A Simple Guide to the Banking Crisis

Posted by: Michael Mandel on March 12

I don’t know why I called this a “simple guide to the banking crisis.” Really, it’s the longest post I’ve written here. But here it is:

Why is the banking crisis so hard to solve? We stood and watched while Hank Paulson and Ben Bernanke fumbled with their response in the fall. Now we are being treated to the distressing spectacle of Tim Geithner struggling as well to articulate a clear policy for dealing with zombie banks. How come these smart and powerful men can’t get a handle on the problem?

I want to lay out 5 simple propositions which will help you understand why the banking crisis is so intractable. Then I will explain what happens next.

Proposition 1: The boom in the U.S. was funded almost totally by foreign money.

This is absolutely the key point for understanding the current banking crisis. Historically, households have been the major source of capital for the U.S. economy. That’s certainly what I was taught in economics graduate school.

But that quietly changed in 1999, when American households flipped from being net lenders to being net borrowers. Foreign money became basically the only source of capital for the U.S.

Take a look at the chart below, which charts net financial investment (adjusted for inflation). Net financial investment for households (the blue line) includes additions to savings and checking accounts, purchases of stocks and mutual funds, and additions to corporate and government pension funds, while subtracting the growth in household mortgages and consumer credit.

bankingcrisis2_8259_image001.gif


Net financial investment for households turned negative in 1999, and stayed that way through 2007 before turning positive in 2008.

To put it another way: In the decade 1988-97, net financial investment for households totalled $2.6 trillion, as households accumulated more financial assets than liabilities. In the decade 1998-2007, net financial investment for households totalled negative $3 trillion.

This was an enormously significant shift. This was the first decade on record where households took more money out of the financial system than they put in.

Who took the place of households as net investors? It was foreign money, pouring into the country in the trillions of dollars (see the light purple line). Foreign investors were buying everything from subprime mortgage-backed securities to hedge funds to purchases of shares.

Proposition 2: Foreign investors preferred to put their money into investments that were perceived as having low risk.

Here’s the story. Suppose you are investing in a different part of the world. You are likely a bit skittish about putting your money so far from home, so you are likely to choose relatively safe investments.

In the same way, foreign investors in the U.S. flocked to investments which offered decent returns and high (perceived) safety. This demand for safety showed up in the Fed statistics. Between 1998 and 2007, foreign investors poured roughly $10 trillion into acquiring financial assets in this country. Out of that total, only about $3 trillion went into supposedly-risky equities, mutual funds, and direct investment in U.S. businesses. The rest went into perceived less-risky investments, such as Treasuries and mortgage-backed securities (after all, housing never goes down!).

But there’s more. Wall Street catered to this foreign demand for safety. Many hedge funds, for example, promised “positive absolute returns”, meaning that they would do well even in down markets (see here). That’s one important reason why hedge funds boomed in this decade—they promised safety to foreign money, which were willing to pay big fees to get it. Many hedge funds were pitched directly to foreign investors. When John Paulson testified before Congress in November, he said that 80% of his $36 billion in assets came from foreign investors.

And when there wasn’t enough “safe assets” to sell to willing foreigners, the intrepid investment bankers created more. Consider, for example, credit default swaps, which pay off if a bond defaults—in effect, insurance on debt. Wall Street saw this as a ‘two-fer.’ They would sell corporate bonds to foreign investors, and at the same time collect fees on credit default swaps on the bonds in order to reassure those apparently too-nervous investors from another part of the world.

But the joke in the end was on Wall Street. The foreign investors bought the bonds, but they also bought the protection—which much to everyone’s surprise was needed. And the U.S. banks and investment banks were left with piles of ‘toxic assets’—the obligation to pay off all sorts of bonds and derivatives.

Proposition 3: Today, after everything has gone bad, many of the counterparties on the other side of the toxic assets are foreign investors, directly or indirectly.

This proposition is based on both arithmetic and circumstantial evidence. The arithmetic is simple. Foreign investors were the main source of funds during the boom years, when these mortgage-backed securities and credit default swaps were being issued in droves. Since not many of these securities are being sold these days, it’s likely that foreign investors are still on the other side of these securities.

Moreover, as companies struggle, more details are revealed of their problem. When Lehman went bust, its bankruptcy filing showed that Lehman’s biggest bank loans came from foreign banks such as Japan’s Mizuho Corporate Bank and Aozora Bank

Bloomberg reported on March 11 that "most U.S. bank debt is held by insurers and foreign investors."

More recently the WSJ had a very good article uncovering the names of the some of the banks who were owed money by AIG. These banks received $50 billion in government funds because they were the counterparties to AIG’s toxic trades. While Goldman Sachs was first on the list, there were also a large number of foreign financial institutions, including Deutsche Bank (German), Société Générale (French), Rabobank Neitherlands), Dankse (Denmark), and Banco Santander (Spain)

One additional point: Goldman Sachs tops the list of companies that received funds from the government via AIG, but that may be misleading. If Goldman marketed its investment funds to foreign investors, these foreign investors are the ultimate beneficiaries of the payments from the government via AIG. There is absolutely no transparency.

Proposition 4: It’s a lot harder for the Federal Reserve and Treasury to resolve a banking crisis where the main counterparties are not American.

The international angle is very important. Geithner and Bernanke keep saying that the problem is that no one knows how much the toxic assets are worth. But that’s not the full story. If the counterparties and beneficiaries of the toxic assets held by American banks are also American, it would be relatively easy for Geithner and Bernanke to gather them in a room and make them come to a ‘reasonable’ agreement about how much these securities were worth. After all, even the most powerful hedge funds must ultimately bow to the power of the Fed and Treasury, especially in a crisis.

