Banking Badly

January 30th, 2009 by Phil Mattera

The markets are abuzz with speculation that the Obama Treasury Department may use a scheme known as a “bad bank” as a new gambit in trying to resolve the widening financial crisis. Despite its name, the concept does not involve pillorying corrupt and reckless financial CEOs for their sins—as President Obama in effect did Thursday in expressing outrage over Wall Street bonuses. On the contrary, it is a way of absolving banks for their misguided lending and investment practices by having the government acquire their tainted assets and place them in a separate entity.

If this sounds familiar, it’s because it is essentially what former Treasury Secretary Henry Paulson insisted back in September was essential to the survival of capitalism. Yet after he steamrolled Congress into giving him authority to spend $700 billion on such purchases, he turned around and pursued an entirely different strategy of injecting massive amounts of capital into the banks. Since that approach failed to restore normalcy to the system, Paulson’s successor Timothy Geithner apparently wants to turn the clock back five months.

The mystique surrounding the bad bank idea comes from the fact that Sweden employed the technique to resolve a similar financial crisis 15 years ago. As the New York Times gushed recently: “With Sweden’s banks effectively bankrupt in the early 1990s, a center-right government pulled off a rapid recovery that led to taxpayers making money in the long run.”

Creating a bad bank is being depicted as an alternative to nationalization of major financial institutions. In fact, stock markets shot up on Wednesday after Geithner said the Administration would “do our best to preserve” the system of private ownership of banks.

What bad bank proponents tend to overlook is that the plan would probably involve nationalization as well. This is what happened in Sweden, where the government did not just relieve banks of non-performing loans and then leave them alone. Gota Bank, one of the weakest institutions, was nationalized and was compelled to merge with Nordbanken, which had been owned partly by the government but was then taken over completely (and privatized years later).

There are some other details about the Swedish experience worth noting. First, the government did not acquire the problem assets of all banks, though it did guarantee their obligations. The main bad banks were the ones spun off from Gota Bank and Nordbanken. Second, the troubled assets the government took over via entities called Securum and Retriva were mostly loans to commercial property owners and shares in industrial companies. Securum and Retriva took control of those properties, and when the commercial real estate market rebounded, they were able to sell off those holdings easily.

The financial world has gotten more complicated since the early 1990s. The toxic assets polluting the balance sheets of major U.S. financial institutions today are complex instruments such as mortgage-backed securities and collateralized debt obligations. These represent packages of large numbers of loans that cannot easily be disentangled. It is one thing to resell discrete office buildings and shopping malls but quite another to seize and resell thousands of bundled home mortgages. Does the federal government want to become a gargantuan version of those amoral people on late-night infomercials bragging about buying up and then reselling foreclosed homes?

Rather than wasting vast additional sums in a bad-bank bailout, why doesn’t the federal government direct its resources toward the creation of a “good” bank? The Federal Reserve is already acting not just as the lender of last resort to banks but has also provided loans to non-financial corporations by purchasing their commercial paper. Why stop there? If the for-profit banking system really is dysfunctional, then the solution may be to have the federal government step in to replace or supplement it in a major way. That’s the kind of intervention that may actually do us some good.

3 Responses to “Banking Badly”

  1. If the for-profit banking system really is dysfunctional, then the solution may be to have the federal government step in to replace or supplement it in a major way.

  2. CounterCorp says:

    The economic priestly caste has decided that the only way to rescue the status quo financial system is to shore up the institutions that overleveraged themselves in a greed-fueled frenzy to draw in ever-more money from investors at the bottom and funnel it to the so-called “masters of the universe” at the top — in effect, absolving them of any responsibility for the Ponzi scheme that is the modern global financial system.

    (Any system that requires constant inputs of new capital investment to maintain itself is a pyramid scheme, rather than a self-sustaining investment mechanism functioning on the basis of increased productivity/output/utility. When banks overleverage themselves to speculate on outcomes that require convincing ever-greater numbers of people to invest ever-increasing amounts of money in order for those outcomes to occur, that’s a pyramid scheme.)

    All the talk about good banks and bad banks misses the larger point that doing either one (or anything tried or proposed by mainstream officialdom or its amen corner in the academic and public policy sectors thus far) will merely shore up and thus further entrench the status quo ante. Who wants to spend trillions of dollars just to get back to where we were a month or even a year before the collapse of the system as it is/was, with the same people in charge of the corporations, the government, and academia? How is that a solution … ?

    The government should simply buy up all the bad mortgages and sort them out. The ones that can be financed at a reasonable, government-backed rate (say, 5 percent) should be re-financed by the government at that rate; if it can create a Resolution Trust Corporation to sort out the S & Ls during the 1980s, it can create a Mortgage Trust Corporation to sort out the mortgages now.

    Anyone who can’t afford to pay their mortgage at even 5 percent probably bought too much house — a rampant problem during the speculation-fueled housing bubble of the late ’90s and early 2000s — and should be made whole again buy having the government seize the house for what the “owners” have already PAID for it in terms of mortgage payments (not what it was allegedly “worth” when it was sold at bubble-inflated prices).

    The “owners” get their money back and find themselves right where they were before they bought the house; the government gets sellable properties more accurately valued then they were before the bubble burst, which they can they sell off to recoup the money paid to the “owners” for them — and perhaps even at a modest profit (to cover the administrative costs of the whole process).

    The housing system gets returned to the pre-bubble status quo, which was not great, but far better than maintaining the bubble, and a lot of people who should never have bought a house in the first place go back to renting. People who can afford a 5 percent mortgage have one, and keep their houses. And the banks get a small percentage of the speculative instruments they hold for the mortgage-backed securities, which is exactly what they — and their investors — deserve for speculating and losing.

    If the banks go under, good riddance. If they take a lot of investors down with them, that’s the price of speculation. Until people learn that Ponzi schemes don’t work, and that modern, non-manufacture/service finance is largely a pyramid scheme, they’ll just shift from one bubble to another, whether it’s stocks (in the ’90s), housing (in the 2000s), or food/water/energy/etc in the 2010s. The problem is not the instruments themselves, but the mentality that sees speculation as synonymous/interchangeable with actual finance and investment.

    We need to take the profit out of speculation, to force people to invest in more tangible and sustainable things, and rescuing speculators — which is what every one of the current proposals would do — hardly discourages speculation …

  3. […] Timothy Geithner is expected to announce next week—a plan that could include the creation of a “bad bank” to allow financial institutions to unload their toxic assets onto the taxpayers. Cracking down […]

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