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Treasury Secretary Timothy Geithner has unveiled his concept for preventing the repeat of the financial system failure which has occurred. It travels the same road of increased and more effective financial system surveillance which has occurred after each failure in the past. This surveillance approach has not worked in the past – and it will not work in the future to prevent the next financial system failure.

When you design a system, you try to make it idiot proof. It always fails at the worst time at the weakest link. The problem, Mr. Geithner, is the system. The system must be designed not to fail in the first place.

You cannot make a rule that says – “You cannot fail”. Nor can you expect audits to uncover deficiencies or wrongdoing. The brightest minds do not become auditors.

The government and Fed officials are fighting fires to keep our banking system intact. Why are we trying to save something that goes into failure mode at times of major economic stress?

One problem with banking is that it does not meet the test of capitalism. Either your money is at risk or it is not at risk. Banks are stuck halfway in between. We are trying to pretend banks are capitalist institutions.

There is a big difference between depositing money (parking money) which you expect back and loaning money. Loaning money is risky and capitalistic. Being given money carries no risk. In most countries in the world, the government is involved in the banking system. In America, the government’s role is to regulate the system and provide guarantees. In other countries, they are a player in the system competing against traditional banks.

The current system which was legislated in 1913 is not working well. Major interventions by government using taxpayers' money occurred during the Great Depression, the Savings & Loan Crisis of the ‘80’s and ‘90’s, and now the Great Recession. Our crisis today added a “too big to fail” ingredient into the pot.

In a capitalistic society – too big to fail is unacceptable. Nothing in Mr. Geithner’s plan addresses this issue because he does not know how to solve it.

A proposed new banking model divides the current banking system into three elements:

  1. Banking (guaranteed deposits, home and student loans)
  2. Credit Banking (Consumer Loans and business loans)
  3. Market Makers (Enterprise Financing and debt purchasing by entities such as BlackRock or PIMCO)

The system revolves around the Credit Banks (pretty much the existing brick and mortar banking system) who make loans and package them for resale to pools of investors (Market Makers). Credit Banks then become only storefronts that turn deposits over to the government (interest rates paid per current treasury rates) and sell loans the Credit Bank has issued to investors (Market Makers).

The deposits to the Government Bank can be commingled with the government’s General Fund (like social security) and used to offset Treasury funding operations (reduce need for Treasury auctions). As there is no need for guarantees anymore – we can eliminate FDIC making the system more efficient. Deposits for the Government Bank can be made at any Credit Bank or Post Office (government would pay a handling fee on money deposited or withdrawn).

Credit Banks would have a relatively small asset base as their function becomes retailers of financial products. Home loans and student loans would be issued against government guidelines, and sold to the government. Other loans would be packaged in a way they would be of value to the Market Makers – and sold off to them.

The Market Makers would market financial packages of loans for investors via mutual funds, ETFs, bonds, or any other investment vehicle. In addition, the Market Makers can put together private pools of money for larger endeavors such as corporate financing. They would specifically be tasked with investing in innovative new companies or technologies which offer employment.

The government (through the Fed) can increase or decrease liquidity in the system by becoming an investor with the Market Makers. To soak up liquidity, they can sell home loans to the Market Makers.

Regulatory Features:

