TARP

8 Items to Learn About Banks and Bailouts #8

The Troubled Assets Relief Program (TARP) is nothing more than an attempt to avoid nationalization of banks that can't carry out their fiduciary responsibilities. It is an attempt to bailout the banks themselves, as well the people who run them, rather than an attempt to bailout the system and the American economy. To learn more about the details behind TARP, I highly recommend the Wikipedia article, even if it does interject politics a bit too much.

I'll leave this to the experts to tell you why this is a bad idea. You can pretty much Google around for anything Paul Krugman, Calculated Risk or Atrios has had to say about. Remember, these are economists who live in the real world. They use evidence to arrive at their opinions.

Every plan we’ve heard from Treasury amounts to the same thing — an attempt to socialize the losses while privatizing the gains. We’re going to buy up all the bad assets at premium prices; no, we’re going to offer the banks guarantees against losses; no, we’re going to let private investors buy the stuff, but offer them de facto guarantees against losses in the form of non-recourse loans.

- Paul Krugman from his blog

By offering low interest non-recourse loans, these public-private entities can pay a higher than market price for the toxic assets (since there is no downside risk). This amounts to a direct subsidy from the taxpayers to the banks. It is amazing how many different ways they've tried to recycle the same bad idea.

- Calculated Risk

The main reason for this post is to highlight how the TARP bailout funds are being carried on the books of the federal government. The cash approach used by the Bush administration overstates the best estimates of the program's costs. Since the size of the deficit and the accumulated debt will be used politically to oppose any further policy measures such as health care reform, it's important to understand the games that are being played in the presentation of the program's cost in the federal budget.

- Mark Thoma at Economist's View

Bailing out these institutions might be necessary, but bailing out executives and shareholders is not.

- Atrios at Eschaton

FDIC Receivership

8 Items to Learn About Banks and Bailouts #7

Outside of Social Security, the creation of the Federal Deposit Insurance Corporation (FDIC) might be the most important legacy of the New Deal. No other institution has done more to alleviate the bank panics that were so common from the birth of the nation to the Great Depression. Essentially, the FDIC guarantees deposits in member banks up to a government specified limit. The FDIC will monitor member banks as well to ensure that they can meet their obligations.

For instance, the FDIC places liquidity and reserve requirements on member banks. When a banks capital ratio (a ratio of banks capital to its risk) falls below 8%, the FDIC will issue a warning to the bank. If the capital ratio falls below 6%, the FDIC can force the bank to take actions to resolve the issue, including a change in management. Still, if a bank's capital ratio ends up at less than 2%, the FDIC will take control of the bank. This is FDIC receivership.

There are two types of receivership that a bank may find itself in: Purchase and Assumption (P&A) or Payoff. In a P&A situation, the FDIC will look for other banks to buy up the collateral from the failed bank. These include items such as bad loans or foreclosed properties. These are often purchased for pennies on the dollar. Still, the FDIC tries to recoup as much money as it can. In addition to the "bad items", the FDIC looks for other banks to buy the remaining pieces of the failed bank. This is why many refer to the process as "preprivitization" rather than "nationalization". The FDIC runs the banks for a short period, but this is done only long enough until all the pieces of the bank can be returned to market ownership.

The other type of receivership is the Payoff method which occurs when the FDIC finds itself unable to execute the P&A method. In this case, the FDIC will payoff all of the failed bank's depositors with funds in insured accounts. Typically, the P&A method can be executed for most banks.

The TARP program seems to be an attempt to avoid FDIC receivership for our largest banks. Still, every Friday lately has seen a number of banks taken over by the FDIC. It's a trend that everyone expects to continue.

Source, Source, Source

The Swedish Crisis

8 Items to Learn About Banks and Bailouts #6

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

So begins a New York Times article from last year about the Swedish banking crisis of the 1990s and their response. In 1992, the Swedish banking system was for all purposes insolvent. They pulled themselves out of it. So, what exactly happened in Sweden and what can we learn from it?

Sweden got into their mess in a manner not unlike the mess we find ourselves in. They went through a period of deregulation in the mid 1980s that resulted in a "frenzy of real estate lending". A bubble developed. The Swedish banks did not do enough to prepare for the possibility that the value of the collateral on their books would decline. Unfortunately, that is what would happen.

How did the Swedish solve their crisis? Nationalization. Here's how it worked:

• The Swedish government guaranteed all deposits held at Swedish banks. (We, of course, already do something similar through the FDIC.) They also guaranteed the creditors.
• A "Bad Bank" was created to hold troubled assets. Any bank whose assets were placed in the bad bank were forced to write down losses. 
• These banks were also required to give the government a large ownership stake in common stock. Existing stockholders were wiped out. (This was a very important step.)
  
• A "Bank Support Authority" was formed to supervise those institutions that the government supported.
• Eventually, the troubled assets were sold off with the money going into the government's coffers, essentially paying back much of the money to the tax payers.
• Additionally, the government would make money selling its ownership stake in the banks back onto the market. (This is why many Americans prefer to call the process pre-privitization to nationalization.)

