Is Obama in a Bubble?

Perhaps.

While Obama was known before his inauguration to have the habit of taking in many sources of information and ideas, it is likely the amount of information and briefing materials available to him daily is stupefying.

So his challenge now is to see the forest in spite of being pushed up against trees every day.

Every form of briefing and information has its presumptions, its bias. The most profound bias is which information is thought to be important enough to present.

For instance, what is most important in Afghanistan is not among these:
a) troop positioning
b) Pakistan's offensive
c) road building
d) military strategies against the Taliban; or even...
e) disrupting Al-Qaeda

Instead, what is most important in Afghanistan might not be in any briefing materials dumped on the President each day.

Instead, the most important factors are likely among these:
f) number of television satellite dishes
g) freedom of the local press
h) distribution of popular local and regional writers of all kinds by various means across Afghanistan (poetry and novels and religious views being of equal significance in the evolution of thought)
i) state of progress with lowering India's tariffs on Afghan trade goods
j) state of progress with lowering Turkey's tariffs on Afghan trade goods
k) respect for local village preferences (if they don't want us there, then leave that area)

Similarly, for financial reform, Obama certainly hears the world view and ideas which dominate the Federal Reserve, no doubt articulated quite well by Timothy Geithner, such as ideas and theories about how to sustain or increase lending. The TARP Bailouts were about sustaining lending. But other forces are at work, and not every one of them might be brought up for examination in the White House.

Does his information intake include the current average household credit card balance and current average credit card interest rate? Does he have an analysis such as this one of how the recent increase in money diverted from local economies by higher card interest rates affects the general U.S. economy?

Or does he have only the competent, convincing presentation of certain points of view, perhaps with two or three angles or alternatives -- alternatives which themselves are only variations on certain presumptions common to a particular world view?

In other words, is Obama in a bubble?


I think it is too soon to say.

Afghanistan will be one of the tests of how well he is able to step back and include broader vision in his decisions. Will Obama be able to bring insights to bear in these complex, real-world situations in spite of powerful interests that are accustomed to continuing along their current paths?


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Update: My wife sent this article that shows way Obama is clearly not in a bubble on Afghanistan.

Usury is OK, and Guns in Parks...

The Senate passed its version of credit card reform today. Several current tricks of credit card issuers will be out of bounds...in the future....eventually...when the rules finally come into effect. But if your card issuer just hiked your rate in a big way, well....

Current usurious rates aren't even on the table. 18%, 25% or 29.99% are all just fine.

One article mentioned that about 1/5 of card holders pay over 20%. Was that data from today?

One of our rate hike notices, which arrived a few weeks back, will raise one card of ours from 12% to about 19%. While these hikes won't affect us much at our house, it's quite easy to imagine the effect on other households. But compare this to the above seemingly reassuring statistic. Our new rate will be below 20%, and isn't in effect yet.

In 6 months, we may find that the above statistic of 1/5 has increased....

The elephant in the room is the question of the rate hikes that have just recently occurred or are on the way, since the card industry could see the new rules coming for miles. Card rate hikes are on the way, notices already sent, and these will slow the economy.

You can check out how your own Senators voted on the question of how many more of your dollars should go to the card industry right now, instead of, for instance, to local businesses where you live. If you are just now starting to pay an extra $40 or $80 a month in interest (a 12 percentage point rise in interest rate on an $8000 balance costs $80/month), will you spend the same amount on local goods and services that you have recently?

If you pay $40 a month more in interest now, will you tip the waiter the same amount? For that matter, will you cut back on eating out even further?

But, while usurious rates are OK with Congress, it's still up in the air whether the guns we need in parks can be loaded:

One amendment attached to the Senate bill by Senator Tom Coburn, Republican of Oklahoma, would restore a Bush administration policy allowing loaded guns in national parks. That provision is not in the House version, so there may be discussions between the two chambers over the issue.

Check to See How Your Senators Voted on Credit Card Reform (Updated)

Here is the first vote to check:

A Yes vote supported a 15% cap on credit card interest rates, limiting usury. A No vote was against the 15% limit on credit card interest. (note that this vote was on whether to include amendment 1062 in HR 627)

Senate Vote on H.R.627: Motion to Waive CBA Sanders Amdt. No. 1062; To establish a national consumer credit usury rate.

People, let's hold them accountable. Let's pay attention. Let's know how they voted, and let's remember and tell our friends.

---------Somehow it doesn't occur to all our Senators that 20% or 25% interest is a bad thing.

Bad for the nation.

One can imagine the lobbying arguments they heard, probably carefully targeted to individual Senators, depending on their temperament and beliefs.

Here are a couple I can imagine:

For a Senator that is a "staunch" "free enterprise" "pro-market" person, but doesn't really understand the basic necessities of markets or enterprise (non-finance enterprise) -- the necessity of having enough potential customers with disposable income left over to buy your product(!) -- an effective pitch could go:
"We gave them a low introductory rate, and planned our business on the premise that the rate later would be higher. Now that defaults are up everywhere, we need higher rates."

For a Senator that is more realistic and down-to-earth, perhaps he'd hear:
"Senator, we'd really like to help you again during your next campaign, but we need your help now."

The 2nd hardly needs any further examination here, but the first pitch is worth batting down.

If a credit card issuer cannot make enough profit at 15% even with a background default rate rising towards 8%-11% for instance (some credit issuers are more careful than others), if that company cannot make it on a 4%-7% spread, then....that isn't a well run company. For issuers that fold at a 15% cap (if any would), we should pleased to let the free market run them out of business and replace them with a company that can live on a 5% or 7% spread of interest (more if the issuer is prudent), which the market would indeed quickly do, in only months. Prohibiting 20%+ interest credit card rates is similar to outlawing an addictive substance that is harmful to health.
---------

Let's illustrate how 20% or 25% interest is ruinous.Consider a typical family carrying a commonplace level of household credit card debt of about $7,000 who then suffer a few (commonplace) financial hits -- too many major expenses at one time, such as multiple large auto repairs in a few months, and some expensive dental work and all of this just after a major replacement expense for a quality refrigerator or money sent to help a kid or relative. (Of course some households could have a previous balance on their cards from items such as furniture before the new expenses...but less discretionary expenditures are also common in debt ramp-ups.) It could easily be the case that after some bad luck for a few months they could end up carrying a significant credit card balance, perhaps even as much as 40% of their annual income for instance.

Let's suppose a family with a household income of $50,000 ended up with a temporary balance on their credit cards of $20,000. Otherwise they are quite average, with a house costing $160,000 at purchase (just a bit over 3 times their annual income) which they bought with 10% down and a good prime mortgage at a nice low fixed 30-year rate of 5.25%.

In other words, a financially responsible family that pays their bills, with excellent credit, who just had some large bills all at once, and not really more than they could handle over time...

...given a normal, reasonable interest rate, such as they expected they would have, due to the advertising of the credit card issuers.

Normally, a credit-worthy family could expect to carry such a balance on a few cards and at an interest rate in the range of 11%-14%.

First, clearly the credit card companies are making a nice, fat profit on balances carried at 12% or 14% interest that are paid over time (account holders that pay on significant balances without defaulting are very profitable for card issuers). In fact, you'll see that shortly.

Do the credit card companies need a higher rate here? Can the family handle a significant rate hike on this existing balance, a practice that is now commonplace according to the news.

So, let's imagine the outcome for this family financially if the $20,000 is carried at 12% in one scenario, and at 22% (21.99%) in the alternative scenario.

What will happen?