But with most of the counterparties in other countries, the job becomes much more difficult. There’s no way for Bernanke and Geithner to force European banks, for example, to accept any particular valuation of derivatives or bank bonds—not without the cooperation of the foreign regulators.

In fact, right now we have the worst of both worlds. U.S. banks own securities which may or may not obligate them to pay a large amount of money to foreign investors. And foreign banks have assets on their books which no one trusts are worth what they say. The uncertainty is killing both the borrowers and lenders.

Proposition 5: The fact that the counterparties are overseas means that out of the three options: bailout, bankruptcy, or nationalization—none are satisfactory.

A bailout means that the government makes good on the value of the securities, including the derivatives which are tied to the collapse of the U.S. economy. That means the worse things get, the more money flows out of the country. Not politically acceptable.

Letting insolvent banks go bankrupt is the option being pushed by some politicians, including John McCain. In some ways it would be the cleanest solution, allowing the bankruptcy courts and the FDIC to do the tough job of allocating the losses from the toxic securities.

The problem, though, is that they tried the bankruptcy option with Lehman, and they nearly broke the global financial system in the process. The Lehman bankruptcy backfired, creating new panic around the world. This reflects how much money many foreign investors had put into the U.S., and how many worried about losing it when Lehman went under.

Nationalization creates a political problem. Once the government buys a company, it is financially and morally resonsible for its debts. It puts the U.S. government in the position of either using taxpayer money to bailout foreign investors, or telling foreign investors, no, the richest country in the world is not going to pay its debts.

What’s the solution?
Conclusion: Sometime later this year we will have a massive global conference aimed at simultaneously resolving the banking crises in the major developed countries. The goal will be a political negotiation of the value of the toxic assets, and a clearing of the books.

If the conference succeeds, then it will be possible to fix the financial system relatively easily. But if it fails, then things get dicey.

Addition: Tyler Cowen makes a related point here:

The best actual marker of the progress of the financial crisis is not stock or real estate prices, but rather how well international cooperation holds up.

I agree.

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Reader Comments

Mike Mandel

March 12, 2009 11:47 PM

Your comments are going through, even though you don't see them right away...so no need to repeat.

CompEng

March 13, 2009 12:18 AM

Mike,
Thanks for this... that's very interesting. I'm skeptical that we can get such a large group of creditors to agree to share the pain in some appropriate way, but we can hope.

Ajay

March 13, 2009 08:56 AM

Excellent post. I do wonder at the credulity of foreign investors, to pour money into the US precisely when US consumers and businesses got out. At least one benefit of this crisis is that household investment spiked, putting the lie to the Keynesian story that household consumption decreases aren't offset by investment increases. Don't foreign investors deserve some losses for continuing to dump money into housing despite unprecedented price increases, no matter what Wall Street was spinning them? The organizational and jurisdictional issues stemming from the free flow of capital around the globe this decade are interesting. I favor the approach that James Hamilton talks about at econbrowser.com: get all the investors and lenders together, foreign or not, threaten them with bankruptcy, and knock heads till they accept some new valuation that appropriately distributes the losses and pain. You claim that foreign banks don't have to listen, but if you threaten them with bankruptcy of the US banks holding their funds, they will toe the line.

Gary Beck

March 13, 2009 02:36 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

Gary Beck

March 13, 2009 02:36 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

Gary Beck

March 13, 2009 02:36 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

Gary Beck

March 13, 2009 02:36 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

Gary Beck

March 13, 2009 02:37 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

Gary Beck

March 13, 2009 02:37 PM

In the middle fifties, we had the 64000 dollar question. When that turned out to be a "Madoff" type scam, I immediately decided not to believe anything that appears on TV. This goes for investing.Many years ago I gave my daughter, through the "Uniform Gift to Minors Act" all of my Mutual Funds. She will survive. Meanwhile I invested simply. Today, here is my total loss from the market BS......0!

empedos

March 13, 2009 03:01 PM

The conference will be successful (assigning probabilities of course). The cost of failure will be too heavy for the majority of the participants.

Viking

March 13, 2009 03:17 PM

Very interesting post.To me it contains a silver lining in that as household savings continue to go up,we will be able to fund more of our budget deficits ourselves,which is a good thing.It also gives us more leverage with other countries who hold our "old" debt,as we can tell them to take a large haircut,because we won't need them to fund our "new" debt.

Ted Ryfiak

March 13, 2009 04:15 PM

You need to go a step farther back to really solve the problem and it isn't as difficult as you might think.
Where did the foreigners [China] get the money to buy us? US based corporations handed it to them when they decided to eliminate a huge amount of manufacturing jobs here just to cut costs. Our economy took two giant steps backwards by losing the jobs and all the profit generated by the production we lost.

Lord

March 13, 2009 04:43 PM

Fortunately it is all dollar denominated so we can provide the dollars and let the lenders decide whether to reinvest it here or take the exchange loss. The lower dollar will make the US more competitive, boost production here, and make it easier to pay off. We would face some inflation, but these days that is a good thing as well as again, reducing the debt.

(The posting system fails to acknowledge, hanging and timing out, leading to the repeat posts.)

Ted Ryfiak

March 13, 2009 04:51 PM

You need to go a step farther back to really solve the problem and it isn't as difficult as you might think.
Where did the foreigners [China] get the money to buy us? US based corporations handed it to them when they decided to eliminate a huge amount of manufacturing jobs here just to cut costs. Our economy took two giant steps backwards by losing the jobs and all the profit generated by the production we lost.

