'Bad Bank' - Bad Idea

Treasury Secretary Henry Paulson blew it, Ben Bernanke blew it and now it looks like Lawrence Summers and David Axelrod, Obama's top economic advisers, are about to blow it big time. The horse is long since dead but the flogging continues.

"The focus isn't going to be on the needs of banks; it's going to be on the needs of the economy for credit," Lawrence Summers on "Face the Nation," on January 19th. In the same segment, both he and David Axelrod agree that Paulson's use of the first $350 Billion of the TARP money was a failure.

The point is to get credit flowing again to businesses and families across the country -- that hasn't happened with the expenditure of the first $350 billion.

The proposal? Set up an "aggregator" or "Bad Bank" into which Wall Street can pour its toxic waste or keep it on their balance sheets while being guaranteed by the taxpayer. Looks like the focus is going to be on the banks after all. The fact that the banks would be unloading more than a trillion dollars in worthless junk paid for by the taxpayer does not seem to Summers and Axelrod as a particularly bad idea.

The emphasis on getting credit flowing again for car loans, consumer credit and mortgages only serves to aggravate the basic problem that these pundits seem to be ignoring. Consumers are flat broke and overindebted as it is, they don't need more credit; they need more jobs. The Banks don't need any more free money; they need to be put into bankruptcy to purge the system of the junk on which they have based their business model. The reason the banks refuse to lend is that they are holding on to the money to cover their accelerating losses. As each company fails, as each debtor loses his or her job, the dominoes are falling faster and are obliterating the banking sector.

When the original disastrous TARP was pushed by the Treasury, the indispensable actions that were not taken were regulation, revelation of the Banks' balance sheets and oversight as to how the money was being used. Any rational investor would want to know what they were investing in but this minimum requirement was brushed aside in the rush to hand over taxpayer funds. As if this were not enough to start alarm bells ringing, the refusal of the Fed and the financial sector recipients to open the books to public scrutiny puts the bailout on the same stage as Bernie Madoff. The latter engaged in fraud to rob his investors just as blatantly as the fraudulent bailout robbed the taxpayers. Now we are expected to believe that, without further ado, repeating the same failed policies is needed to cure the economic woes of the country.

Let's examine the results of similiar policies in Europe.

The U.K., Ireland, France and Germany are among the other victims of the same mistakes. Ireland and the U.K., after pumping billions into the banking sector, have only succeeded in pushing themselves to the verge of bankruptcy and reduced the available capital to do anything actually constructive. Nicolas Sarkozy succeeded in getting Societe Generale to break even by injecting taxpayer cash. What kind of logic is it that says that this is a good thing? Any unprofitable company can break even if it receives taxpayer money to blot out the red ink. The fact remains, it is an unprofitable enterprise and, by any interpretation of market rules, should fail to free up more profitable ones.

The formation of the "Bad Bank" will prove to be another miserable failure. The time to call a halt to the madness is long since past and more rational policies need to be coming from Washington before the country goes bankrupt.

Comments

[Ishortyou:]

if you want your economic miracle get rid off the 18 months oversupply in housing inventories and the 600K+ new house starts and voula there you have your miracle.

Jan 22 07:53 AM

[morph366:]

The financial services sector is "downsizing" and will be less significant in coming years but we still have to deal with the here and now which is causing financial market turmoil and that is not conducive to job creation and confidence.
Bankers behaved stupidly, inspired by a complete failure at the intellectual level to model financial risk, and we are all suffering as a result.
Could be better to take the hit once and for all and provide a warehouse, underwritten by the taxpayers, for all of the troublesome structured instruments for which at the moment, and conceivably for a very long time, there is zero liquidity and no real way of quantifying what value, if any, they have.

Jan 22 07:55 AM

[john s. gordon:]

morph - i agree.
job creation is paramount need.
warehouse for structured toxic "assets" is best of the available options.
> jack

Jan 22 08:32 AM

[birder:]

Excellent statement of the problem. It absolutely amazes me that the government's idea of how to solve the problem is to lend more money, when in fact it was the lending of money that got us into this problem to begin with. I suppose intelligent government policy is an oxymoron.

Jan 22 08:32 AM

[tedS:]

Hi, high-flying Birder. I have very similar opinion about this weird idea of fueling the fire with more fuel. How can they be called intelligent when their idea is stupid and dangerous?

Jan 22 09:21 AM

[kelm:]

There is also something wrong when we enshrine housing at the center of our economy. far too many people who have lost their homes or who are at risk of losing them never should have been buying a house in the first lace. They had no capital and no credit. They were in reality simply paying on a very expensive rental plan. I agree with the comments above namely: we need to force bankruptcies and let the overhang work it's way through the system. Instead we are in effect transferring the systemic risk from the private sector to the US government under the delusion that a government - and especially ours - can't fail. many great nations have lost their dominance over the centuries while believing they could not fail. We are destroying our national solvency. We will see capital flight before this is over.

Jan 22 09:42 AM

[jgonion:]

Reader Beware

The so-called "bad bank" is often misunderstood. It may appear on the surface that the purpose of the proposal is to help the banks and saddle taxpayers with bad debt. - And this would be true.

It may also appear that we are encouraging more consumer debt and irresponsibility instead of helping the economy. This would be false.

Consider that the health of the economy is inextricably tied to money supply. This is why the Fed lowers interest rates during recessions (raising the money supply to push the economy into growth) and increases them during inflationary periods (reducing money supply to prevent it from growing too fast). The more money supply there is, the faster the economy grows. Money supply is the gas-pedal for the economy.

