Geithner's Dragon

At the end of the brilliant 1969 movie The Italian Job - SPOILER ALERT -- (starring Michael Caine, Noel Coward, and Benny Hill, not to be confused with the charmless 2003 remake), our heroes are gathered at one end of a bus that is teetering on the edge of a cliff. At the other end of the bus, threatening to pull everyone to oblivion, is an enormous chest full of gold. The last line in the movie (as I recall) is Michael Caine saying "all right, here's the plan."

That's about how things looked last week. Since then, however, we have begun to see the plan laid out. On Monday there was a joint announcement by five regulatory agencies that going forward any government money given to banks would be used to purchase preferred stock, which could later be converted to common stock and sold if conditions improved, thus recouping money to the taxpayer and getting the government out of the banking business. On Wednesday, Treasury Secretary Geithner added some more details, including a description of a "stress test" that will be used to evaluate banks' solvency going forward.

The plan is a modified version of the "Swedish model." In the mid-1980s, confronted by a somewhat similar situation, the Swedish government relieved private banks of their ownership of toxic assets and parked them in a newly created national "bad bank." Eventually, when the assets recovered their value, they were sold, netting the Swedish taxpayers 50 ore on the kroner. The Geithner plan is similar in that it represents a partial and temporary nationalization program; the main difference is that the bad assets will not be isolated, and the government will have a direct stake in the banks until such time as that stake can be profitably sold.

The purpose of the stress test is less clear. The working assumption seems to be that it will be used for purposes of triage: banks that are found to be too damaged to save will be allowed to go under, banks that are in some trouble but can be rescued will receive government money, and banks that don't really need help will not be able to siphon bailout funds to be used for M&A's or parked to improve the company's future bottom line. Since receiving money from the government involves giving up ownership shares, that aid is less attractive than it might be; the assumption, therefore, is that banks that don't need the aid won't want it.
There is a lot to be said about this program. The application of the stress test will be based on valuing assets at their average mark-to-market valuation for the 20 days ending February 9th. Obviously, if the market value of those assets goes up or down from that valuation, the government's purchase at the earlier price will represent either a subsidy or a penalty.

There is also the idea that this stress test will be applied with an eye toward the future, not just to immediate conditions. Here's Geithner in a PBS interview with Jim Lehrer: "The basic framework is designed again to look at the scale of losses they might face ... if we went through a more challenging environment -- economic environment. And again so that they can reassure the world and we can be confident that they've got that necessary cushion of resources that allow them to lend to support recovery. Because you know right now there's this cloud of uncertainty over the economy and the financial system . . . These banks now have very substantial amounts of capital relative to what you would have seen in the U.S. economy going into previous recessions. But we want to make sure again they have that additional cushion, even if things deteriorate further going forward, that they're going to be able to lend and be in a strong position." The problem with that is the assumption that we know what assets to look at in order to determine how well a bank is equipped to handle the next recession. Models tend to be a lot better at post-diction than prediction; this time the crisis started in housing, so we will look especially at mortgages. But what happens if the next crisis comes up in the service sector, or heavy industry? Which banks will be vulnerable then? Will this "stress test" be able to predict which are the relevant assets to value without knowing in advance where the next crisis will come from? One question that might be worth asking is how much of a bank's assets are in the form of derivatives? More on that in a minute.

Critics like Robert Reich complain that the whole triage approach is unduly and unnecessarily speculative. "It would be far cheaper, quicker, and safer for the government to just take over every questionable bank. This is the only way we can get the truth about which should be shut down. And the way taxpayers who will be bailing out salvagable banks can ever recoup our costs. Why should any upside gains go to private shareholders who made bad bets or to bank executives and directors who got us into this mess in the first place?"

Other critics wonder why we maintain our commitment to private banking at all. After all, we don't care about banks for their own sake. We care about banks because a) people need a safe place to keep their money, and b) the economy needs a reliable source of credit. Why should that be a private, for-profit undertaking rather than a government service? Calls for nationalization have come from some interesting quarters of late, including not only Nouriel Roubini but also Lindsay Graham, Alan Greenspan, and American Enterprise Institute's John Makin.

