Posted by MataHarley on 29 September, 2008 at 3:33 pm. 6 comments already!


We have been left with no good options. And today, Democrats and Republicans in Washington have agreed on an emergency rescue plan that is our best and only way to prevent an economic catastrophe.

Barack Obama… da man of “hope”

“Best and only”??? If it’s the *only* way, then it has the dubious honor of being not only the best, but the worst of selections… LOL

H/T to Curt on his post for the priceless Obama quote.


I think many of us already see the risks of this gamble the Bush WH, Treasury Dept and many Congressional members were rushing thru. And thank heavens enough constituents spoke up, and representatives listened with today’s vote.

Rather than go thru the extreme downsides of this totally flawed plan, the more important question is… where do we go from here? And for that, I’ve been reading and listening to the lesser acknowledge voices of economists out there…. the ones too many of the media ignores, focusing instead of spreading the “Great Depression” fear if we don’t act (even unwisely) immediately.

One such voice, who I thought laid out the scenario well, is Nouriel Roubini, a Professor of Economics at the Stern School of Business at NYU, and Chairman of RGE Monitor.

In a Sept 29th article on his website, he points out the flaws of the current proposal. Even with the GOP recommended changes, the principle remains the same… a government buy out.

Let me explain now in more detail why we are now back to the risk of a total systemic financial meltdown…

It is no surprise as financial institutions in the US and around advanced economies are going bust: in the US the latest victims were WaMu (the largest US S&L) and today Wachovia (the sixth largest US bank); in the UK after Northern Rock and the acquisition of HBOS by Lloyds TSB you now have the bust and rescue of B&B; in Belgium you had Fortis going bust and being rescued over the weekend; in German HRE, a major financial institution is also near bust and in need of a government rescue. So this is not just a US financial crisis; it is a global financial crisis hitting institutions in the US, UK, Eurozone and other advanced economies (Iceland, Australia, New Zealand, Canada etc.).

And the strains in financial markets – especially short term interbank markets – are becoming more severe in spite of the Fed and other central banks having literally injected about $300 billion of liquidity in the financial system last week alone including massive liquidity lending to Morgan and Goldman. In a solvency crisis and credit crisis that goes well beyond illiquidity no one is lending to counterparties as no one trusts any counterparty (even the safest ones) and everyone is hoarding the liquidity that is injected by central banks. And since this liquidity goes only to banks and major broker dealers the rest of the shadow banking system has not access to this liquidity as the credit transmission mechanisms is blocked.

Yes, the previous bail outs have not thwarted banking failures. As I pointed out, despite the buy out of AIG, the Bank of Switzerland is still in trouble. And this problem is not unique to the US, with RGE’s Edward Harrison chastising Europe on the heels of their criticisms of the US over problems in banking.

See other economist comments on the RGE Forum INRE the folly of this “cure”

Since the American public, and enough Congressional members, have come to the conclusion that the current proposition on the table is bad juju, just what is an alternative? And what we find is that banking failures are not without precedence.

In Roubini’s article the day before, Is Purchasing $700 bil of Toxic Assets the Best Way to Recapitalize the Financial System?, he points out that government purchase of bad assets was the exception, rather than the rule, in previous events.

A recent [Sept 2008] IMF study of 42 systemic banking crises across the world provides evidence on how different crises were resolved. First of all only in 32 of the 42 cases there was government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any government financial intervention. Of the 32 cases where the government recapitalized the banking system only seven included a program of purchase of bad assets/loans (like the one proposed by the US Treasury). In 25 other cases there was no government purchase of such toxic assets.

In 6 cases the government purchased preferred shares; in 4 cases the government purchased common shares; in 11 cases the government purchased subordinated debt; in 12 cases the government injected cash in the banks; in 2 cases credit was extended to the banks; and in 3 cases the government assumed bank liabilities. Even in cases where bad assets were purchased – as in Chile – dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets. Of course in most cases multiple forms of government recapitalization of banks were used.

But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay. Even in six of these seven cases where the recapitalization of banks occurred via the government purchase of bad assets such recapitalization was a combination of purchase of bad assets together with other forms of recapitalization (such as government purchase of preferred shares or subordinated debt).

In the Scandinavian banking crises (Sweden, Norway, Finland) that are a model of how a banking crisis should be resolved there was not government purchase of bad assets; most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead – in most cases in which it was used – made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).

Roubini rightly points out that there is no basis in fact over history that supports the notion that injecting $700 bil of taxpayers’ cash results in recapitalization of the market. He calls the plan a disgrace… a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown.

In fact, from the Conclusions of the IMF 80-pg Sept 2008 study, they find that government purchases of toxic assets have proved largely ineffectual.

Government-owned asset management companies appear largely ineffective in
resolving distressed assets, largely due to political and legal constraints.
Next, the adverse impact of the stress on the real economy need to be contained. To relief indebted corporates and households from financial stress and restore their balance sheets to health, intervention in the form of targeted debt relief programs to distressed borrowers and corporate restructuring programs appear most successful. Such programs will typically require public funds, and tend to be most successful when they are well-targeted with adequate safeguards attached.

So now we have some insight into alternatives to what Congress proposes. Roubini has a 10-step proposal for dealing with the financial crisis. Even so, he warns that the recovery will be painful.

Even if the Treasury TARP plan is implemented fairly and efficiently the US will not avoid a severe U-shaped18-month recession and a severe financial and banking crisis: the recession train has already left the station in Q1 and the financial/banking crisis will be severe regardless of what the Treasury and the Fed do from now on. What a proper rescue plan can do is to avoid having the US experience a multi-year L-shaped recession and extreme financial crisis like the one that led to a decade long stagnation in Japan in the 1990s after the bursting of their real estate and equity bubbles.

I have also argued that, in order to resolve this financial crisis it is not enough to take the bad/toxic assets off the balance sheet of the financial institutions (a new RTC); it is also necessary and fundamental to reduce the debt overhang of millions of insolvent households via a significant debt reduction on their mortgages (an HOLC program like the one that was implement during the Great Depression); and also recapitalize undercapitalized banks with public capital in the form of preferred shares (as the RFC did with 4000 banks during the Great Depression). An RTC scheme without an HOLC and RFC component would not resolve two fundamental problems: millions of households are insolvent and unable to service their mortgages; the financial system is vastly undercapitalized and needs capital to avoid an ugly credit crunch and to foster new credit creation that is needed for future growth.

That is why I proposed the creation of a HOME (Home Owners’ Mortgage Enterprise) that would be a combination of an RTC, a HOLC and a RFC. Let me flesh out this proposal and its key elements and compare it to the Treasury TARP proposal that in its current form has many flaws.

Unfortunately, it’s a subscription to get those 10 steps… grrrr. You can subscribe anddownload an audio file of a Sept 24th conference call all that lays out Roubini’s 10 steps.

But the basics are three fold:

1: Take the toxic assets off the balance sheets with a newly created RTC (a Resolution Trust Corporation)

2: Reduce the debt via mortgage reduction via a new HOLC (Home Ownership Loan Corporation, ala Great Depression style)

3: And recapitalize the distressed banks with public capital via preferred shares (ala the Great Depression’s Reconstruction Finance Corporation which made loans as well as purchasing stock)


Another similar cure comes from the Financial Times blog, in a post by Larry Kotlikoff and Perry Mehrling. They suggest establishing a price for insurance to be sold to the banks (part of the GOP suggested alternative… tho not a mandate for the participating banks)

What kind of insurance are we talking about? One such insurance contract, for example, is the credit default swap on the various tranches of the subprime mortgage ABX index. Once we set these index swap prices, then implicitly we set the prices of all assets that are priced with reference to these index prices, which is actually a good chunk of the troubled asset universe.

Part two of their suggestion was addressing the banking solvency by allowing purchases of credit insurance to pay via preferred stock.

By setting the price of insurance we establish a price of assets, which may well be below the value at which financial institutions are carrying these assets on their books. Mark the assets to market and you make the solvency problem worse. That’s the biggest problem with the Paulson plan (unless he overpays for the assets, and that raises additional political problems). In our plan, we solve the solvency problem by letting buyers of credit insurance pay for that insurance with preferred stock.

The result is that, after buying insurance from the government, buyers will be able to carry the assets at par, or sell them at par (by packaging them with the insurance) in order to raise cash. Either way the value of their assets will be marked up by the value of the insurance, and that markup is also the amount of recapitalization. Both problems are solved at the same time.

There is yet another voice – former Merrill Banker Christopher Ricciardi. In a NYT’s article on Sept 26th, he laid out objectives in an open letter to Henry Paulson and the US Treasury with suggestions that bear similarity to the above proposals. He suggests a resurgence in securitization.

Needless to say, there are other alternatives, and many voices speaking up. A responsible Congress owes this to all of us to explore these possibilities before embarking on an irreversible road to socialization at high cost to the American taxpayer. The first two above plans have commonality with the preferred shares and insurance. The GOP did attempt to place some of these options into the plan, but the overall premise remained the same… a government buy out.

None of these cures will alleviate the pain all of us will experience for this undeniable Congressional failure. But that pain can most certainly be lessened, and the time of recovery shortened, with the majority of the financial responsibility shouldered by the private market, and not the US taxpayer.

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