Guest Post: The Real Reason the Giant, Insolvent Banks Aren’t Being Broken Up

By George Washington of Washington’s Blog.

Why isn’t the government breaking up the giant, insolvent banks?

We Need Them To Help the Economy Recover?

Do we need the Too Big to Fails to help the economy recover?


The following top economists and financial experts believe that the economy cannot recover unless the big, insolvent banks are broken up in an orderly fashion:

  • Dean and professor of finance and economics at Columbia Business School, and chairman of the Council of Economic Advisers under President George W. Bush, R. Glenn Hubbard
  • The leading monetary economist and co-author with Milton Friedman of the leading treatise on the Great Depression, Anna Schwartz
  • Economics professor and senior regulator during the S & L crisis, William K. Black
  • Professor of entrepreneurship and finance at the Chicago Booth School of Business, Luigi Zingales

Others, like Nobel prize-winning economist Paul Krugman, think that the giant insolvent banks may need to be temporarily nationalized.

In addition, many top economists and financial experts, including Bank of Israel Governor Stanley Fischer – who was Ben Bernanke’s thesis adviser at MIT – say that – at the very least – the size of the financial giants should be limited.

Even the Bank of International Settlements – the “Central Banks’ Central Bank” – has slammed too big to fail. As summarized by the Financial Times:

The report was particularly scathing in its assessment of governments’ attempts to clean up their banks. “The reluctance of officials to quickly clean up the banks, many of which are now owned in large part by governments, may well delay recovery,” it said, adding that government interventions had ingrained the belief that some banks were too big or too interconnected to fail.

This was dangerous because it reinforced the risks of moral hazard which might lead to an even bigger financial crisis in future.

If We Break ‘Em Up, No One Will Lend?

Do we need to keep the TBTFs to make sure that loans are made?


Fortune pointed out in February that smaller banks are stepping in to fill the lending void left by the giant banks’ current hesitancy to make loans. Indeed, the article points out that the only reason that smaller banks haven’t been able to expand and thrive is that the too-big-to-fails have decreased competition:

Growth for the nation’s smaller banks represents a reversal of trends from the last twenty years, when the biggest banks got much bigger and many of the smallest players were gobbled up or driven under…

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand.

BusinessWeek noted in January:

As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business owners…

At a congressional hearing on small business and the economic recovery earlier this month, economist Paul Merski, of the Independent Community Bankers of America, a Washington (D.C.) trade group, told lawmakers that community banks make 20% of all small-business loans, even though they represent only about 12% of all bank assets. Furthermore, he said that about 50% of all small-business loans under $100,000 are made by community banks…

Indeed, for the past two years, small-business lending among community banks has grown at a faster rate than from larger institutions, according to Aite Group, a Boston banking consultancy. “Community banks are quickly taking on more market share not only from the top five banks but from some of the regional banks,” says Christine Barry, Aite’s research director. “They are focusing more attention on small businesses than before. They are seeing revenue opportunities and deploying the right solutions in place to serve these customers.”

And Fed Governor Daniel K. Tarullo said in June:

The importance of traditional financial intermediation services, and hence of the smaller banks that typically specialize in providing those services, tends to increase during times of financial stress. Indeed, the crisis has highlighted the important continuing role of community banks…

For example, while the number of credit unions has declined by 42 percent since 1989, credit union deposits have more than quadrupled, and credit unions have increased their share of national deposits from 4.7 percent to 8.5 percent. In addition, some credit unions have shifted from the traditional membership based on a common interest to membership that encompasses anyone who lives or works within one or more local banking markets. In the last few years, some credit unions have also moved beyond their traditional focus on consumer services to provide services to small businesses, increasing the extent to which they compete with community banks.

Indeed, some very smart people say that the big banks aren’t really focusing as much on the lending business as smaller banks.

Specifically since Glass-Steagall was repealed in 1999, the giant banks have made much of their money in trading assets, securities, derivatives and other speculative bets, the banks’ own paper and securities, and in other money-making activities which have nothing to do with traditional depository functions.

Now that the economy has crashed, the big banks are making very few loans to consumers or small businesses because they still have trillions in bad derivatives gambling debts to pay off, and so they are only loaning to the biggest players and those who don’t really need credit in the first place. See this and this.

So we don’t really need these giant gamblers. We don’t really need JP Morgan, Citi, Bank of America, Goldman Sachs or Morgan Stanley. What we need are dedicated lenders.

The Fortune article discussed above points out that the banking giants are not necessarily more efficient than smaller banks:

The largest banks often don’t show the greatest efficiency. This now seems unsurprising given the deep problems that the biggest institutions have faced over the past year.

“They actually experience diseconomies of scale,” Narter wrote of the biggest banks. “There are so many large autonomous divisions of the bank that the complexity of connecting them overwhelms the advantage of size.”

And Governor Tarullo points out some of the benefits of small community banks over the giant banks:

Many community banks have thrived, in large part because their local presence and personal interactions give them an advantage in meeting the financial needs of many households, small businesses, and agricultural firms. Their business model is based on an important economic explanation of the role of financial intermediaries–to develop and apply expertise that allows a lender to make better judgments about the creditworthiness of potential borrowers than could be made by a potential lender with less information about the borrowers.

A small, but growing, body of research suggests that the financial services provided by large banks are less-than-perfect substitutes for those provided by community banks.

