How to Solve the Banking Crisis

The Paulson plan is an extremely inefficient and inappropriate method of taking care of the problem we are facing. At its heart, its actual intent is a convoluted attempt to  bail out the balance sheets of 4 or 5 big banks that have managed to get themselves (and us) in the position where if they fail they could bring down hundreds of other banks and companies in a cascade of failures that would wreak havoc with the real economy. The reason this could happen is because these problem banks have guaranteed billions of dollars worth of credit default swaps (which is basically insurance on commercial bonds) to hundreds of other smaller banks and other companies. So, if any one of these problem banks went bankrupt, all of the small banks and companies which had bought the credit default swaps (commercial bond insurance) from them would be completely exposed to the risk of defaults on the bonds they had tried to insure. 

Alas, and alas, and alas, due to incompetence and greed, these problem banks not only guaranteed billions of dollars in credit default swaps, but they loaded up their balance sheets with mountains of complex derivatives backed by subprime mortgages, and liar loans, and negative amortization loans and god knows what else, all of which is depreciating even as we speak. The reason the credit markets are "seizing up" is the legitimate fear on all of their parts that one or more of these banks is going to default. 

One has to wonder where the regulators were during this whole process. I am still waiting for the announcement that any one of them has been fired for gross malfeasance. Oh, yes, and the rating agencies, like Moody's and Standards and Poor's, what were they doing while all this was going on? Why someone hasn't filed a lawsuit or two or ten against them for gross incompetence is more than I can understand. But, perhaps the suits are still being prepared. 

Anyway, regardless of who all should share the blame (and there is obviously plenty of it to go around), our purpose here has to be to discuss how to fix the problem that has landed in our laps. And by we, I mean the US taxpayers and voters, who woke up on Sunday to discover that Hank Paulson's solution to the problem was to take $700 billion dollars out of their pockets and use it to repair these banks' balance sheets. This is not going down too well, I understand, amongst the average taxpayer and voter, since they are about the only group that isn't on the list of persons responsible for the mess. Even worse, Paulson's plan is a woefully inefficient and inequitable means of accomplishing the task.   Congress has been working hard all week to improve his original plan. What they have come up with, although a vast improvement on the original plan, is still fatally flawed in a number of ways.  

First, there is no reason of any kind for the US to buy the toxic assets from these banks, or waste any time at all trying to figure out what these toxic assets are worth, or what a fair value to pay for them would be, or how much more we would actually have to pay for them to accomplish our actual goal (bailing out those banks), or anything else. All we need to actually do is lend them some money.  Quite a lot it looks like. I doubt that anything like $700 billion dollars would be required, but I'll leave that up to the experts. The important thing  however isn't the exact dollar amount, it is how the loans are structured. Three things are absolutely required:

First, any loans that the US makes to these banks should be backed  by senior debt on the banks themselves, debt that is more senior than any existing debt they have. This is a fairness issue. If these banks go bankrupt, the US taxpayer should not take a loss of any kind unless all of the existing shareholders and debt  holders have been completely wiped out. They got themselves into this mess and they should be the ones to pay, not the taxpayer. The goal of this plan isn't to bail these banks out, it is to protect all the rest of us, the US taxpayer, the hapless companies that bought bond insurance from them, and all the rest of the innocent bystanders from the consequences of these banks' irresponsible behavior.

The current plan, even Congress's improved version, does not provide this protection to the US taxpayer, and thus is fatally flawed. Even the improved version from Congress only provides for the US to get an equity position in the banks that we assist. That approach would result in a very high likelihood of the United States taking a bath on this deal, since only the shareholders would lose their investment, while bond holders would be completely shielded from absorbing any of the costs of bankruptcy. That MAY have been appropriate in the case of Freddie Mac (FRE) and Fannie Mae (FNM), where the US had to a certain extent (alas) implicitly guaranteed their debt to the marketplace. But the US has not, and SHOULD NOT guarantee the debt of these other, private banks. Just like in the case of Washington Mutual, both the shareholders AND the debt holders are the ones that should take the loss, not the US taxpayer.

