of commercial banks. Economists
have failed to make a distinction between bank assets representing goods on
offer for sale and others representing goods not on offer for sale
in the markets. This distinction between the two types of bank assets is
fundamental. The value of those of the first category is faithfully reflected
in the balance sheet, as the market is continuously testing these values
against existing and changing marginal utilities. In case of any discrepancy,
correction is instantaneous and automatic. The same, however, is not true of
assets of the second category. Here the balance sheet notoriously overstates
values. These assets are sheltered from the trials and tribulations of the
market place. They are protected against wear and tear due to the ravages of
declining marginal utility, brought about by repeated market test.
For example, a house that is being built for the
housing market by the contractor is on offer for sale, and a bridge-loan
against it is a bank asset of the first category. By contrast, a home equity
loan is a bank asset representing an item, your home, which is not on offer
for sale (you hope) and, therefore, it is a bank asset of the second
category. The seeds of a credit collapse are sowed by the banks themselves in
loading their portfolio with assets of the second category. When the crunch
comes, these assets are thrown on the market simultaneously and
indiscriminately as the banks scramble to regain solvency. The market, which
follows the law of declining marginal utility (rather than the wishful
thinking of over-confident bankers) refuses to
validate the fancy values at which these assets are carried in the balance
sheet. The day of reckoning has dawned. The banks are confronted with the
truth, and they are forced to absorb huge losses.
The practice of carrying assets of the second
category is just another instance of illicit interest arbitrage. Once the
banks usurp control over social circulating capital, they can borrow at the
lower discount rate and peddle these funds at the higher interest rate to
their clients. They can make this practice look legitimate with the
connivance of the bank inspector who is trained to "hear no evil, see no
evil, say no evil". But this activity cannot go on forever. Depositors
who can read balance sheets will move their business from the illiquid bank
(indulging in illicit interest arbitrage to a greater extent) to a more
liquid bank (indulging in the practice to a lesser extent). The depositors'
arbitrage (known in banking circles as 'disintermediation') will squeeze the
illiquid banks. The liquidation that follows spawns the boom-bust cycle. It
may take down sound businesses along with the shaky ones into bankruptcy. This
reveals the most evil aspect of illicit interest arbitrage. Along with the
guilty, the innocent is also made to suffer.
The key to preventing the boom-bust cycle is not to
allow banks to carry assets of the second category in excess of capital
accounts. Bank assets of the first category include gold (as all gold above
ground is deemed to be on offer for sale under a gold standard) as well as
bills of exchange drawn on goods that will be sold to the ultimate
cash-paying consumer in less than 91 days. These bills are the most liquid
earning assets that a bank can have. By contrast, assets in the second
category are not liquid. They include stocks, bonds, mortgages,
finance and treasury bills, or loans collateralized by these. Unlike
self-liquidating bills, they are all subject to great fluctuations in value. In
case of forced liquidation (for example, when a number of illiquid banks are
scrambling to get liquid) all bids for them may be withdrawn, creating a
panic.
But if all banks limited their portfolio to assets
of the first category, then no runs and panics could occur. Even unusually
large cash-withdrawals could be met without forced liquidation of assets. As
one bank experiences cash-withdrawals, another with surplus cash will be
eager to buy the bills of the former. At any rate, more than one-ninetieth of
all banking assets backing sight liabilities is
maturing every day, obviating the need for asset-liquidations. If the
cash-shortage was brought about events outside of the control of the banks,
such as natural disasters (e.g., crop failure, flood or earthquake destroying
property), then the banks can adjust smoothly to the changing circumstances
by discounting fewer bills during the construction period. It is virtually
impossible that all bids for bank assets of the first category be withdrawn
simultaneously. Shortage of cash here always results in a surplus of cash
somewhere else. The latter will then start scrambling for liquid earning
assets such as bills of exchange.
Crime and
Punishment
This is a world of crime and punishment. The crime
of illicit interest arbitrage cannot avoid receiving its just punishment
eventually. It makes the positive spread between the interest and the
discount rate vanish. This undermines not just the
lucrative monopoly of the banks, but also the entire financial system. When
the discount rate catches up with and surpasses the rate of interest, panic
in the credit market will ensue. Bids for bonds are withdrawn. Bond prices
will collapse, and the rate of interest will shoot up. This will render much
of the productive capital of the country submarginal,
causing depression.
Earlier I have quoted an old saying on Lombard Street
that the easiest business in the world is banking, provided that the banker
can grasp the difference between a bill of exchange and a mortgage. If
bankers occasionally flunked this test in the 18th and 19th
century, bankers in the 20th did not even understand what the fuss
is all about. They shrug off the criticism. An asset is an asset is an
asset... Money doesn't stink. It has no quality outside of its quantity. Ghosts
that used to haunt bankers in their sleep, such as assets of dubious quality
in the balance sheet, have been interned for good, thanks to
government-administered safety nets.