It is simply not true that we need the mega-banks. In fact, as many top economists and financial analysts have said, the “too big to fails” are actually stifling competition from smaller lenders and credit unions, and dragging the entire economy down into a black hole.

The Giant Banks Have Recovered, And Are No Longer Insolvent?

Have the TBTFs recovered, so that they are no longer insolvent?


The giant banks have still not put the toxic assets hidden in their SIVs back on their books.

The tsunamis of commercial real estate, Alt-A, option arm and other loan defaults have not yet hit.

The overhang of derivatives is still looming out there, and still dwarfs the size of the rest of the global economy. Credit default swaps have arguably still not been tamed (see this).

Indeed, Nobel prize winning economist Joseph Stiglitz said recently:

The U.S. has failed to fix the underlying problems of its banking system after the credit crunch and the collapse of Lehman Brothers Holdings Inc.

“In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,” Stiglitz said in an interview today in Paris. “The problems are worse than they were in 2007 before the crisis.”

Stiglitz’s views echo those of former Federal Reserve Chairman Paul Volcker, who has advised President Barack Obama’s administration to curtail the size of banks, and Bank of Israel Governor Stanley Fischer, who suggested last month that governments may want to discourage financial institutions from growing “excessively.”

While the big boys have certainly reported some impressive profits in the last couple of months, some or all of those profits may have been due to “creative accounting”, such as Goldman “skipping” December 2008, suspension of mark-to-market (which may or may not be a good thing), and assistance from the government.

Some very smart people say that the big banks – even after many billions in bailouts and other government help – have still not repaired their balance sheets. Tyler Durden, Reggie Middleton, Mish and others have looked at the balance sheets of the big boys much more recently than I have, and have more details than I do.

But the bottom line is this: If the banks are no longer insolvent, they should prove it. If they can’t prove they are solvent, they should be broken up.

The Government Lacks the Power to Break Them Up?

Does the government lack the power to break up the TBTFs?


One of the world’s leading economic historians – Niall Ferguson – argues in a current article in Newsweek:

[Geithner is proposing that] there should be a new “resolution authority” for the swift closing down of big banks that fail. But such an authority already exists and was used when Continental Illinois failed in 1984.

Indeed, even the FDIC mentions Continental Illinois in the same breadth as “too big to fail” banks.

And William K. Black (remember, he was the senior regulator during the S&L crisis, and is a Professor of both Economics and Law) – says that the Prompt Corrective Action Law (PCA), 12 U.S.C. § 1831o, not only authorizes the government to seize insolvent banks, it mandates it, and that the Bush and Obama administrations broke the law by refusing to close insolvent banks.

Whether or not the banks’ holding companies can be broken up using the PCA, the banks themselves could be. See this.

And no one can doubt that the government could find a way to break up even the holdign companies if it wanted.

FDR seized gold during the Great Depression under the Trading With The Enemies Act.

Geithner and Bernanke have been using one loophole and “creative” legal interpretation after another to rationalize their various multi-trillion dollar programs in the face of opposition from the public and Congress (see this, for example).

And the government could use 100-year old antitrust laws to break them up.

So don’t give me any of this “our hands are tied” malarkey. The Obama administration could break the “too bigs” up in a heartbeat if it wanted to, and then justify it after the fact using PCA or another legal argument.

Is Temporarily Nationalizing the Giant Banks Socialism?

Many argue that it would be wrong for the government to break up the banks, because we would have to take over the banks in order to break them up.

That may be true. But government regulators in the U.S., Sweden and other countries which have broken up insolvent banks say that the government only has to take over banks for around 6 months before breaking them up.

In contrast, the Bush and Obama administrations’ actions mean that the government is becoming the majority shareholder in the financial giants more or less permanently. That is – truly – socialism.

Breaking them up and selling off the parts to the highest bidder efficiently and in an orderly fashion would get us back to a semblance of free market capitalism much quicker.

The Real Reason the Giant Banks Aren’t Being Broken Up

So what is the real reason that the TBTFs aren’t being broken up?

Certainly, there is regulatory capture, cowardice and corruption:

  • Joseph Stiglitz (the Nobel prize winning economist) said recently that the U.S. government is wary of challenging the financial industry because it is politically difficult, and that he hopes the Group of 20 leaders will cajole the U.S. into tougher action
  • Economic historian Niall Ferguson asks:

    Guess which institutions are among the biggest lobbyists and campaign-finance contributors? Surprise! None other than the TBTFs [too big to fails].

  • Manhattan Institute senior fellow Nicole Gelinas agrees:

    The too-big-to-fail financial industry has been good to elected officials and former elected officials of both parties over its 25-year life span

  • Investment analyst and financial writer Yves Smith says:

    Major financial players [have gained] control over the all-important over-the-counter debt markets…It is pretty hard to regulate someone who has a knife at your throat.

  • William K. Black says:

    There has been no honest examination of the crisis because it would embarrass C.E.O.s and politicians . . .
    Instead, the Treasury and the Fed are urging us not to examine the crisis and to believe that all will soon be well. There have been no prosecutions of the chief executives of the large nonprime lenders that would expose the “epidemic” of fraudulent mortgage lending that drove the crisis. There has been no accountability…

    The Obama administration and Fed Chairman Ben Bernanke have refused to investigate the nature and causes of the crisis. And the administration selected Timothy Geithner, who with then Treasury Secretary Paulson bungled the bailout of A.I.G. and other favored “too big to fail” institutions, to head up Treasury.

