oftwominds-Charles Hugh Smith

How to Fix the Financial Sector

Continuing the theme established on Saturday--a Contrarian's Contrarian list of ten positives ( Today's Contrarian Entry: The Positives)--here is #11:

11. New and better ideas abound. Longtime contributor Michael Goodfellow recently proposed a radical banking-sector fix which is too practical to ever be implemented--its fatal flaw is that it doesn't bail out "friends of Hank Paulson"-- but nonetheless it shows excellent ideas do exist if we only reach outside the MSM/PTB (mainstream media/Powers That Be) box.

The Powers That Be are rapidly using up all their ammo. They will be scrambling for a new "solution" this weekend, but it seems guaranteed that it will be some kind of nationalization of banks, possibly as part of refinancing them.

The problem I have with any kind of bailout, whether it is asset purchases (the original Paulson plan) or refinancing, is the uncertainty of it. No matter what they say they are going to do at this point, the markets have to wonder how it will really play out, what political changes will be made down the line, and whether a better deal could be coming in the future. If they just do a refinancing, the bad assets are still out there, and no one knows where they are exactly, or how bad they will become. On top of this, you have the obvious problems that you don't want the government picking winners and losers (which banks, out of the thousands in the U.S., to refinance), you don't want them politicizing all the decisions of the banks (more community lending, modification of mortgage terms, etc.) and don't want the banks gaming the system, trying to "stay sick" in order to extract more taxpayer money.

So rather than nationalizing the banking system and then sitting around trying to think of what to do next, the Fed should create a bunch of new, "clean" banks. They would just charter them, restrict their activities (no MBS, no CDS?), and give them a pile of money. Maybe even give them some branches from one of the failed banks.

These new banks would have absolutely clean balance sheets with no liabilities, and there would be no question they were credit worthy. They could immediately dive into the commercial paper market, or the conventional 20% down, 30-year fixed mortgage market. Since there would be several of these, there would not be the problem of government micromanagement. They would just compete with one another as normal.

Then let the rest of the banking system gradually deflate. Some of the existing banks are insolvent due to mortgage assets. They would not be able to compete with the new clean banks. Others are solvent and should be able to keep some amount of business. For the ones that collapse, go through the normal FDIC process, with one modification. Sell off their assets, wipe out their stockholders, but also have the government assume their debts at some fixed discount. This is to prevent a domino effect of one bank collapse killing another bank.

If you took your $500 billion, and created five banks with $100 billion assets each, with even 10-1 leverage (a lot less than banks have been employing), you'd inject $5 trillion in new credit. Isn't that a more effective use of the money than buying $500 billion in bad mortgages, or shares in current banks (who may just sit on the money, to repair their balance sheets)?

The advantage of just creating new banks is that everyone knows the rules, and once created, it would presumably be hands off. The goal is increased transparency and predictability. Nothing I've seen from the Fed so far even moves in that direction. Neither does asset purchase (since we don't know the terms), or refinancing (since it doesn't get rid of the bad assets.)

Of course, what I expect at this point is a completely political solution, where we have zombie banks for years, and repeated attempts to bring the system back to life. The Japanese model, in other words, despite all the protests that we would never do that here. The Japanese didn't get into their situation because they were idiots. It happened because their political system was not willing to take the short term pain of bankruptcies, not as long as there was some mirage of recovery they could hope for. Instead of a painful set of bankruptcies, they got a long, deep recession. If we do that, we'll just extend this crisis past 2011 when Social Security starts to bite and creates a new crisis.

Thank you, Michael. I am not an economist or banker, and so perhaps I've missed reasons why this couldn't work, but this certainly look like a much better, cheaper, faster and more equitible fix than the "everything but the kitchen sink to bailout my buddies" mess which has been thrown at the problem helter-skelter.

Another well-conceived proposal (the Genesis Plan) has been put forward by Web hero (at least to me) Karl Denninger over at the Market Ticker.

The short version of The Genesis Plan is:

1. Everyone must expose their balance sheet; all Level 2 and 3 assets must be declared and all models disclosed in full immediately and every quarter hereafter.
2. The CDS monster must be caged by forcing it onto an exchange where O/I and margin supervision can be maintained. This is already in process and must be completed.
3. Leverage must be returned to no more than 12:1 across the system - no exceptions. If you agree with either (or both) of these proposals, please make that known to your elected officials (even if it seems improbable they will act on anything but political self-interest) and anyone who despairs that the financial sector can be fixed.

Reader Essays:

Part I: A 70 Trillion Dollar Counterfeiting Ring(Zeus Y., September 23, 2008)
According to several sources the market for so-called “credit default swaps” last year alone was nearly equal to the total global GDP, around 70 trillion dollars by some estimates. Yet these derivatives have no discernible "origin" or value.

NEW ESSAY: Part II: How the Credit Default Swap Scam Works (Zeus Y., October 13, 2008)
Instead of asking the obvious, complex, and obscuring question, "What value DO they have?”, one should ask the elegant and simple question, "What value COULD they have?" Even a cursory examination would seem to indicate that the answer is either zero or less-than-zero.

NEW ESSAY: Part III: Credit Default Swaps Create Less-Than-Zero Value (Zeus Y., October 13, 2008)
Now, how can a supposed “asset” like credit default swaps have a “less-than-zero” (negative) value. First, credit default swaps were insuring debt. Debt is not an asset as I explained in previous essays, but a liability. Mistake number one was to confuse asset and liability.

Part IV: There Is Ultimately No Gaming the System: When the Micro Crash Reflects the Macro Crash (Zeus Y., September 29, 2008)

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