Suppose our responsible family with excellent credit spends quite carefully during the next few years, and even gives up their previous plan for a ski trip, settling for a much less expensive trip to SeaWorld once a year.

So, the family is cutting back, paying what they can.

What will happen?

Let's see.

A plan that reduces financial risk is to aim to pay back a high balance like this in around 4 years, because it is likely there will eventually be further expenses, and the family needs to be making real progress reducing debt before those unpredictable future expenses hit.

Putting our balance of $20,000 into the calculator for a 4-year payoff at 12% and 22% yields the following monthly payments:

12% -- $527/month
22% -- $630/month

So, only a difference in our scenario of $103/month more. Is that enough to matter?

Let's see, over 4 years, the roughly $103/month extra adds up to about $4,944 in extra payments (all interest).

Leaving aside for a moment what that $4,944 could have bought, such as two years of $2,470 contributions to an IRA, or $4,944 put into a 529 plan for college for the kids, while the years until college are still enough to earn some returns on the contribution, or....say a replacement used car when the old wagon goes.

Well....the last isn't a trivial example (though neither are the first). Because, in our example this frugal and responsible family has already chosen to repair their old car instead of buying a replacement, because the repair was still cheaper than buying another used-car as replacement....but, in several years, that old car is going to need some more repair, or replacement finally with a newer used car.

hmmm.....

So, there is already a danger this budget difference could put the family on a "crash" course.

But, let's go ahead and look at the budget numbers carefully.

For their monthly mortgage payment on the house described above with $2000 in annual property taxes and a quality $700/year homeowners insurance policy, and PMI (loan to value is 90%) of about $60/month, we arrive at a monthly house payment of $1,080/month.

Let's suppose our family has 1 child, 2 cars, one with a payment of $420/month for another 2 years, and the other older car paid off.

While both parents work, they pay $500/month for daycare for their 3 year-old.

While neither employer provides health insurance, the family has a good quality blue cross policy with a $3500 deductible for which they pay $750/month. To cover their deductible in case of a major medical expense (their regular office visits are covered at a $25 co-pay and no deductible), they funded an traditional IRA last year with $2500, as an emergency fund for medical care (IRA withdrawals are allowed for medical expenses).

For comparison note that the national average health insurance cost for a family is $12,000/year. This family is carefully aiming at a lower cost, but using a significant deductible, for which they have saved up money to help cover.

This is a frugal, money-careful family.

Normally, they contribute $2000/year to a Roth IRA, and this is the only retirement savings they have.

Being an old hand at Turbotax, I ran through all of this family's 2008 tax year. They were able to itemize deductions, due to the costs of medical insurance and home mortgage interest.

With only 5 $25 office visits during 2008, the family had no major medical expenses other than just the basic cost of health insurance. They are healthy and lucky, and don't have significant health costs other than the braces they just had to get for their kid's teeth.

Turbotax revealed they received $600 for their child tax credit, and also a significant child-care tax credit of $1,000, which was a major help, reducing their family federal taxes from about $2800 down to under $1200.

We'd like to list the federal income taxes in our budget, so to figure the family take home pay, we'll subtract only FICA taxes (social security and medicare taxes), and nothing else. All other expenses -- income taxes, health insurance, and retirement will not be withheld, but paid in our budget below.

Take home pay after FICA for our family is then $46,175 or $3848/month.

Also, our lucky family lives in a state with no income tax.

Nice. So this careful, prudent family, who are in many ways lucky and who Uncle Sam has treated very well in 2008, how will things turn out for them financially?

So, with all these advantages, with all these favorable basic facts, but with a few typical large expenses all at once of $20,000, will our family make it financially???

Let's suppose the family doesn't mind sweating some in the summer and is lucky enough to choose a low-cost electricity plan at only 10 cents/KwH. Nice. Their electric bill will average out over a year to only $120/month.

This is a careful, conservative, prudent family, remember?

So here are the budget results (on a few items like gasoline I just use some commonplace amounts):

Monthly Expenses before Credit Card Payments:
Housing Payment: $1080
Health Insurance: $750
Roth IRA Savings: $167
Auto Payment: $420 (5-yr, 6% auto loan for a car just under $22K)
Auto Insurance: $80 (they have good $100K/$300K insurance but comprehensive on 1 car).
Auto tags/inspections: $12 (about $140/year)
Child Care: $500
Federal Taxes: $100
Electric Utility: $120 (average over year)
Gas Utility: $35 (average over year)
Trash/sewer/water: $65
Grocery Budget: $600
Eating Out: $80 (yes, that's only $80 for a whole month -- they cook a lot at home)
Gasoline: $110
Phone and Internet: $75 (our frugal family forgoes cable TV and uses an antenna)
HOA fees: $20
Cell Phones: $65 (this may seem low, but these people are frugal)
Movie Rentals: $15 (cheap entertainment)
Clothing: $35 (some work clothes, some GoodWill clothes)
Dog food: $30 (most families have a pet)
Haircuts, cosmetics, toiletries: $45
Life Insurance: $50 (both parents, prudent, are insured with term life insurance)
Health Club: $20 (they have a deal!)
Babysitter: $25 (obviously, this is about 1 night's worth, again: think frugal)
Ok....let's see where we are at with this very basic, frugal family budget
-----------------------------------------------
Basic Frugal Budget $4499


....

UH OH

(it seems paying the full cost of health insurance has shot this family's budget)

....

It seems our family can't quite....live....this basic budget on $50,000/year.

OK, let's suppose the parents have been working quite hard at their jobs, and are great at them, and they just got BIG raises....(perhaps in part due to their employers canceling health insurance benefits).

Let's revise the family income upwards to a very average family level of $60,000

$10,000 is a nice raise, yes?

But...we'll keep that credit card debt unchanged at $20,000, now about 1/3 annual income.

Federal taxes increase (TurboTax says) to about $232/month.

Take home pay after FICA withholding only is now increased to $55,410 or $4618/month.

The basic budget though is increased by only the new income tax increase, or another $132/month:Basic Frugal Budget $4631

whew....not so good...

It seems $60,000 is not enough for our "frugal budget" above.

Notice that some or several of the items are *less* than your own family spends?

Ok, let's cut costs to the bone, and put on a 2nd job for dad.

Of course, some families don't have a $420/month auto payment.

Let's give them a cheaper car there.

Let's cut that car payment to $350/month -- they bought a cheaper car to begin with, say. This cuts the basic Budget by $70/month.

Dad is now working 55/hours week (40hrs + 15 hours on the 2nd job at $9/hour) and brings in an extra $6750/year now in 50 weeks.

The little boy sees less of dad now, but....life is sometimes hard (and sometime made harder by decisions of other people though), and that's a reality.

Of course, another job will require a little more gasoline, and probably the family will need fast food a few times also, being too exhausted to cook sometimes. Let's suppose $20 more for gasoline, and $25 more for fast food.

This brings home another 6233/year after FICA, or $520/month, for a total of $5,137/month. Federal taxes increase by another $91 to $323/month now. Against the increase of $91/month in taxes we decrease the car payment by $70, then add $45 for more fast food and gasoline for a net increase of $66 in the budget:

Basic Frugal Budget $4697/month

Ok, now with 3 jobs and a cheaper car the family is bringing in enough for their basic frugal budget and will have

$440/month left to pay on... credit cards.

hmmm.....

remember this payment amount on the $20,000?:

12% -- $527/month
22% -- $630/month

We are still not making it here...
ok, we have to be somehow more favorable, less desperate. Let's say that that credit card balance for those unexpected expenses all at once was only $15,000.

