Tuesday, February 10, 2009

There ARE Solutions to the Banking Crisis

Treasury Secretary Geithner presented his new financial rescue plan on Tuesday, which impressed no one. The plan was confused, unfinished and intellectually contrafactual. In this posting, I will expand on my solution to the banking crisis, which involves a system of what are called “covered bonds” along with the creation of new banks.

After the plan was introduced and poorly received, Geithner defended himself by saying that there was “no historical precedent” to this crisis. Nothing could be further from the truth. Simply giving the banks taxpayer money to spend as they please, a.k.a. the “Bush/Paulson/Geithner solution” is what lacks a historical precedent, simply because it’s so infinitely stupid.

Geithner, along with what seems to be the entire American political and economic establishment seems to be completely in the dark in terms of economic research and economic history. I’m saying that there are many precedents to this crisis, and that there are many precedents on how to solve it.

There are 2 main, related problems that must be solved as soon as possible:

1. the banks are insolvent, and

2. the mortgage securitization market is dead

The banks are insolvent because they own worthless assets that nobody wants to buy. Geithner’s plan involves trying to convince private investors to buy these worthless assets, but the reason they’re worthless is that these same investors didn’t want to have anything to do with them in the first place.

The assets are like rotten apples in a fruit stand, and however much such apples are promoted, I think it’s pretty safe to say that few people will ever by them.

The mortgage securitization market is the market where banks sell off mortgages to private investors in the form of mortgage-backed securities, which is the same thing as the assets I mentioned above.

Nobody wants to participate in the mortgage securitization market anymore because housing prices have imploded, so the market is dead with little chance of being revived any time soon. In other words, if housing prices don’t go up, the mortgage securitization market will continue to be dead.

Now to my suggestions of solutions to these problems. In a catastrophic banking crisis, the solution has in the past been either nationalization or the creation of new banks.

Nationalization is the more common solution, but if a bank’s debts are five times its market value, what is the point of rescuing it by nationalizing it? Spending five dollars to make one dollar doesn’t make a lot of sense… In light of the banks’ situation, nationalization would be the least severe destiny awaiting them. It would, however, be extremely expensive for the taxpayer.

Because the U.S. Government is ideologically opposed to nationalization, my bet would be that Bank of America and Citigroup (along with many smaller banks) will have the same fate as Lehman Brothers.

Instead, I believe that the creation of new banks is the appropriate solution. This was done in the 1800s in the United States during a catastrophic banking crisis. Under this plan, the government would simply set up a new bank, inject it with money for lending and write strict rules on how it can operate. That would instantly create a stable, prudent and dependable bank.

The government would then sell off 49% of the shares to private investors and keep running the bank according to prudent standards until the crisis is over. At that point, the bank can be sold off completely.

Instituting a system of covered bonds would be a good solution for the mortgage market. This is a very stable system that has been used for hundreds of years in Europe. Basically, all the banks would get together and put all their mortgages in a giant pool.

As soon as one mortgage defaults, it is immediately taken out of the pool, and the loss is shared by all the banks at once. All the mortgages, meaning the investments that the banks have made, are hence “covered” by all the participants in the system.

Under this system, the mortgages remain on the banks’ balance sheets. It is a collaborative effort, as well as being a system where each bank has to take responsibility for its own lending practices. This system encourages prudent lending standards by all participants, stabilizes the housing market in general, and improves the trust in the financial system.

We need to think in new ways about the crisis, which Geithner acknowledged in his speech, but he is so ignorant that he does not know of any solutions like the ones I just described.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


an average patriot said...

They just do not get it! Greenspan set this up for Bush and it coming to a head at this time is no coincidence. Most do not realize it but so far we have given $10 trillion in Bailouts. Non of them worked and this will not either. They estimate it will take another $10 trillion. I doubt it! It took a world war last time!

Amitabha Mukhopadhyay said...

As I have been writing for some time the American government may form a corporation by the name STOCK HOLDING CORPORATION OF AMERICA and pump in as many trillions of dollars as required to buy all the toxic debts from the ailing banks. These will inject liquidity in the system.The money required will be printed and it will not create inflation. Total amount of goods and services in the economy is intact but only the matching money supply is not there. Even if some inflation occurs then prime rate of the fed can be increased. Other major economies would also suck up excess dollar to raise its value artificially high. Then gradually these houses would be sold to the original buyers at a suitable time frame.

Jacob said...


I don't quite understand your proposal. Would the "Stockholding Corp. of America" actually buy the toxic debt? Are you saying that the crisis will deflate the economy and that printing new money will essentially re-align the entire pricing structure of the country, as well as altering international currency rates?

Wouldn't that be like simply switchig to a new currency?