Ted Ryfiak

March 13, 2009 04:58 PM

How do we fix our economy? Use stimulus money to immediately boost production of useful goods manufactured within the USA. Countless tax-paying, health-care providing, economy supporting jobs will help all the average American citizens that need it and give the confidence level of our whole nation a big lift. Just like the WWII production boost without the military twist. GM and Chrysler alone could probably bring back a million or more jobs at the supplier level, if they quit buying foreign parts to put on our cars, just for the length of this downturn. Unfortunately, this solution is too simple and makes too much sense to be taken seriously.

Peter Lawrence

March 13, 2009 06:01 PM

Another interesting article, and I had not comprehended the extent of foreign investment.

But I still don't understand: Proposition #4. Why does anyone need to 'force' anyone to accept a specific toxic asset value? The value is what the market will pay. Period. It was, after all, the market that persuaded these foreign banks/investors to enter the US market ... absent the necessary due diligence, etc. And if the market value means that numerous foreign and domestic banks go under, why won't the market - to which the world pays homage - encourage new banks to spring from the ruins, hopefully with the lessons of the bankrupt seared into their charters.

And wouldn't a better use of the TARP funds be to underwrite, in some clearly defined way, the Phoenixes which rise from the ashes of this unregulated greed-fest? That underwriting based on the new businesses' acceptance of regulation and transparency?

What am I missing? (Other than an understanding of my own naivety ... )

Jim Carpenter

March 13, 2009 06:05 PM

Great analysis on banking crises. I beleive (tell me, Michael, if I'm wrong)that this analysis validates the idea that the crises was indeed caused, at least in part, by we as a nation "living beyond our means". If we were a closed economy that didn't trade then it would be impossible for us, as nation, to live beyond our means, i.e., we cannot consume what we don't produce. And in fact, I was getting a little irritated by all the talk of "living beyond our means", knowing this fact. But by bringing in the global perspective, you show that we in fact were consuming more than we produced. Of course, new residential housing is treated as an investment rather than consumption, but that's only because of its long life and not because it contributes to our productive capital. All this borrowing from abroad has not, as far as I can see, increased our long term economic well being, e.g., helped us transition to an economy based on renewables. If anything, the suburban sprawl of large single family homes financed by foreign dollars makes us more vulnerable to future energy problems and makes us burn more fossil fuels.
Incidentally, I find it interesting that no one is talking about how the solution to our current economic crises(spend more)contradicts what many environmentalists, including myself, believe is necessary to solve our climate/resource crises (spend less and reject the consumer culture).
I think a better response to the downturn in spending is promoting more work sharing and voluntary part time work rather than layoffs. Not only would this approach help us move towards less consumerism but I believe this approach may actually reduce the severity of the downturn by reducing the increased household savings that is now contributing to the downward spiral. When people work part time they will save less. But this is a complex issue that I haven't completely thought through. Any thoughts on this?

soonhock

March 13, 2009 07:42 PM

Sir, i believe your analysis is flawed:
1. Credit default swaps positions are mostly held by US banks especially Wall Street institutions not foreigners. JP Morgan alone has US$87 trillion derivatives positions outstanding. US bankers and traders in different departments were too greedy they ended doing both side of the CDS transactions without knowing the other hand because it was totally unregulated and off balance sheet and they were incentivised to take as much risk on each side as possible.
2. Structured financial products from Wall Street were sold throughout the world. For example, Singapore and Hong Kong retail investors bought many of these products without knowing effectively they were conned into actually selling CDS.

As usual people at fault always like to point outward for their problems they created from reckless and harmful behaviour. Your reasoning sounds along that of Mr. Greenspan who is unrepentent. Foreign capital inflows were a result of monetary, fiscal policies of the US plus the Hollywood "AAA" salesmanship of Wall Street. The world was conned.

Of course the problems created are global because US is the world largest debtor and the US dollar is the only global currency. Americans can have a free ride for so long because the US dollar was and is still the global currency.

Mike Mandel

March 13, 2009 10:45 PM

Soonhock,

Taking your points in reverse order. I agree with you 100%--the U.S. is taking advantage of the fact that the dollar is the global currency. We won't be able to get away with that again.

On the structured financial products being sold around the globe--I agree with you 90%--they were sold as safe investments, but the buyers may not have known they were buying into derivatives.

On the first one. That may have been true when the crisis first broke, but any credit defaults swaps which could be netted out within the same bank have been, I'm sure. I'm also sure that if other Wall Street banks were the main holders, it's a comparative easy problem to solve via the big hammer approach.

tom e

March 13, 2009 10:50 PM

Good read. Now tie this in with how Wall Street encouraged and cajoled main street businesses to offshore production KNOWING it would create extra money flows that they would profit on. Companies that did not offshore enough were downgraded by the analysts of investment banks who were the beneficiaries of these foreign funds. Basically Wall Street sold out and hollowed out the rest of the country for their own profit. When people finally figure this out the hatred of Wall Street will grow.

tom e

March 13, 2009 10:52 PM

Good read. Now tie this in with how Wall Street encouraged and cajoled main street businesses to offshore production KNOWING it would create extra money flows that they would profit on. Companies that did not offshore enough were downgraded by the analysts of investment banks who were the beneficiaries of these foreign funds. Basically Wall Street sold out and hollowed out the rest of the country for their own profit. When people finally figure this out the hatred of Wall Street will grow.