We are now under 1/4th of family income from that expensive, unlucky 4 months.The new 4-year payment amounts (on $15,000) are:
12% -- $395/month
22% -- $473/month


Ok, now we've made it. The family can pay the credit cards. Sort of.

They can pay about $400/month at 12% interest. Or with the help of Congress, they can pay more, about $470/month, lining the pockets of bank executives and investors. Perhaps they can save somewhere else in the budget to close that $33 a month gap needed to make the $473 payment when the interest rate is 22%.

Is one scenario better for the economy than the other?

I'm not just being rhetorical with that question. The $78 more each month the family has available under the lower interest rate is sustainable (non-credit) money that will be spent, sooner or later (more later if saved first), in the ordinary economy -- giving a waitress an extra tip, or buying a little iPod. It's discretionary money like this that ultimately provides you and I with our jobs. If that is sent off instead as extra interest, it can go to investors overseas, or into an U.S. high-wealth portfolio of securities somewhere, and be socked away for decades.

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Update: A helpful reader pointed out that the example of buying a couch (in addition to medical and repair bills) suggested the example family wasn't prudent enough, so I substituted an equally realistic example without a couch. But ultimately the issue wasn't what a family chose to buy in piling up debt, so much as just simple usury, and worse usury after the fact.

I liked this metaphor from Austan Goolsbee in a NYTimes article on the credit card reform bill to describe the practice of raising rates exorbitantly on existing balances:

Austan Goolsbee, an economic adviser to President Obama, said that while the credit card industry had the right to make a reasonable profit as long as its contracts were in plain language and rule-breakers were held accountable, its current practices were akin to “a series of carjackings.”

“The card industry is giving the argument that if you didn’t want to be carjacked, why weren’t you locking your doors or taking a different road?” Mr. Goolsbee said.

The Best of the Week

As a regular feature I'll be posting on the weekend a Best of the Week, which will occasionally be updated on Sundays also (if not posted on Sunday to begin with). Work is proceeding on the final draft of the book I've been working on (see my profile).

This week a couple of pieces stood out for drama:

Charlie Rose had an interview with Neel Kashkari (notes below):



some interesting moments (times):

9-11 minutes: house prices, loan modifications, what will end the "housing crisis"
17-23 minutes: the $700 billion, the crisis, the changes, the reasoning
24: "Nationalize (sic) the banks" vs. reality

...

And not to be over-shadowed, Adam Davidson, whom is usually fun to listen to, ended up going overboard on Elizabeth Warren, finally resorting to labels and pigeonholes. Of course, such don't fit so well. If Elizabeth Warren is "left", then the left is smaller than I thought, and we'll be needing a new label (or not) for what used to be "left". If you listen, here are a few economists Adam forgot when he said no economists agree that the problem of household debt is a central, primary problem on par with fixing banks (and I'm including any public/blog/interview statement to the effect that consumer/household debt is central and a main source of the problems banks face):

Ken Rogoff
Timothy Geithner
Nouriel Roubini

There are more (for instance Krugman has suggested this a few times lately), but these three could suffice. (Still if readers want to suggest more or offer links, I'll include them).

Notice these three don't fit in a common pigeonhole, unless it's "realist".

Ok, here's the link for that interview.

We hope Adam will re-balance. Sometimes a person has to make a mistake in order to find their own next step.

Update: After Adam's apology Monday, Planet Money posted the full unedited interview on Tuesday, which really is a lot more interesting.

...

One broad point I'd like to make: No one really knows the economic future. We have profound insights such as from Irving Fisher, but even standing on the high platforms of insights such as these don't afford a clear view through the fog of all the ever-changing decisions and efforts that together will sum and multiply and modify each other into true complexity.

One insight I can offer: ultimately our economy is a joint decision of all of us. We can indeed decide to move up, down, or in a new direction, and the mass decision of tens of millions moving together in response to the bully pulpit is no small matter. It could be decisive.

The Great Depression...and Now (updated 6-09)

While listening to Simon Johnson on Bill Moyer's Journal tonight, it struck me that the primary cause of the Great Depression, the main factor that deepened then prolonged the 1929-30 recession, isn't clear for many people. Near the end of the first segment in Moyer's program, Simon quips that economists will still be debating the Great Depression 50 years from now. While some may, I believe we can decipher these events in a way that will decisively end the general debate soon.

When I reflect on the hundreds of articles and blog posts I've read on the Great Depression and our situation now, and on my own evolving thoughts over the last two years, one fundamental economic process stands out in this grand worldwide train wreck. Let me illustrate this decisive force and its play within the complex string of events.

The 1929 recession came after a period of significantly increasing consumer installment and mortgage debt. When a growing stock speculation bubble continued in 1928, the Federal Reserve raised rates to slow the expanding stock borrowing. A recession began in the summer of 1929, which in turn helped destabilize the stock market bubble, leading to the October crash, which contributed to a reduction in demand and availability of consumer credit. As job losses mounted from the 1929 recession into 1930-1931, increasing numbers of bank loans went bad, which made more and more banks reluctant to lend just as more consumers became reluctant to borrow. Banks were taking in payments from those able to pay on their (still significant) debts, but not lending out much. This was a reversal of the run-up in credit, and the deflation which followed made debts harder to pay and the balloon mortgages unrefinanceable.

Various other effects further crimped demand and income: tax increases meant to gather more revenues from those still working, and trade wars which destroyed jobs in export industries.

As the job losses and fear mounted, many with jobs became more cautious in spending what they had. The circle of reduced spending leading to job losses which in turn further reduced spending drove the economy downward towards its essentials, its base, where what was being produced and sold were largely necessities. The slide continued under its own momentum.

By early 1933, this process had advanced far enough and long enough that the remaining demand and economy still in operation was the harder stuff of necessity. From this point, it should be no surprise that Roosevelt and Congress were able to quickly halt the downward drift and move things upward by ending the bank runs for the surviving (hardier) banks with new FDIC insurance, by widening economic rescue efforts, and by calming the people with fireside chats.

By 1933 the weak, frothy parts of the 1929 economy were all gone, and only the strong, hard base remained, ready to build upon.

Nevertheless, people had been trained into frugality by this time, and the debt burden was still significant. It would take years of gradual psychological gains in general confidence and the gradual development and appearance of new products and new wants to strengthen and broaden the economy so that more and more people could find work. Time was required to re-weave economic fabric exactly because so many who had lost jobs were also broke and had unpaid debts, so that even when they worked they were still miserly. World War II capped this process of slowly building up jobs and paying down debt, ending the remaining lack of demand and unemployment and accelerating technological innovation. By the end of the war, the U.S. was prepared in all essential ways for significant economic growth -- with increased general confidence and new technology ready to be put to work -- and only needed to be turned loose from wartime governmental control, which is exactly what happened next.

An analogy for America and its economy of 1928-1945 would be a story that starts with a drunk driver on a mountain road.

Drunk on overindulgence (stock speculation and debt) and driving too fast, our Driver careens into roadside trees at high speed (October 1929). But then worse, our hero tumbles down the cliff face (1930-31), taking further injuries, and finally goes without help or food for days (1931-33).

After what seems an eternity, our desperately injured Driver is finally rescued and put in hospital for a long, slow recovery (1933-1940). After gradually regaining health in this painful, slow recovery, our patient is then put into a strenuous, lengthy physical therapy program (WWII).

Finally, our Driver is released one day (1945), after what seems ages, now hale and full of strength and power, his confidence restored. He is a new man.

...

Will it take us 10 or 12 years to get back to a thriving economy?