    Now Lawrence Summers, head of the White House National Economic Council, and Mr. Geithner argue that no fundamental change in finance is needed. They want to recreate a secondary market in the subprime mortgages that caused trillions of dollars of losses.

    Traditional neo-classical economic theory, particularly “modern finance theory,” has been proven false but economists have failed to replace it. No fundamental reform can be passed when the proponents are pretending that there really is no crisis or need for change.

  • Harvard professor of government Jeffry A. Frieden says:

    Regulatory agencies are often sympathetic to the industries they regulate. This pattern is so well known among scholars that it has a name: “regulatory capture.” This effect can be due to the political influence of the industry on its regulators; or to the fact that the regulators spend so much time with their charges that they come to accept their world view; or to the prospect of lucrative private-sector jobs when regulators retire or resign.

  • Economic consultant Edward Harrison agrees:Regulating Wall Street has become difficult in large part because of regulatory capture.

But there is an even more interesting reason . . .

The number one reason the TBTF’s aren’t being broken up is [drumroll] . . . the ‘ole 80’s playbook is being used.

As the New York Times wrote in February:

In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

In other words, the nine biggest banks were all insolvent in the 1980s.

And the Times is not alone in stating this fact. For example, Felix Salmon wrote in January:

In the early 1980s, when a slew of overindebted Latin governments defaulted to their bank creditors, a lot of big global banks, Citicorp foremost among them, became insolvent.

So the government’s failure to break up the insolvent giants – even though virtually all independent experts say that is the only way to save the economy, and even though there is no good reason not to break them up – is nothing new.

William K. Black’s statement that the government’s entire strategy now – as in the S&L crisis – is to cover up how bad things are (“the entire strategy is to keep people from getting the facts”) makes a lot more sense.

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  1. anon

    “In other words, the nine biggest banks were all insolvent in the 1980s.”

    Well, that’s interesting. If they were insolvent, how did they survive?

    Answer: The measure selected as representing “insolvency” was misleading if not downright fraudulent as an indicator of viability.

    The same thing is happening now.

    Have a look at John Hempton’s posts on the banking system as well as on Fannie/Freddie to get some idea of what kind of thinking is required here, beyond the naive marked to market approach.

    That fact is that popular measures of “insolvency” are ideologically biased as much as they are rational. And if those who embrace them don’t understand they are ideological, it just points to the stupidity of their ideological mind set otherwise.

    “In contrast, the Bush and Obama administrations’ actions mean that the government is becoming the majority shareholder in the financial giants more or less permanently.”

    Nonsense. You know no such thing.

    “Some very smart people say that the big banks – even after many billions in bailouts and other government help – have still not repaired their balance sheets.”

    Good grief. The fact that they may not have fully repaired their balance sheets is hardly an indictment, in the middle of the worst recession since the Depression. “Some very smart people” are always invoked when there are other equally smart or smarter people who believe the first group are ideologically and practically moronic.

    1. Richard Kline

      Oh, puh-leeeeze, anon, it would do you credit and us a favor if you’d bother to research the issue of the bankruptcy of the N’Yawk Nine before you opened your orifice and launched forth on the motives of others, here. Do you actually know _why_ those banks didn’t go under? Because they were bailed out, indirectly. Those foreign governments who were in default were told by Washington via the IMF and other related organizations that it was just not on to default, and the money was advanced to them to repackage their debts. The results were refloated as bonds in to a secondary market for specualtors, backed by further guarantees from the US and said international lenders, and the Nugatory Nine dumped their shares at prices phoney to market but which finished close enough to be in the money for them. The endebted countries were still on the hook for substantial payments to the bonds, which said international lenders were only too happy to _lend them_, effectively absorbing the money center banks losses while pushing much of Latin America into debt slavery and hyperinflation.

      —But the banksters got their hides out whole. And through that whole episode, the Nugatory Nine were give huge forebearance by government regulators who were charged with closing said meshuganas down. Despite the fact that said money center ninnies _had talked the Latin sovereigns into taking on FAR more debt than they could service_: that crisis was MADE IN NEW YORK. The governments involved couldn’t believe all the money that was shoved at them. So to get the picture right, the Nine Broke Gamblers created a crisis from greed and incompetence, and should have, most of them, suffered the moral consequences: instead Daddy Feddy and Uncle Sham moved heaven and earth to bail them out. The result: the Eighties stock bubble and the S & L Crash, together with the endless push to repeal Glass-Steagall because the money center banks needed new venues to speculate having tarnished their names in ‘the colonies.’

      You really don’t know what you’re talking about, buddy, so it’s no surprise you hide yourself beyond an ‘anon.’ Bye now.

      1. anon

        And how much did USG lose on the deal, hot shot?

        Actual losses now. Not your usual smoke and mirrors.

        1. Skippy


          The point is the problem was causation via Wall St. not the other way around. The reason they survived is by citizens intervention via government *help* and not by sound financial practice and with out dialog with said citizens.

          Skippy…we should take the advice we give others um mm [?] or are we Omnipotent and make and break the rules day by day…eh.

        2. Richard Smith

          It wasn’t really a ‘deal’ anon. That’s kind of the point.

          There was a big capital hole that was ultimately filled by tax payers at no charge, by a variety of imperspicuous mechanisms. If that is the right take on what happened (which part do you disagree with?), accusing RK of using smoke and mirrors looks decidedly unfair!

