Bank On It No More

Robert Borosage

What will the Obama administration do with the banks that are now on life support? Pump in more taxpayers’ money to keep the zombies alive? Radical surgery? Pull the plug? The decision – with new announcements rumored for next week — is critical to any recovery plan.

We’re not really invited to this discussion. This is the province of experts, of bankers and financiers. Even economists who opine about most everything don’t understand finance. But, we better bust into it because literally trillions of taxpayer dollars are at stake. And we’ve all learned that a lot more gets stolen with a fountain pen than with a gun.

The challenge is apparent. The big financial houses atop the U.S. economy — Citibank, Bank of America, JC Morgan, Chase, Morgan Stanley, Goldman Sachs — are deemed, probably correctly, as "too big to fail." They are the commanding heights. Yet they are also basically insolvent. Their coffers are still stuffed with toxic paper of dubious value, so called "troubled assets." They don’t mark them to the current market price — if there is one — for the losses would far exceed their reserves. They would go belly-up without U.S. intervention. They are too big to fail and too weak to save.

Under the Bush administration, Fed Chair Ben Bernanke, Treasury Secretary Paulson (formerly head of Goldman Sachs) and New York Fed Director Tim Geithner (now Obama’s Treasury Secretary) launched an intensive care effort. The Fed provided dough in exchange for toxic assets, and issued trillions in guarantees of various sorts. Treasury used the first $350 billion of the emergency bailout passed by Congress largely to make direct equity infusions. Paul Krugman called this a new form of voodoo economics, "The belief that by performing elaborate financial rituals we can keep dead banks walking."

The effort succeeded in keeping the banking system from collapsing, but left the "commanding heights" of the US financial system on life support. They used the government money to bolster their balance sheets, not make new loans. Yet, despite a trillion in write offs, their holdings keep getting worse, as housing prices keep falling, the commercial real estate bubble bursts, and staggering jobs losses in the real economy lead to higher defaults on credit cards, auto and personal loans. (The IMF describes the worsening conditions here.)

The Obama administration has floated a series of trial balloons about the potential next intervention. Unnamed officials have suggested that the Treasury would set up a "bad bank," that would buy the toxic assets from the banks, to let them get on with their business. There’s talk about extending what might be called the Citibank golden gift package to others: putting more money in directly as equity while guaranteeing large swaths of toxic assets. (For Citi, the government dumped in $45 billion in equity and guaranteed the value of $306 billion of dubious paper, largely mortgage backed securities.)

But both of these operations are costly and neither work very well. A "bad bank" would have to decide how to price the toxic paper purchased from the banks. Price the securities at market value and the banks go belly up. Price them at or near nominal value and taxpayers are looking at literally trillions in potential losses, while the banks’ managers and shareholders pocket a massive windfall.

Given the collapse in the value of the banks, if the government buys shares with its money, it would own the banks. If it doesn’t, once more taxpayers take the risk and managers and shareholders get the benefits — magnified by the cost of guaranteeing the value of paper based on loans going bad.

Clearly the folks who had the party — among the wealthiest people in America — shouldn’t have their losses covered by the taxpayers who are the victims of their excesses. That makes no sense in morals or in economics.

There is a sensible way to go forward: do what the government does routinely with badly run banks that face insolvency. As Rob Johnson, the former chief economist of the Senate Banking Committee at the time of the Savings and Loan crisis, and a member of my board at the Institute for America’s Future, describes it:

Put them in receivership. Replace the managers. The shareholders take their losses. Make an independent assessment of the assets. Net out the credit default swaps that are the scariest threat to all. If necessary, the creditors take a hit, and have some of their loans turned to equity shares. If necessary, strip out the toxic assets, with federal contractors selling them over time. Reorganize a stronger and smaller bank and sell it back to private investors or merge it with other banks.

The FDIC knows how to do this, and has done so with banks large and small. (William Black a former FDIC litigator describes the process here). Admittedly, taking on the commanding heights banks at once would be a formidable challenge. But it would be a lot less costly and a lot more certain than continuing the voodoo.

You can hear the howls: this is nationalization, socialism, un-American. No, it is how the FDIC has operated since the Great Depression to deal with the incompetent, the unlucky, the scoundrels and wastrels that run banks into the ground. It enforces responsibility. Managers get fired, rather than pocket bonuses. Shareholders lose their investments, rather than getting a taxpayer funded boondoggle. Creditors are protected, but only to an extent. The zombies are put to rest; the strong carry on.

No doubt this would be painful. Some of the shareholders are pension funds and proverbial "little old ladies and gents" who thought they were putting their money in the safest of all investments. But forcing them to recognize their bad bets is the only way to insure prudence and caution going forward.

Luckily, many of America’s banks are strong, not weak. Many regional and community banks didn’t fall for the exotic instruments hawked by the big guys. Many stayed close to their communities and their businesses. Ironically bailing out the scoundrels and wastrels puts the prudent at risk. The weak banks are using the capital provided by the Treasury to purchase other, often better managed banks.

The question really isn’t one of nationalization or any of the buzz words. The question is coming to grips with the scope of the crisis. The Bush administration never got it. The unspoken assumption was that with sufficient mystification, and some cash, some Fed guarantees, lower interest rates, easier money, "confidence" could be restored. The banks would raise new capital; their assets would regain some value; they could write their losses off slowly and get back into business. Got that wrong.

In reality, we’re in a global financial meltdown, surely the worst since the Great Depression. Confidence isn’t going to come back with cosmetics or with voodoo. The zombie banks can be kept on life support, but they can’t be saved, unless the federal government spends literally trillions picking up their bad bets. And that means we’d be paying $100 billion or more a year forever to clean up their mess.

Why would Washington tax the working families who are now suffering from the crisis to bail out the shareholders and managers who helped create it? [Or worse, cut Social Security and Medicare as part of a "grand bargain" to help balance the budget after Wall Street has pockets a trillion or so].

Why is Washington filled with faux populist promises about curbing bonuses, capping executive pay, forcing banks to lend, even as the managers that drove the banks off the cliff are still keeping their jobs, collecting their paychecks and issuing their bonuses and dividends?

One reason might be that these same bankers and financiers are leading donors to both political parties. Thus far, they’ve been getting an amazing return on investment with a few million in political contributions yielding hundreds of billions to keep them breathing.

Obama’s Treasury Secretary, Tim Geithner, according to Politico has announced that: "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to our best to preserve that system."

Exactly. And that’s why the zombie banks can’t be kept on life support. The management failures can’t be rewarded. The shareholders must take their losses. To sustain a private banking system, we’ve got to let the failed banks die. And to do that, without bringing down the entire system, we have to arrange a dignified burial, and orderly dispersal of the assets.

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