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The Audacity of Dopes

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We are being played for chumps. The Bush and Obama plans could only have been designed by failed bankers -- for their principal beneficiaries are failed bankers. We already know enough to confirm that the Bush administration made us the "fool" in the market by massively overpaying for assets. The Obama administration is about to compound that scandal with a "guarantee" program. The bankers that caused the crisis designed both programs. The senior officers at big bank aren't very good lenders, but they are expert in maximizing their compensation.

Worse, Mr. Geithner, the senior public official who, with former Treasury Secretary Paulson, designed the failed Bush plan is the architect of the disastrous Obama plan. Indeed, as the New York Times has just revealed, it should be called the Geithner plan. He overcame intense opposition within the Obama administration and designed a plan that is even worse than the failed Bush program. Geithner's gifts to the bankers that caused the crisis include: a unnecessary taxpayer bailout of "risk capital," a massive coverup of their banks' insolvency, gutting the proposed limits on executive compensation, and devising a "guarantee" mechanism designed to hide the expenses of the unprincipled bailouts from the American public. Remember, executive compensation is not "merely" a fairness issue. Executive compensation and the compensation systems used for appraisers, accountants, and rating agencies were designed, and served, to create the perverse incentives and ethical rot that caused the ongoing financial crises by producing a "Gresham's dynamic" in which fraudulent and abusive lending and accounting practices drove good practices out of the marketplace.

Here's the amazing part -- the bankers are so arrogant that they bragged to a sympathetic CNBC commentator they are playing us:

"What a delicious irony this is--last week, just as President Obama was publicly bashing the stupidity of the banks ... his economic team [was] privately begging for input from Wall Street. The administration was conducting around-the-clock discussions and interviews with senior Wall Street executives, including many from the same firms he was theoretically appalled with, about how to fix the lingering financial crisis. "

There are proven ways to resolve the crisis that are far cheaper and more effective because they don't subsidize bankers and "risk capital." We know how to resolve failed banks. The Federal Deposit Insurance Corporation (FDIC) can place even the largest banks in "pass through" receiverships on Friday at the close of business and reopen them as "New Federal" bank Monday morning with minimal disruption to customers and creditors and retain "going concern" value. This is how the Reagan administration resolved failed S&Ls during the debacle.

The FDIC appoints a senior manager to ensure that "New Federal" is run prudently. There is plenty of unemployed banking talent available. Hundreds of good bankers lost their jobs during the financial bubble because they refused to make bad loans. Research has shown that its sister agency, FSLIC, appointed receivership managers that greatly reduced losses during the S&L debacle. Leaving the managers in charge of failed banks that they led into insolvency is suicidal. The new senior leader is picked based on expertise in prudent lending and integrity. If we want failed banks to return promptly to making prudent loans and help lead an economic recovery an S&L style "New Federal" is the best possible device. The existing managers have terrible incentives -- to cover up existing losses and to make bad or even fraudulent loans that produce the greatest (fictional) accounting income and to "live large" through bonuses and perks. (The Obama compensation limits are political cover. The bankers have designed the "guarantee" plan to ensure that the compensation limits will be illusory.)

The FDIC managers have the correct incentives to finally produce an honest evaluation of which assets are toxic and how much they are worth. This transparency is essential if we are to end this crisis. Under the Bush and Obama plans we retain the existing managers that have overwhelming incentives to cover up the losses. The bankers have designed the guarantee plan to encourage banks to continue to cover up their toxic assets and not recognize their losses. These cover-ups make a financial crisis last longer and increase the taxpayers' costs.

The FDIC managers preserve the going concern value by making prudent loans and get the "New Federal" in shape to be acquired. By providing reliable information about the toxic assets the managers reduce acquisition risks, which expands the number of bidders and reduces the financial assistance required to aid the acquisition.

"New Federal" receiverships dramatically reduce cash needs. Most costs are deferred until the New Federals are sold.

Pass through receiverships save the taxpayers money and prevent perverse managerial incentives because they do not subsidize "risk capital" when banks are insolvent. Common and preferred stock and subordinated debt in banks are "risk capital." Their holders are supposed to receive nothing if a bank becomes insolvent, but the Bush and Obama plans reward them. There is no need to do this. Subsidizing risk capital and maintaining the failed managers at insolvent banks creates the worst possible incentives. It will cause future crises. It will delay the recovery from the ongoing crises. It robs the U.S. taxpayers and primarily benefits the wealthy -- many of them non-U.S. citizens. The contract they made was that they would get nothing if the bank failed. It has failed, and they are often complicit in those failures. The bankers have convinced the Bush and Obama administrations that the taxpayers should be looted to bail out risk capital. We should stop listening to the folks that caused the crisis and have interests hostile to our interests. Let's stop them from using us as chumps.



William K. Black, Associate Professor of Economics and Law, University of Missouri - Kansas City. He held senior regulatory positions during the S&L debacle and is the author of "The Best Way to Rob a Bank is to Own One" (2005)