These experts are all calling for temporary nationalization followed by resale of assets to private markets. But there are plenty of people who are starting to wonder why we are well served by a private banking sector at all. For one thing, no matter how it is structured, one consequence of the bailout is that executives and shareholders will be held harmless for stupid, reckless, or greedy decision-making processes. For another, credit provision has become among the most predatory, exploitative, socially regressive areas of American economic activity. What public good is served by allowing these practices to continue? Regulation might help, to be sure, but regulations can be gamed, enforcement is never perfect, and the incentives are all on the side of cheating unless we do away with the corporate veil that protects individual executives from liability under almost all circumstances.

The counter-argument is that the government is likely to be not very good at running a bank, that private lenders come up with creative and competitive forms of financial instruments, and that modern capitalism is simply too complicated and too varied to be run in any centralized way. Maybe so. But there's a much, much bigger problem to worry about, and it goes to the heart of the idea of encouraging creative banking. The focus for the moment has been on the bailout; that is, on the government spending side of the equation - whereas discussions of derivatives really belong on the regulatory side. But the transformations of the banking sector that are going to be required in that area positively dwarf anything that is taking place on the spending side. In the past 20 years, "creative" people in the financial sector have remade global capitalism in their image; the global banking system today is a Frankenstein's monster version of the system that was in place when the Bretton Woods agreement was signed. In the next few months, governments are going to have to decide whether to kill Frankenstein's monster or try to tame it.

Time to play with numbers. When we talk about the bailout, we are talking in billions, sometimes hundreds of billions. AIG - remember them? -- recently announced that in the fourth quarter of 2007 it lost $60b and is likely to need additional government aid beyond the $150b it has already received.

$150 billion is a lot of money. But when we talk about derivatives and ask what our and other governments will do to get those markets under control, we are using numbers that start with different letters altogether. When this crisis broke, the U.S. mortgage market was around $40 trillion, of which an estimated $1.7 trillion were questionable loans. Derivatives on those mortgages totaled $40 trillion.

Think those are big numbers? We aren't even warmed up, yet. In 2007, the total value of derivatives held by U.S. commercial banks was $170 trillion. At the beginning of 2008, this dropped to only 164 trillion, according to the OCC's Quarterly Report on Bank Trading and Derivative Activities, Fourth Quarter 2007. Compare that to $9 trillion at year-end 2006 . . . or $97 billion way back at year-end 1997. The OCC report for the third quarter of 2008 showed the notional value of derivatives held in U.S. commercial banks at $175.8 trillion - 78% in interest rate products, a bit under 10% in credit products. 99% of these credit products were accounted for by the infamous "credit default swaps" that are dragging AIG under (again) as we speak; 97% of those are held by five banks. (You can find that report here).

But that's just U.S. banks. Think globally. I have been seeing a lot of references to figures produced by the Bank of International Settlements, in Switzerland, which tracks the global markets in derivatives. One figure that kept coming up boggled my mind: at the end of 2007, according to various sources, BIS figures showed a global derivative market of 1.14 quadrillion dollars. Could that be right? What macroscopic phenomenon on earth could possibly require the use of the word "quadrillion" to describe it?

When I was a child, I vividly remember how my imagination was captured by numbers like "quadrillion." These are weird numbers, numbers that have nothing to do with ordinary existence. Unless you are a mathetmetician involved in a very particular area of math or an astronomer who insists on working in kilometers rather than light years, you have never used or even seen the number 1 quadrillion recently. You might want to borrow one of your children's math texts, here. You are certainly going to need a better calculator than the one you got at Target last summer. Here we go.

There are two distinct types of derivatives at issue, here: "over the counter" derivatives that take the form of contracts between two parties, and "credit derivatives" - those based on futures contracts and options - that are traded on exchanges. As of June 2008, BIS reports a total of $684 trillion in notional amounts outstanding of OTC derivatives.