Rag

March 14, 2009 12:01 AM

Mike,

I would like to ask you if mass outsourcing of manufacturing jobs to China has been a bad thing for the US households? Where did the Chinese get all this money to owe to the US? Have the US corporations screwed over the US people by outsourcing?

Rag

JiaMing

March 14, 2009 01:45 AM

Michael, I agree with your analysis fully. But I don't think the US can get out of this recession without some permenant damage. Washington and the media should be straight with the American people. The bankruptcy solution basically makes to investors eat most of the losses. The bailout or nationalization makes the American taxpayers eat the losses. It is a tough choice between destroying the US brand while walking away from the obligations(bankruptcy) and keeping the US brand but pay a heavy price by Americans. The solution will probably be a compromise between the two. Foreign investors will have to eat some of the losses while Americans have to pay their part. The US brand will surely take a permenant hit and the dollar will be a lot weaker. The government cannot restore the US markets back to the way it was. But it can go after those responsible. The bank CEOs who knowing took on high risks and deceived money from both investors and American taxpayers need to be brought to justice. It is the only way the US government can restore some of the confidence in the American markets.

Larko

March 14, 2009 02:09 AM

Is it true that every major world war has roots in economics?

I hope this doesn't turn into a gun fight.

1999 - Coincidence?

March 14, 2009 04:27 AM

1999 : The year that the Glass Steagall act repealed. Obviously this is a policy failure! Those who repealed the act are responsible for the mess.

Glass Steagall act

March 14, 2009 04:29 AM

1999 : The year that the Glass Steagall act repealed. Obviously this is a policy failure! Those who repealed the act are responsible for the mess.

m.r.

March 14, 2009 06:12 AM

the present economic mess will be solved in time, for sure. but, unless the underlying reason for its cause, which was lack of oversight and downright fraud is addressed,the chance of it happening again very soon is great. which is why, to the displeasure of some, there is a need for police and traffic signals! given the speed,global reach and complexity of money execution,
it is imperitive to employ sensible transparent accountability that evaluates these transactions and transactors.
and...if trust is lost by the public, there will be many more problems to follow.

Bank-tan-amo

March 14, 2009 06:49 AM

It looks to me that the magnitude of this mess is so large that by the time the American economy recovers the American people will be in for a shock. The worlds largest economy wont be America, it'll be China. It was projected to happen in the long run anyway, but it will now happened decades early than it should have.

This great toxic asset swindle formulated by the banks and delivered to the heart of US economy has inflicted so much damage that this makes the financial losses caused by terrorism look like spare change.

The Banks have done far more harm to the US than Al-Quida ever did or could.

SAAD

March 14, 2009 07:20 AM

good work///////////

Tom

March 14, 2009 09:34 AM

What would it cost to fix the toxic mortgages adequately?

FBEye

March 14, 2009 11:21 AM

It's interesting that there aren't too many Articles about the Publicly Held Companies who were loned millions, tens of millions, & even HUNDREDS OF MILLIONS of dollars, in the past several years who now may NOT be able to make good on these loans!!! I believe I can recall a PRNewswire from 11-17-2005 where BOA, JP Morgan & Merrill Lynch, loaned $150 MILLION to a Publicly Held Company that has had its stock value go from over $25 a share to about $1.50 a share. You can 'Google' that PRNewswire by simply typing in- SONIC AUTOMOTIVE ANNOUNCES OFFERING OF $150 MILLION OF CONVERTIBLE SENIOR SUBORDINATED NOTES, and read that 11-17- 2005 Article. If there were hundreds, or even THOUSANDS, of loans made like this to Publicly Held Companies, & these corporations CAN'T pay back the loans, then shouldn't the 'public' be alerted? They ARE 'Publicly Held Companies', right? WHY are ordinary PEOPLE being targetted in regards to mortgages they can't pay, & at the same time there might be large corporations who are in the same boat? Oh, I forgot!!! These large corporations PAY a lot of money to the mainstream media in advertising revenue. Silly me! Sorry.

Glass Steagall act

March 14, 2009 04:39 PM

What a terrible coincidence? 1999! That's the year they abolished
the Glass Steagall act. All the zombies released with it.

cm

March 14, 2009 04:59 PM

Jim Carpenter: I'm probably not answering your main/aggregate question, but a few points to consider:

(1) "living/importing beyond our means" -- what is often left out of the (offshoring) equation is that while US offshorers are exploiting "cheap labor" overseas (or rather have overseas business managers/governments exploit them), there has been a substantial amount of "free" technology/equipment transfer and workforce training for offshore workers and "free" assistance building offshore business infrastructure, esp. in "tech".

(2) "work sharing/part time" -- I myself (software engineer) would take this up in a heartbeat, especially when it leads to a reduction in my hours. However, again esp. in relative complex tech jobs and other job categories, work is not easily divided and/or parallelized. When I work on nontrivial stuff, all of that stuff has to be "inside my head", and dividing it up between several people will often not improve things, but take MORE of my effort to get the same thing done.

That's from a subject-matter perspective. From an labor arrangement perspective, there is no meaningful concept of "part time benefits", unless healthcare/retirement/social insurance etc. are decoupled from labor. As a secondary consideration, there is workplace infrastructure. When e.g. two NN% part-timers can share the same office/equipment then it will scale, if everybody needs their personal chair/desk/laptop/locker/... it won't.
Also there are more-or-less fixed per-person overheads for getting to work etc., which figures into environmental/logistic/cost equations (on the sides of both employers and employees), esp. when people find it necessary to have several part-time jobs.