A second provision that is absolutely required, is that the upper management in these problem banks HAS to be replaced.  It was their irresponsible management that got us into this mess in the first place. Paulson's plan was going to leave them in place, and throw money at them in the hope that they would clean up their own mess. The improved version from Congress also seems to envision retaining them, and  "punishing them" with a cut in pay. This is preposterously inappropriate. They don't need to have their pay cut, they need to get fired, and replaced with responsible, prudent, competent managers. It would be the height of folly to leave these men in charge. They have proven by their conduct that they are unworthy of the trust that has been placed in them, and are incapable of responsibly managing the companies that have been placed in their care. I don't know if they were incompetent, or if they were just criminally irresponsible, or if they were corrupt, and I don't much care. The only important thing is that they be replaced before they do any more damage to their shareholders, the other stakeholders in these companies, and to the American economy. 

A third necessary condition for this bailout, is for these problem banks to be broken apart. They are engaged in two separate and distinct lines of business that should not be allowed to co-exist: banking and bond insurance. Banking is by its very nature a highly leveraged business, and is going to see the greatest stress on its balance sheet during a recession - the exact time when (surprise, surprise) the greatest number of bonds are going to default. Therefore, Congress should forbid, by law, that any bank be allowed to write credit default swaps.

Furthermore, Congress needs to require, by law, that any company that writes credit default swaps be subject to strict regulatory oversight, and frequent examination of its balance sheet to ensure that it is maintaining an adequate amount of loss reserves on the bond insurance that it has written. This is insurance. Any company that offers it has to be supervised to ensure that they are actually capable of paying in the event of a disaster. This is true of flood and fire insurance, this is true of hurricane insurance, and this is most emphatically true of  bond insurance. The first, and most important, regulation would be the regulation specifying the minimum amount of loss reserves companies would be required to hold on any 'bond insurance' that they write  And Congress needs to get cracking on this too, because right now the regulations are so inadequate that even hedge funds are allowed to write credit default swaps. The bond markets aren't going to settle down again until this problem is taken care of. And that's bad news for all of us, because until the bond markets settle down, and are willing to start lending again, the economy is going to go nowhere but down.

Now, the actions I have already talked about will take care of the emergency that Paulson's Plan was introduced to take care of, i.e., the meltdown of the entire financial system if and when one of these big problem banks goes bankrupt. But we need to save more than just those 4 or 5 big problem banks if we want to get the economy back on track. There are a lot more than 4 or 5 banks that are in trouble and need to be re-capitalized. The free fall in real estate has impaired the balance sheets of a lot of banks, to the point where they are likely to fail, or simply slow their lending to a crawl due to their massively impaired balance sheets.  These smaller banks with inadequate capital need to be taken care of too, one way or another - either recapitalized, or shut down and their assets taken over by another healthy bank. Because until these smaller banks have been dealt with one way or another, to the point where they can start lending again, well, see above re the economy, and where it is going to be headed. 

But there are hundreds of large and medium sized banks, and thousands of small community banks, and hundreds of savings & loans, and credit unions.  Sorting out the sheep from the goats, and deciding which ones should be assisted, and which ones should be allowed to fail is a pretty  massive undertaking. The only agency that seems qualified or even capable of doing the job is the FDIC and its sister agencies that regulate credit unions, and savings & loans, etc. They will have to be brought on board, and given the task of deciding which banks are healthy, which banks should be allowed to fail, which banks should be re-capitalized, and how much additional capital they will require. In fact, we should probably give them the job of supervising the entire operation, and of course, the funds to do the job. 

You're probably screeching right about now about the kind of money it would take to do this job, suggesting we inject capital into banks, left, right and center.  Believe me, I am not a free spending liberal. Very much the converse. I think the  Federal Debt is far too large already. But, as long as we re-capitalize these banks correctly, with a guarantee that US debt is senior to all existing debt and equity, we really are only talking about a loan. We, the US taxpayer should get most or all of it back again, in a few years. The vast majority of the banks that we re-capitalize won't fail, because of our timely assistance. The few that do, will have most or all of their losses covered by their unfortunate shareholders and bond holders. The US taxpayer won't take the hit. Heck, we might even make a little bit of money on the deal. The interest rates that banks are currently offering on CDs are pretty darn good.

