Bank Bailout 3.0

I’d have to agree with this. As we’ve said all along, saving the banking system was necessary, saving the bankers was not. Now we’re set up for the next bailout of the financial elite. What a great casino this is: heads they win, tails we lose.

The bank bailout of 2008 was unnecessary. Fed Chairman Ben Bernanke scared Congress into it

By Dean Baker

This week marked 10 years since the harrowing descent into the financial crisis — when the huge investment bank Lehman Bros. went into bankruptcy, with the country’s largest insurer, AIG, about to follow. No one was sure which financial institution might be next to fall.

 

The banking system started to freeze up. Banks typically extend short-term credit to one another for a few hundredths of a percentage point more than the cost of borrowing from the federal government. This gap exploded to 4 or 5 percentage points after Lehman collapsed. Federal Reserve Chair Ben Bernanke — along with Treasury Secretary Henry Paulson and Federal Reserve Bank of New York President Timothy Geithner — rushed to Congress to get $700 billion to bail out the banks. “If we don’t do this today we won’t have an economy on Monday,” is the line famously attributed to Bernanke.

The trio argued to lawmakers that without the bailout, the United States faced a catastrophic collapse of the financial system and a second Great Depression.

Neither part of that story was true.

Still, news reports on the crisis raised the prospect of empty ATMs and checks uncashed. There were stories in major media outlets about the bank runs of 1929.

No such scenario was in the cards in 2008.

Unlike 1929, we have the Federal Deposit Insurance Corporation. The FDIC was created precisely to prevent the sort of bank runs that were common during the Great Depression and earlier financial panics. The FDIC is very good at taking over a failed bank to ensure that checks are honored and ATMs keep working. In fact, the FDIC took over several major banks and many minor ones during the Great Recession. Business carried on as normal and most customers — unless they were following the news closely — remained unaware.

 

The prospect of Great Depression-style joblessness and bread lines was just a scare tactic used by Bernanke, Paulson and other proponents of the bailout.

Had bank collapses been more widespread, stretching the FDIC staff thin, it is certainly possible that there would be glitches. This could have led to some inability to access bank accounts immediately, but that inconvenience would most likely have lasted days, not weeks or months.

 

Following the collapse of Lehman Bros., however, the trio promoting the bank bailout pointed to a specific panic point: the commercial paper market. Commercial paper is short-term debt (30 to 90 days) that companies typically use to finance their operations. Without being able to borrow in this market even healthy companies not directly affected by the financial crisis such as Boeing or Verizon would have been unable to meet their payroll or pay their suppliers. That really would have been a disaster for the economy.

However, a $700-billion bank bailout wasn’t required to restore the commercial paper market. The country discovered this fact the weekend after Congress approved the bailout when the Fed announced a special lending facility to buy commercial paper ensuring the availability of credit for businesses.

 

bailout-cartoon-2

Without the bailout, yes, bank failures would have been more widespread and the initial downturn in 2008 and 2009 would have been worse. We were losing 700,000 jobs a month following the collapse of Lehman. Perhaps this would have been 800,000 or 900,000 a month. That is a very bad story, but still not the makings of an unavoidable depression with a decade of double-digit unemployment.

 

The Great Depression ended because of the massive government spending needed to fight World War II. But we don’t need a war to spend money. If the private sector is not creating enough demand for workers, the government can fill the gap by spending money on infrastructure, education, healthcare, childcare or many other needs.

There is no plausible story where a series of bank collapses in 2008-2009 would have prevented the federal government from spending the money needed to restore full employment. The prospect of Great Depression-style joblessness and bread lines was just a scare tactic used by Bernanke, Paulson and other proponents of the bailout to get the political support needed to save the Wall Street banks.

 

This kept the bloated financial structure that had developed over the last three decades in place. And it allowed the bankers who got rich off of the risky financial practices that led to the crisis to avoid the consequences of their actions.

 

While an orderly transition would have been best, if the market had been allowed to work its magic, we could have quickly eliminated bloat in the financial sector and sent the unscrupulous Wall Street banks into the dustbin of history. Instead, millions of Americans still suffered through the Great Recession, losing homes and jobs, and the big banks are bigger than ever. Saving the banks became the priority of the president and Congress. Saving people’s homes and jobs mattered much less or not at all.

 

Dean Baker is senior economist at the Center for Economic and Policy Research and the author of “Rigged: How Globalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer.”

bailout-toon2

Advertisements

Not Too Big to Fail

too-big-to-fail2

We need a means of imposing financial discipline and restructuring banks in a system where some are deemed Too Big To Fail. This is one proposal from Nobel economist Vernon Smith (from the WSJ):

Bonds, Not Bailouts, for Too Big to Fail Banks

 

Call the bonds Class R, for reorganization. Owners might take a haircut, but they’d also become owners of the bank.

