On the Contrary

I think most people understand that banks may have a problem and they won’t lend, increasing the problems our economy is facing, but there is no real understanding of the “problem”.  So I thought that in my simple minded way I would take on the economic-babble and try to turn it into plain English.  I, of course, will oversimplify, probably to the point of actually making sense.  When you listen to the economic-babble, what gets lost are some fairly simple concepts wrapped in some deeply established conventional wisdom about free markets inculcated through years of dreary study.  As a structural engineer I liked to use terms like transverse loads and horizontal force resisting systems to hide some fairly simple concepts and always look serious so I could earn the big bucks.  It is part and parcel of the mystic of being a professional.

Okay, what is wrong with the banks and why won’t they lend money?  Because they don’t have any!  Wait, you say, what about the $350B we gave them?  Well it costs a lot of money to pay bonuses and continue with all those off-site conferences.   People are depressed with only getting six figure bonuses and motivation seminars in Vegas and Santa Monica with concerts by Chicago are not cheap.  Do you have any idea what an open-bar for 3000 costs?  Besides, corporate jets don’t run on water you know.

Seriously, they really don’t have any money because all that money they were taking in with your deposits they invested in CDOs (Collateralize Debt Obligations- Securitized Mortgages sliced and diced) to earn the maximum interest to pay for all the free services they offer you, the return on your money market accounts, and all those great bonuses.  As if those ATM fees weren’t enough.  In order to make your accounts liquid (funny how economist like to refer to cash flow as something that runs through you hands), i.e., the ability to cash you out when you want, they have to have cash on hand.

They have to borrow that money since the real money they got from you and stockholders is invested to earn them profit for what they are doing.  So when other banks look to loan them money, they want to know that their loan will be secured by the assets the bank holds so that if stuff happens, they can get their money out.  It has to be secured by the assets of the bank.  Ah and there is the rub.

If those assets are only worth about 20¢ on the dollar, your dollar that they invested in CDOs, that means that the banks liabilities exceed their assets. If things get tougher or there is a real run on the bank (people want their cash), the bank will collapse because they can’t sell the assets to cover this demand much less borrow it from anyone else.  You and anybody who loaned them money and invested in their bank will lose.  That is why the banks are holding on to the money the Fed gave them.  It improves their balance sheet and staves off the wolves.  They won’t loan it to you even if you are a good bet because they may need it to cover a run, bonuses or off-site motivation seminars.  How do you think they keep those really smart guys on their payroll that make those bad investments in the first place?

Worse, is that each of the banks also holds loans from each other.  This interconnectedness means that if one collapses, meaning their loan payback is now worthless; it impacts all the other bank’s viability.   Now comes the transparency thing.  Nobody knows who owns what and how much of a bank’s net worth is based upon these “toxic” assets.  So everybody is holding their cards close to their bodies and hanging on to their cash.

So with all this uncertainty, we have dollar constipation.  Now the way to solve the problem is to make the banks solvent again.  one way is to stop the mortgage crisis, stem falling housing prices to shore up the value of these “toxic” assets.  But that is a whole other story that I will take up later and just threw it in here to make the point that all of this is interconnected.  The other option is to increase their cash.  Secretary Paulson tried this by giving them $350 billion and it turned out not to be enough by a whole bunch.  Meanwhile taxpayers are wondering why they need to bail the banks for these bad decision on investments and want some protection on their money. The reason is that if all these banks domino, the net worth of the United States goes in the dumper and we as a country collapse.  But the concern about some return on taxpayer funding is a valid one.

Now the obvious solution is to nationalize the banks.  What this accomplishes is that the banks, now backed by resources of the federal government guaranteeing the worth of these assets, no longer fear a run, are recapitalized and can loan freely in an attempt to get back on their feet.  The government takes on and “insures” the liabilities of the banks and in an ownership role, can change management and benefit if the banks and their assets rebound.

But now comes the convention wisdom that governments just screw up markets.  This ignores the reality that the FDIC does this kind of thing all the time, but hey, when did facts and reality count for anything?   This belief in government bad, private ownership good is the result of all that dreary learning necessary to get your PhD in economics.  So here come all the exotic plans to recapitalize the banks while protecting the taxpayers where the government doesn’t really own the banks and it is left in private hands.  These go something like this and these are grossly over simplified.  There are multiple variations to either limit government control or try to change the heads banks win, tails taxpayers lose scenarios of anything less than nationalization:

• Insurance – The government insures the banks assets so that private capital will then feel secure enough to recapitalize these institutions (selling stocks and bonds).  Downside – banks keep their existing management that got us where we are and the government takes all the risk with no pay back.  If the assets collapse taxpayers are on the hook, if they rebound, the banks gain.
• Good Bank/Bad Bank – In this case the government establishes a “bad bank” that takes the bad assets off the hands of the bank leaving them capitalized to get back to work.  Downside – same as above, and the money to buy off all those assets comes from taxpayers.  If the assets (housing prices) come back, the government may recoup some losses, but that depends on the price the government initially pays for these assets.  Banks don’t want to admit the real price of these assets in today’s markets so this one is unlikely
• Continuing to Capitalize the Banks through preferred stock – This is basically what TARP did but has been adjusted recently.  It buys stock that is “preferred” in that they get a guaranteed return on the sock of 5%-8%, but have no voting interest.  The banks can then choose to convert this preferred stock to common stock getting out of the burden of the dividends, but then giving the government voting interest in running the bank.  Considering the price of most banks stocks and the cash needed, this would actually nationalize the banks without calling it nationalization.  Downside – While it infuses cash, it probably is not enough and requires Congress to authorize more, and it skirts the ownership issue leaving bad management in place unless the bank opts to turn itself over to the Feds.  If you really want to have your eyes roll back in you head, clink on this link to understand the details of this type of investment (The Baseline Scenario).

Note that all these solutions have one thing in common:  Don’t violate the conventional wisdom that these banks should remain in private hands.  Those private hands did a bang up job so far.  So for the short term they need to lose their license for running banks.  In my mind the uncertainty in the market is never going to be solved by the conventional wisdom of putting on a happy face and letting banks dangle.  We need to identify the problem, nationalize them, sell off their good assets, and re-privatize them as markets improve as smaller entities.  In a sense reboot the whole system and get the pain out of the way.

Most addicts understand that before recovery, you have to hit bottom or you are not ready.  The conventional wisdom is that we need confidence in our system so people will start spending again.  But we have not hit bottom so we will make the changes necessary to really correct our present situation.  Republicans still think Ronald Reagan applies and until they face reality, we are going nowhere.  That is why this obvious solution is still going to be a hard fight.  Until then, nationalization is a dirty word.  Or for the wingnuts, be afraid, the black helicopters are coming to take over our country.  First it’s the banks, then it will be national health care.  I say bring it on.