          It would be normal to charge something for a big gob of interim capital, wouldn’t it? Surely that seems like underpricing to you too, irrespective of your ideology.

          So there may be a chunky opportunity cost there (I daren’t try to put a number on it, but I think you can see it must exist), plus the moral hazard aspect that RK alludes to, plus the antidemocratic aspect that Skippy sees.

          Fast forward to the 2008-9 bailouts and the high-level pattern looks quite similar.

          What is your own view? I can see you disagree with folk here but it would be nice to have a peep at your own opinions.

  2. interregna

    Why does the Administration cling to US casino finance?

    Perhaps the Administration understands that we lack better options or prospects.

    With industry and its support markets ‘off-shored’ by US multi-nationals to maximize their return on investment, nearly all we have left, as a nation, is our ‘service economy’ –
    mowing one anothers’ lawns and cutting one anothers’ hair.
    However, the so-called service economy generates no new wealth – we merely redistribute, often inequitably, credit tokens amongst ourselves.

    With US ‘investment’ banking unrestrained, running a global financial casino for hot and dangerous speculation is a ‘service’ the US has offered for export. US $dollar credits are ‘chips’ – and the action invariably favors the house. Indeed, some of the ‘tables’ are fixed by the FedTreasury, who may see everyone’s cards.

    By all appearances, the Administration is betting that global, baser instincts remain attracted or addicted to our engineered ‘bets’ – sundry derivatives and ($dollar denominated) debt-related instruments (including ‘quant’-engineered speculation on the contractual performance of packaged debtors.) In my view, this is why there has been no attempt by a thoroughly incorporated Administration to tighten investment banking regulations. During our New American Century, our greatest economic line item – accounting for about 40% of GDP – has been US ‘finance’ operations.

    Is this is our new American epoch? Croupier to the world, indeed.

    Though offering no hope for middle and lower class employment or income generation, casino operations, as long as they continue, may pad the coffers of the top 5% demographic, who have the wherewithal to tag along on ‘investment’ banking shirttails.

    However, casinos are opening elsewhere – where the creditors reside – where the games and tables aren’t ‘fixed’ to a $dollar reserve currency that is now publicly discussed in the past tense.

    New York and London were the great financial centers of the 20th century. London is in terminal decline. As liquidity invariably gravitates to zones of surplus versus debt, it is certain, in my view, that New York’s prominence will be sorely tested – that the Administration’s ‘casino service exports’ will invariably wane.

    Welcome to the jobless recovery and the jobless economy. Place your bets as you may – there are managed markets for a few, and the lotto for lumpens.

    This is not a viable fiscal or social structure for a Republic.

  3. bob

    When are we going to see some honesty?

    I can’t wait to be able to turn on the TV late at night and see Mr. Pandit, lounging pool side with 3 beautiful blonds.

    “Do you want to get rich too? Fail, but the secret to my strategy is to fail big enough. Do you see my Cars, my girlfriends and my gold? Do you think you get that buying a house and flipping it in So Cal? No, I got rich lending the money to other people to do that.

    Send 29.95 for your free brochure on TBTF. Internet Millions? How about TBTF Trillions. Call today, limited time offer.

  4. Hugh

    We need a return to Glass-Steagall. It covered both banks and insurance companies. In this regard, I would like to point out to AIG, the holding company. Its management were informed that they were being taken over, no negotiation, no debate. So in fact when the Treasury and Fed want to move against a holding company they can. They can finesse it by saying they are buying a controlling interest or whatever but bottomline if they want to do it they can.

    Along with Glass-Steagall, we need to cut the investment arms off from government sponsored credit lines and we need to establish position (think of JPM and derivatives) and leverage limits. I also quite like Volcker’s idea of banning investment banks from trading on their own account.

    The financial industry will really hate all this and want to fight it like crazy. The best way to deal with them is to initiate forensic audits, followed by fraud investigations and prosecutions of employees, management, and the companies themselves.

  5. Jim

    The whole system is already broken and past fixing.
    The masters are simply in denial.

    The rest of the world is inching toward the door
    and the U.S. pretends we will continue with status quo.

    How sad to see the collapse of an empire…
    how awesome the falling Tower of Babel.

    The world (as we know it) is doomed
    Few have the courage or honesty to deal with the endgame.

    Hope you have skills needed for a local economy.

  6. joebhed

    Here we go again.
    The banks.
    They’re too big.
    They’re too powerful.
    They’re too risky.

    Once more. Here a clue.
    It’s not the banks that need changing so much as the money system.
    The debt-money system of fractional-reserve banking is what I am talking about.
    Did I say the ponzified, pro-cyclical, secreted fractional-reserve banking system, which NEEDS ever more amounts of new DEBTS in order to keep itself going?

    I know that’s probably not too important for all those economists who listened to their professors and didn’t dare look down that road of monetary reform.
    Nothing here, just keep moving if you want that diploma.

    But, you know, Milton Friedman, here in his 1992 Foreword for the 10th printing of his book: ‘A Program for Monetary Stability’.

    Says Friedman: “One major reform that I recommended in the third lecture to achieve the objective of monetary stability was 100% reserve banking, a proposal that had been made by a group of economists at the University of Chicago during the 1930s, and that was strongly supported by the greatest of American economists.”