On Aug. 3 the Portuguese government announced a €4.9 billion ($6.55 billion) bailout for Banco Espírito Santo, another reminder that the “too big to fail” doctrine still prevails six years after the financial crisis. At least in this case junior bondholders—those who invested less than a year ago—and shareholders were forced to take a haircut. That’s progress for those who argue that economic recovery is impeded when monetary and fiscal authorities rescue private institutions from the consequences of their decisions.Too big to fail remains unresolved in the U.S. Last week the Federal Reserve and the Federal Deposit Insurance Corp. said that not one of the nation’s 11 largest banks could fail without threatening the broader financial system. The news came after regulators reviewed the banks’ “living wills,” the emergency plans required under the 2010 Dodd-Frank law.Living wills, according to resolution plans from the FDIC and the Fed, should “not rely on the provision of extraordinary support by the United States” and should “prevent or mitigate any adverse effects of such failure or discontinuation on the financial stability of the United States.” Most of the living wills, including those for the four largest banks— J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo —are based on a combination of Chapter 11 bankruptcy of the parent firm and sales of subsidiaries.

But selling business units in a liquidity or solvency crisis is hardly a viable plan. When Lehman Brothers filed for Chapter 11 in September 2008, the U.S. financial system spiraled into disarray, which led to public intervention. And Lehman was small compared with Bank of America and Citigroup, both of which have roughly three times the assets that Lehman had when it went under.

Instead of living wills or government bailouts, we propose that banks issue a class of bonds to privately secure the financial system against a cascade of failures. Let’s call them Class R or “Reorganization” bonds. Class R bonds would function like any other corporate-debt instrument in normal times, meaning that bondholders would have no control over the corporation.

In the event of the firm’s imminent failure, Class R bondholders would form a committee to develop contingency plans to appoint a new board of directors and reorganize senior management.

In bankruptcy, the existing board of directors would be dismissed, the equity of the firm would be eliminated and the Class R bonds would immediately be converted to equity. The Class R bondholders might take a haircut, but they would also become the owners of the bank, free of claims from prior management or shareholders. This bondholder capital avoids the involvement of the federal government, allows the firm to shed a substantial portion of its liabilities, but compensates Class R bondholders with control of a firm with a healthier balance sheet.

Bear Stearns is an example of how Class R bonds would work. Bear had about $350 billion in assets before its collapse, so if the firm had issued Class R bonds for 8% of its assets, the face value of the bond issue would have been roughly $28 billion. The firm was sold to J.P. Morgan Chase for $1.2 billion packaged with $29 billion in asset guarantees by the Federal Reserve. If the buyer needed guarantees of 24 times the sale price, the firm was worthless at the point of sale. Hence, Class R bondholders would have taken a substantial haircut when they came into possession of the firm.

Reorganization through bondholder committees has a long tradition in corporate bankruptcy, but it has not been used with banks. In finance, the Fed and other regulatory agencies have been charged with guarding against systemic risk. But that approach did not prevent the 2008 crisis.

For depository institutions, our proposal would work well with policies in place at the FDIC. Since 2008 the FDIC has handled 489 small- to medium-size bank failures using procedures that transfer ownership of most assets, and responsibilities for most liabilities, to new owners.

This approach has been successful in avoiding serious bank runs during reorganization, but the Class R approach could improve the process. The FDIC could continue to insure deposits, but it would no longer need to assume loss-share agreements with a bank that is taking over a failed institution. The Class R bondholders would assume the losses.

For a well-managed institution, the risk in these bonds should be minimal. If the viability of the institution comes into doubt, it should be signaled in lower Class R bond prices, but their owners would have the potential upside of coming into control of the firm.

We estimate that banks would need to issue Class R bonds for up to 8% of their institution’s balance-sheet liability, which includes demand and time deposits, loans from other banks and corporate bonds.

In the event of a failure, the firm’s liabilities will be reduced by 8%. In every case except AIG, this was well in excess of the amount of support that the government provided to maintain firms in the 2008 crash; and in most cases the firm’s loss approximated only about half of their outstanding corporate bonds. Crucially, to maximize a bank’s ability to finance new growth after a failure, its losses need to be absorbed by incumbent investors to enable a fresh start.

The living wills discussion is part of the process of finding a better institution for dealing with bank failures. Our proposal seeks to promote systemic stability by securing each of its private elements.

%d bloggers like this: