At a press conference when Albert Einstein retired, a journalist asked the great physicist to identify the most important mathematical formula in history. Einstein’s theory of relativity led to the nuclear and thermonuclear bombs that Einstein warned against, as well as thousands of peaceful applications. Yet he smiled and said: “One plus i to the x.” Einstein observed that the formula for compound interest had had more impact on humanity than any other equation. ¹

The theory of financial stability minimizes both i and x in the formula when applied to the assets and liabilities of financial intermediaries. That is how equilibrium in finance achieves the maximum level of equity and productivity growth for all sectors of an economy. Using that same formula, moreover, we can calculate the precise impact of changes in i on the investment value of any given level of cash flow that an economy produces. That result is illustrated in Table 9.1.

Financial stability minimizes the burden of finance on production and maximizes the efficiency of investments that generate productivity. It does so, however, by minimizing the margin that financial firms often use to fund compensation paid to financial managers.

It is easy to demonstrate the long-term growth benefits to financial institutions from minimizing margins that maximize the growth of their customers’ wealth and thus their needs for financial intermediation—the business of banking. It is almost impossible, however, to get managers to accept that low margins are good.

This dichotomy between the self-interest of management and the broader interests of institutions and society is the foundation of all moral hazard frauds and deceptions (e.g., off-balance sheet liabilities and shadow banking) by which high-margin and highly leveraged financial schemes are justified and then hidden from investors and regulators. The desire to limit competition, to rig the game using two measures to hide speculations, is as old as humanity itself.

The formula for compound interest is the Rosetta stone of finance by which macroeconomic benefits of low-spread margins are demonstrated. Table 9.1 uses base rates and spreads to set valuation cap-rates that translate cash flow into values of debt and equity that conform theory to experienced results.

Over time, it is only the value of an entity’s (or nation’s) cash flow that can support an economic valuation of wealth. By a long-established rule of law known as absolute priority, debt must be paid before equity is entitled to the benefits of cash flow. Therefore, the cash flow needed to support debt must be subtracted before valuing what is left to equity. Though viewed as essential for economic preservation, the 2008–2009 assistance packages provided to AIG, Bear, Stearns & Co., and Citigroup violated this ancient rule of priority, but that political fact does not change the basic analysis and Dodd-Frank precludes such assistance in the future. To receive future assistance, an entity must first be placed in receivership, with FDIC as receiver.

The rate and spread assumptions used are set forth on Table 9.1. From there, one plus i to the x does everything. The available cash flow is calculated by reverse analysis of the assumed debt/wealth reflected in the top/middle box and then kept constant for the other calculations. When economic conditions cause available cash flow to rise, all else staying equal, the values in Table 9.1 will necessarily rise.

In a low-spread complete market, the total value of a constant cash flow shown in Table 9.1 rises 68.5 percent as the base rate falls from 5 percent to 0 percent, and falls 30 percent as the base rate rises from 5 percent to 10 percent. By 50 percent leverage, however, equity rises 137 percent as the base rate falls and falls 60 percent as the base rate rises.

In each assumed base rate scenario, spreads have a much greater impact. At a 0 percent base rate, the difference between a complete market spread and the Armageddon of 2008 is a 55 percent decline in total value (a 123.5 percent rise by reversing the Armageddon effect) and a 78.6 percent decline in equity (a 366.5 percent rise by reversing the Armageddon effect). At a 10 percent base rate, the comparable numbers are a 23.5 percent decline in total value (conversely, a 31 percent rise) and an 82.6 percent decline in equity (again, conversely, a 474.3 percent rise).

The difference between a normal market and the application of two applied theories for regenerating normal when Armageddon hits is also portrayed using the same table. During the crisis of 2008, the United States went from normal credit spreads to Armageddon with 0 percent base rates. In the Great Depression, the United States (whether forced by law to do so or not) applied a draconian version of the laws at that time and fell into Armageddon while raising base rates, creating a 93 percent reduction of equity values.

In effect, the leaders of that era went back to Bagehot’s original dictum that high rates were necessary to pull liquidity back into the markets, but were blocked by law from recycling that liquidity to entities in need. After seven years of government intervention, the evidence suggests that having the Fed provide excess reserves is not by itself inflationary. We need to see an acceleration of growth (rising cash flows) to turn around the stifling postcrisis force of disinflation. Rising demand is needed to really declare victory over the specter of debt deflation.