Then there are the exchange-traded credit derivatives, those based on futures contracts and options. The total turnover in credit derivatives in 2007 was more than 2.8 quadrillion dollars. In the first half of 2008 alone there was more than $1.3 quadrillion in turnover of credit derivatives: $600 trillion in the second quarter, down from $629 trillion in the first. (Here.)

The numbers become a little less staggering if one focuses on the value of the amounts outstanding on these credit derivatives: in the second quarter of 2008, that figure was a mere $84.3 trillion. The gross market value of OTC derivatives as of December 2007 was only $14.522 trillion. (These figures are from the BIS quarterly review, Sept. 2008; some are from the Report, others from the Statistical Annex.

Oh, by the way. In 2008, the Gross Domestic Product of the entire world was $70.5 trillion. I am suspicious of that number, since in 2007 it was $55 trillion. In other words, I suspect that an awful lot of that growth exists only on paper. But since that is true of everything else we are talking about, let's stick with $70 trillion for reference purposes.

That's the dragon in the dining room that not enough people are talking about. National banks, regulated private banks, whatever we call it - we have to kill the dragon. At a bare minimum, we have to get it out of the living room before it burns down the house again. What's the plan?

Comments

[schatsie]

Nationalize them now...At least that can put a stop to the management looting...

[dadw5boys]

Geithner played it right !!!!!!!!

Geithner is getting STOCK now for all the free moeny that Paulson gave away..

[Sundialsvc4]

When I lived in Arizona, I went down to Mexico quite frequently because that was the closest place you could go to play on the beach. So-called "Fisherman's Point" is a really nice quiet place (or it was, until the real-estate folks discovered it).

It was there that my wife and I had our first $145,000.00 dinner.

Actually it was just a couple of hamburgers and beers. But there were "all those zeroes," dutifully ignored by natives and by visitors alike.

We're going to have to "kill the dragon," Howard, because ... the dragon does not actually exist.

Oh, we've got "all those zeroes," sure enough, but they "exist" only in the figment of a gambler's imagination. These zeroes no-more reflect the underlying reality ("two hamburgers and a couple of beers") than did the number on my credit-card slip that night. (Eventually, the Mexican government wiped-away that system with the introduction of the "nuevo peso.")

"Credit default swaps" must be declared illegal, and null-and-void, effective immediately. Likewise, "creative" financial arrangements must be forbidden. If it isn't grounded in two-burger­s/two-beer­s REALITY, then it does not belong in banking.

Once we start getting rid of those zeroes, and the greedy practices that lead to them (but that ultimately lead to ...nothing), then we'll be left with a reality. That we can use.

[sptatt]

Played with the number 2.8 Q a bit at 1000000 a second that's 887.87 years.

[Herrington]

Notional value is the worth of the thing of value on which a derivative is based. If, for instance, you have a derivative contract on a car, the contract pays you a percentage of the value of the car even though you don't own the car. The notional value of the derivative on the car is the price of the car. For a clear definition of what a derivative is, see http://www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html. Why notional value is referenced at all is a complete mystery and is misguiding as to the total "value" of derivative contracts that exist.

[Sundialsvc4]

A leprechaun's gold was "real gold" as long as people believed it. The emperor's new clothes were the greatest finery...

[jerrypl]

I have not heard anyone speak about why we need private banks. The real question is why do we need private banks that are too big to fail, and mega corporations that are also too big to fail? It is time to go after these monopolistic corporations and financial institutions and take them apart.

The mega banks need to be nationalized. The government must get inside their balance sheets and expose the assets and debt and toxic crap. Take the toxic assets and auction them off, getting them immediately off the balance sheets, and combine assets from these newly nationalized banks. Begin to lend the capital to newly ready manufacturing companies that are able to produce products for our future economy, which can also be exported.