    Can we say full-reserve banking?
    Can we say no more FDIC?
    Can we say less misplaced power to regulate?
    Can we say removing the cartel privilege to create the nation’s money supply from the private bankers at the Fed?

    That’s what Ron Paul is calling for, as is Dennis Kucinich.
    And those other monetary heretics like Milton Friedman.
    And Henry Simons.
    And Irving Fisher.
    And Paul Douglas.
    and Frank Graham.

    Read ‘How Debt Money Goes Broke’.
    We need a new money system.
    The Money System Common.

  7. John M

    Niall Ferguson is wrong about the authority used to take over Continental Illinois Bank. In 1984, Glass Steagall was still in existance and Continental Illinois was solely a commercial bank which was nationally chartered and insured by the FDIC. It wasn’t allowed to have securities, derivitives or insurance arms. Taking it over and cleaning it up was fairly easy.

    The 1999 law which eliminated Glass Steagall created the regulatory mess we have today since the regulatory structure was not updated to take into account the fact that the megabanks mingle commercial banks insured by the FDIC with securities, derivitives and insurance subsidiaries. The Fed and the FDIC have the power to takeover and close down Citibank because this is a nationally chartered bank insured by the FDIC. However, they do not have the regulatory power to take over the parent CitiGroup. The problem with this is that Citibank may be solvent while the other parts of the company may not be. (I have no idea if this is true – it’s an example).

    I support reinstating Glass Steagall but if that isn’t done then I support a regulatory structure which regulates all parts of the megabanks rather than this absurd policy we have now.

  8. visitor

    right – the trajectory of the price of a common share of bank of Bank of America to the strike price for options of Ken Lewis, the CEO, from the period January 2008 to January 2009 says it all. Shareholders be damned. That was the mantra at Enron and it continues with BAC and others. There was a huge destruction of wealth for long term BAC employees, just like Enron, but that did not make the news. For those that follow, this is an indirect result of money in politics. In the financial industry, look no further than Sanford Bank’s former CEO and his footprint within Washtington. That bank was never a paragon of virtue. That the First Amendment has become the pillar of lobbyist pornographists one of the great ironies of our times.

  9. Reggie Middleton

    When the FDIC blatantly states that it is insolvent, why would anybody even bother to question if the banking industry that they insure is solvent or not?


    According to the FDIC, we are about 25% through this crisis, with the worst yet to come and to come quickly, yet they have a negative capital balance and don’t foresee it being returned to normal for 19 years sans extreme and unprecedented actions. How could anyone possible doubt that the banks are insolvent???

    1. anon

      Thank’s for the info “Reggie”, and nice try, but you make my point for me in spades.

      That’s not the FDIC talking.

      That’s the personal “translation” (read distortion) of one “Reggie Middleton”.

      Unlimited spin from the distortionista crowd.

      1. Richard Smith

        Could you spell out your own position on the real state of banks’ balance sheets a bit more anon? I can’t quite tell where you are coming from, so far, but I am interested to hear more.

        1. anon

          Where I’m coming from:

          Time horizon.

          Anybody with a left wing agenda can choose a 1 day time horizon and declare by essentially guessing that the banks are technically insolvent. Mind you, it takes an inbred lack of imagination and an agenda in order to do this with a straight face and a clear conscience. I can find “some smart people” of my own that will tell you that none of the people in the above list understands the operation of a fiat money system, let alone the solvency of a bank.

          The key variable is time horizon. The reason is that banks have something called operating earnings. Time plus operating earnings allows balance sheet positions to sort out and banks to earn their way out of substantial losses.

          The only counterargument to this is a 1 day time horizon with slam bang marked to market “accounting” – a failure of imagination that is indicative of nothing that relates to the viability of a banking system with operating earnings. It only serves a constipated left wing agenda by deliberately presenting the most distorted, compressed in time, falsely urgent picture possible in order to trump up calls for broad scale nationalization.

          The following post by Australian blogger John Hempton is well worth reading. I generally dislike his personal style, but his thinking is right on at least one count here. Have a look at his solvency test # 3.

          Key points:

          “Here I am counted as a radical. The system in my view clearly has positive economic value. I did that calculation in my voodoo maths post. To me the issue is unequivocal. The pre-tax, pre-provision income of the banking system normally funded is probably 300 billion. It is probably much larger if the funding costs were reduced to near Treasury levels. If you haven’t noticed interest rate spreads and hence pre-tax, pre-provision profits of the banking system should (presuming normalised funding) be way way up. 300 billion is an underestimate.So if there are 2 trillion of losses and 1.4 trillion of starting capital then four or five years and we are back to fully capitalised. We would get back there faster than that – because the banks have raised considerable capital on the way down and not all the 2 trillion of end losses are born within the banking system. Indeed against “Test 3” I think the system is brimming with solvency. Individual banks are possibly insolvent against this test – but the system is not and anyone that tells you otherwise is just not doing maths.

          Now when a blogger or an analyst tells you a bank or the system is insolvent then ask them what definition of insolvency they are using and test them against that definition. Then test them against others – and work out – in the context given – whether the institution is solvent against the definition appropriate for the circumstances. People who do not think clearly as to definition of insolvent are being sloppy – and that includes most the bloggers I most admire including Paul Krugman. The context in which the banking system is insolvent is that (a) it is illiquid because people don’t trust it and (b) it can’t get enough liquidity because it has to sell assets into a market in which they are trading considerably below their “yield to maturity or GAAP price” and if you sell it at that price you reveal “mark-to-market” insolvency as per Roubini. However provided the banking system could remain liquid it is unlikely it will actually be insolvent though individual banks might be. [I should note that this is a US conclusion. The UK banks started much more thinly capitalised and I think they are insolvent.]”