Currently, the banks of we world have decided to be irresponsible and have gotten into a bad situation. Loans have been packaged into opaque securities that the banks have invested in. Because the securities are opaque, nobody can sort-out how many of the loans are good and bad. Performing and non-performing loans are mixed together. Thus, the securities are no longer marketable. Even though they have value, nobody can tell what that value is, and so they can't be sold, effectively giving them zero-value to the bank holding them.

This situation causes the banks to be unable to determine how much money they really have, since they can't sell these opaque debt securities. This uncertainty has caused the banks to stop lending, and may banks are writing-off these securities as having zero-value.

It turns-out that lending makes-up a large portion of money supply. The effect on the economy is the same as if taxes or interest rates were raised very high: Money supply decreases, slowing the economy.

Allowing the banks to go bankrupt will not increase money supply, it will reduce it further by making credit less available.

It's easy to equate lending with (possibly irresponsible) consumer debt. The truth is that much lending is to businesses. Some examples: A ship-breaking yard that must borrow money in order to purchase a derelict ship before it can break it down, sell the scrap, and pay-back the bank.

Another example are businesses that import iron to manufacture a product. They will get a loan to pay for the iron (picture a huge freighter full), manufacture products, sell them, and pay-back the bank. The stores that purchased large amount of the product may get a loan to pay for it, sell the product nationwide, and then pay-back the bank.

This is why this credit crunch is so devastating to the economy. Yes, there are people losing their homes in droves, but what hurts the economy far more is the unavailability of credit. Banks that feel they are on the verge of bankruptcy aren't going to loan money. This causes 2 problems: Businesses cannot get loans to continue business, and creditworthy consumers have a harder time getting car loans, etc. So not only are businesses suffering because they cannot get credit, they are suffering because their customers cannot get credit to buy products.

Fact: The taxpayers of the world are going to shell-out a ton of money to get out of this crisis whether the banks fail or not. However, if the banks fail, credit becomes even less available, and the money-supply shrinks, causing the economy to shrink. That's bad. We're talking Great Depression.

A "bad bank" would buy-up the opaque debt at a discounted rate, taking it off of the books of the banks. This allows the banks to get a clear picture of their balance-sheets, and (hpoefully) lend money in a manner consistent with their financial health, which they would have a clear picture of. Freeing-up credit will increase money-supply, make it easier for businesses to operate, and easier for consumers to purchase goods. Getting 20-cents on the dollar for something they can't sell (opaque debt securities) beats holding on to it and writing it off completely.

And it's not like these opaque securities represent 100% bad debt. Since nobody can tell what's in them, they have no marketable value. The government may also be in a position to make the debt securities transparent through governmental authority, something that private industry simply cannot do.

Alternatively, we could let the banks fail, and the government could go into the lending business (issuing credit cards, car loans, etc). Since most governments of the world have a hard-time picking their nose without causing a huge screwup, I don't think we cant that.

The boys over at the Fed believe that this will cost the government (which means you and me, really) less money than the any other alternative. Whether this is true or not remains to be seen, but in uncertain situations you are forced to put your best foot forward.

Our taxes are going to be going up in the future because of this situation. There is no avoiding it. So since we can't avoid it, we should minimize it.

Allowing the banks to fail, which reduces available credit, which reduces the money supply, which slows the economy, and which makes the problem worse, is not the direction *I* would want to take. Since I'll be paying for this in the long run through higher taxes, I'd prefer the bill to be as small as possible.

Jan 22 10:20 AM

[jgonion:]

This article does an even better job of explaining it:

seekingalpha.com/artic...

Jan 22 10:29 AM

[AndrewBaker:]

The banks' irresponsible lending and their packaging of that lending into arcane bonds that not even the financial architects who designed them understood has combined to not only bankrupt them, if the truth were known, but also crippled other businesses, and individuals, whose only crime is that they can't get the money now they need to continue with their above-board and properly managed businesses and lives. As well as breathing heavily down the necks of bank personnel to make sure their future actions are aimed at putting things back to rights, we also need to get those tainted bonds, loans and other toxic financial instruments into a place where not only can they be managed to get the most out of them that is reasonable, but also to avoid total write-offs which benefit no-one. If that means a "bad bank," then so be it: as long as the assets it holds are worked to give the best possible return for Main Street, not Wall Street.

Jan 22 01:14 PM

[MSmailbox:]

It looks to me like the banks need to (effectively) declare bankruptcy. An open-book analysis of how each bank has managed their business, over the past 10 years, would be helpful in deciding their fates, in a consolodation. Life-support in the form of tax-money, or palliative care, also tax money, to help them (the bad banks) to shutdown and smoothly (without loss) tranfer their customers to performing banks. Guaranteed solvency, but each performing bank would compete for profit, restore dividends and seek indpendance from subsidy. Non-performing banks would not exist. Bottom-line, the taxpayer pays for a revamped and vital banking system. It does so, by absorbing toxic debt, providing necessary capital for liquidity, neutralizing bad-banks, reward good banks with customers from extinct banks. Regulate these good banks, so that they stay good banks. A smaller, better herd of banks, might help in the long-run.

Jan 23 07:49 AM

[Bobco23:]

Excellent!

This should be required reading before submitting intemperate comments to SA.




On Jan 22 09:42 AM kelm wrote:

> There is also something wrong when we enshrine housing at the center
> of our economy. far too many people who have lost their homes or
> who are at risk of losing them never should have been buying a house
> in the first lace. They had no capital and no credit. They were in
> reality simply paying on a very expensive rental plan. I agree with
> the comments above namely: we need to force bankruptcies and let
> the overhang work it's way through the system. Instead we are in
> effect transferring the systemic risk from the private sector to
> the US government under the delusion that a government - and especially
> ours - can't fail. many great nations have lost their dominance over
> the centuries while believing they could not fail. We are destroying
> our national solvency. We will see capital flight before this is
> over.

Jan 23 10:44 AM