Only if we have years of downward spiral, which is a threat due to the weight of household debts. And for the "thriving" part -- only if we undergo serious re-conditioning.

But our tumble down the cliff (joblessness) is being seriously fought and contested by the Fed and the Federal stimulus program, with multiple ropes.

Our modern Accident included air bags.

Rescuers are hard at work, bringing the Driver water and oxygen through the broken car window, hanging by ropes on the face of the cliff.

We may not need a 12-year recovery -- we have not yet suffered 1931-1933.

The ropes are creaking, and several have snapped or slipped off, but others have been hurriedly attached.

Nothing is clear yet at this point. ...Except, perhaps, that the old jalopy is totaled.

Nothing is certain. The car may yet go tumbling, or the ropes may hold.


----

Update: Here is a good source of ongoing world economy graphs showing our progress vs. the Great Depression. It takes time for the effects of the stimulus program, and also of general confidence to show up in this kind of data. Perhaps by late summer we will have a better idea whether the world economy can deviate upward from the Great Depression trends we have followed so far.

Congressional Oversight Panel's Hearing with Sec. Geithner

For those wanting the complete video of the Congressional Oversight Panel's hearing with Sec. of the Treasury Geithner click here. The hearing starts around 17.5 minutes into the video (expanding the video size can help with adjusting the time slider).

Starting at about 50.5 minutes, Geithner offers an overview of the current economy-wide credit situation and broad economic goals, concluding everyone's opening remarks/statements. (The opening statements of panel members earlier will be interesting to many). Questions and answers follow.

Just past 66 minutes, comes Citigroup -- the issue (discussed on this blog here and here) of how little equity (future upside potential) taxpayers have gotten in return for all their money and having taken on the massive risk of bad Citigroup securities. This is a major question.

The question on Citi from Silvers here includes interesting charts and seems headed to the central issue of whether taxpayers have the appropriate upside potential in Citigroup that our taxpayer dollars should reasonably purchase. But then Silvers clouds this essential question with the irrelevant issue of exchanging the weak seniority of the current taxpayer-owned TARP-1 preferred shares (more "senior" investments take losses after other classes of investment lose first if Citi goes into receivership or gets restructured) vs. common shares (aka "equity", which takes losses first). Being second in line for losses after common shareholders is practically being first in line for losses (as the common stock would already be near $0, since the net value of Citi would presumably be significantly negative in that scenario, or only of value because of use of the taxpayer-funded guarantees of much of Citi's risky securities). Put another way, if taxpayer guarantees of Citi's risky holdings protect common shareholders enough for Citi stock to have value, then will taxpayers receive an appropriate amount of Citi stock in the end (regardless of stock price) if those guarantees cost taxpayers significantly? In other words, the question of seniority clouds the real issue.

The real issue is entirely whether taxpayers have upside in Citi in proportion to their total funds put into Citigroup including the taxpayer guarantees of risky Citi securities after a restructuring or massive actual guarantee costs. i.e. -- would taxpayers get a proportional share of new stock like any typical debt-for-equity swap (where bondholders and other bank creditors get stock in exchange for their loans to a business being restructured). Silvers recovers somewhat at the end, asking a more open general question, but the cloudiness makes the obscures the broad question.

Geithner then gives the standard response about saving the entire economy as being the taxpayer upside. Of course, Geithner cannot suggest Citi is insolvent (or would have been without the massive blank-check-like guarantees). As Sec. of the Treasury, he cannot suggest any particular bank is in any particular condition, until after the fact. But he does not address the essential question about why the rescue of Citi involves so little upside for taxpayers.

We can rescue Citi with or without transferring taxpayer wealth to rich bank investors.

Question we'd like to hear: "Why are we effectively transferring so much taxpayer wealth to bank investors when it was not necessary in order to rescue Citigroup or for bigger goals of restoring credit and system-wide stability?"

I use present tense because we do not have to make bondholders (senior bank investors) 100% whole at taxpayer expense. These bonds are already at some market discount (below their original value) exactly because they rely on what will likely become a semi-political decision as to what degree of losses they may eventually take. We should define that possible "haircut" precisely ahead of time, to remove uncertainty, and thus encourage private capital, as the Secretary no doubt wishes to do.

It's fair to guess that Geithner wishes to avoid adding extra complexity. Congress should specify the precise losses bank investors take in a restructuring or massive taxpayer guarantee infusion of funds so that the question is resolved. The "haircut" link just above is an example of how to do that.

----

There is much more in the hearing, and many will find it rewarding.

I especially recommend just past 84.5 minutes, where Warren raises the big picture issue of just what is on the table to address failing banks.

IMF: $2.7 Trillion in Losses from U.S. Loans

The Wall Street Journal reports the IMF estimate of total financial system losses from 2007 through 2010 from bad U.S. loans to be $2.7 trillion dollars, and over $4 trillion from bad loans around the entire globe:

U.S. and European banks need to raise $875 billion in equity by next year to recapitalize banks to a level similar to the pre-crisis years -- and twice that amount to match the level of the mid-1990s, the International Monetary Fund estimated.

The steep funding requirements reflect a financial crisis that the IMF said continues to deepen along with the global recession. The banking sector's woes have spread from the housing sector to commercial real estate loans and emerging-market debt. Overall, the IMF estimates that the U.S., European and Japanese financial sectors face losses of about $4.1 trillion between 2007 and 2010. Of that amount, banks are confronting $2.5 trillion in losses, insurers $300 billion and other financial institutions $1.3 trillion.

The banking sector has already written down $1 trillion of those losses, said the IMF, which didn't estimate how much other financial firms such as insurance companies and hedge funds, have written down thus far.

"Without a thorough cleansing of banks' balance sheets of impaired assets, accompanies by restructuring and, where needed, recapitalization, risks remain that banks' problems will continue to exert downward pressure on economic activity," said the IMF's Global Financial Stability Report, its twice-yearly review of the world's financial sector.

While problems in the U.S. mortgage sector are generally blamed for the global financial crisis, the IMF report, showed there other regions played a big role too. About $2.7 trillion of the losses from 2007 to 2010 were attributable to the U.S. market, the IMF reported, while about $1.2 trillion came from bad loans and security losses in Europe.

U.S. banks have written down roughly half their anticipated $1.06 trillion in estimated losses from 2007 to 2010, the IMF said...

Elizabeth Warren Offers a Clear, Comprehensive Review of the Situation with Banks

The author (co-author) of the great "The Two Income Trap", which explains one of the key facts and seeming contradictions of the modern American economy -- how a two-earner family can become less secure than a one-earner family through competitive bidding with other families to buy expensive homes in neighborhoods with good schools -- brings us more of her clear, insightful thinking below. This is a great overview of the entire banking situation and our options in a scant 8 minutes. Warren shows why she was chosen as a key public watchdog to report to Congress on this entire mess, and I recommend this video for anyone interested in this subject, from experts to those wanting to digest a well-explained summary in a few minutes. (Also see interesting excerpts from the full report and my comments after the video.)




The report is here.

Two highlights of many:

In addition to drawing on the $700 billion allocated to Treasury under the EESA, economic stabilization efforts have depended heavily on the use of the Federal Reserve Board’s balance sheet. This approach has permitted Treasury to leverage TARP funds well beyond the funds appropriated by Congress. Thus, while Treasury has spent or committed $590.4 billion of TARP funds, according to Panel estimates, the Federal Reserve Board has expanded its balance sheet by more than $1.5 trillion in loans and purchases of government-sponsored enterprise (GSE) securities. The total value of all direct spending, loans and guarantees provided to date in conjunction with the federal government’s financial stability efforts (including those of the Federal Deposit Insurance Corporation (FDIC) as well as Treasury and the Federal Reserve Board) now exceeds $4 trillion.