          1. Richard Smith

            Well, I find myself referring back to that Hempton post from time to time too. A little finance blogging classic IMO; starting point for a much more nuanced perspective than one typically got back in Q1 ’09 when the world was about to end.

            On time horizon I half agree. MTM is useless when the market is in such a blind funk that there’s no trading anyway: some of the prices are bound to be stupid. In other words, just when you’d like to know whether your cpty, or your bank, is solvent, you can’t really tell. On the other hand, held-to-maturity type accounting (HTM) is a carpet under which all sorts of horrible stuff can be brushed, for years at a time. Its lousy track record is the whole reason why MTM was tried instead.

            Well, courtesy of a) some regulatory forbearance, b) the way the Basel II framework has been discredited and c) occasional fancy footwork by banks, we are back in the HTM world now fro all practical purposes. Over time (lots, sometimes) HTM and MTM valuations coincide. So we will eventually see whether the market’s gloomy guesses about bank assets turn out correct or not. If you really think subprime assets and securitizations will recover, though…well, you should be out there bidding, and good luck with that.

            However (you knew there would be one of those, didn’t you?) there are a few things to add.

            First, even if you think that some asset valuations will recover over time, it is obvious that some banks were carrying far too little capital to cope with these MTM excursions. Their ROC was therefore juiced by leverage and ridiculously fragile (I agree that shadow banking was a big factor here as RK says). The terms on which the banks were propped up still look outrageously cheap to me. Diluting shareholders and haircutting bondholders more would have distributed the pain much more fairly & accurately. This I think is something on which folk of all sorts of political persuasions ought to be able to agree. Kind of a weird idea, that, in American politics, agreeing about something, across party lines, but some mental athlete will pull it off one day, I’m sure.

            Keeping the leverage under control would have averted such a messy scramble of course but regulators were way too late for that.

            Secondly, the other aspect of ‘time horizon’ is that it gives time for a massive subsidy to bite, namely, the artificially induced spread between short rates and long rates, from which banks profit. This is something else that Hempton scoped nicely back in Feb/March. It is a dole to the banks, that sticks it both to the thrifty (bank depositors at the short end, who get a lousy rate) and to long term capital projects (that cost more because they borrow at the long end). And it doesn’t really get accounted for anywhere. Net result – in banks, relatively happy incumbent bondholders, shareholders, and management, when they don’t really deserve to be the least bit happy. And all sorts of innocent worthier types get stiffed. Meantime Hempton buys in and laughs all the way to the bank; good for him, I say.

            So – the banks are solvent iff you wait for a couple of years to earn the needed capital back. That is the other leg of your time horizon point. The other thing, though, is that you have to studiously ignore the giant yield curve subsidy. That’s quite a *big* qualification that is not so easy to swallow. I can’t see why a business-minded conservative isn’t mighty embarrassed by this – it is certainly massive government intervention.

            Third, I suspect that there is an extra category of “insolvent” (from Kedrosky or Ehrenburg, I forget which), namely ‘massively insolvent’. That is to say, far too bust to be remotely worth rescuing. Looking at the fallout, Lehman may well have been in this category.

            With the three of the four US TBTFs (JPM, Wells, BoA) one can speculate about risks that haven’t yet materialized, and grouse about some pretty massive subsidies, and deplore ‘moral hazard’. It is somewhat more of a long term project to sort them out (not that there’s any sign of the will to do what needs to be done).

            But(I may be all wet here so be gentle), Citigroup may be quite a bit closer than the others to ‘massive insolvency’, the wrong side of the event horizon as it were, though it appears to be tabu to suggest this. As that situation evolves (I can’t believe it is stable at all), it might focus minds a bit.

          2. Skippy


            Said…Anybody with a left wing agenda can choose a 1 day time horizon and declare by essentially guessing that the banks are technically insolvent.

            Are you inferring political bias to accounting standards right at onset of your clarification. The poli are yet to sort out their final positions it seems, as they all, are just starting to become educated enough to_even begin_to dicker over such nuances. Granted this will firm once they get their heads around it with time bringing future events closer to us and decide where to bank their capital.

            Anon said…The key variable is time horizon. The reason is that banks have something called operating earnings. Time plus operating earnings allows balance sheet positions to sort out and banks to earn their way out of substantial losses.

            I submit for your digestion this thought in regards to future time lines subjected to (temporal) accounting standards:

            Temporal summation is an effect generated by a single neuron as a way of achieving action potential. Summation occurs when the time constant is sufficiently long and the frequency of rises in potential are high enough that a rise in potential begins before a previous one ends. The amplitude of the previous potential at the point where the second begins will algebraically summit, generating a potential that is overall larger than the individual potentials. This allows the potential to reach the threshold to generate an action potential.

            So are you prepared to risk all for a *promise* (HTM) of action potential extended further into the unknown with exponentially generated fiat/SIVs financial mass over our heads. Will the day come (if they can actuate) to create extension dampeners or will chest beating ensue and an another party start aided by the same time machine accounting standards created just to escape todays reality’s for connivance sake. Are not our seeds of destruction latency trading, financial universes created and destroyed in hundredths of millisecond and will this not create a improbable time horizon upon which any standard of accounting can be applied with regards to reality/reliability. This would bring into question the *confidence* required by our currency (all brands) creation system and its perceived value, would it not.

