The Bank Bailout Trap

We’ve cornered ourselves trying to bail out the “Too Big To Fail” banks. In trying to keep them alive in the name of saving the financial system we’ve been pumping them full of our childrens’ tax dollars to little effect and we wonder why they’re not really lending. The downward spiral of their balance sheets from both toxic assets and falling stock price continues but how to stop that spiral is being debated hotly in boardrooms, financial markets and congress.

What’s preventing a solution from emerging is the “Too Big To Fail” trap. Until we recognize that these banks have already failed and we are throwing good money after bad we will continue pouring money down a bottomless hole. It’s like lending ‘grocery money’ to a junkie. We can’t allow ourselves to be held hostage by a handful of big banks.

I believe the only a comprehensive solution will get the financial system working again on a long term basis. Below are eight steps that are critical components of such a solution.

1- Place the insolvent banks into receivership now matter how big they are. This can be done by forcing failed banks to be split into a deposit bank and an investment bank preserving the deposit bank if possible and liquidating the investment bank portion.

2- The assets of these liquidated banks should be placed into Resolution Trust Company 2.0 (RTC) and sold off. The majority of these assets are mortgage backed securities (MBS) and credit default swaps (See 7 and 8, below for more). It’s the proper valuation of these assets is the real sticking point. It has been reported that 90-95% of the loans in the MBS are performing therefore the loans in each may have to be broken out individually so that the good loans can be sold at a price that reflects their value. As an alternative a regulated trading market along the lines proposed by the Chicago Mercantile Exchange could be created to trade these securities with a minimum price set by the Treasury with the funds from TARP.

3- The cleaned up banks then can be sold themselves, with new management in place or to come on board. If no buyers come forward for a particular bank it will be shuttered. The idea is that sales of the assets and the cleaned up banks will help offset some of the billions Treasury and Fed (read Taxpayers) have and will spend to save the financial system.

4- Glass-Steagall should be un-repealed so that banks cannot be in both commercial banking and investment banking. This is one of the most important lessons ‘unlearned’ from the banking crises that triggered the Great Depression. See my post Nov. 19 Entitled “Those Who Fail To Learn From History…“.

5- Deposit (Commercial) banks will funded by deposit accounts, make only portfolio loans or loans guaranteed by a revamped Freddie/Fannie and be backed with Federal depositors insurance. The new Freddie/Fannie will only back loans originated by deposit banks and will carry the full faith and credit of the US Government which should (or be mandated to) keep loan rates below what is available on securitized loans which will not have govt. backing. Deposit banks will serve the needs of depositors and borrowers looking for secure institutions backed by the government.

6- Non-bank lenders and investment banks will have capital requirements and be regulated by a revamped SEC as manufacturers of securities. Their loans can be held in portfolio or sold in the MBS market. These entities will not be allowed to take deposits nor will they have any government protection beyond SIPC. The ownership of these entities will be restricted to accredited investors, institutions, mutual funds and ETFs.

7- Mortgage backed securities will be treated as securities and regulated by the SEC. The regulation needs to include provision for standardization of the contracts so that the mortgages contained in each are clearly stated and easily identified.

8- Credit default swaps (or whatever name given them), which are actually an insurance product need to be regulated as such and their issuance restricted to nationally regulated insurance companies with specific capital requirements.

Someone was quoted recently saying that any institution to big to fail is too big to exist and I agree, particularly when it comes to our financial system. That a few large banks getting caught with bad speculations can bring our (and the entire world’s) financial system to the brink of disaster is confirmation of that fact.

We are also enduring the proof stage of an experiment testing whether human nature has evolved sufficiently since the 1920’s to function long term in an unregulated financial system. Clearly human nature has not evolved and it is just as clear that our financial system needs regulation to insure it’s integrity. A viable financial system should serve as the foundation of our dynamic economy but to do so it must be protected from our tendency to employ ‘creativity’ in the service of greed. The eight steps I’ve outlined above should be the starting point for rebuilding and maintaining that viability.

Giovanni Isaksen
Ashworth Partners Ltd.

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