What this is saying: The Treasury Dept. is working in tandem with the Federal Reserve, and using the Federal Reserve's ability to create new money by just printing more of it and buying bonds and securities to effectively double down and triple down and quadruple down (well...etc., you get the idea) on their bet -- the uncertain gamble that bailing out various types of lending, from auto loans to credit cards, will work out for the best.

If it doesn't work out, if the loans go bad en masse, then the Federal Reserve could lose considerable capital. But that capital value is stored ultimately in the value of the dollar itself, what you and I rely on to conduct our economic lives. In other words, if the Fed loses, you and I are the actual ones that lose.

--------

The second highlight:

[One of several questions from the oversight panel to Sec. of the Treasury:]

2. The thrust of the TALF [the Fed's latest way to lend more money] appears to be to attract investors with large enough pools of capital, such as hedge funds, to the ABS [Asset-Backed Securities, or basically all sorts of lending packaged into a type of bond] market by allowing them to purchase ABS on a highly leveraged basis with risk of loss largely transferred to the taxpayer directly or, through the Federal Reserve System, indirectly, in a manner that confers substantial benefits on these private investors who have little at stake. Please explain in detail the rationale for such a transfer of risk to the taxpayer with so much of the benefit transferred to private investors and please provide the facts and figures that support this rationale.

[Geithner's response:]

"...Because the questions you have raised pertain primarily to the structure and operation of the FRBNY [Fed. Reserve Bank of NewYork] lending facility [TALF], FRBNY staff has taken the lead in responding...." [Note Treasury Sec. Geithner was the FRBNY president previous to his current post.]

The detailed response by the FRBNY below points out the risk capital (private investors' money) which those taking TALF loans put up (and if their gamble goes bad due to bad loans, they lose part or all of their risk capital; this is referred to as a "haircut" in the response), the risk-premium interest rate such TALF loans carry, and...this notable, perhaps hopeful, bullet point:

[excerpt from FRBNY response:]

"The current economic situation is extraordinary and the outlook is therefore especially uncertain. We accounted for that uncertainty by making very conservative assumptions when calibrating the haircuts. The haircuts are designed so that, even if the economy evolves in a manner significantly worse than we currently expect, all credit costs will be more than covered by the haircuts and the excess interest rate spread paid by investors, resulting in no credit losses for the Treasury or Federal Reserve."

hmmmm....

Let's hope so.

This is as well designed as can be, no doubt.

It's a gamble though.

A reasonable gamble. A double or triple-down.

In the end, it's reasonable to try to save the old system, to try to make it as easy as possible to get a car loan or a credit card for those that want to buy on credit. The only primary danger in the wide range of governmental efforts to prop up parts of the old status-quo I see is maintaining semi-dead corporations (including banks) that can't really flourish long-term without real restructuring, and thus crowding out better competition (such as better-managed banks) that might replace the subsidized corporations with something much better if they had the open space and opportunity.

But...too much household debt (vs. income) was and is the problem (see here, here, here and here.) We still need to reduce consumer (personal) debt, and the faster this finishes the better, and here's how to speed this up.

Add Some Nuance to Bank Restructuring (Updated)

(Update: further refinement of bond haircut, and notes on the subject from The Baseline Scenario and Naked Capitalism blogs)

We often hear options about "temporarily nationalizing" or restructuring banks which lay out a choice between protecting creditors of banks (those who have loaned banks significant sums of money, also called bondholders) or wiping them out. Similar language is about whether to guarantee all bank debt, or only certain kinds. While it's widely said that bank restructuring of a failed bank should leave stock shareholders with nothing (since the bank itself is worth nothing on net), it's sometimes said that we can't wipe out the bondholders since this kind of bank debt is so widely held as an investment by pension funds and many other institutions.

Also, bank investors (creditors, bondholders) need some sense of what the rules are for the future, in order to have confidence enough to lend money to banks.

But just as in much of life, it isn't necessary to choose between 0% and 100% here.

One intermediate form of bondholder protection is to convert the bondholders of failed banks into shareholders in a taxpayer-restructured bank. But, this can reduce the upside for taxpayers, who sometimes will have put in far more money than the bondholders, unless the taxpayers get the great majority of the stock and bondholders relatively little. Even if such a scheme is followed, there remains the critical question of just exactly what percentage of the new stock the bondholders will get. Should they get exactly a proportion of the new stock that their original capital would represent as a percentage of the total money bondholders and taxpayers together put into the banks?

I have one little proposal. When bondholders of banks are given a return of their money, let the bondholders take a "haircut" (partial loss) exactly equal to a fixed multiple of the interest rate they would have gained if the bank hadn't failed.

In other words, if a bank bond has an interest rate of 6% and the multiple for bond haircuts in bank failures is set to 1.5, then when such a bank fails the bondholder takes a haircut of 9% (1.5 * 6%), receiving the remainder of his original capital (91% in our example just now) back during the federal restructuring of the bank.

In a case where debt is converted into new stock, the bondholder receives a share of stock in proportion to a reduced capital amount after a haircut and then in proportion within all capital sources for the bank, including taxpayer bailout money in all forms.

These two methods solve the problem of socializing too much of the losses onto taxpayers and the resulting reverse-robin hood effect of making bondholders perfectly whole at net middle-class taxpayer expense.

In the future, with the possibility of a real partial loss (yet also a limited, predefined risk), bank creditors/investors (bond buyers) would examine banks more carefully, and banks themselves in turn would be managed more prudently in order to attract capital.

Baseline Scenario points out declining confidence in bank bonds, and points out how the bond market is estimating the future of such banks. James Kwak also notes the Fed might try buying such bonds to increase confidence. This all begs the question of whether propping up such banks is a tenable solution. For another view on this see Edward Harrison's guest post on Naked Capitalism, in which he says we need to guarantee bondholders be made whole. But the need is to remove uncertainty, and this can be done by creating a defined haircut that is predictable and known, as I have suggested above.

Geithner Mentions "Unsustainable" Debt vs Income

We've learned to expect Tim Geithner to be precise and careful to only say what a Secretary of the Treasury should say. We expect to hear him making confidence- enhancing comments and laying out plans in a way that aims to bring more people on board with the administration.

But it's hopeful, and I think genuinely confidence-enhancing, when a Secretary of the Treasury clearly states how things truly are.

We need to have a clear picture of the real situation, in order to be able to do something effective about it.

So I'm encouraged to hear this 33 minutes into Geithner's interview on Charlie Rose:

Geithner: "...if you look at the amount the American people were borrowing, relative to income, you just had a huge, unsustainable rise in the basic debt obligations of the American people.....

"You know, uh, people borrowed and spent beyond their means..."

!

This is the basic reality we are dealing with.

All the other descriptions of our current situation that aren't centered on or in recognition of the fact of the credit bubble are either erroneous or beside the point. Even talking about wages is incomplete without an inclusion of the debt picture. Economics is not the entire picture of our lives, but so far as the economic and personal budget side of our lives goes, this is the most crucial fact.

I am reassured about Geithner's understanding of the situation -- that he can recognize and clearly state this central fact of unsustainable debt levels. Yes, we still have to wait to see just how willing the Fed and Treasury and Administration are to deal effectively with zombie banks, but at least there is no delusion about the real situation on the part of the Secretary of the Treasury. Since Geithner clearly understands the full picture (regardless of how he may estimate or misestimate the complexities of receivership), we can reasonably hope he'll correct mistakes and modify plans more quickly than without such an understanding.