Nomix

March 14, 2009 05:11 PM

1) There is no solution to the current financial crisis involving the banking leaders who created it. All banks receiving TARP funds should automatically have C- and E-level executives dismissed without compensation regardless of contract, promises, golden parachutes, etc.
They have already started lying about profits in an effort to fool the public into believing they are solvent.
2) Factual accounting must be used. False and fraudulent accounting should be prosecuted. The defense "I was following orders" is not valid. Any accounting professional that assists a company in creating fraudulent accounts, moving liabilities "off book", etc, should be prosecuted. Their assets should be seized for recovery of losses to shareholders. Any liabilities or assets moved to other accounting systems should be treated as any other financial transfer and listed on the books as a debit or credit.
3) The fundamental problem of lack of ethics in financial services must be addressed. The belief among members of the financial community that it is okay to steal so long as it is done with paperwork reflects this lack of morals. License banking executives. Punish executives that create bad banks by loss of licensure. Publish the names of executives at troubled banks on the internet for all to see for 3 years. Create a registry of licensed execs that depositors can check to find banks with large numbers of "troubled executives". I am sure not putting my money in these banks. Before you argue that this will make these execs unemployable, let me say that is the point.
4) All banks needing TARP money should be nationalized. Unravel the lies and get rid of the crooks.
5) Break up any bank that is "too big to fail." If necessary, dismantle it completely. Rewrite banking regulations to limit the size of banks. No banks should be "national" in scope. Banks can form alliances to share services nationally or new, banking transaction services companies can serve the banks across the country. Banks should serve the economy, not run it.
---------
We should not look to the financial services industry for solutions. The industry should be dismantled and rebuilt by honest citizens (very few of which can be found in finance or the related businesses). I do not care if you are a finance exec and are offended. I am offended by your lack of ethics, scruples and honesty. Leave the country if you can't behave yourselves.

Brian

March 14, 2009 05:48 PM

Previous comment is correct, i.e. The Banks have done far more harm to the US than Al-Quaeda ever did or could. When Bush went looking for weapons of mass destruction he was looking in the wrong place. He should have been looking on Wall St. Would have saved everybody a lot of trouble.

David Doney

March 14, 2009 06:05 PM

There are short-term fixes to get us out of this and longer-term reform ideas. Some examples of solutions recommended by top economists, regulators and financiers below:

Short term
1) Reduce outstanding home mortgage balances by 20-30% across the board.
2) Systematically reduce mortgage payments to 31-38% of income.
3) Ask bondholders of major banks to take a 20% haircut (or more), via debt for equity swap like the GM bondholders are doing.
4) Inject large amounts of capital into the banks via common stock, based on the "stress test."
5) Suspend payouts on all credit default swap contracts until this crisis is over.
6) Allow mortgage "cram down" in bankruptcy.
7) Require banks to value securities at expected cash flow value, rather than market (what you could sell it for today) value.
8) Create a fund seeded with public capital to buy toxic assets. Guarantee the related treasury bonds sold to the public so private capital will flow in to buy the garbage.

Long-term
1) More stringent capital requirements / leverage restrictions on the banks. Restrictions increase for larger banks.
2) Reduced trade deficit through energy independence. Build about 100 nuclear plants--what great stimulus projects!
3) Minimum 10-20% down payments for all homes.
4) Charge larger banks via an insurance premium to reflect their systemic risk.
5) Break up institutions that are "too big to fail." For example, a Bank of America could become 6 regional banks.
6) Bring back Glass-Steagal -- separate investment banks and depository banks as the cultures are incompatible.
7) Tax each purchase and sale of stocks and bonds, to pay for truly independent ratings.
8) Establish a panel to scrutinize new financial products the same way we do with food.
9) Require consolidation of all off-balance sheet entities.
10) Establish regulators with clear authority over each institutions type and staff them with former Wall St. types who know how these instruments actually work, so they can monitor / audit effectively.
11) Require certification for Board members for all larger financial institutions. They should have a week of training / continuing education from accredited programs every other year on how to better handle their responsibilities.
12) Restrict short-selling during financial crises more generally and via the uptick rule.
13) Dramatically improve disclosure rules. Nobody knows what these companies are worth or had clear visibility to the risks under various housing scenarios. There should be ongoing "stress tests" reflected in the books of these companies and on their websites.

William L. Welch

March 14, 2009 06:21 PM

Things are worse today than they were in the aftermath of Sept 15, 2008.

The reality is the US government can seize or nationalize any institution operating under federal license for the benefit of the United States with no concurrent moral OR legal obligation to creditors of the nationalized institution beyond assets over and above guaranteed accounts (the US gov't is the first lien holder).

The most efficient path is to let financial institutions sell what they can before government auditors show up to value the institution and if necessary liquidate it.

The government can auction assets from institutions not capitalized at a survival standard, cover guaranteed assets first, then pay out the rest in some fair distribution with investors getting anything left after creditors are paid.

Bottom line: credit is going to be more expensive anyway, so where money came from (e.g. offshore) is not really an issue. Investing is not beanbag: them that puts their money down takes their chances.

Sounds simplistic and it is, but it will work because: 1) there is a lot more to it than a generation of wiped-out investors; 2) the US is the primary consumer nation; and 3) until the US starts consuming again, significant parts of the industrial world world are on hold.

Tom Krebsbach

March 15, 2009 12:20 AM

Tim Geithner wants to set up funds financed by the government and private investors to purchase toxic assets off the balance sheets of the banks. I am skeptical of this approach because I doubt anybody is going to be willing to pay a price for the assets that the banks will demand. Why should a bank sell a mortage backed security at a bargain basement price when there is a possibility that asset may end up being worth much more than anybody is willing to pay presently? Time has a way of healing many things. In this case, time may make whole, or near whole, assets that are viewed as extremely toxic at this point.