  1. The Market Makers must use some of their own funds in each product. There can be no leverage (hedging) as this is part of the banking system. Leveraged products are subject to failure during economic events and do not belong in a banking system designed to withstand economic maelstroms.
  2. There is a limit on the fees the Market Makers charge for managing these investments (my opinion is not more than 1%).
  3. There will be no Federal Auditing program per se. Monthly, an audited balance sheet will be submitted to the SEC. In the event an irregularity is uncovered, both the auditor and all individuals involved will be subject to criminal prosecution. It will be assumed that the entire chain of the command is guilty of wrongdoing unless reasonable management oversight could not have discovered the wrongdoing. (Management in large companies purposely insulates themselves from day to day knowledge to avoid implicating themselves in wrongdoing.)
  4. There can be no common ownership between the Market Makers and the Credit Banks. Transactions between the Credit Banks require government approval. Transactions between Market Makers require government approval.
  5. No Credit Bank or Market Maker can grow larger than 1% of the market size.
  6. The Credit Banks must repurchase all loans sold where due diligence was not exercised in qualifying buyers or assets being purchased.
  7. The Government Bank will provide criteria for lending standards for all loans it purchases. The Market Maker can also provide criteria for lending standards – or can rely on stated standards the Credit Bank used (as the Credit Bank is essentially warranting the standards for the loans as they will be required to repurchase if they do not meet those standards). All bank records (including correspondence) will be on-line, be to an established government standard, and available for government review 24/7.
  8. Quarterly, government regulatory authorities will produce a Banking System Risk Report quantifying the risks and trends of the banking system.
  9. No lobbying or contact between the Credit Banks or Market Makers and Congress unless it is in an open Congressional hearing. If a congressman receives campaign contributions from any bank, corporate member of any bank, or board member of any bank – the congressman is considered to have a conflict of interest and shall excuse himself from voting.

This model completely changes the relative importance of the banking sector, and removes the systemic risk of a banking failure during economic contraction. In the event of a failure of a Credit Bank, only the employees and owners would feel the pain. The Market Makers are creating “backed” securities (not derivatives) – and in a case of a Market Maker bankruptcy, the role of the market maker would simply be transferred to another company. Investors in Market Maker products would only take a bath if what they purchased turned into crap – this is the risk of all investments. Mark-to-Market debate disappears.

We can have a discussion on the virtues of the phantom money created by the current fractional reserve system. In this new system, the government would have to create real money. But this argument is academic at this point as the massive printing operation by the Fed has proven printing massive amounts of money has little effect on the dollar.

We are spending a lot of money to save a defective banking concept. Is it worth it?

Disclosures: None

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  • Excellent article... I agree wholeheartedly, that the first issue that needs to be resolved is to come up with a regulatory framework that limits/eliminates the "too big to fail" scenarios. Oversight of such large institutions with complex instuments is quasi impossible. And the last thing I would like to see is a bloated army of government agency "experts" (accountants, lawyers, etc...) growing exponentially along with growing pay cheques to match the expertize required. There are limits to the amount of tax subsidies we can afford if we are to thrive.

    A cheaper solution is not to allow any one organization to become too big to fail
    2009 Mar 27 07:06 AM Reply
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  • Here's the solution. No FDIC insurance on interest bearing accounts. This will make the depositor perform the necessary due diligence to weed out the bad actors. FDIC insurance will be allowed on checking accounts.

    If you want to give the bank a loan so that it can make additional loans then do at your own risk.
    2009 Mar 27 07:27 AM Reply
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  • Bravo and well stated! Banks, with the Fed and Treasury as their salesforce, want to keep the competitive advantage of placing public money at risk to make profits. It is incredulous that Congress can't or won't see this point. We either need to be a capitalistic system or not and the promise of guarantees by the taxpayer has no role.
    2009 Mar 27 08:45 AM Reply
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  • Steven,
    Your article provides food for thought, and contains worthy ideas. I also like the two ideas many have raised to begin correcting a deeply flawed system:
    1) Bring back Glass-Steagall to separate insurance, banking, and brokerage; and,
    2) Enforce the anti-trust laws to keep uber companies (so big that they incur systemic risk) from forming.
    The first would clarify who is in charge of regulation and what regulations apply. The second would prevent the systemic failures and eliminate the greed opportunities (or at least minimize them) in the future.