Because the currently described plan has some flexibility -- for instance in just how much common stock taxpayers may end up holding in some banks in time -- we can plausibly imagine that the outcome would have some fairness for taxpayers in getting equity in banks (the potential for upside in return for their money). Until I see that we refuse to take a majority stake in Citigroup (for instance when certain guarantees cost us more as time passes), I am not going to presume that we won't "temporarily nationalize" (restructure, etc).

So we still have a possibility that Geithner's plan, or ongoing adjustments, could be a flexible and effective way of dealing with the banks that is good enough, within the context that there is no cheap or easy way out of this mess.

Geithner and Bernanke on Banks

The Commerce Department reports today that January 2009 shipments of durable goods are down -17% year over year (Jan. 2009 versus Jan. 2008), and new orders down -26% year over year (yoy).

What does this have to do with Geithner (here and here) and Bernanke on banks?

A great deal.

For instance, computers shipments and new orders are down -30% and -27% yoy respectively, and non-defense capital goods ex-aircraft (goods like autos, appliances, computers, etc.) shipments and new orders are down -11% and -20% yoy. In short, consumers have pulled back in a major way, saving more instead of buying more. They are doing this in order to have something to retire on, since their home-equity wealth illusion has disappeared and the stock market appears to be offering less of a contribution to retirement security.

So while some recovery of demand is inevitable in time due to the need to replace old and broken items, a reduction in consumer need for credit to buy things like computers, new cars, bigger houses, appliances, etc. is evident and likely to be lasting. (This is similar to what happened in Japan, and needs addressing like this.)

In other words, even if the American economy stabilizes and grows moderately, America no longer needs as much growth in consumer credit as it has had in the past few years.

But this may not be a part of Geithner's and Bernanke's plans.

Normally, when there are too many companies providing a good or service to a market, some weaken and fail, and are either bought out by stronger companies or sold off piecemeal.

This has happened a few times with airlines, for instance.

For banks, this would likely mean further consolidation.

But in order to have more consolidation, we would have to allow weaker banks to fail so that they could be bought out by stronger banks or sold off in pieces to stronger banks.

The current plan being signaled by Geithner and Bernanke, though, appears to be to progressively provide capital over time to the existing major banks to keep them going, and to prevent any more of the major banks from failing.

For instance, if a major bank had even more losses, that would result only in additional capital being injected, and presumably a larger taxpayer ownership stake in the bank. (Note this bypasses the question of whether taxpayers should already have acquired a majority ownership of a certain major bank in return for their money to date. Also see Krugman on the Newshour here for another take on this.)

From Marketwatch on Bernanke before congress on Wednesday.

Bernanke spent much of the hearing on Wednesday trying to reinforce his message to Congress that the Fed and the Obama administration now have at least the outlines of a bank rescue plan in place that will show results over time and that banks are not on an out-of-control course to nationalization. [Hal here: "nationalization" would eventually result if taxpayers get ownership stakes in full return for their dollars, instead of only partial return.]

"The focus on nationalization kind of misses the point," Bernanke said.

While the federal government may acquire large minority positions in the nation's largest banks, it has no plans to run the institutions and zero out shareholders, Bernanke said.

"It may be the case that the government would have a substantial minority share in Citi (C) or other banks," Bernanke said. But the government has the tools already it needs "to make sure that banks just don't sit there," he said.

So in the judgment of Geithner and Bernanke, the thought appears to be that there has been enough consolidation of banks, and no more major banks should fail because this would be damaging to confidence.

They might be right -- perhaps enough banks have been consolidated that if a recovery ensues we'll have the right amount of banking capacity. They might be wrong -- it may be after the eventual recovery that there are too many banks, and consolidation will be inevitable. It may be that somehow general confidence would be better if a major bank was kept on life-support instead of being more seriously restructured or sold off. Or the opposite could be true.

At this point, this course of action allows for both possibilities -- keeping zombie banks on life-support, or in contrast truly fixing them. For instance, over time the Federal (taxpayer) stake in a major bank could eventually become so large as to amount to full or near full ownership, even at a diminished rate of exchange of stock for taxpayer dollars. And once such majority or near full ownership occurred, the bank might then be sold off in part to other banks, resulting in some consolidation.

But the words Geithner and Bernanke spoke suggest they feel it's better for general confidence to continue transferring more taxpayer dollars to existing shareholders in part (by accepting disproportionally small stakes in ratio to dollars injected) instead of having a more rapid nationalization of certain banks. That momentary confidence in the stock market is more important than other considerations, and that banks' further losses won't be that much, as the economy recovers.

It may be this view has to do with not wanting to recognize the American economy suffered the growth of a huge credit/debt bubble -- implying that past policies of the Fed permitted an actual bubble -- and that the current situation is therefore the collapse of a credit/debt bubble, instead of only a housing-led downturn.

This is how the Geithner/Bernanke plan appears at the moment, with the stress tests yet to be finished. And in fairness, plenty of decisions are yet to be made. The plan has a lot of room for flexibility. They might even make the best possible choices under their flexible parameters. These are the questions the coming months will answer.

The Single Best Commentary on Banks

Amid the diverse and great on-video commentary on what to do about banks comes the best I've seen so far in terms of combining detailed knowledge with theoretical understanding and then communicating especially well. This is from a venue rarely if ever referenced in the economic blogosphere and I caught it by chance.

I'll excerpt part of Bill Moyer's intro to introduce this piece:

"There comes a time in every economic crisis, or more specifically, in every struggle to recover from a crisis, when someone steps up to the podium to promise the policies that — they say — will deliver you back to growth. The person has political support, a strong track record, and every incentive to enter the history books. But one nagging question remains. Can this person, your new economic strategist, really break with the vested elites that got you into this much trouble?"

And here's the man who asked that question. Simon Johnson is former chief economist at the International Monetary Fund. He now teaches global economics and management at MIT's Sloan School of Management and is a senior fellow of the Peterson Institute. He is co-founder of that website I quoted — baselinescenario.com — where he analyzes the global economic and financial crisis.

Watch the video interview here.

The Language of "Nationalization"

Not long ago, you and I knew what the word "nationalization" meant.

Perhaps, someday again, we will know.

In the last year, the word "nationalization" has been used as a lever against some bank rescue plans, although now an effort is being made to simply bypass the tricks of this changed meaning of "nationalization" by just using the word anyway even for sensible market-style (getting stock in return for money) plans.

While this new usage of the term as a label even for the good rescue plans may work out, let's step back and examine this loaded word.

This post isn't about whether this "nationalization" is the right course -- it is -- but instead I want to remember our normal meaning and look at what is happening to this important word.

--------------

In real use in everyday language, for decades now, until the last few months, nationalization had a clear meaning.

It meant the government seized a company or group of companies -- sometimes by outright theft -- from the previous owners.

There were only three possibilities of nationalization in regard to the value of the company (or industry) -- appropriation (theft), purchase, or taking on responsibility and ownership of failing companies that were insolvent or heading into insolvency.

Nationalization as theft we read of at times in backward countries in Latin America or Africa. Nationalization as purchase was unusual.

Nationalization as rescue of a failing company was European.

But what distinguished nationalization from other measures to handle a failing company was whether the government intended to keep and operate what it had seized.

After all, we did not refer to FDIC seizure as "nationalization" (perhaps this will change too; who knows).

A taking into intended permanent national ownership -- that was "nationalization".

It meant owning a company or industry and running it, as a national industry, for the benefit and national purposes of the government and the nation.

...