Ultimately, the cost to Swedish tax payers has been less than 2% of GDP. Their nationalization program was a huge success and the Swedish have travelled the work evangelizing about their program. Have Americans listened? Of course not.

We'll explore the current mess that is the American program in a post early next week, but know that many prominent American economists, most notably Brad DeLong and Paul Krugman, believe that the Swedish solution is the best option we have for getting out of this mess. It may go against the first instincts of most free market Americans, but I think anyone who studies up on the Swedish repsonse would have no choice but to agree that it worked for them and it will work for us.

(Source, Source, Source, Source)

FDR's Response

8 Items to Learn About Banks and Bailouts #5

When FDR took the oath of office on March 4, 1933, the nation's banks were closed. He knew that the banking crisis was the most pressing matter facing the country. He would not move forward with any other item from his agenda until the banking crisis had been dealt with.

On his first day in office, Roosevelt issued two major proclamations. The first proclamation was to convene a special session of Congress on March 9th. The second proclamation was to declare a banking holiday that would last into the beginning of the special session. The plan was to keep the banks closed until they could get banking legislation passed. 

The long closing of the banks had a calming effect upon the nation. It gave the impression that we had finally hit rock bottom and there was nowhere to go but up. Combined with the changing of the guard in Washington, the people began to hope again.

FDR and his team went to work immediately putting together legislation so Congress could act at soon as the special session began. The bill provided a test to determine if a bank was financially secure. Those banks that were so determined were allowed to reopen. Within three days, over 5,000 banks had passed the test and opened their doors. Public confidence in the banks slowly returned. The FDR team has bought themselves some breathing room.

Later in 1933, FDR and Congress would work together to pass the Glass-Steagall Act which would usher in an unheard of period of stability in the American banking system. The most notable accomplishment of the act was the creation of the Federal Deposit Insurance Corporation which would ensure depositors in the nation's banks. (The act would be weakened by the Republican Congress in 1999. This deregulation has played a large role in the problems we face today.)

Banking in Early 1933

8 Items to Learn About Banks and Bailouts #4

Years after he left office, Herbert Hoover would say that the baking system was "the weakest link in our whole economic system." As President during the early years of the Great Depression, he never sounded like he was anything less than confident in the banking system. He would tout "the strong position of the banks." Even when he soured on banking late in his term, he would still not propose major reforms. He was negligent and the people paid the price.

In the first three years of the Great Depression, five thousand banks went out of business. People, tired of watching, turned on the banking system. The level of mistrust in the nation's banks had never been higher. The secrets uncovered by the Pecora Commission  deepened that mistrust. There would continue to be runs on the banks.

Hoover was desperate to find a way to stop the runs and restore confidence in the system. He convinced himself that if he could convince FDR to disavow his proposed New Deal and commit to a "sound fiscal policy", confidence would be restored. Roosevelt refused to make any public proclamations before he assumed office on March 4th. Hoover was furious with FDR, but FDR would not budge. (When you think of the capacity of Republicans to delude themselves, remember that Hoover, soundly thrashed at the polls in November 1932, believed that FDR needed to disavow his own reforms and support the Republican agenda. Hey, Hoover thought he had beat the depression in 1932 too.)

Hoover could not be convinced that the government needed to play a larger role in solving the crisis. He believed to the end that was all just a matter of confidence. He was a tragic figure.

On the eve of Roosevelt's inauguration, Hoover made one last attempt to get FDR to make a public proclamation in support of Hoover's policies. Predictably, he refused again. Various officials in the Hoover administration would then press Hoover to call for a national bank holiday, but he wouldn't hear of it. He did not believe it was necessary. 

Late into the evening of March 3rd (or rather, early in the morning of March 4th), the governor of New York was convinced to shut down all banks on Saturday by Hoover treasury officials. Illinois would respond in kind. As Arthur M. Schlesinger Jr said, "the banks of the nation seemed in rigor mortis". The banking situation was a stand still.

None the less, time had run out on the Hoover administration. It was Roosevelt's problem now.

Source - The Crisis of the Old Order by Arthur M. Schlessinger Jr.

Bank Panics After the Civil War

8 Items to Learn About Banks and Bailouts #3

Here's a short glance at some, but not all, of the banking panics that struck our nation after the Civil War, but before the Great Depression.

