Could our financial prescription of creating a “bad bank” to acquire trillions in toxic assets be similarly misguided?
The shifting of toxic assets from private borrowers to the federal government might be no more curative that shifting deck chairs on the Titanic. The systemic failures resulted from multilayered problems that defy simple solutions. They reflect problems with our traditional banking system, the “shadow banking system,” and the evolution of complex derivatives.
Much attention has focused on the problems of our traditional system. New York University Professor Nouriel Roubini estimates that total loan losses ($1.1 trillion) and securities write-downs ($700 billion) could reach $1.8 trillion. That exceeds FDIC-insured banks’ capitalization of $1.3 trillion.
Banks’ weakened state has curtailed lending. But, in large part, the freezing of credit primarily rested outside the traditional banking system.
The decimation of our shadow banking system has significantly aggravated the pain. “Shadow banks” refer to financial institutions that avoided normal regulations. Their business model partially depended upon unloading highly rated, asset-backed securities onto investors around the globe. These ratings were inflated.
The subsequent high default rate on thousands of asset-backed securities imploded the system. The current inability to market these securities because of a buyer strike will keep credit tight even if banks resume normal lending.
New Treasury Secretary Tim Geithner shared with other key financial players a misunderstanding of our growing systemic risks. In a speech on Sept. 15, 2006, titled “Hedge Funds and Derivatives and Their Implications for the Financial System,” Geithner represented these optimistic assessments: “The resiliency we have observed over the past decade or so is not just good luck. It is the consequence of efforts by regulatory, supervisory and private financial institutions to address previous sources of systemic instability. Risk management has improved significantly, and the major firms have made substantial progress toward more sophisticated measurement and control of concentration to specific risk factors. What seems to have been most critical in preventing financial market turmoil from translating into a significant reduction in credit provision by banks and other financial institutions were the steps taken by regulatory authorities and financial institutions alike to strengthen capital in the core of the financial system, and to measure and manage risk.”
In fairness to Geithner, he privately was pessimistic. He even supported regulations to oversee the mushrooming derivative trading activities of investment banks, commercial banks and hedge funds. The industry and politicians fought regulation, arguing it would force business overseas.
The creation of a bad bank to acquire the toxic assets of all financial institutions reflects a magical belief that we can just wipe the slate clean. Even worse, it undermines efforts to investigate possibly illegal behavior.
The transfer of bad debts to the federal government obscures the source. Citigroup allocated $850 billion to Citi Holdings, the institution’s bad bank. That represents about 45 percent of the former Citigroup’s entire balance sheet.
Nobody has asked several relevant questions. First, how could toxic assets grow to some 45 percent of Citi’s portfolio? That percentage represents a staggering, incomprehensible number. Inspector Clouseau financiers must have infiltrated the bank.
Secondly, were $850 billion dollars of toxic assets created within the past year? We need clarification of whether accountants, management and the board of directors engaged in a cover up.
The creation of a bad bank repository could hide sins that dwarfed Enron. Despite the incredible losses involved, America regulators seem unconcerned. We took strong action after Enron. America passed Sarbanes Oxley and criminally charged Arthur Andersen, Enron’s accounting firm. The financial firms that aided and abetted Enron’s misdeeds paid hundreds of millions of dollars in fines.
After some 18 months of increasingly pessimistic reports, the nation understandably wishes that a financial bloodletting — the transfer of toxic assets to a bad bank — could restore our economic health. But we need to vet this $1 trillion gamble because of the enormous costs to the taxpayer and the danger that our financial institutions could generate more toxic assets.
Dr. Feelgood only provided momentary relief.
Originally published in the Sarasota Herald-Tribune