Disclosure: none

Comments

[sickofthehype:]

Great job as usual to the government for establishing oversight to this complex/insane form of gambling going on. Buffett says CDS/derivatives are financial WMD, but what I want to hear is WHAT IS THE RESULT OF THIS GOING TO BE. We know they're bad, we know they're claims cannot be paid, so what is the end result?

We've gone from not knowing about them at all, to now being explained what they are and what they consist of, but how about some forsight into the result of their demise??? What does Buffett say about the outcome? I can't believe he's too worried about it putting $5B in GS.

Any thoughts?

2008 Sep 28 03:53 PM

[countrybanker:]

you are correct.

In addition to funding the toxic assets in their current shells, I would not be opposed to using taxpayer money to invest in some of the non-zombie institutions. But taxpayer wants to hire Buffett to set the terms. Goldman Sachs needs to pick its pants up, any time now, after Buffett was finsihed with them.

Wall Street will eat Treasury's(taxpayers) lunch in the Paulson Plan, but Buffett could protect the taxpayer. That would just be an appetizer for the Nebraska boy who just fell off the turnip truck

2008 Sep 28 06:45 PM

[pkscottx:]

Finally, some sanity.

The Pols and the Pundits are rushing in to point the finger of blame to anyone but themselves. Truely there is enough blame to go around. This train wreck was decades in the making while every critic who predicted it was marginalized as a nut job.

There are arguments aplenty against the "bailout: Moral, Constitutional, and Economic. But the biggesst and the best is that IT WILL NOT WORK.

I've read the new and inproved version, it still won't work.

WE are witnessing the collapse of classic Ponzi scheme designed by economists who actually believe the absurd notion that you can build economic prosperity out of a mountain of debt.

It worked great as long as more debt was being shoveled into it.

Unfortunately this mountan of debt was built on the back of the American Consumer and we are TAPPED OUT.

This plan is an end game ploy to create more debt by confiscating our future earnings using the force of law as taxation.

The banks get the money right now. The taxpayer gets a deeper hole and an intergenerational transfer of wealth.

Does anyone see the flaw? It's a Ponzi scheme. It doesn't matter how much money/debt you shovel into it, unless you have infinate money/debt, it will inevitabley fail.

Theoretically you can "create" infinate money, but in the real world that didn't work out too well for Zimbabwe.

2008 Sep 28 08:49 PM

[Alan von Al...:]

Extremely good article, 100% correct. Thank you.

2008 Sep 28 09:29 PM

[Grabeard:]

The news has repeatedly mentioned $2000 as the added debt load for the U. S. taxpayers resulting from the Paulson $700,000,000,000,000
bailout plan. Perhaps my math is flawed but if you divide $700,000,000,000,000 by 305,283,091(9/28/2008 est. U.S. population)= $2,292,953 debt for every citizen. Perhaps providing this amount to each citizen in lieu of the banks would pay approximately 40% to the U.S. government for taxes, a substantial amount for state taxes, payoff a very large percentage of the bad mortages, provide a substantial nest egg for bank or brokerage deposits to fuel our economic engine , and fund a large increase in education for the future
of our country. Another alternative would be to bypass the government by providing warrants and/or shares of any profits directly to the debtors I.E. the taxpayers. A potential boost for future retirement and medicare needs? What are your thoughts?

2008 Sep 28 09:43 PM

[Grabeard:]

The news has repeatedly mentioned $2000 as the added debt load for the U. S. taxpayers resulting from the Paulson $700,000,000,000,000
bailout plan. Perhaps my math is flawed but if you divide $700,000,000,000,000 by 305,283,091(9/28/2008 est. U.S. population)= $2,292,953 debt for every citizen.

Perhaps providing this amount to each citizen in lieu of the banks would pay approximately 40% to the U.S. government for taxes, a substantial amount for state taxes, payoff a very large percentage of the bad mortages, provide a substantial nest egg for bank or brokerage deposits to fuel our economic engine , and fund a
large increase in education for the future of our country.

Another alternative would be to bypass the government by providing warrants and/or shares of any profits directly to the debtors I.E. the taxpayers. A potential boost for future retirement and medicare needs?

What are your thoughts?

