CONFUSED AGAIN II

There's this old joke about the Abbot who sends a young, brilliant novice down into the cellars of the abbey to translate and recopy one of the ancient manuscripts from Aramaic into the more modern Latin. A few days later he is told the novice has been found wailing and screaming and rolling on the stone floor. Rushing to his side he cradles the poor boys head and asks, "My son what is so terrible?"

"The previous translations father. They are all wrong!"

"Dear God, my son, how so?"

"The word is CELEBRATE not CELIBATE!!!!"

In D.C. last week I overheard an interesting discussion that went something like this:


Somewhere in the bowels of the Fed there is a young, bright thing, armed with a brand new algorithm that shows without a doubt that QE II will, despite all it's faults, prove right for America in the long run. In the end, what will happen is the easing will push down long term rates and make borrowing more attractive thereby stimulating investment and therefor growth.

---Yeh, but the difference between 2% and 1.8% may be 10% in percentage term but don't mean a thing in real life. By the by, there is already $2 trillion in liquidity out there.
---The shorrt end of the curve will be unaffected
---That means the yield curve will flatten
---Banks really don't like a flat yield curve; they make money in arbing the curve
---I thought we were all worried about bank solvency? No earning are not good for solvency.

Oh, but it's just a temporary thing. Banks can make money in other ways.

---Very true, through investment and trading, but guess what, under the new finance reform act bank activity in this area will be restricted...and least we think so inasmuch as nobody has written the rules as of yet to conform to the legislation and half the folks who are supposed to write them don't understand what it is they are supposed to write, the other half is lying and with the election half of everybody is going to be gone anyway one way or another.

Banks have faced this before and come out ok.

---Yes, but in the past there were certain other options, for example banks could add leverage and while the return on assets employed shrank, the return on equity could remain more or less the same. Can't do that now.

Why not?

---Well, the way to do it was to stay very short in order to reduce the risk but now, under the new regs the reporting periods for overall gearing have been greatly reduced which means you simply can't "get square" as we used to say, at the end of every quarter; you have to "be square" all they way along other wise your newly minted capital requirements will blow up even more.

So what's wrong with that?

--Nothing really, if you want to make the system more secure but one must be aware that the flexibility comes out of the system big time. Profitability as well. So just keep in mind that if you mess with one part of the equasion, the game which it controls changes in ways you haven't thought about. Some guys out there are going to change as well. You have, in order to try to fix the economy built more risk into the system because as sure as God made green apples those guys are going to be prepared to accept risk they otherwise would not have taken in order to preserve their profitability.

You mean like a few years ago?

---Yep, and remember, that started with the algorithms that they had developed that showed, without a doubt, that there was no real risk at all.

*******************

That left me still confused and more than a little concerned.