On 31 March 2009, the Senate Committee for Banking, Housing, & Urban Affairs held two panels on Lessons from the New Deal. (This video is about two hours long.)

Panel 1: Christina Romer, Chair of the Council of Economic Advisors.

Panel 2: Professors James Galbraith (U of Texas at Austin), Bradford DeLong (UC-Berkeley), Alan Winkler (Miami [Ohio] Univ.) and Lee Ohanian (UCLA).

On 30 March 2009, Michael Kranish (Boston Globe) wrote Pension Insurer Shifted to Stocks.

This is not good news.

Boston University Finance professor Zvi Bodie, who advised the agency against such a policy, ‘questioned why a government entity that is supposed to be insuring pension funds should be investing in stocks and real estate at all. Bodie once likened the agency’s strategy to a company that insures against hurricane damage and then invests the premiums in beachfront property.’

Suppose the International Monetary Fund (IMF) performed the same diagnosis and proscribed the same tough medicine for the US as it would for any financially-distressed emerging economy.

That is exactly what Simon Johnson lays out in The Quiet Coup, appearing in the May 2009 issue of The Atlantic. Simon Johnson, currently a Professor at MIT’s Sloan School of Management, should know; he was Chief Economist at the IMF during 2007 and 2008.

Johnson summarizes the characteristics of financial crises with which the IMF has dealt over the last few decades, the tough remedies prescribed, the resistances these countries have presented, and the results. ‘Every crisis, of course, is different.  … But I must tell you, to IMF officials, all of these crises looked depressingly similar. … [T]he economic solution is seldom very hard to work out. … [but] the biggest obstacle to recovery is almost invariably the politics of countries in crisis.’

As you read about these crises, you will be amazed (and I daresay depressed) by the similarities to our own current situation.

Johnson is particularly concerned about implicit ‘partnerships’ between the government and ‘oligarchs.’

‘Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.’ (…)

‘At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.’ (…)

‘To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards—contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.

‘Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse’

I recommend you read the whole article.  I can’t do it justice in this post.

Simon Johnson will be interviewed 31 March 2009 on NPR’s OnPoint.

I am a big fan of Paul Krugman.

However, to show you how open-minded I am, I point you to Obama’s Nobel Headache, appearing in the 6 April 2009 issue of Newsweek.

On 19 March 2009, Matt Taibbi (in overly salty prose) wrote The Big Takeover (provocatively subtitled ‘The global economic crisis isn’t about money – it’s about power; how Wall Street insiders are using the bailout to stage a revolution’) in Rolling Stone Magazine. He describes some of the internal workings at AIG’s Financial Products subsidiary in London which was responsible for AIG’s credit default swap (CDS) business. He describes the lax (and, sometimes, non-existent) regulatory oversight of the business, and some of the deregulation history. He bemoans the repeal of the Glass-Steagall Act engineered by Senator Phil Gramm and enacted in the waning days of the Clinton administration. And he expresses concern over whether the Obama administration will be able to assert appropriate control over the financial services industry.

The article is long but intriguing, going into some details of AIG-FP that I had not heard before.

Note: Rolling Stone has now truncated the version of this article on its website. However, Alternet is mirroring the full article.

On 23 March 2009, Treasury Secretary Geithner introduced his Public-Private Investment Program (PPIP) for helping to cleanse ‘toxic assets’ from banks’ balance sheets. A bank (with FDIC approval) may auction off troubled mortgages to ‘Public-Private Investment Funds’ (PPIF).  The PPIF’s are financed as follows:  85% through non-recourse debt from FDIC, 7.5% through equity from US Treasury, and 7.5% through equity from private investors. Under this structure, the most that private investors can lose is all of their equity investment but if there is net gain on the ultimate disposition of the troubled mortgages, the private investors share the net gain equally with Treasury.

Two decades ago, a famous former professor of mine (with one foot in academe and the other on Wall Street) said, ‘There is no regulation of financial markets that a smart investor cannot get around.’

I was reminded of this professor when I read Karl Denninger’s Open letter To The FDIC Ombudsman on the ‘Market Ticker’ blog. He poses a case of a bank which is carrying a mortgage at 80% of face value but could only sell it in the open market for 30% of face value. If the bank sold the mortgage at 30% of face value, it would have to recognize the loss in book value and would weaken its  equity for regulatory purposes. Suppose, says Denninger, that the bank offers this mortgage for auction under PPIP and then bids to buy its own mortgage for 75% of face value (clearly winning the auction). The hit to regulatory equity is minimal. In the event that the mortgage subsequently becomes worthless, all the bank then loses is 7.5% of the bid price on the mortgage (i.e., its equity investment in the PPIF); FDIC and Treasury absorb the remaining loss of 92.5% of the bid price.

I think we can safely assume that the FDIC will disallow such a transaction, especially after Denninger’s warning letter.

However, what if banks implicitly collude to buy each other’s troubled assets under PPIP? I can see my old professor smiling.