Universal Translator

Thursday, September 29, 2011

Nationalizing the Banks Looks Better and Better

If Germany would just write them a check, that would solve the problem.  But the German taxpayer is asking, ‘why are we using our hard-earned tax dollars to prop up these profligate countries?’  Seventy percent of the German electorate is against bailouts.  It’s not like the United States where there’s a commonality of purpose and a vision of national unity.

                                                --Desmond Lachman,
                                                in an interview w/Ezra Klein

Oh, that comment made me laugh so hard that I spit out some of my morning tea.  A “commonality of purpose and a vision of national unity?”  In a country where:  (i) a sizeable percentage of the population – including one GOP presidential frontrunner – casually tosses around the notion of states seceding from the union whenever they’re unhappy with the federal government; (ii) the states themselves (in the words of former Michigan Governor Jennifer Granholm) compete to attract business away from each other in a race to the bottom in terms of workers’ wages, benefits, rights, and working conditions, and, of course, low, low corporate tax rates; and (iii) the only animating force in the Republican party is a visceral hatred for anybody who isn’t them?  That’s the country referred to as being bound by a sense of purpose and national unity?

Oy vey.

The quote in question, as noted, comes from Ezra Klein’s interview of Desmond Lachman, a resident fellow at the right-leaning American Enterprise Institute think tank, about the European financial crisis.  Klein has to draw it out of him, but eventually Lachman admits that this isn’t just a question of the thrifty Germans bailing out profligate Europeans in other nations:

It’s like the housing bubble in the United States.  You couldn’t have had a bubble without the financing.  In Europe the debt bubble was financed by German and French banks.  So for them to throw all the blame on the profligacy of the Greeks or the Spanish housing bubble is ridiculous.  So just in terms of the blame game, it’s unfair just to blame the Greeks.  But in terms of a solution, that’s a big part of the problem.  Once you’re in a fixed exchange rate and you have these huge imbalances, they can’t be redressed without economic collapse.  So the Germans and French don’t want the Greeks to default because that will force French and German banks to recognize losses and then they’ll have a banking crisis.  It’s easier for them to keep these countries afloat than to bail out the banks.  (emphasis added).

That comports pretty well with everything else I’ve read about the European mess.  The bailout of Greece and the other PIGS (Portugal, Ireland, Greece and Spain) isn’t about giving money to these countries so much as it is about using these countries as a pass-through so that they can pay back their loans to the French and German banks.  Those banks carry more than 900 thousand million ($900B) dollars in credit exposure to those four nations and it all is looking increasingly shaky.  The French and German taxpayers are being told that their tax dollars will have to be used to “bail out Greece (and maybe the other nations),” but that money is really being used to bail out the big French and German banks. 

Something very similar happened in the United States, when the government decided it had no choice but to bail out insurance giant AIG.  Sure, federal money went to bail out AIG, but AIG – like the Greek government over in Europe – was more or less a pass-through.  That money was given to AIG, which promptly turned around and paid 100 cents on the dollar to the Big Money Boyz – Goldman Sachs not least among them – on its obligations.  Led by Goldman Sachs, the big banks recouped 100% of their investment despite the fact those banks had made some really bad investments. [see below for more detailed information]*

Where is all that squawking about “moral hazard” now?

* * *

Matthew Yglesias had a really good post up the other day titled “Bankers Are Highly Trained Experts In The Lending Of Money Until Things Go Wrong And They Turn Into Victims” in which he pointed out:

[i]f you ask a moneylender why his enterprise is so profitable, he’ll give you two reasons.  One is that the profits are a consideration in exchange for the risk he’s running.  The other is to observe that he personally is making big money because he personally is skilled at the moneylender’s trade. . . .  [H]ouseholds borrowing money and paying interest are not purporting to be skilled borrowers.  They’re just regular folks participating in a marketplace dominated by well-compensated professional lenders, whose compensation is based on their alleged skill at the trade.

. . . .  When bankers sit down with borrowers to discuss loans, it’s the lender who’s putting himself forward as a highly trained compensated expert in the field of lending money.  If it goes bad, it’s because the allegedly expert lender has turned out to be bad at his job. (emphasis in the original)

This, I think, is why Wall Street apologists have been so busy over the past three years trying to convince the American public that blame for America’s disastrous housing bubble and the resulting financial collapse deserves to be placed at the feet of “home buyers who should have known they couldn’t afford their mortgages,” or on “Fannie and Freddie,” or – well – anybody who isn’t Wall Street.  

Because if you sit down and think about it, only Wall Street is to blame for this mess.  But if the American people started thinking about how badly Wall Street screwed up at its job, they might start thinking that no one deserves to be as highly compensated as these screw-ups are.  Indeed, nobody who screwed things up this badly deserves to keep their job at all.