In contrast "investment" -- an all-American thing -- was buying a stake in a company, through stock or bonds or similar methods.

...

So...how did we arrive at a place where bailouts combined with investment (getting preferred stock in exchange for capital, like TARP 2008), becomes "nationalization" if we even temporarily end up with more than 50% of the stock, for instance?

Are bailouts with investment now to be called "nationalization" all the time?

Is "up" now "down", and "left" "right"?

This is quite a moment for ideologues, and every other American too.

The irony of it. The only plans for rescuing our banks that actually make good old market sense like getting something in return for our money (investing) are now "nationalization" -- while actually just giving taxpayer money away for free (in part or whole) is only an innocent "bailout".

But there is indeed a normal common usage for this alternative to "nationalization" -- a bailout where we simply give away taxpayer money for free to a favored group.

In America, we usually call most variations of this kind of transfer...

socialism.


And when the favored group is a wealthy elite, this is similar to the practice of "corrupt communism" in the Soviet Union for instance.

Another phrase for these non-"nationalization" bailouts is "crony capitalism."

But in favor of general public clarity, we'll need to stick with something more concrete and transparent for the alternative to "nationalization". I suggest:

Insolvent bank stockholder bailout.

Japan

The parallels are building.

The New York Times offers a sharp new article here.

For those in a considerable hurry, let me offer a few bits from this worthwhile read:

Only in 2003 did the government finally take the actions that helped lead to a recovery: forcing major banks to submit to merciless audits and declare bad debts; spending two trillion yen to effectively nationalize a major bank, wiping out its shareholders; and allowing weaker banks to fail.
By then, Tokyo’s main Nikkei stock index had lost almost three-quarters of its value. The country’s public debt had grown to exceed its gross domestic product, and deflation stalked the land...

...the Japanese first tried many of the same remedies that the Bush administration tried and the Obama administration is trying — ultra-low interest rates, fiscal stimulus and ineffective cash infusions, among other things. The Japanese even tried to tap private capital to buy some of the bad assets from banks, as Mr. Geithner proposed.
One reason Japan’s leaders were so ineffectual for so long was their fear of stoking public outrage. With each act of the bailout, anger grew, making politicians more reluctant to force real reform, which only delayed the day of reckoning....

Also encouraging is this article Large Banks on the Edge of Insolvency, which states forcefully:

Instead, the experts say, the government needs to plunge in, weed out the
weakest banks, pour capital into the surviving banks and sell off the bad
assets.

Let's hope this is a sign that the scattered voices calling for a more forceful (effective) solving of the problem are beginning to be joined by more and more of the media.

Update: (from many lips to God's ear -- since I wrote this, the media is seriously talking about it on a widespread basis, starting with the Sunday talk shows.)

Geithner's Competence Reassuring but...(Update)

We are in the midst of dealing with the one of the most far reaching situations our democracy has ever faced -- a swirling mix of moral hazard, the interests of the people, our economic outlook, and complex questions of how to pull some good out of the huge mess that is the end of the decades-long credit bubble.

Since it's already clear to most people that we have many banks likely to be revealed as insolvent, and perhaps all too many (some on that below), I'd like to focus on a few big picture aspects and thoughts of the moment.

While the general outline of the new plan for banks doesn't yet have the decisive details that will determine the eventual return of future taxpayer money sent to rescue banks, the outline itself is encouraging to me in a couple of ways. A suggestion of some good possibilities (or better rather than worse choices) appeared today. Here, I'm only going to give some impressions and initial thoughts.

By combining several fundamental ideas, the new plan seems likely to have effective elements -- its odds of at least partial success are raised by a combination of solutions.

But the most striking thing listening to Geithner’s testimony today was his general and specific competence.

Update: The open question though is whether Geithner will try to maintain vested interests at taxpayer expense (such as reverse-Robin-Hood welfare for shareholders of insolvent banks). As of 2/23, this remains to be seen.

The combination of ideas together with first-rate competence give me reason to hope for as good an outcome as might be managed. We'll see.

In the meanwhile, Calculated Risk has an interesting post with a general outline for the "stress test" (examination of bank solvency).

Yves Smith points out many or most of the likely and possible bad aspects of what we know to date. I'm sympathetic to her wariness. Recent history suggests when there is a possibility of transferring wealth unjustly through government, it often happens.

As to the estimates of how much U.S. banks are in the hole, it's notable that Kenneth Rogoff gives a number like $2T (says Yves). (here's a brief CNBC Rogoff bit -- "$2 or $3T")

One good question this raises is whether if we willingly put some large banks into FDIC or other restructuring-like processes after an examination ("stress test"), just how many large money center banks might we wish to insist on saving, once the worst case banks are removed? (Because we all know perfectly well we won't disappear all the large banks.)

Taxpayers are already on the hook for the losses because FDIC was created federally with federal backing. FDIC has something like $35-$40B in its reserve. Compare that to $2T.

I understand perfectly the righteous anger that would want most all of the bank officers that have achieved insolvency to go. I still hold we should prefer some (more than 1 but less than most) of the worst larger banks to be restructured or dissolved --which means FDIC or similar process -- new control, new bank officers or absorbed into other banks, etc. We then choose to recapitalize the better-managed large banks. And finally, encourage the best banks to expand. (and specifically to allocate capital to favor the best!) This is a pragmatic idea of trying to give more lending power to the best lenders. Speaking in general terms, I could imagine something like up to eventually 1/3 (or in a worst case 1/2) of the biggest existing banks getting processed and their officers losing control, and then some of the remaining banks diversely gaining portions of the pieces.

But to specify much presumes more information than any one person has (I think!). We don't yet know precisely how good things are at some of the presumably better banks, those with lower portions of nonperforming assets, once "stress tested".

Of course, we should like to see some relatively well-managed banks, of all sizes, and especially the best banks of medium to larger size, expanding a great deal within a year or two. That would demonstrate a good outcome.

---------------

Update: we have a nice bonus -- Krugman and Rogoff on the Newshour

Or video of complete segment with intro.

More on Banks....or on Not Becoming Japan (and on Avoiding a Reverse Robin-Hood)

In December 2007 I was thinking about Japan, and whether the US would or would not go through a Japan-like stagnation. This was a complex question, and much discussion has happened during the last 12 months. Gradually a consensus has emerged in recent months among many economists and bloggers that one of the key facts of Japan in the 1990s was that banks were allowed to pretend to be solvent and continue operating -- so they functioned like deadwood that nonetheless sucks up water and light, obstructing growth by robbing economic nutrients, just by being in the way.

How were Japan's bad banks in the way?

They continued to hold depositors' money and savings, but became overly conservative in lending in the 1990s because they were trying to recover from having bad loans on their books that they refused to admit made them insolvent.

The overly-conservative attitude helped drag on Japanese confidence and thus the Japanese economy.

It wasn't that Japanese banks were obstinate or wanted to support big salaries/bonuses or dividends.

In the popular modern usage, many were "zombie" banks -- walking around and taking up crucial economic space, but essentially dead.

Thus Japan did not have a normal process of lending and investing, and this contributed to the unusual Japanese stagnation which happened even while the world economy was growing.

This is the view of many economists, and the only qualifier I can think of is that once Japan's economy was in one of it's several recessions during this time, there was less need for lending of course. The time lending matters more is when a tentative recovery begins. When a recovery is starting, can banks step up with new lending in a more normal fashion?

This is the reason many believe something has to be done about American banks. So that we can avoid one drag that contributed to Japanese stagnation in the 1990s.

But....as you would guess, the story then becomes more complex.