Panic of 1873 - A period of rampant growth after the Civil War, with little in the way of government regulation. Abuses were common and ignored by the government. One of the nation's largest banking firms, Jay Cooke and Company would declare bankruptcy due to losses on the underwriting of the railroad industry. The series of events even included the New York Stock Exchange closing for 10 days. The usual consequences played out with banks closing, many mortgages ending up in foreclosure and a drying up of credit. As usual, this led to rampant unemployment. The economy would not recover until 1878. Perhaps the most important outcome of the early stages of the so-called "Long Depression" was the unrest that would pit labor against banking and business interests. (Source, Source, Source)

Panic of 1893 -The Philadelphia and Reading railroads would collapse due to overbuilding. Eventually, the Union-Pacific, Northern-Pacific and Santa Fe railroads would find themselves in bankruptcy. We were in yet another depression caused by the railroad industry and the banking industry's support of the railroads. The government, led by President Grover Cleveland, did not believe that the government had a role to play in the business cycle. As a result, poor Americans were ignored and began to feel that they were at the mercy of giant business interests. This was the backdrop to the beginning of the Progressive movement. (Source, Source)

Panic of 1907 - In 1907, numerous businesses went bankrupt, including some Wall Street brokerages. When Knickerboxer Trust and Westinghouse Electric failed that October, the panic began. Stock prices would plummet, losing 50% of their value over the previous year. The usual conditions were felt from bank closings to unemployment. J.P. Morgan would lead an effort to move capital from stronger institutions to weaker institutions. This effort would alleviate many of the effects of the panic and would help bring the period to a close. Arising out of this panic were a series of banking reforms that would lead to the creation of the Federal Reserve System. (Source, Source)

Bank Panics Before the Civil War

8 Items to Learn About Banks and Bailouts #2

Here's a short glance at some, but not all, of the banking panics that struck our nation before the Civil War. One thing to remember when reading these short paragraphs is that when a bank went under, the depositors lost everything.

Panic of 1819 - After the War of 1812, there was a period of economic expansion. This expansion ended with the Panic of 1819. Although there had been previous downturns in our economy, this was the first crisis within the American economic system. There were many causes. In 1815, years and years of conflict between the French and British came to an end, which meant that they would no longer be importing as many goods for the U.S. During the boom cycle, Americans had been purchasing western land as if the good times would never end. Western banks were all too happy to make the loans. The Second Bank of the United States then began employing rather conservative credit policies in response to what they perceived as reckless lending practices. Loans were called in, and many landowners could not repay. Mortgages went unpaid. Unemployment became rampant. President Monroe would respond conservatively maintaining a sound fiscal policy. Congress was a bit more ambitious passing the Land Act of 1820 and the Relief Act of 1821. No matter, the panic would last until 1923. (Source, Source, Source, Source)

Panic of 1837 -This depression would begin in 1837 and last until 1943. It was a period of misery with the usual rampant unemployment, with major food riots taking place in American cities. The period of prosperity before the panic was based on a speculative bubble in real estate. People were buying up federal land as quickly as possible and paying in state bank notes. Andrew Jackson would institute the Specie Circular near the end of his second term which required the Treasury to only accept gold and silver as payment for public land sales. The result was rapid inflation. Banks called in loans as depositors tried to withdraw their accounts.Over 40% of our nation's banks would fail. President Van Buren, who took over from Jackson, did not believe the government had a responsibility to help the economy, which may have led to the Whigs capturing the White House for the first time. (Source, Source, Source)

Panic of 1857 -The Ohio Life Insurance and Trust Company would fail in the midst of a major financial scandal. A hurricane would destroy a boat carrying a large shipment of Gold of which the banks were in need. British investors would begin removing funds from American banks. Grain prices would fall. Railroad companies were failing. Unemployment was spreading. A severe depression would engulf the nation. To combat the depression, the government began selling bonds and would also reduce tariffs. Some states tried bank holidays to stop the runs on their banks. Ultimately, the effects of the depression were felt until the Civil War. (Source, Source, Source)

Crisis

8 Items to Learn About Banks and Bailouts #1

From the birth of our country through the great depression, financial crisis leading to bank panics were not uncommon. The situation would play out around every 20 years. Citizens would flock to their banks and withdraw their savings. Banks would go under. The banks that didn't go under would stop lending. Businesses, unable to receive loans, would stop hiring. Unemployment would rise. One crisis after another.

We thought we had learned our lesson after the Great Depression. The problem was solved. Through the judicious use of monetary policy, through the control of the money supply, it was thought that any recession could be controlled. We now find ourselves in a liquidity trap where the interest rate for Fed loans to the banks is already zero. Monetary policy is not an option on the table.

It doesn't help that we are no longer a nation of thousands of community banks. Mergers and acquisitions has left our system controlled by a handful of large national banks. These banks, we are told, are too big to fail. It is feared that they could bring down the whole system. The fears are not unfounded.

Here we sit in the midst of the largest financial calamity this country has faced since the Great Depression. We seem to be relying on the minds of the very people who got us into this mess to get us out. No one in the administration or the Congress seems to be listening to our finest economic minds and their prescriptions for handling the mess. People, both lay and expert, are cynical. Yes, everyone agrees that things will get worse before they get better, but how bad will they get? How long will the recession last?

Here's the problem: there are no easy answers and politicians like easy answers. They do not want to stick their necks out, not while a small group of rabid conservatives lie, distort, and scream about every move made. After all, there surest path back to power is to obstruct any chance to end the crisis. Until the administration and the Congress face up to the challenge, we will sit where we sit today. In trouble, with little hope in sight for a conclusion.