            I both fear and hope for their success with the caveat that shorter leashes must be applied, time travel is but a theory and if we wish to stress test it with our Nations nay the Globes future I would feel better if their heads were on a block, as a bond.

            Skippy…Thank you for taking the time to post your thoughts…mabe, just maybe, many of us are walking down the same hallway, but just in a different building…hoping to get to the same door. So could you stick around and lend a hand, time to time?

        2. anon

          “Over time (lots, sometimes) HTM and MTM valuations coincide. So we will eventually see whether the market’s gloomy guesses about bank assets turn out correct or not.”

          That’s the key.

          In the interim, fully disclose bank MTM asset values without forcing them all through capital accounts. Then let the market interpret the applicability of MTM over time, and thrash out its consequences as to the market value of the stocks – which is the relevant domain for MTM – except for most people on this blog, who’ve likely never owned a bank stock.

          The yield subsidy is the price of the demand for liquidity. Bank depositors are free to take a run at treasuries or high yield debt. Nobody’s forcing them to keep their money in the bank, anymore than anybody is forcing the high yield market to trade wherever it is.

          I don’t know about Citi. What I do know is that those who spout certitude on its insolvency, like those who spout generalized certitude about the insolvency of the entire system, are fools. This blog tends to feature that special brand of moronic certitude.

          On the other hand, you seem to couch your thinking in reasoned probability. You make good points.

          1. Richard Smith

            “In the interim, fully disclose bank MTM asset values without forcing them all through capital accounts. Then let the market interpret the applicability of MTM over time, and thrash out its consequences as to the market value of the stocks – which is the relevant domain for MTM – except for most people on this blog, who’ve likely never owned a bank stock.”

            Love this idea, cynically doubt how much traction it would get; suspect the reversion to HTM may be motivated by this “extend and pretend” thing, but again I’ll have to wait patiently for evidence. Dunno about blog commenters’ investments…

            BTW any idea how much of the shadow banking system is still functioning? I have no idea myself, just curious.

            As for “certitude about the insolvency of the banking system”: as you might expect, I think “*ex massive and often underpriced government intervention*” is an underused and worthwhile qualification.

            Re Gov’t jacking up the cost of liquidity preferences – nicely put and a better slant than mine.

            I had better stop with this burst of enthusiasm, I am all over this thread, and where I am, the sun is shining.

          2. Dave Raithel

            Like Mr. Smith, I just don’t see transparency as being in the interest of the banks. I also suspect that most of us who do not own bank stocks would not care THAT they might be insolvent (even using the most charitable standards re citing Hempton and the MTM/HTM timelines) if not for the public utility function private banks are ostensibly to provide. I’ll take it that you’ve already read Megan Whitney’s WSJ editorial re credit still freezing up? Or is she also blind to conflations of rationality and ideology, rendering her practically moronic?

          3. anon

            Assume you mean Meredith (not Megan) Whitney.

            Her big scare tactic these days is lines of credit, which is a lot different than utilized credit. Utilized household credit in the US is about $ 2.5 trillion. Down $ 100 billion from the peak. Big deal.

            She’ll be proven to be another stopped clock in due course.

        3. anon

          My sense is that shadow banking is not working. That’s part of the system capital adequacy and lending problem; the only suppliers of credit where it is being supplied now are the the Fed and the bank balance sheets that pre-dated shadow banking. Banks cautious about new but as yet unknown capital standards is another glitch. Clearly the system needs more equity capital than was previously deemed necessary; that I certainly agree with; inextricably linked with the “measurement” of risk; the purpose of capital being to absorb risk. The problem is the transition, which again requires time.

      2. Dave Raithel

        What exactly is the spin? The figures he gives are in the September 28th FDIC memo to its Board of Directors, page 3 – to which he links. Is the spin his being rhetorical in asking: “…why would anybody even bother to question if the banking industry that they insure is solvent or not?” True, one cannot infer from the FDIC take-overs each weekend, and the expectation of more to come, that banking as a whole is insolvent. It is only one reason. Is that the spin?

          1. Dave Raithel

            I don’t have much of an imagination. You’ll have to be more explicit.

            To say that Reggie lies about “what the FDIC position on the issue is” is to say (to me): The FDIC asserts “p”; Reggie says the FDIC says “-p”; and Reggie knows that the FDIC says “p” when he says the FDIC says “-p”.

            You’ve escalated from accusing him of making “spin” (oh, roughly, rhetorical tactics using true statements to persuade people to believe something that accrues to the benefit of the spinner’s interest in circumstances where a simpler propositional accounting of the facts is not to the spinner’s interest – given other assumptions about the target audience, but of course …) to accusing him of a telling a lie.

            You’ll have to point it to me.

            I don’t know the man, I have no reason to suppose he has a motive to lie.

          2. anon

            It’s point 3. of his “red font translation”.

            Lying is the essence of his translation. There’s really no other reason for him doing it. I have no real problem with him doing it. Just recognize it for what it is. Perhaps I should refer to it as an agenda, rather than lying. On the other hand, if he believes what he’s doing is some sort of truth, he’s delusional.