Exactly how should we "rescue" our banking system?

I've answered several of the difficult questions a few days ago here.

But one thing I did not explain then is why the overwhelming majority of bloggers and many or most economists don't like most of the of the past ideas that Congress considered (plans spread by bank lobbyists). Now the administration is said to be considering a "bad bank" plan.

The question about any "bad bank" plan is whether it is structured so that it will essentially take money from taxpayers and effectively give to it poorly-managed banks (by relieving them of their bad loans and securities they chose to take on) in exchange for....nothing or little. Just money for free, or for a small portion of the actual value, when the money doesn't need to be given away for free in order to rescue the banks!

Many plans have been aimed to essentially create a transfer of wealth from average taxpayers to rich bank investors, disguised as a financial system rescue. It is a disguise, because it is not necessary to permanently transfer wealth in order to rescue banks.

We have excellent plans available to rescue the financial system that do not try to permanently transfer (give instead of loan or invest) wealth from taxpayers (you and I) to bank investors on average much richer than you and I are.

Will the administration's "bad bank" plan be structured differently, so that it is not just a taking from taxpayers?

We'll have to wait and see what the details of the plan are to discover this.

Be assured, several bloggers (yours truly included) have shown they can penetrate and understand the implications of various proposals in terms of these long term bottom line effects.

It's a trillion dollar question. Literally.

It's now understood overall losses of various sorts will be at least $1 trillion. So when $1T or more of our money is eventually, gradually taken, will we get a stake in return the way we should?

If you are an average tax payer, your personal stake in this question is likely at least $8000-$10,000 (over time).

We are literally and exactly talking about whether over years of time perhaps $9000 or more will be taken from your own pocket and be given to much richer investors.

Will we "rescue" banks by robbing taxpayers through future taxes and possible future inflation, and giving that money in preference to the bad gamblers at the remaining banks -- actually rewarding those gamblers (banks CEOs and officers and bank investors) more when they gambled more and made more bad decisions?

Yes, that's more money given to the least successful gamblers.

These are normal possible dangers of a "bad bank" plan (which might be avoided through a lot of modifications of the basic idea).

There's no end to the injustice and just plain wrongness of this, if it happens this way. And to the anger it would cause that will last and rebound.

This is why it's better for more bad banks to go into FDIC before a general rescue, so that stockholders and bank officers responsibly take more losses instead of only taxpayers paying 100% of the loss. In the FDIC process pieces of the bad banks are then revived and come back alive with new owners, just exactly like many recently have (Washington Mutual for instance). Pieces, whole parts, or total banks are absorbed or bought by better banks and thus get better management.

But not every bank still alive or that has made acquisitions is actually a well managed bank.

How do you know which banks are well-managed?

The ones that are in better condition are the ones that have been better managed, and better examination can determine this.

It's like a hospital ward where some are beyond saving, some are moderately sick, and some are barely sick. We need to rescue the moderately sick and not lose too much of our limited energy and resources trying to heroically revive those that are really and truly dead but still here -- the "zombies". (see Yves Smith discuss the real meaning of triage)

We let the zombies get recycled, and save the moderately sick.

This results in a much better outcome for our whole economy, because we do not have an unlimited ability to borrow against the future without regard to the amounts.

The price does matter, and keeping better managers and letting go of bad managers does matter and aids in future economic results. When bad loans aren't made, then good loans have lower interest rates.

And when we rescue banks, we want this to be an investment because you and I deserve to own the stock, ownership shares of banks, that we are putting money into.

In other words, when we save a bank, we can either give money for free to existing owners, or we can instead rescue banks by purchasing a new stake (investment) in the bank.

Both ways rescue the bank. The first way is a reverse-Robin-Hood -- a transfer of money from middle class taxpayers to stockholders and officers of those banks in exchange for....nothing, or less than enough. Essentially a sophisticated form of...well, of theft. The latter (investment and actual public ownership of stock or preferred shares or bonds) is right and just. Taxpayers actually get something in return for their money -- a stake in the recovery of the bank -- what any other investor would get.

To prevent "zombie banks", we just need to truly examine them. That's what my previous post laid out in critical detail, along with important points of how to structure the rescue.

What to Do about Banks

In a way, one good bank solution is simply to continue existing strategies, with an emphasis on resolving which banks are solvent.

Consider -- if you have Washington Mutual branches in your city, you may have noticed they are still there and still in business. They just have different owners. We can trust our current process for handling insolvent banks -- it works well.

When TARP investments were initially injected into banks, the main objective was to stop the accelerating general bank run.

Enough time had passed before TARP that many of the worst actors -- CountryWide, Washington Mutual, IndyMac, Bear Stearns, Lehman -- had been removed or absorbed. The initial necessity to let market discipline take out the worst actors had been accomplished, and when Wachovia was taken out it began to look like enough had been done in terms of an object lesson and it was time to begin the recapitalization.

There is no fundamental reason why the whole previous plan isn't still a good approach, but there is a reality that some banks that looked ok, like Bank of America, were not so ok. In Bank of America's case, the late acquisitions of CountryWide and especially Merrill began to weigh down this previously strong bank, showing that it's never too late for mismanagement during a crisis.

At this point, we (literally all of us US taxpayers) are now on the hook for Bank of America's choices, which complicates what could otherwise be such a simple proposition:

Let them fail, and let FDIC, with taxpayer money, reimburse the depositors to the FDIC limit.

At this point though, we've already put big money into many remaining banks, so....

....it's time to consider what FDR did shortly after taking office in the midst of a continuing bank crisis more severe in some ways than we face now, but not so much more severe in other ways.

He weeded out the bad banks and created a convincing guarantee of the remaining "good" banks, ending the bank crisis in 1933. This was one of FDR's greatest successes.

We could do the same now.

We won't need a general bank holiday, as some work has already been done. The step here for us now is to investigate which banks are really too close to the edge, and put them into the arms of the FDIC a little sooner.

Essentially, we'd just make the FDIC uptake process more aggressive and put in the taxpayer dollars the FDIC will need as determined during the examination phase.

What are the presumptions about house prices (or commercial real estate, etc.)? Exactly that the bubble in the Case-Shiller price graph(s) will be erased fully, so that prices return to levels of the year 2002 (this accounts for inflation). We can then simply extrapolate defaults from current trends. This will yield a reasonable prediction of the near future cash flow value for mortgage backed securities and their derivatives. Similar principles can be applied to commercial real estate, and using trend extrapolation can even be applied to credit card lending, etc. Some banks will then be clearly insolvent, by more than a few percent of their nominal assets. These are rounded up and sent to the FDIC.

The political way to present this is we are fulfilling the FDIC promise we have made to each other as a nation. It's money we are paying ourselves.

And then, once more bad banks are removed, we can recapitalize the survivors in proportion to their assets at market value, thus proportionally favoring the stronger banks -- adding more lending power to those lenders that have shown better management. When a bank's assets are of high quality, it then proportionally receives *more* new capital, not less. We want to put loan decision making into the hands of better decision makers.

As to how to recapitalize, in addition to the proportional-to-asset-market-price principle, taxpayers must gain ownership stakes in exchange for their money, like any stockholders naturally have. Stock is a perfectly fine method.

The percentage of taxpayer ownership that results is less relevant than simply the fact that taxpayers aren't victims in a transfer of wealth. No. Something a little more just happens.

Taxpayers are the investors. They have voting rights, which could be administered by a congressionally-appointed board. Their shares can gradually be sold at a profit, 5 or 10 years from now.

Instead of a taxpayer rip off, we have a taxpayer investment.