Submitted by Rolfe Winkler, publisher of OptionARMageddon
The Congressional Oversight Panel released its latest report yesterday. Luckily news outlets reporting on the release (see Bloomberg and Housing Wire) are skipping Warren’s YouTube and Executive summaries–awkward exercises in establishing consensus both of them. They focus instead on the report’s more provocative suggestion, that liquidating failed banks would be a better way of solving the economic crisis.
And we’d better get a move on. The report makes a very good point that unlike Japan and Sweden, we can’t rely on international consumer demand to rescue us:
…we may in fact be more economically vulnerable to a weakened financial system than either Sweden and Japan were because we cannot rely on some larger economy to generate consumer demand for our goods and services.
Unfortunately, the report is not able to conclude that liquidation is the way to go. Three panel members—John Sununu, Richard Neiman and Jeb Hensarling—remain convinced that we’re facing a short-term liquidity problem, not a long-term solvency problem. With that in mind, they think Treasury’s plan to subsidize banks is the least bad option. Keep them stumbling along until favorable lending conditions return them to profitability. But if the banks ARE insolvent, then subsidizing them is pouring public money down the drain. We know this from Japan’s experience. They kept banks on life support for a decade, which solved nothing. They ran up stupendous budget deficits in a failed attempt to stimulate an economy weighed down by broken banks. Hard as they tried, Japan couldn’t borrow its way out of its bank crisis. And neither can we.
This point of contention is easy to spot when reading the report’s executive summary next to the John Sununu/Richard Neiman “alternative view.”
From Warren’s exec summary:
One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.
Were internet stocks “artificially depressed” after the bubble burst in 2001? If you think so, then I’ve got eToys stock I’d like to sell you for $50 a share. With that in mind, it’s absurd to think real estate prices are now “artificially depressed.” They are returning to valuations that are fundamentally sound, i.e. supported by actual cash flows as opposed to easy credit. “Mortgage-related assets” are secured by real estate. If houses are declining in value, the loans made to purchase them at obscene valuations must also fall. Back to Warren…
If its assumptions are correct, Treasury’s current approach may prove a reasonable response to the current crisis….
On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth. The actions undertaken by Treasury, the Federal Reserve Board and the FDIC are unprecedented. But if the economic crisis is deeper than anticipated, it is possible that Treasury will need to take very different actions in order to restore financial stability.
She is bending over backwards to give Sununu/Nieman a fair shake. Here’s their view:
We affirm that it is entirely reasonable to assume that a liquidity discount is impairing these assets, and thus that the Treasury has adopted a viable plan based on this valid assumption. Further, we believe that a viable plan should be given the opportunity to work. Speculation on alternatives runs the risk of distracting our energy from implementation of a viable plan and needlessly eroding market confidence. Market prices are being partially subjected to a downward self-reinforcing cycle that could be exacerbated by unwarranted consideration of more radical solutions such as nationalization.
How Sununu and Neiman can justify this opinion is beyond me. Banks have but a fraction of tangible common equity relative to their assets, which means there’s no cushion to absorb losses. To argue that this is a liquidity problem, one needs to prove that asset values are temporarily depressed, that the values they reached during the bubble were in fact “correct.” But of course they weren’t. So why give equal weight to bullshit arguments that assets tied to real estate are “depressed?”
Winning this argument is crucial to getting through this crisis with our national balance sheet intact.
Fannie and Freddie are insolvent to the tune of hundreds of billions (so far Obama has committed $200 billion to each of them). You no longer hear arguments that these institutions are just temporarily illiquid. The banking sector has been the recipient of far larger subsidies in total yet opponents of seizing them still delude themselves that banks are still fundamentally sound.
How interesting that a Republican like Sununu is helping to lead the charge here. No doubt he justifies his opposition to “nationalization” on some sort of bastardized free market grounds. The last thing he probably wants is government control of banks. But he’s missing the forest for the trees. The socialist solution to the problem isn’t taking control of the banks, it’s having taxpayers absorb bank losses. Capitalism is about failure. Bad businesses fail and good ones rise in their place. This leads to employment volatility in the short-term but more growth and innovation in the long term.
Because economic activity is particularly sensitive to the fates of the financial sector, we have a particular way of dealing with bank bankruptcies. Receivership or liquidation as directed by FDIC. That’s the only “solution” to the bank crisis.
But it’s not fair to single out Republicans for permitting this travesty to continue. Yes, the bailout policy originated with the Bush administration, but clearly Obama has taken ownership of it. This is a shame. Having heard him speak about the superiority of the Swedish solution to the Japanese one, I think he knows that a proper bank recapitalization needs to happen. Yet he clearly doesn’t have the cojones to deliver the goods. He can’t even stand up to his own economic team; Geithner and Summers will move mountains to protect banks and their creditors. This will continue until Barack puts a stop to it.
Hopefully by firing both of them and putting Paul Volcker in charge.
(You can read this guest author’s blog here)