A very straightforward solution is to set up an aggregator bank which will purchase questionable assets at the value they are marked at on the banks balance sheets. The government can then hold onto these assets until the economy has recovered. When the economy has sufficiently recovered, then the federal government would liquidate the assets. If the government took a loss on an asset, the original owner would be required to make up the loss over time. Terms for repayment would be negotiated between the government and the bank. Because the asset would be liquidated after the economy had recovered, the bank would likely be profitable and in a good position to make good on the loss over time. If the government sold the asset at a profit, part of the profit would be awarded to the bank as a tax credit.

In this way, toxic assets would be removed from the bank's balance sheets, the tax payer would likely not lose anything, and the federal government would not be forced to put a value on assets which are impossible to value at this point.

I refer to this as CONDITIONAL REIMBURSEMENT, because financial institutions would reimburse the government, depending on the eventual liquidation price of the asset.

This just makes so much sense to me. It seems it should be an obvious solution. But I guess simple and obvious solutions are not inviting if you are a knucklehead working for the government.

Christopher Holland

March 15, 2009 02:57 AM

So the solution to the financial crisis is have a global conference whereby the Chinese Communist Party will agree to wipe out the savings of millions of peasants and workers, so Americans can continue to enjoy a lifestyle they can only dream about. Good luck with that one - it makes selling lung cancer look like a snap.

Ballbuster

March 15, 2009 03:43 AM

As early as 2002, Peter Schiff warned the world about the fake-bubble US economy and during 2006 to 2008 repeatedly warned America on national TV and radio about the imminent catastrophe awaiting the US economy. Now, BW Chief Economist, Mandel, is jumping on the wagon delivering his post dog-and-pony show, starring Mandel. Where was the brillant prognosticator Mandel during the past years? Where was his wise commentary? or his insightful five points about the banking industry? Answer: Mandel was either busy pushing his Econ-101 book for simpletons or he was found at "Gehen wo the Czar gehes." Like the Roman emperor who wrote poetry while Rome burned, Mandel wrote nonsense while the US economy was heading off the cliff. Now, Mandel wants to sound intelligent or to claim some prescience after other economists such as Peter Schiff deciphered the financial crisis to him. What is more phony than the US bubble economy is the phony Mandel. It is high time that BW rid itself of this imposter economist and appoint someone who truly understands economic and worthy of the title.

Mike Mandel

March 15, 2009 05:14 AM

Christopher Holland:

Two points. China seems to mostly own Treasuries and agencies, both of which are directly guaranteed by the U.S. government. So they are not so involved in the bank issues.

But in the larger sense, yes, that's the foreign policy problem.

Mike Mandel

March 15, 2009 05:28 AM

BB:

Yes, I was late to the doomsday party. I turned pessimistic in fall 2007, but even then I didn't fully understand what my reporting was telling me.

However, I find Nassim Taleb more interesting than Peter Schiff. I'm going to have a black-swan-related post soon.

MIP

March 15, 2009 08:32 AM

Sadly the only fix to this whole mess is global thermonuclear war. Strange game we play when there can be no winner.....

KRISHNA N KAUSHAL

March 15, 2009 08:36 AM

It is a thought provoking article.They all must read Kutilya arthshastra- Economics by Chanakya of the darbar of Chantragupta. It was written in BC but is relevant in AD as well.
The Govt. once sleeps the thief (financial thief-cum-wizrd) fleece the public. They have done and earned big fees per transaction.
Let public settle for the hair cut on their investments, foreigners await the future and keep mum for the present, Americans to learn handicrafts,in Gandhian spirit. They should relieve stress by Yoga to develop re-confidence though lowergraded.
I wish my magt consultant friends to work overnight w/o disturbings others nights. Be Kumbh-karna -the brother of great Ravana

krishna

March 15, 2009 09:45 AM

dear sir,
Click open and check my comment posted,
It contained Hindi language words. This perhaps your filters didn't allow.
It was redressing present day financial crises by using the texts given in a book on Economics by an indian economist of all time repute in BC era.I am not writing the Hindi words to avoid failures. Pl adjust your filters.

joe

March 15, 2009 10:53 AM

To Mike Mandel: Thanks for this great article. As a reader, I am sick of the articles that tell us the stock market has reached the bottom, or good life is ahead of Americans, or we are the country will come out of this kind of mess stronger. This kind of propaganda benefits the Wall Street only. What we need are no slogans, no propaganda, and no misleading optimism. What we need to know is why lots of American 401K accounts have dropped 50%, and why average stock market dropped 40-50% but average hedge fund dropped only less than 20% last year, and why majority Americans were told to "BUY AND HOLD" the mutual funds which had to be in the market even the fund managers knew market would drop. Please don't tell me you still believe in "BUY AND HOLD" and "dollar average investment" that kind of garbage. The financial media has not told us the truth including BW until recently. This crisis is a financial manslaughter to majority of Americans. The Wall Street cannot do it by itself without the help from the financial media by luring Americans into the house bobble. You guys failed to do the right thing. But it's not too late.

ASpencer from Canada

March 15, 2009 11:24 AM

This is the first time I have really understood what happened and what may be at stake. Thanks for this helpful analysis.

mitchong@yahoogroups.com

March 15, 2009 11:27 AM

Bank Crisis for Dummies

Tim

March 15, 2009 01:02 PM

Do you blame Californians who own Nevada's assets or fund NY's debt? Do you blame the US savers who don't consume? The irresponsible lending and financing is the real culprit, don't just pick anything to blame... it's ridiculous.