  10. AvgJohn

    Ya places your bets, ya rolls your dice and if dey come up snake-eyes, you lose brother and ya hand da bones to the next roller. Dems da rules. Dey been violated and now everbody knows da game is rigged.

  11. anon

    The mega banks haven’t been resolved because they are too big and no one – not at the banking agencies, nor in the banks themselves – has a handle on what the banks hold, or how it would be unwound in an orderly way. Also, the FDIC has no where close to the man power or expertise to deal with a mega bank failure. Of course regulatory capture at the OCC and Fed has something to do with it as well.

    1. Richard Smith

      Well that all sounds right. To make an analogy: it is like negotiating with someone who is wired to explode, and then suddenly realising that not only are there no bomb disposal experts (read FDIC) in the vicinity, but the guy himself (read megabank) doesn’t have the faintest idea how to defuse his own bomb. And the higher level authorities one might call (read OCC, Fed, Congress) aren’t answering the phone either.

      I think you would guffaw grimly if someone rocked up at that point in your negotiations and said “I’m a Socialist/Libertarian/Republican/Democrat, I can fix this”, wouldn’t you?

      What you *want* is a bomb disposal guy. And I think you would not care very much how he went about his business, and most particularly not, how he voted.

      And (this is very much a side issue, mind you) it would piss you off mightily if the bomber spotted the bind you were in, and used it as a pretext to reiterate his ransom (read bonus) demands, wouldn’t it?

  12. RueTheDay

    The REAL reason why the mega banks are not being broken up is the simple fear of upsetting the apple cart when it APPEARS conditions are stabilizing. Unfortunately, (and believe me, I hate using stock indices as proxies for the economy) it will take a sudden 10-15% drop in the DOW along with another large financial institution finding itself on the brink of collapse for us to revisit needed reforms.

    Those needed reforms certainly include a new process for the orderly resolution of bankrupt TBTF institutions (the author’s claims that the FDIC can simply seize the banking org and ignore the parent holding company is downright silly) as well as a new set of firewalls between the various sectors of the financial industry (Glass Steagall II).

  13. Another anon

    This discussion is partly over my head, but does it take into account that many of the “assets” may be uncollateralized credit derivatives?

  14. Phillip Huggan

    If only you bailed out your credit unions, small banks (no cartel lobbying behaviour and focused on local branch customers over lobby for bigger casino divisions) small business banking divisions and enacted some nationalized State-owned banks (States could’ve used a new asset on balance sheets) instead. Now big players will lobby against any future solutions and little political will for more finance welfare. You could’ve just forced banks to spend that bailout money on the above Main Street activites, take it or leave it. $3T is 1000x too much to spend on a morale boost. The consequence is middle class people will revisit their McJob days of youth. The consequence is rather than skill and initiative, future jobs will be given to whoever knows rich bankers.

    If I’m a greedy banker who doesn’t mind seeing my country cede econonmic superpower status I blow the money in a fee generating way before regulations are enacted. This is logical and is what they are doing right now. At least is a lesson for the world.

  15. Dave Raithel

    To the Anon engaging in most the exchanges with Richard Smith (and I have much appreciated the latter’s replies):

    The nesting of replies is becoming cumbersome, so I’ll put this here:

    Yes, I did mean Meredith, not Megan, Whitney. But I am horrible with names – though some people do use theirs for me to mangle.

    I’m a bright guy. I have some inkling how you must feel – though your misery is incalculably greater than mine. Being ignored by mental midgets and seeing the world run on stopped clocks is humiliating. The burden of unrecognized genius is angst, cloaked in anonymity – chosen or imposed. Poor man … or woman …

    My torment is less than yours because I don’t know so much. I’m trained in a whole different field and I make a living doing a job for which I was never trained – in fact, OJT has been my way of life – but I digress. So I come by here to learn what I can and usually learn something. Every once in a while, something will irritate me to the point I interrupt – exasperated, or confused, or ignorant. But sometimes I just get pissed off at anonymous assholes, and you might just be one of them. My most recent evidence is your whimpering last response to Mr. Smith:

    “Clearly the system needs more equity capital than was previously deemed necessary; that I certainly agree with; inextricably linked with the “measurement” of risk; the purpose of capital being to absorb risk. The problem is the transition, which again requires time.”

    Lordy, talk about ideology and rationality, smashed up in a minor key. Who would most likely benefit from THAT minimal amount of financial reform?

    So, which of the TBTF’s do you work for, or what’s your … what is it you people say …. book?

    Wait a minute: Did this all get started because YOU have some kind of personal beef with the pseudonymous “George Washington?”

  16. mannfm11

    The amazing thing about all of this isn’t that the banks are still broke, but that there has been no investigation. This may be why Geithner was made Secretary to start. But, the idea that an industry where the entire world economy was put on its edge, while the people responsible shoveled maybe $100 billion into their pockets, merits no arrest, no legal action in suit and no investigation screams conspiracy and coverup. Geithner ran the NY Fed while the banks under his supervision made mistakes a freshman finance major wouldn’t make, all the while making themselves filthy rich. A few in the hedge fund business saw the folly and made billions like shooting fish in a barrel. Here in Texas they looked under rocks to imprison S&L execs who were quite often merely engaging in the trend of the business, using an industry that was already defunct due to the market value of their assets being wiped out by a huge swing in interest rates. There was no such economic disaster here. This was not only the economic disaster, but the looting as well.

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