2008 Sep 28 09:55 PM

[Jonathan Ch...:]

Perhaps I am not fully awake, but this whole thing seems to be very simple, at least the way I look at it. So by the numbers:

1. During the Clinton era, the wall between Investment Banks and all the other banks was torn down by the repeal of a Depression Era law that was Created because this kind of problem had lead (in part) to the Great Depression - the name of this law: The Glass-Spiegel Act. With the repeal, banks were freed to get more involved in highly lucrative - and highly speculative brokerage and similar activities. Things like CDS, CMO and all the other toxic devices come to mind.
2. These new debt instruments changed the relationship between banks and their depositors and loan purchasers. No longer did banks care about getting re-paid, since they were selling off the loans to other institutions, and were no longer responsible for the loans. they began earning money by creating and selling loans, instead of collecting principal and interest.
3. At the same time they began to lose sight of customers in terms of loan makers, they began to lose sight of customers as depositors. The Federal Deposit Insurance Corporation, acting under orders from the Federal Legislature (House and Senate), increased deposit insurance to $100,000 per account, and created or left open loopholes that allowed a family to obtain insurance on about $500,000 per institution they had accounts at. With that freedom, depositors mo longer looked to see if a bank was safe -they looked to see who offered them the lowest costs and the highest rates.
4. Banks (and mortgage companies) also began to see that they need not worry about how risky their loans were. the money they got was insured, and the loans they made were sold off. Mortgage brokers, in banks and other institutions made loans according to the rules, and the rules were very lax. Who created this problem? CONGRESS did, aided and abetted by Clinton AND Bush.
5. As things began to get sticky, as house prices rose, and loans no longer reflected the borrowers ability to pay, banks noticed that their defaults were starting to rise, and their capital base began to erode. So what did they do? they began to create more CD's to provide capital. That was no problem, since CD are insured. But there is a little clause in the system which PREVENTS banks with marginal capital from issuing CD's. So these banks applied for exceptions to the law - which they were permitted to do. And guess what,? It appears that in every case the exception was granted, allowing the weaker banks to pile on more debt.

So how do we get out of this - simple - REVERSE the changes in the laws that created the problem.
1. Banks do banking under the limits of a Glass Speigel revisited.
2. Derivatives are treated as insurance and are only issued by insurance companies, with appropriate capital and reserves.
3. Rating agencies cannot do any business other than rating and companies cannot shop for the best rating agency. A regulated board will assign rating agencies in some non-uncompromisable process.
4. The Treasury will only be allowed , under the "bailout" to purchase individual mortgages, and none of the insurance products, such as CDS or derivatives products, such as CMO's.. The value of these mortgages will be set at the prevailing market of that area. The current mortgage maker (homeowner) is th have the right of first refusal to purchase a mortgage at a bank's offering price, (which will be at least as high as the price offered by the Federal Government).
5. Federal deposit insurance will apply to households, and will not exceed more than $100,000, no matter how many banks or accounts the money is spread across.

This will do the following:
1. The Federal Government will be paying no more than it should
2. Homeowners would have the opportunity to refinance at the current market values and stay in their homes. The Mortgage-holding bank would be foolish to let them get away if they are at all qualified, sisnce it will get less money if it sells to the FED.
3. Banks with poor management would fail and uninformed investors would lose their money. Bad managers will lose their jobs.

2008 Sep 29 01:01 AM

[Californian:]

Grabeard,

700 billion is 700,000,000,000 . You have added 3 decimal places (showing 700 trillion). So, dividing by 305,283,091(9/28/2008 est. U.S. population)= $2,292 debt for every citizen, pretty much what Treasury says.

The trouble is that middle class citizens will pay more for this because lots of people pay no taxes. So, if your family net taxable income is 100K, I suspect this will cost your family perhaps twice as much, or $4500 per person, on average.

2008 Sep 29 01:30 AM

[paul:]

Jonathan, It is the second Glass-Steagall act that was passed in 1933 was known as The Banking Act of 1933. It was an attempt to prevent another stock market crash like the one in 1929. This was then repealed in 1999, a bill signed by President Clinton. ref: en.wikipedia.org/wiki/...

2008 Oct 01 04:41 PM