Abdullah Anwar

March 15, 2009 03:20 PM

This is exactly what I had discussed with friends a few days ago. The key is international cooperation and they can't let politics get in the way to make things more complicated. However, we do need these regulatory agencies, which are influenced by their respective countries, need to settle on a "fair" price to get through this mess, otherwise like Michael said, dicey.

PJL

March 15, 2009 03:43 PM

This is the downside of globalization.
We can't have good globalization without good international regulations in place.

Easy to say, hard to do.

James Wood

March 15, 2009 06:07 PM

Thanks for a most interesting article. I have one question of substance. Your analysis of who funded the "US boom" leaves out US financial institutions. This seems incorrect. The decade ending in 2007 ended with the greatest increase in US financial institutional leverage and therefore purchase of US financial assets. Additionally you have the incredible growth of private equity and hedge funds, plus off balance sheet vehicles. I believe this assumption of toxic assets by US financial institutions is what puts the US financial system at risk of systemic failure, particularly when we speak of CDS.

It is certainly true that non Americans purchased large amounts of US originated assets. However, it is worthwhile to note these purchases were made primarily by financial institutions and not "non financial" institutions. Individuals simply did not buy large amounts of CDO's guaranteed with CDS's. It seems inconsistent to include foreigner's purchases of US assets by financial institutions and leave them out of the US analysis. Your Proposition 3 even concludes that all the the firms being bailed out that are foreign are foreign banks.

mader

March 15, 2009 06:42 PM

So they will print more money and more and amore and more. Money is not a problem.

Strategery

March 15, 2009 08:52 PM

1999 was about the time that Clinton finished selling US to the Chinese, by giving them military technology and securing their place in the WTO. Then, Bush was asleep at the wheel as he hid 'Made in China' labels at a distribution center for a press conference while the US recorded record trade deficits. As you can see from the chart, it took us 10 years to get into this mess. It will take us another 10+ years to get out of it, and still another 10 years to return to 80s level US-based investment dollars. Allowing these banks to go bankrupts is the best option. Sure, a few people might panic, but for the average American, they couldn't care less about Lehman. Bring home the troops and secure OUR borders in case foreign investors get restless. And, slap tariffs on imports to protect remaining US industries. Yes, the rest of the world will cry about protectionism, but they need the US a lot more than the US needs them. Also, their tariffs in retaliation will be useless because they don't buy US products anyway.

Mike Mandel

March 15, 2009 09:34 PM

James Wood:

Interesting points. I was viewing the U.S. financial system as a black box "intermediary" between sources of capital and users of capital. Possible sources of capital to the U.S. financial system includes U.S. nonfinancial players and all funds from the rest of the world. I think this approach yields some useful insights because it clarifies who is the ultimate beneficiary of a lot of investments.

The fact that financial institutions can themselves own assets does not make them sources of capital, since they have to borrow the money from elsewhere.

To put it another way, even though financial institutions can buy securities, that requires money which is raised by borrowing or some other means. Ultimately they are still just intermediaries.

Mahagwa

March 15, 2009 10:16 PM

My 2 cents:
First of all, this essentially shows that we as a country have literally sold ourselves to the rest of the world.
Second, it acknowledges lack of accountability and responsibility on the part of the american. Ever wonder why the person who owes more on their credit cards has a better credit score and has tons of credit cards thrown at them; yet the person who lives on a cash basis has a low credit score?
There is a fix. As someone pointed out, why does China have the money to lend the US trillions of dollars? Because we gave them all of our manufacturing..and in doing so, placed thousands (if not millions) of americans on the unemployment lines..net result, lost tax revenues, increased state and federal expenditures.
We have also exported many high payng tech jobs to India and now the Philippines...once again, lost tax revenues, and increased government costs.
I am in no way a socialsit, but I think at times like this we (america) need to revive protectionism. We need to restrict our industries from off-shoring manufacturing and tech jobs (hell, there are restrictions on what countries encryption products can be sent to)...so we need (not offer incentives) but mandate laws that basically say NO US COMPANY CAN OFF SHORE ANY JOBS (SERVICES OR MANUFACTURING) UNTIL WE GET THINGS BACK IN BALANCE.
As Americans, we need to become responsible and stop this insane spending..to that end, we need to place restrictions on credit card issuance -- change the policy -- such that the basis for additional credit is not how much debt you have, but your income and your current debt load.
We need to stop buying foreign products, the government should actually promote BUY AMERICAN, and not just that, but we need to identify those american companies who employ over 80% americans and brand those as american..the rest, we consider NON-AMERICAN.
As for the foreigners and their not wanting to take their losses...well, i trade stocks and options and futures...when i guess wrong, and the market turns against me, I don't go cry to the CME or OCC and demand a full refund..i take my losses, wipe my tears and roll again..it is called speculation. If anyone needs to remind these foreigners, let it be known that after WWII US rebuilt Japan and Europe (recall the Marshall Plan??), currently, US literally provides military protection for Japan, Europe, Israel, Mid-East...so if they throw a fit, hell, we pull out our military and leave them be
FINALLY, all these execs and financial engineers and operators at all these banks and hedge fund who cooked up this baloney, should be tried as common criminals for fraud and intent to de-fraud; given the magnitude of the mess they created, they should be charged for treason against the country and executed and have the execution televised.
One final point, why not just dissolve the existent financial system..it didn't work in the 30's, not the 80's and not now...let us set up something new, something that truly serves america.