    Geithner's approach seems overly complicated and is fraught with what I call experimental exuberance. Too much is untried and subject to failure at a colossal scale. His actions to date are characteristically doomed to bankruptcy of the department he runs. We simply cannot afford his mistakes any longer.
    2009 Mar 27 08:49 AM Reply
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  • There is a 'social justice' political party called the American Revolutionary Party (they have a website if you google it) that calls for a kind of taxation platform that penalizes businesses that grow over a certain size. I think the schedule was designed so that the hit would be gentle enough to promote sell-offs over generations, not abruptly. I believe they were speaking of all businesses, not just banks, but I offer the idea here as a way to keep banks from getting so big that they 'cannot fail.' I think this is the heart of the problem over-all.

    It is a principle of distributism that ownership (as opposed to income per se) needs to be widely dispersed for healthy capitalism. 'Back in the day' they were speaking of land ownership and had programs to literally move the poor out of cities and onto small farms, but I keep musing that it could apply to anything, and waiting for someone to apply it to more intangible capital.


    On Mar 27 07:06 AM Chezfrederick wrote:


    >
    > A cheaper solution is not to allow any one organization to become
    > too big to fail
    2009 Mar 27 08:55 AM Reply
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  • Why aren't all banks cooperative, like my own? (Riverset Credit Union in Pittsburgh, formerly the Pittsburgh Teachers Credit Union--it is small compared to the one in Hillsborough County, Florida.) Does anyone know how a cooperative bank is structured, compared to the plan here? I know they didn't invest in any of the bad mortgage investments--so they told me when I moved my retirement money out of the market and into their cd's.

    Steven's scheme here is such a powerful analysis of the problem. He keeps trying to get down to the structure of the problem.
    2009 Mar 27 08:59 AM Reply
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  • I would take issue with one of your concluding remarks..."the massive printing operation by the Fed has proven printing massive amounts of money has little effect on the dollar."
    It seems premature to be nonchalant about the consequences of QE for the dollar. Already there are serious discussions going on about a new global reserve currency and who knows what kind of inflationary genie has been let out of the bottle - we have some time to wait before that becomes clear.
    2009 Mar 27 09:18 AM Reply
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  • ...And yet, here in OZ we are told by Kevin Rudd,the prime minister of Australia that mr Geithner is the greatest fiscal genius to have ever walked on water and that mr Rudd has the full approval of President Obama.
    But isn't Geithner giving the US tax payer( and eventually the OZ citizens) 90% of the risk?.
    it all appears to be a a non recourse loan that ,if it goes bad will be bourne by the US tax payer .
    Here in OZ we are going to be loaded with a 78 billion dollar loan from the Chinese .A loan Australia really shouldn't need to borrow,and this with the approval of Geithner and Obama ,or so our press tells us. perhaps the loan isn't the only Chinese thing we are getting.



    2009 Mar 27 09:29 AM Reply
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  • Thanks, Mr. Hansen, for the helpful and clear write-up, but I'm not sure it gets to the root of the problem which is (as morph alludes to) the ability of governments or quasi-governmental entities (like the Fed) to debase currencies. The current crisis is the result of the Greenspan Fed's USD debasement in response to the dot.com bubble. The next crisis will result from the Bernanke Fed's much more massive debasement.

    As long as governments have this power, global economies will move from crisis to crisis.
    2009 Mar 27 09:30 AM Reply
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  • run and hide,,the king doesn't like to hear he has no clothes
    2009 Mar 27 09:30 AM Reply
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  • Agreed. And these recent Auction Failures are a swift reply from the market. Sovereign debt (aka fiat money) at negative yield won't hold sway for long.