New energy, transportation, infrastructure, agriculture, and more. Once that begins to move forward and jobs begin to be created, and new tax revenues are realized, then sell off these nationalized banks to local and regional solvent banks that are interested in acquiring these assets.

It is not complicated. It is simple. This economy must be a bottom up initiative.

http://eye-on-washington.blogspot.com

[GrahamInCanada]

Too big to fail is common, we are surrounded by human creations too big to fail. Not that they can't fail, but that it would be so so bad if they failed that we go out of our way to make sure they don't fail.

Think of a private toll bridge, over a major industrial river with billions in daily traffic that would be blocked for three months if the bridge failed. Too big to fail. All sorts of regulations and laws entangle it to make sure it will never fail. If the owner suddenly calls up the government, and says, help, it's failing, come shore it up, yes the government should go in and shore it up, and then it should investigate what happened, criminally, if appropriate, and regulatory and law, and any other aspect to help prevent something too big to fail to need shoring up.

But we wouldn't ever think, lets stop building these bridges and buildings and anything too big to fail, we would think, these things must not fail, where did we go wrong, and correct our behavior.

It seems in some ways we stopped going out of our way to make sure banks too big to fail did not fail. That is not to say that we should get rid of them entirely.

[Sundialsvc4]

But how "big" is that bank? How big, REALLY?

If it's considered "big" because of {billions, trillions, heck-why-not trillions or quads} of dollars of purely-notional value ... then ... "is it real, or is it Memorex?"

(Sorry, Memorex.) It's obviously NOT real.

So... why don't we open the windows, turn on the fans, blow all the smoke out of the room and see what we've actually got left?

[larry278]

One way or another, US banks & most other financial operations are going to be nationalized-if the Prez is serious about saving American capitalism. The Prez may have to nationalize things to save America since the capitalists have been such greedy, clumsy, crooks for 20 to 30 years. It would be a hoot if the capitalists have destroyed American capitalism. Obama is dead serious about saving American capitalism.
Are America's capitalists at all interested in saving America's capitalist system? It looks like capitalists don't have a clue & are resigned to the death of American capitalism. The memorial to American capitalism may be dull, duller, Dulles. Brinksmanship is a deadly game for dullards. 9/15/08 wasn't a meltdown; it was a crash of the world's financial structures. They fell into dust. The dust has scattered. Do the capitalists have any plans for completly new, much stronger structures?
Rebuilding the old failed, jury rigged, jerry built structures is no longer possible. We know that they would again fall into dust in a 2 mph breeze & you can't use shifting sand as a foundation either.

[Maschine]

Would be a Hoot....htey already have. Welcome to the USSR of the 21 st. Century.

[Rule Of Law]

'In other words, I suspect that an awful lot of that growth exists only on paper.'

This is what the neo-con shills who post on the business pages refuse to see or admit.

Bush inherited a surplus. His tax cuts and his wars depleted it. Enter the Recession. His mortgage based housing bubble with its inflationary home values and incredible growth in derivative products were created just to hide the very fact that he had not brought an end to the Recession he created with the tax cuts and wars. He churned money through the system, not product, jobs, or any tangible metric of growth. Just numbers in a file.

Those bets that the financial corps. made were made with money they did not have. To my way of thinking that makes every one of those deals fraudulent. Fraudulent contracts can be unwound, by law. Let's do it.

[boophus]

You invest --> You are gambling --> that is what the interest collected is for... to hedge your bet.
Wall Street is a casino. By allowing banks to become casinos they are set up for a loss and going broke...except they are using depositors money. This is why the smart ones have pulled money (pulled their bets)and put it into vehicles that pay no interest but have Very little risk... they know how its gotta play out.

Sweep the table and pay off the winning hand holders (depositors) and rake in the chips (assets).
Then set up for another round of gambling with discretionary moolah by those who feel lucky or smart. But for petes sake don't reward the gamblers and encourage them to bet on every possible outcome because they know it will pay off even if it is a BAD BET