Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

28 February 2009

Shock Therapy Now


Plan A: Control, Quarantine, Slice and Dice
Plan B: Nurture and Empower Local Banks
Conclusion
P.S. Warren Buffet Pans Derivatives

[For comment on the Obama Budget, click here.]

There are times when being right is not a happy feeling. Four days ago I wrote the following:
“[T]he truth is everything is collapsing at once. Credit, banking, finance, industry, housing, mortgages, employment, consumer sales, auto sales, international trade, and confidence in all of the above—all are collapsing simultaneously. The world is in economic free fall. So far that free fall is in slow motion, but it could accelerate without warning.”

Little did I know: the acceleration already had started. Yesterday the Commerce Department reported that our GDP shrank 6.2% last quarter. To people who think in numbers, that’s a deathly scary report.

What does it mean? That’s one quarter’s contraction. In the rosiest of all possible scenarios, in which the economy flatlines by this spring, it means our current quarter will be similar or worse. So in the best of all possible worlds, we will have suffered a cumulative economic contraction of at least 6%, and probably much more, for half a year by the end of March. (Successive quarterly drops in GDP do not add up because each is relative to the corresponding quarter in the previous year.)

Furthermore, the best of all possible worlds is extremely unlikely. In the Great Depression, the stock market took three years to bottom out, at about 10% of its peak. Our multiple crises began with housing-related finance. Housing moves much slower than stock, and we haven’t even begun to address the housing crisis or the derivatives crisis that it spawned.

What does this mean for Geithner’s “stress test” plans? Through no fault of his own, he’s a quarter late and several trillion dollars short.

The idea of the “stress test” is to guess whether big banks will meet regulatory capital and liquidity requirements under the “stress” of a prolonged downturn. The trouble is, the “worst case” scenarios in Geithner’s “stress tests” assume an economic downturn for 2009 that is at least twice as shallow as what this new GDP number suggests. The obvious conclusion: few big banks, if any, will pass a realistic “stress test” based on current and reasonably projected economic conditions.

So in their present condition, our big banks can’t possibly do the heavy lifting, anytime soon, that we need to raise our economy by its bootstraps.

What can we do? Here are two very different plans for shock therapy that might work:

Plan A: Control, Quarantine, Slice and Dice.

According to Yahoo Finance, Citigroup’s market capitalization as of Friday was $ 8.18 billion. On Monday it may be lower. After Geithner consummates his recently-announced conversion of the taxpayers’ preferred to common stock, “we, the people” reportedly will own 36% of Citigroup. The next 15%—which gets us to absolute numerical control—will cost $1.2 billion at Friday’s price.

That’s pocket change today. So we should do it. The government should buy numerical control of Citigroup on the open market (secretly, of course, so as not to disturb the markets or overpay). That act would bypass all the ridiculously irrelevant debate about “nationalization,” which, according to Bernancke, means wiping out shareholders by government fiat.

All by themselves, our free markets have virtually wiped out the shareholders already. But never mind. This plan will make them no worse off. For those willing (or forced) to hold for the long haul, it might even give them an upside. I don’t think we need cry for speculators who bought recently hoping to make a quick profit.

So much for the shareholders. What this plan will do is allow the government, with minimal expense, to fire the directors and officers and assume control. For a mere $1.2 billion in additional investment, the government can have absolute control and manage trillions of assets. That’s leverage!

Once the government assumes control through fair market purchases (not government fiat), the plan is simple. The government restructures Citigroup to quarantine its bad assets. Then it slices and dices the company into viable portions or lines of business in which private markets will invest.

The heart of the problem is so-called toxic assets, principally securities backed by bad or shaky mortgages and the derivatives that split them up or attempted to insure them against default. These assets are probably worth something, but nobody knows how much. Nobody will know until the housing market, if not the economy as a whole, stops free falling. That may take years. In the meantime, the big banks that hold these assets are not lending or borrowing.

So the government quarantines the toxic assets and sits on them until: (1) the markets figure out what they are worth, (2) the economy recovers and they are worth more, or (3) both. The government can do this because it’s not a private investor and doesn’t have to worry about stock market fluctuations or the next quarterly report.

With toxic assets quarantined, the rest of the plan is easy. Government sells as much of the rest of Citigroup’s assets as private investors are willing to buy, all at fair-market prices. If necessary, it breaks up Citigroup’s subsidiaries to do the same thing: quarantine their bad assets and slice, dice and sell the rest.

Surely Citigroup has some lines of business untainted by the mortgage crisis and irresponsible securitization. The goal of this plan is to get those lines of business in the hands of new private investors and under sound management as quickly as possible. Control, quarantine, slice and dice.

Bank of America is next. It’s current market capitalization is $18.82 billion. Fifty-one percent control will cost under $ 9.6 billion, less whatever “we, the people” already own after converting our current “investment.”

Buy control, quarantine, slice and dice. Continue through as many of the top ten banks as the government has to manage to get all their viable lines of business in new hands and soundly managed. Shoot for a deadline of thirty but no more than sixty days.

What’s left in the holding companies will be toxic assets, proceeds from the sale of viable lines of business, and whatever else may be unsalable. The government probably should hold these assets until the economy recovers in several years and then liquidate them (slowly, carefully and responsibly) for the shareholders’ benefit.

For example, the primary shareholders in Citigroup reportedly will include the governments of the United States, Singapore and Saudi Arabia. These are long-term investors. They probably won’t mind waiting a few years to maximize their return and to help save the global economy in the process.

