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The Washington Independent
The Washington Independent

A Path to Economic Recovery

The recession is getting worse, with the jobless count steadily rising and credit markets still far from operating smoothly. A big part of the problem is that government bailouts are encouraging banks to mask the extent of their balance-sheet problems. It’s time for the banks to come clean if the economy is going to restart.

Liam Evans
News
Last updated: Jul 31, 2020 | Dec 08, 2008

Last week’s horrendous jobs report actually understates the nastiness of the recession. Along with the 533,000 jobs lost in November, the government nearly doubled previous job-loss estimates for September and October, bringing total losses thus far in 2008 close to the 2 million mark. In short, we are well into what is shaping up as the worst recession of the postwar era.

Depressingly, the downturn is accelerating despite more than a year of extremely aggressive remedial actions by the Federal Reserve and the Treasury, which together have pumped some $2.5 trillion of new liquidity into the financial system, with almost no visible result.

Why isn’t the reflation program more successful?

Illustration by: Matt Mahurin
Illustration by: Matt Mahurin

For one thing, the government seems to be encouraging the banks to mask the extent of their problems. For instance, in a deal currently being finalized with Citigroup, the government would guarantee about 90% of a $306-billion portfolio of toxic assets in return for $7 billion in preferred stock. The purpose of the deal seems to be to minimize more Citigroup writedowns, even though its portfolio’s real value is almost certainly much less than the carrying amount. The Fed is similarly propping up ersatz valuations at dozens of other institutions by exchanging hundreds of billions of its Treasuries for a variety of shaky assets at something close to par.

No wonder banks are hoarding cash. They don’t trust even each others’ numbers. There are at least $1 trillion of unrealized losses and writedowns still sitting on banks’ books, and credit markets will not revive until they are cleaned out. Here’s one way to get things moving again:

*Create a temporary bank-auditing control board. *Coordinated audit teams from the Fed, the Securities Exchange Commission and the Comptroller of the Currency should conduct an urgent systematic review of all bank and brokerage portfolios, starting with the biggest, forcing realistic writedowns against consistent standards. Such an expert board, with both government and private-sector members, would set the standards and resolve disputes. The goal would be force honest accounting, no matter how big the losses.

*Move all assets that are underwater into a “bad bank.” *A bad bank is an entity that absorbs toxic assets at realistic values. The technique has been used successfully in many other countries, and also in the United States after the banking disasters of the 1980s. The bad bank manages the collection process and/or sells off assets to specialist vulture investors. Its equity is supplied by the banks that contribute assets or by the government. Its shares can be distributed to existing bank shareholders or held in a separate entity controlled by the contributing banks. The ‘good’ banks left after the disposition of their bad assets will finally have clean books and should be able to get back to the business of lending.

In the current crisis, it would far preferable to have a single über-bad bank controlled by all the banks contributing assets rather than by the government, as envisioned by Treasury Secretary Hank Paulson’s original Troubled Asset Relief Program, or TARP. Under Paulson’s plan, the government would have been negotiating prices of hard-to-value toxic assets, which is a set-up for financial rape. In a bank-controlled bad bank, board members would be vigilant against sweet deals for their rivals, so pricing would be realistic.

Make a sufficient one-shot equity infusion to recapitalize the banks. Probably $1 trillion of new equity would be required to cover the losses disclosed by the audits and to capitalize the bad bank. That would have to come from the government, and it should be in the form of common equity. Common equity is more highly weighted in bank-capital calculations, and it doesn’t impose the drain of interest or preferred dividend payments.. Pricing should be arm’s-length, ideally negotiated by another temporary board of pricing experts. The current process of huge, opaque, midnight deals hammered out by a small group of officials has a dangerous catch-as-catch-can air. Common equity infusions on the scale required would wipe out all or most current equity at many banks. But that’s the deal equity holders sign up for, and there’s no reason why they should be subsidized.

*Create a fiduciary structure for holding government-owned stock. *Neither the executive branch nor Congress should have any control over government-owned bank stock stemming from the restructuring. A simple solution would be to donate the stock to the Social Security Trust Funds under the control of a fiduciary board, like those at mutual funds, to manage, or sell off, the shares in the interest of Social Security beneficiaries.

This, or some process like it, would take at least a year to complete, but it would be far preferable to the current semi-random process of throwing trillions of dollars at the credit problem with little effect. And while cleaning up the banks would be a necessary condition to ending the credit crisis, it would not be sufficient. Other things must be done.

President-elect Barack Obama’s just-announced infrastructure spending program is a good start toward creating jobs and restarting economic growth. But it will take time. It also depends on the rest of the world’s willingness to keep absorbing U.S. debt.

The new administration might also explore privatized infrastructure construction, with lenders reimbursed from tolls and user fees. Those may be attractive investments for dollar-heavy sovereign wealth funds and would help repatriate the huge international overhang of dollars.

Because new stimulus programs will not have immediate effects, they should be paired with much-improved income relief for the large numbers of lower-income workers who are losing their jobs. The United States consciously accepts a higher level of economic instability than other industrialized countries but puts a disproportionate amount of the adjustment burdens on the backs of lower-income families.

The new administration should not try to reverse the rapid decline in consumer spending that started this fall. The grossly overleveraged consumer sector created by Wall Street’s lending binge is the main reason we’re in crisis. Trying to gin up high levels of consumer borrowing again is simply crazy. Households understand that they have to pare down debt and boost their savings. They are behaving far more sensibly than the Fed or the Treasury.

The sad reality is that we’re deep in the grip of a truly nasty recession that will probably run at least through 2009. Tiding over poor families is of crucial importance. Jollying along the banking sector, and assisting in the cover-up of their true losses, will ensure only years of stagnation.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

Liam Evans | Liam Evans is a freelance writer and social media manager who specializes in assisting finance professionals and Fintech entrepreneurs in growing their online audience and attracting more paying customers. Liam worked as a bank teller and virtual assistant for financial firms in the United States and the United Kingdom for six years before beginning her writing career.

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