Sketching Out the Housing Collapse and Financial Crisis

A thumbnail sketch of my understanding of the housing crisis goes something like this.

Immediately in the wake of the tech bubble collapsing, the people in charge of global savings (sovereign wealth funds, pension funds, insurance funds, etc.) started looking around for somewhere to park their money.  They wanted something safe, but also something that would give them the highest rate of return possible.  Unfortunately, because Alan Greenspan et al. were trying to gin up the economy again by lowering interest rates to the floor, the return on US bonds – safest in the world! - was very, very low.

But then Wall Street decided it could sell bonds on pools of home mortgages that would provide a fairly high rate of return and that also were very safe.  And, in the past, most mortgages had been fairly safe investments for a number of reasons.  To begin with, the borrower usually had to make a substantial down payment on the purchase price of the house.  Additionally, the borrower had to have a high credit rating, a provable source of income, not too much outstanding additional debt, etc. – he or she had to be a good risk.  And, finally, most people pay their mortgages because they don’t want to lose their homes; they’ll skip a credit card or a car payment, they might not save for their children’s college fund, but they will by God keep their roof over their heads.

So Wall Street put the word out to local banks that it was interested in buying up home mortgages.  Wall Street then pooled those mortgages, sold bonds secured by those mortgages to large investors, and charged fat fees for having done so.

Unfortunately for Wall Street, the number of mortgages at any given time is limited, but demand for bonds secured by those mortgages seemingly was not.  So Wall Street began letting local banks know that they would be willing to purchase mortgages that did not quite meet the exacting standards that previously had been required. 

Of course, there was no danger to the local banks in writing slightly riskier mortgages – they knew they’d be pocketing the transaction fees and then selling the mortgages themselves on to Wall Street.  The local banks were more than happy to take direction from Wall Street and as time went by – and at Wall Street’s urging – they wrote increasingly risky loans, culminating in the infamous NINJA (no income, no job, no assets) loans written right before the entire housing market went belly-up.

For its part, Wall Street didn’t care about the increasingly risky nature of these mortgages because it wasn’t really going to be holding on to them either.  It was going to sell them all off in the form of bonds to its investment clients. 

But Wall Street did need to have some cover for selling crappy products to investors that were looking for “safe deals.”  It obtained that cover by mixing and matching crappy loans from a wide variety of different sources in a single large pool, and then having math experts opine that this mixing and matching of a bunch of different crappy loans had “diversified away” the risk of the pool as a whole.  They were then able to convince the ratings agencies – whom the investment banks themselves paid – to accept these claims and rate the bonds secured by these pools of crappy mortgages as “AAA.”

All of the above seems pretty clear; it is only the last step that still puzzles me.  I am unsure whether Wall Street still knew it was selling crappy products, or whether it had come to believe its own lies.  My best guess is that it is some combination of these two factors.

On the one hand, we have examples of out-and-out fraud, such as Goldman Sachs and John Paulson teaming up to create the "Abacus fund," which was intentionally designed to default but which they peddled to unsuspecting clients as a safe and secure investment.  On the other hand, we have Wall Street’s gleeful trading in Credit Default Swaps (CDS’s).

As set forth in Michael Lewis’s The Big Short:  Inside the Doomsday Machine, only a handful of traders – none of them at the Big Money Boyz firms – recognized the U.S. housing bubble for what it was.  These traders wanted to profit by betting against the housing market, but there was no effective way for them to do so.  Accordingly, they started lobbying the bigger investment banks to create CDS’s – which are really just insurance policies – that would pay out in the event mortgage-backed bonds went bad.

Once Wall Street wrapped its head around what these people were asking for – “You want to pay millions of dollars for an insurance policy on an AAA-rated investment that you don’t even own?” – it was more than happy to sell these insurance policies.  So, especially, was AIG Financial Products.  It appears that, at least in the beginning, the Big Money Boyz were convinced that these people were giving them free money; after all, if the thing you’re insuring is “AAA”-rated then it is safe as houses, will never default, and you will never need to pay off on your insurance policy.  Led by AIG Financial Products, Wall Street started selling these insurance policies in many multiples more than they could ever hope to cover in the event of default.

So when the underlying crappy mortgages started to go bad, it wasn't just the loss of all the bonds that had been secured by those mortgages we were looking at; it was also the many, many insurance policies that had been written to cover these bonds - which collectively represented much greater losses than the underlying bonds themselves.


(Reading Lewis’s book is a bit of a head-spinning experience.  He lays out precisely the problems inherent in the housing market and how a bubble was being formed, and makes it seem like the easiest thing imaginable to spot.  When he introduces the characters who actually were clear-sighted enough to see the problem, the reader naturally roots for them – because they are, y’know, smart and not responsible for the bubble to begin with.  It is only toward the end of the book that the reader, upon reflection, realizes that these smart characters for whom one has been rooting are also directly responsible for exacerbating the resulting financial crisis well beyond the original housing collapse.)  

