The Quiet Coup

The best and most comprehensive assessment I’ve seen yet of our current financial crisis is Simon Johnson’s article in the latest issue of The Atlantic, The Quiet Coup. Here’s the summary:

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

I’ve been very disappointed with the Obama administration’s handling of the crisis – they are letting the banks continue to run the show. As Johnson’s article makes clear, the financial sector wields preponderant influence in both political parties. Josh Marshall at Talking Points Memo explains the current politics of the situation well, as the extent of malfeasance in the financial sector becomes known, and public anger rises:

The problem is what appears to be the president’s mortifying impotence in the face of bankers and financiers who created the problem… I think the American people have demonstrated over the last six months that they’re willing to expend vast sums of money and endure great economic hardship without holding the damage against their political leaders. Effectiveness, in the sense of how long it takes to turn the economy around, is something they seem willing to be flexible on. But not on who’s in charge… From Geithner and Summers, and indirectly from Obama, we keep hearing financial-legal versions of ‘It’s bigger than the both of us’. Like we’re along for the ride, still taking dictates from the people who got us into the mess we’re in.

And Johnson, in the conclusion of his Quiet Coup article, is very clear about the economics of the situation:

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.

To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards—contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.

Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse.

To give credit where it’s due, Robert Reich (Clinton’s Labor Secretary) had it figured out back in January:

Back in the banking crisis of 1907, J.P. Morgan got all the major bankers into one room and forced a kind of reorganization on all of them. We need the same today — a giant reorganization of the banks, in which their shareholders lose what little value they have left, their creditors get paid 20 cents or so on the dollar, and their assets are written down to about 20 percent of their face value. In effect, it’s an industry-wide reorganization under bankruptcy. This way, bank balance sheets are cleared up, there’s no run on any one bank, everyone starts anew, and taxpayers aren’t left holding the bag.

Reich also emphasizes the urgency of the situation:

Six months ago it may have made sense for the government to buy up so-called “toxic assets,” based on home mortgages that should never have been issued. Three months ago it may have made sense to establish a “bad bank” to store them in, until they could be resold.

But as the Mini Depression worsens, “toxic assets” are no longer all that distinct from a vast and growing sea of non-performing or endangered loans on the banks’ balance sheets. Toxicity has spread to loans made to people and companies that were good credit risks as recently as early last year but are now bad risks. You don’t have to be an honest financier (no oxymoron intended) to figure this out: Ten percent of Americans are behind on paying their mortgages. Millions more are behind on paying their credit-card bills. Hundreds of thousands of small businesses are behind on paying their own bills. Auto suppliers can’t pay their bills. And so it goes.

A “bad bank” collecting all these non-performing or in-danger-of-becoming non performing loans might well become larger than the rest of the banking system — nationalization through the back door of lemon socialism, where the government (and taxpayers) own and control this vast sea of junky loans.

The current Treasury plan doesn’t force any transparency on the banks – it doesn’t require any honest accounting of the value of their assets. Instead it’s essentially an offer by the government to underwrite all the risk for anyone who will invest in banks, leaving the government (taxpayers) to absorb the losses if the investments fail. It’s a plan that again leaves the banks holding all the cards, serving no one’s interests but their own. If, for example, a bank owns a mortgage with a face value of $300K, and the home is foreclosed, the bank still has a $300K asset on its books. The home currently may be worth only $200K, but what incentive does the bank have to sell it at that price? Sales like this would bring in cash, but would dramatically reduce the value of what’s on the bank’s balance sheets. Enough such sales would likely push them into insolvency. The bank’s incentive is to instead find a way to persuade the government and investors to pay far more than what the assets are worth, or to just not sell them at all, and hold out for another bailout. (Credit for the observations in this paragraph goes to Maria, who understands the financial sector at a much deeper level than I do).

In the end, I’m forced to agree with this cynical observation from the comment section on a post about the possibility of banks gaming the plan (i.e. through proxies, bidding up the sale price of their own assets and leaving taxpayers on the hook for the difference):

As far as I can tell, the endless succession of plans offered up over the last six months has had one goal: come up with something complicated enough to provide political cover for foisting the huge losses of the banks off on taxpayers. Even assuming no cheating/gaming, best-case scenario – isn’t that the whole point of the plan?

Another voice worth hearing on the economic crisis is Paul Krugman at the New York Times (scroll down to the “columns” section). And to avoid ending on too depressing a note, give a listen to the song Hey Paul Krugman:

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