Plan B: Nurture and Empower Local Banks

One of the best-kept secrets in this banking crisis is that our country has over 9,000 banks. (No, that’s not a typo.) Unfortunately, the top ten currently control the overwhelming majority of banking assets and credit. Concentrating all that financial power in the hands of so few financial managers was, of course, an idiotic idea. It was an important cause of our current collapse and yet another example of government being asleep at the switch.

So why not use the current crisis to reverse this disaster and re-establish a healthy, geographically diversified, decentralized banking system? Here’s how.

A second best-kept secret about our banking system is that there are conservatively managed, well-run banks among the “little guys.” The Washington Post ran a wonderful story about one of them in its own backyard a few months ago. Not only were these banks untouched by the subprime meltdown. Many of them remained profitable throughout our multiple crises and still are today. And they have a vital advantage over the big national banks: they know their local communities. They understand who is likely to weather the economic storm and to whom to lend responsibly.

At the moment, the “big boys” are in stasis. They claim they are sound, but they won’t lend or borrow. They don’t really know what their assets are worth, and they don’t even trust each other. So why not bypass the whole rotten system and build a new one, based on local control, proven competence, and community support?

No government mandates need be involved. The government already knows who the “good little guys” are through its bank examination process. It simply asks each of them, “would you like to be bigger—and to help your nation’s economy survive—by taking low-rate government loans?” Then it publishes the names of those that say “yes” on the Internet and provides (in the form of low-rate, flexible-term loans) whatever resources they need to expand their lending in their local communities as rapidly as possible. The government waives its capital requirements temporarily, for the duration of the emergency, for banks that agree to participate in this plan, meet stringent requirements for safe lending, and agree to stricter-than-usual, minute-by-minute government supervision.

Then people who need credit can go their local banks. Small businesses, home buyers, and students can. Big businesses can. Even GM can, if it can convince any good small banker that it’s a viable business.

Best of all, American’s banking system will return to its roots. Once again bankers will be conservative, stodgy folk who lend money carefully and know their local communities up close and personally. And even if many still fail, the decentralized system will provide greater strength, flexibility and resilience as our economy recovers.

Conclusion

Probably both of these plans are worth pursuing at the same time. If the big banks have enough viable lines of business now, Plan A will probably work faster. Plan B has the advantage of producing, in the medium term, a much healthier, more resilient banking system.

Both plans avoid the bugaboo of “nationalization” and the sterile debate about the role of government. In Plan A, government would be a market participant of last resort, not a market usurper or controller. In Plan B, government wouldn’t even do that much. It would just encourage good, small bankers to expand their activities rapidly, give them loans to help them do so, and give them free Internet publicity to help them reach potential customers.

Plan B, however, would tie up far more government money than Plan A, for Plan A relies on the enormous leverage that current low market valuations of supposedly sound big banks provides. If government uses that leverage, it can achieve sufficient control over the big banks to rationalize their holdings and business without ever muttering the word “nationalization,” even under its breath.

P.S. Warren Buffet Pans Derivatives

It’s nice when a certified investment oracle, in effect, confirms your analysis. Today Warren Buffet released his annual investment letter, explaining (among many other things) the biggest decline in 43 years in his iconic Berkshire Hathaway holding company.

Here’s what he wrote about derivatives:
“Improved ‘transparency’—a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks—won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.”
There’s lots more to the same effect in Buffet’s letter, which you can read in full if you subscribe to the Wall Street Journal’s on-line edition.

The clear implication of this language is that Geithner’s “stress tests” are not enough. They wouldn’t be even if his “worst case” assumptions were still realistic, which they are not. Nothing we can do with these instruments in the short term will make them any less toxic. No one with any brains or caution will buy them, so “bad banks” holding them will be non-starters.

The only rational thing to do with derivatives is to quarantine them, as suggested above, for the duration of the emergency. And the only institution strong and resourceful enough to do that on the scale now required is the U.S. government. Fortunately, the leverage that shaky banks’ low market values now provide should let government do it on the cheap.

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2 Comments:

  • At Sun Mar 01, 02:15:00 PM EST, Anonymous Anonymous said…

    Jay -- I don't understand why there are no comments on your blog ... is it that you lack readers or is it that the only response to your writing is "well said!"? If it is the former, then I need to send a link to your blog to my network, because you deserve to be widely read. If it's the latter ... let me join in their unvoiced opinion (if something that is "not written" can be said to be "unvoiced") and say "Well said!".

    Doug Lakey

     
  • At Tue Mar 03, 11:16:00 PM EST, Blogger jay said…

    Dear Doug,

    Thanks for asking. I don’t get a lot of traffic, just enough to keep me from shutting the blog down.

    As far as SiteMeter reveals, lots of my traffic comes from abroad and from educational institutions. That keeps my teacher side happy. Traffic died down a bit since Obama got elected, as many of his supporters liked my take on his candidacy.

    By all means, plug my blog into your network. Even though I’m keeping the blog anonymous, I still crave hits as much as the next blogger. I may drop the anonymity in a year or so, when I retire from teaching.

    As for comments, they’ve been sporadic and focused on particular issues. I got lots on an early post on health care, hits on which exploded after Andrew Sullivan threw me a link. Some comments have inspired posts of their own, for example, on abortion and on corporations and corruption.

    I think the main reason for the low number of comments is that I’m not getting that much exposure. Also, my posts may be too long; my wife thinks so.

    If you have a comment, please feel free to post. So far they’ve been rare enough that I’ve been able to respond personally to each one.

    Jay

     

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