    On Mar 27 09:18 AM morph366 wrote:

    > I would take issue with one of your concluding remarks..."the massive
    > printing operation by the Fed has proven printing massive amounts
    > of money has little effect on the dollar."
    > It seems premature to be nonchalant about the consequences of QE
    > for the dollar. Already there are serious discussions going on about
    > a new global reserve currency and who knows what kind of inflationary
    > genie has been let out of the bottle - we have some time to wait
    > before that becomes clear.
    2009 Mar 27 09:36 AM Reply
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  • Well Today Obama Meets with Big Bankers to BEG for there forgiveness for that bill Congess passsed trying to STOP those crooks from ripping off MORE of Your Tax money . He'll assure them the Bills dead and his boy Timmy will make sure that they can UNLOAD ALL of there Toxic Loans on the American Tax Payer for WAY more then there worth and then they'll really be able to give out HUGE Bonuses next year !
    He'll also promise NOT to Do Or say anything that they might take offense at !
    Is this the Change He promised , when he said he was going after the bad actors on WS ?? No this just another slick politcian , once again lying to The People to get elected then doing what evers going to make him Richer when He leaves office ! So there it is all the other stuff is just the usual smoke and mirrows , this guy is out for Himself period . He could care less about the American People ,, Kinda like when Clinton said "I feel Your Pain" while he was really feeling someting else ;) So Its Washington and WS ,, Vs You who do You think will be better off 4 years from now ???
    2009 Mar 27 09:41 AM Reply
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  • Agreed---Geithner's in over his head.
    2009 Mar 27 10:01 AM Reply
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  • Gentlrmen,
    Take a lesson from the Canadian banking institutions.To further understand the monetary system-refer to zeitgeistmovie.com.
    You can down load addendum free.
    2009 Mar 27 10:03 AM Reply
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  • It is refreshing to see some ideas come forward. It is the American "way"! Keep it up and take it forward to the administration and your congresspersons as they seem to be open to it! The comments to your article are also worthy.
    2009 Mar 27 10:20 AM Reply
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  • Geithner"s " Own Ponzi Scheme" to steal as much of the taxpayers money as possible before taxpayers deside they will no longer "work",because all they earn is going to the goverment! Why work or produce something if it disapears into another goverment black hole? To think this man in charge of the IRS,is like putting Barney Franks in charge of commanding a Sinking Ship!@ Barney would take the only life boat,while all the crew is left to the sharks!
    2009 Mar 27 11:02 AM Reply
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  • More regulation? For who? The SEC doesnt do its job and ignores enforcing the rules anyway, so why enact more laws? To better ty up honest citizens and free the big guys to better take our money, thts why!

    The way it works is that We The People are bent over a table with our pants pulled down. The guy behind us is crying about how badly we are being raped and promising to find the culpret, surprized OJ isnt in charge of the investigation.

    I think that guy is congress

    2009 Mar 27 11:02 AM Reply
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  • Steven,

    This is a well thought out article. Now what is the plan to get it communicated to those who could start a meaningful discussion and perhaps get it implemented?

    Jack

    2009 Mar 27 11:50 AM Reply
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  • Steve - - -

    Thanks for putting these "outside-the-box" ideas out here for discussion. We need more original thinking on the question of financial system structure.
    2009 Mar 27 11:52 AM Reply
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  • The system is completely defective and hence it broke. All current policy is centered on propping up a failed system. It is costing too much and will not work. We still have the same system – the exact same management – CEOs, boards, etc; with the very same perverse incentive structures – golden parachutes, short term profits, etc.

    Since the banks were too big to fail so the solution has been lest make them bigger by all these shotgun mergers. Most of these institutions are insolvent and simply too big to succeed (and save). Banks etc have lost touch with reality – their customers. All their business models are centered on quick buck – derivatives etc, and not on giving credit to business for economic growth. GE, with GE capital, is the classic example – 50-60% of its profits come from financing. Now finally Immelt realizes that is the wrong model and they have o revert back to ‘producing things’. Obama is saying the same thing.

    G-20 next week all these issues will be front and center, China, Brazil, Russia are making clear they want drastic change, a system led by west and America is unacceptable. Lula (Brazilian president) yesterday said: “Blue eyed white bankers have caused all these problems, they claimed to know everything; facts now show they know nothing”. The only thing western bankers have done last two decades is – create one bubble after another and collect hefty bonuses, with the help of one and the only Greenspan, and now his disciple Bernanke.
    2009 Mar 27 12:39 PM Reply
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