* * *

But regardless of whether the financial industry – and I mean the global financial industry – is in such dire straits because of cupidity or incompetence, the fact remains that both our own government and the governments of Europe seem to have a bottomless appetite for bailing out these banks.  And here, when I say “these banks,” I really mean “these individual banksters.”

When the U.S. bailed out GM, which cost the country a very small fraction of what the financial crisis has cost us, it involved making some bridge loans to the company, forcincing its CEO to resign, taking an equity stake in the company, and then shepherding GM through a fast-tracked bankruptcy proceeding.  By all recent accounts this worked out pretty well for GM as a whole:  the company is still in business, many employees who otherwise would have lost their jobs did not, and a plethora of other, smaller businesses (suppliers, distributors, etc.) did not go under.  GM looks to be in position to repay the money it borrowed from the government, and its unions seem content with the new labor contracts they’ve negotiated with the company.

Of course, GM’s shareholders got wiped out, but that is what happens when a company is mismanaged into the ground.

By all accounts, the same thing has happened to all the big financial firms.  We have been told ad nauseum that these firms must be bailed out - by us - because otherwise they will go under and take the entire economy with them.  So pretty much by definition the management at these firms have not proved competent to keep their companies from going down the drain in the absence of substantial taxpayer assistance.

Keep in mind Yglesias’s description of what a moneylender is supposed to be:  a highly trained, extremely competent expert in the field of lending money.  Even if one assumes that all of these big financial firms’ screw-ups were simply mistakes, and not attempts to bamboozle, defraud and steal, what does their record look like?

We can diversify the risk of crappy loans with more crappy loans.  (Wrong)  We can issue as many insurance policies on AAA bonds as we can sell, because we’ll never have to pay off on those policies.  (Wrong)  It’s a good idea for the German and French banks to loan vast amounts of money to the PIGS.  (Wrong)  It’s a good idea for U.S. banks to loan vast amounts of money to the French and German banks who loaned vast amounts of money to the PIGS.  (Wrong)

In the Ezra Klein interview that began this post, Desmond Lachman points out that U.S. banks are exposed to the European banks for about one millionmillion ($1Tr) dollars.  So . . . what we are potentially looking at is default by one or more of the PIGS countries, which hits the French and German banks, which in turn hits the U.S. banks, which results in another credit crunch, which finally leads to another economic recession directly attributable to the financial industry – the second brutal economic beating Wall Street will be giving Main Street in just five years.

Seriously . . . do any of these “highly trained, extremely competent moneylenders” even look at the creditworthiness of the institutions to which they lend money?  Do they even know how to evaluate creditworthiness?

I don’t see any reason why -- instead of continuing to feed these incompetent financial institutions apparently unlimited buckets of cash -- we can’t simply nationalize them the way same way we nationalized GM.  Kick out the existing management, force the institutions into bankruptcy, wipe out the shareholder value and make good on the banks’ debts with all the money we're gonna end up giving them anyway.  If we can’t get Congress to enact meaningful financial reform, then maintain an equity stake in the companies after they come out of bankruptcy, keep a couple of seats on their Boards and have internal rules in place to ensure that these firms don’t continue making stupid, stupid loans that end up biting us all in the ass again.

Lord knows, it’s gotta be cheaper than what we’re doing now, and it may even keep us from going through round after round of economic hits brought about by these guys’ sheer inability to do their goddamned jobs.  

*Actually, the AIG Bailout was a bit more complicated than that.  The “really bad investments” mentioned above refers to other big banks writing insurance policies on AIG itself.  Essentially, Goldman Sachs had covered part of its trades with AIG with $2.5 billion worth of insurance policies (known as Credit Default Swaps) it bought from other big banks to insure against an AIG default.  Essentially, Goldman Sachs demanded that AIG pay out 100 cents on the dollar or else it would declare AIG in default and then turn to the other big banks to collect its $2.5 billion in insurance.  This threatened to trigger a financial meltdown that the government (and Timothy Geithner in particular) wished to avoid – a sort of “financial mutually assured destruction.”

The real problem stemmed from the other big banks that had issued insurance policies on AIG that apparently they were unable to pay.  What Goldman Sachs proposed was that it would deliberately destroy the nation’s financial industry if all of its financial positions were not redeemed in full. 

Of course, redeeming all of Goldman Sachs’ positions with government money meant that AIG did not default, and thus the big banks that had so imprudently issued those insurance policies got to keep the money they had charged Goldman Sachs when they issued the policies but they never had to actually pay off on those policies.  All told, it was a win for Goldman Sachs, it was a win for the insurance policy-writing big banks, and it was a win for AIG.  Only all the rest of us got screwed.

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