On Table 9.1 the top center box represents the precrisis level and is used to establish the assumed fixed-cash flow. The bottom left box is the Armageddon situation of 2008 using the policy followed by the U.S. Fed (0 percent base rates). The bottom right box is Armageddon with a Depression-era liquidation solution. Using the solution the United States applied, total wealth is 41 percent higher (and equity is 625.7 percent higher) than using the liquidation solution.

The hurdle for recovery, moreover, favors the U.S. solution to recreate stability by an even higher proportion. To recover from a crisis after using a Depression-era liquidation solution requires a 1,328.6 percent increase in equity values. Using the U.S. solution of 2008, only a 98 percent recovery is necessary. That means it is 13.56 times as hard to recover from applying the liquidation model used during the Depression as from the theory of financial stability applied by the United States in 2008.

Of course, for those that short or simply hoard cash to await the effect of a crisis, a deflation scenario solution creates an opportunity to buy equity at 7 percent of precrisis levels (versus 50.8 percent using the Fed’s approach). When Henry Ford accelerated the banking crisis of 1933, he believed that he could survive the contagion, a stunning act of indifference to the suffering that would follow for millions of Americans. That’s also the same selfish opportunity J. Pierpont Morgan pursued when he convinced fellow bankers to support his private solution to the 1907 panic.

Is it possible that Morgan convinced those who drafted the 1913 Federal Reserve Act to preclude the new central bank from paying interest to attract free reserves because he wished to perpetuate that opportunity for control and generate still more wealth for himself in a later crisis? It is unlikely records will ever prove that intent, but history certainly supports the possibility. The ease with which the current Fed liquefied the U.S. economy (and profited, at least temporarily, by doing so) once it had the authority to pay interest on excess reserves amply demonstrates the benefit of removing that impediment.

The effect of rising credit spreads on enterprise value and default rates on loans is also evident from the table. Even the best policy for handling a crisis after it arises reduces total equity by roughly 50 percent when credit spreads rise from the equilibrium of a complete market to Armageddon levels. Without any change in base rates, equity falls by about 75 percent.

If those are averages, of course, many marginal borrowers will be in default at just a 50 percent decline in total market equity. If people who track corporate defaults compare any of the corporate credit spread graphs used with this book to their default data, they will see a near-perfect correlation. Defaults rise and fall in sync with rising and falling spreads, respectively.

That rising credit spreads drive some enterprises into default causes their impact to be greater than that of rising base rates. When base rates rise, over time (as new debts replace old) the winners and losers offset each other. Thus, the U.S. Fed sees little long-term impact on the overall economy when it changes short-term rates. These numbers do not consider that offsetting impact, however, because the offset disproportionately impacts firms based on when bonds mature. If considered, this would place even greater weight on the impact of changes in credit spreads compared to changes in base rates.

To show how rising credit spreads/defaults impact banks, let’s compare a bank characterized by the 1960s-era Rule of 3-6-3 to one with a lot of bad assets, using the formula for compound interest to show changes over time. If a 3-6-3 bank has $1 billion of loans, $900 million of deposits, and operating costs that are 2 percent of assets, its equity will rise 13 percent per annum, producing a compound rise of 84.25 percent in value over 5 years and a 239.5 percent rise over 10 years.

If defaults rise to a level at which operating costs offset asset earnings, and rising credit spreads cause the cost of deposits to rise 200 basis points (a modest increase compared to the 2008 experience), the 3-6-3 bank will be insolvent in two years.

Thus, when leverage is good it is “very good indeed” for banks, but when it is bad, leverage is “horrid” for banks. Since banks are essential for the functioning of society, any and all steps required to stabilize finance must be taken during good times and especially as bad times approach. When bank liabilities are ultimately insured by taxpayers, it is ridiculous for any liability or speculation of a bank to be reported off-balance sheet.

It is market control that allows managers to control lending margins and it is high lending margins that convert good loans into bad ones. Open markets and enforcement of restrictions on fraud are the keys that support reduced margins/spreads. The theory of financial stability is, therefore, supported by the laws of mathematics that apply to financial markets.