Mansa

March 15, 2009 10:18 PM

My 2 cents:
First of all, this essentially shows that we as a country have literally sold ourselves to the rest of the world.
Second, it acknowledges lack of accountability and responsibility on the part of the american. Ever wonder why the person who owes more on their credit cards has a better credit score and has tons of credit cards thrown at them; yet the person who lives on a cash basis has a low credit score?
There is a fix. As someone pointed out, why does China have the money to lend the US trillions of dollars? Because we gave them all of our manufacturing..and in doing so, placed thousands (if not millions) of americans on the unemployment lines..net result, lost tax revenues, increased state and federal expenditures.
We have also exported many high payng tech jobs to India and now the Philippines...once again, lost tax revenues, and increased government costs.
I am in no way a socialsit, but I think at times like this we (america) need to revive protectionism. We need to restrict our industries from off-shoring manufacturing and tech jobs (hell, there are restrictions on what countries encryption products can be sent to)...so we need (not offer incentives) but mandate laws that basically say NO US COMPANY CAN OFF SHORE ANY JOBS (SERVICES OR MANUFACTURING) UNTIL WE GET THINGS BACK IN BALANCE.
As Americans, we need to become responsible and stop this insane spending..to that end, we need to place restrictions on credit card issuance -- change the policy -- such that the basis for additional credit is not how much debt you have, but your income and your current debt load.
We need to stop buying foreign products, the government should actually promote BUY AMERICAN, and not just that, but we need to identify those american companies who employ over 80% americans and brand those as american..the rest, we consider NON-AMERICAN.
As for the foreigners and their not wanting to take their losses...well, i trade stocks and options and futures...when i guess wrong, and the market turns against me, I don't go cry to the CME or OCC and demand a full refund..i take my losses, wipe my tears and roll again..it is called speculation. If anyone needs to remind these foreigners, let it be known that after WWII US rebuilt Japan and Europe (recall the Marshall Plan??), currently, US literally provides military protection for Japan, Europe, Israel, Mid-East...so if they throw a fit, hell, we pull out our military and leave them be
FINALLY, all these execs and financial engineers and operators at all these banks and hedge fund who cooked up this baloney, should be tried as common criminals for fraud and intent to de-fraud; given the magnitude of the mess they created, they should be charged for treason against the country and executed and have the execution televised.
One final point, why not just dissolve the existent financial system..it didn't work in the 30's, not the 80's and not now...let us set up something new, something that truly serves america.

Mahagwa

March 15, 2009 10:35 PM

To Businessweek..check your site, my post appears 5 times, because it kept timing out, this would truly irritate some readers.....

Christopher Holland

March 15, 2009 11:39 PM

So the solution to America's debt problem is to get the unelected Chinese Communist Party to agree to wipe out the savings and retirement funds of millions on its own poverty stricken citizens, so that profilgate Americans can continue to enjoy a lifestyle the Chinese can only dream about. Anybody who thinks that is going to happen before hell freezes over has nothing between their ears.

Ayearth

March 16, 2009 12:35 AM

In my perusal of these blogs, I've yet to see anyone go back to the basics of money, and the present day practice of fractional reserve banking. The only reason the banking industry gets away with this practice, is because depositers allow them to. It doesn't seem right for a bank to accept my deposit, allow me to make withdrawels against that deposit, and then to loan 90% of those funds to a borrower who deposits the borrowed funds into his account, and he in turn makes withdrawals, while the bank takes 90% of his "deposited" funds and loans them again. After 20 "loan-deposit" transactions, my original deposit has resulted in 8.78 times the amount of money in circulation. It works until all 20 depositors get "scared" and want to withdraw their money at the same time! With the link to gold removed, the only expedient solution is for the Federal Reserve to inflate the currency by printing more "money"

ernest

March 16, 2009 06:23 PM

so let me get this straight:

you are putting the responsibility on 'foreign lenders' for the fact that the US decided to take on so much debt (350% of GDP as of 2007)?

the solution is that the US gradually reduces its debts, and pays back what it owes

thats usually the honourable solution to when someone goes out and spends more than what they have..

LAO

March 18, 2009 11:49 AM

Great article, I don't know how I overlooked it until now. It's interesting to recall how hard Paulson worked to get China to join the banking game, and it's probably a good thing they didn't.

As for those critics who cry that BW didn't warn them, let me point out that they gave us frightening statistics and stories about creative mortgages and foreclosures, at least back to 2007, and monitored the upward march of Fed rates and the market's fearful response. I knew something had to go sour, I just couldn't put my finger on what it was, but it was enough to make me pull back. Ridiculous home prices compared to wages were there for all to see; it was only on TV stations owned by people I don't trust that I heard reporters say that home prices never go down. True, to the best of my knowledge, like other media they didn't lay out whose money was at risk or how much leverage there was nor what might happen if it hit critical mass, but wouldn't that be because our wretched regulators were determined to have no transparancy? Did you never wonder how you could have a $36 trillion stock market out of a consumer base that spends $10 trillion at most in an economy with a trade deficit (GDP reporting)? Anyway, would you really expect a business magazine to deliberately spawn a crisis of confidence? Is there no such thing as critical thinking any more?

Squeezebox

March 18, 2009 01:18 PM

It's no wonder that banks aren't allowed to restructure mortgages. People halfway across the world hold the mortgage and won't renegotiate because they don't understand (or don't care) how a foreclosure will make their losses worse.

Thank you for your interest. This blog is no longer active.

 

About

Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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