However, it is doubtful that governments can legislate business risks and asset quality out of
existence. The qualitative difference between a genuine bill of exchange and
a mortgage cannot be denied (securitization of the latter notwithstanding). The
former is easily negotiable before maturity without bribe or blackmail. At
maturity it is cash by the sale of goods on which it is drawn. No safety net
and no coercion is needed to promote its
circulation. The latter is by no means readily negotiable. Mortgages or loans
on real estate require two expensive and time-consuming processes: surveying
and title search, before they can be transferred. Moreover, the real estate
market, just as the bond market, could get demoralized as a result of the
withdrawal of bids. The market in self-liquidating bills could never seize up
the same way.
The quality of an asset cannot be improved by
burying it deep inside of a bank's balance sheet. Non-disclosure and
misrepresentation can only damage assets. For this reason, illicit interest
arbitrage is even more dangerous when practiced by banks. The conspiracy in
which the Acceptance House engaged was bad enough, but at least the dubious
assets stayed in the public view. The bill market was still a level playing
field, and the Discount House was still acting as an umpire, blowing the
whistle whenever fair play was put in jeopardy. There was a feed-back which
prompted self-correction, in so far as the quality of credit was concerned. No
more. Commercial banks have removed the dubious assets from public view,
sheltering them in their balance sheet. The public is no longer in the
position to scrutinize those assets, and is powerless to prevent further
deterioration in the quality of credit. Bank assets are diluted, and the
self-correcting mechanism of the credit market is short-circuited. The effect
is a cumulative deterioration of bank credit. When credit collapse finally
comes, it will be all the more devastating. Recovery will be more painful and
take longer.
* * *
Small Is
Beautiful after All?
Don Lloyd of Peabody,
Michigan, comments on Mises' position on bank notes of small denomination (re:
Lecture 9, "Small Is Ugly"). He disputes that there is a misprint
on p 494 of The Theory of Money and Credit where Mises
calls for the issuance of bank notes in denominations of one dollar, fifty
dollars, and upwards. In other words, Mises thought
it was admissible to issue bank notes of small denomination, in spite of
objections of English authors finding the issuance of small bank notes
detrimental to the interest of the working classes.
My own interpretation is that Mises
was convinced that in the interest of the preservation of the gold coin
standard he was advocating, and for the protection of the working people who
would be cheated out of their possession of gold coins by small bank notes,
the issuance of such notes should not be authorized. However, if Mises really meant that one dollar bank notes be
circulated under the new gold coin standard he was describing, then he would appear to be condoning the practice of
withholding gold coins from the working classes. I would regret it if it was
true. At any rate, I think more research into the question of Mises' attitude with reference to bank notes of small denomination
should be carried out to clarify this point.
Money and
Morality
One of
the recurring themes of this lecture series is money and morality. Therefore
it was very rewarding for me to receive the following message from Carl Luxem, Jr luxemir@aol.com.
Dear Professor:
I have been reading your lectures at Gold-Eagle.com.
They bring to mind something one of my mentors told me years ago, namely,
that "God designed life so that it does not work without Him, nor
without the order He established for it". Given how far the world has
departed from the economic order you are describing, I expect the coming
reality shock to be quite devastating. Your attempts to warn and educate us
about the evil inherent in the present system are admirable. I have tried to
do the same with some success by viewing the problem from a moral
perspective. I deeply appreciate your work because, as a money manager and a
student of economics, it has been a long time since I have been able to find
anything that makes as much sense as your lectures.
Sincerely, etc.
Carl, I think we are getting through. Just keep up
the good fight.
September 23, 2002
Antal E. Fekete
Professor Emeritus
Memorial University
of Newfoundland
St.John's, CANADA A1C5S7
e-mail: aefekete@hotmail.com
GOLD UNIVERSITY
SUMMER SEMESTER, 2002
Monetary
Economics 101: The Real Bills Doctrine of Adam Smith
Lecture
1: Ayn Rand's Hymn to Money
Lecture 2: Don't Fix the Dollar Price of Gold
Lecture 3: Credit Unions
Lecture 4: The Two Sources of Credit
Lecture 5: The Second Greatest Story Ever
Told (Chapters 1 - 3)
Lecture 6: The Invention of Discounting (Chapters
4 - 6)
Lecture 7: The Mystery of the Discount
Rate (Chapters 7 - 8)
Lecture 8: Bills Drawn on the
Goldsmith (Chapter 9)
Lecture 9: Legal Tender. Bank Notes of Small Denomination
Lecture 10: Revolution of
Quality (Chapter 10)
Lecture 11: Acceptance House (Chapter
11)
Lecture 12: Borrowing Short to Lend
Long (Chapter 12)
Lecture 13: Illicit Interest Arbitrage
FALL SEMESTER, 2002
Monetary
Economics 201: Gold and Interest
Lecture
1: The Nature and Sources of Interest
Lecture 2: The Dichotomy of Income versus Wealth
Lecture 3: The Janus-Face of
Marketability
Lecture 4: The Principle of Capitalizing Incomes
Lecture 5: The Pentagonal Structure of the Capital Market
Lecture 6: The Definition of the Rate of Interest
Lecture 7: The Gold Bond
Lecture 8: The Bond Equation
Lecture 9: The Hexagonal Structure of the Capital Market
Lecture 10: Lessons of Bimetallism
Lecture 11: Aristotle and Check-Kiting
Lecture 12: Bond Speculation
Lecture 13: The Blackhole of Zero
Interest
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