Monday, February 9, 2009

What to do with the Banks?

Allow me to explain, in plain language, what the whole discussion about the troubled banks is about. A lot of the banks, most notably Bank of America and Citigroup, are already insolvent. The only reason that they haven’t had to file for bankruptcy is that they’re claiming that their assets are worth much more than they actually are.

The banks are saying: our assets are worth a lot, but nobody is willing to pay anything for them now, but the value of them will go up in the future, so give us money now.

The very foundation of a capitalist economy is that any asset, whether it’s a house, a painting or a complex financial product is only worth what someone is willing to pay for it. In a communist economy, the government decides what assets are worth, but that is not, as we all know, how things are done in the U.S..

The assets that the banks are claiming to be worth so much money are actually completely worthless, because nobody is willing to pay anything for them. They’re like houses in a ghost town.

According to financial regulation you have to “mark assets to market”, which means that you have to value them according to what people are willing to pay for them, which is in line with the capitalist economy. However, the banks are hiding all these assets away from sight of regulators, investors and the public, so that they can get away with not doing this.

They do this by putting worthless assets in what they call “special purpose entities”, which do not appear on the balance sheet. It’s as if someone were to have a secret credit card with a huge balance that they have hidden away from their spouse, while telling that spouse that they have no debts.

Currently, the U.S. government is trying to figure out how they can relieve the banks of these assets (of which the government actually has no idea how much there are, or of what they are made up). Tim Geithner will present a plan tomorrow at 11 a.m., and the most important factor in this plan is that the government will try to buy these worthless assets from the banks.

What they have to do, in actual fact, is to decide a price of the assets, just like communist governments used to do. It is strange for the government to engage in communist economic policies in order to save capitalism. The taxpayers will pay for the assets, but whatever price is above zero is too high, so the American taxpayer is without question being ripped off big time… again.

The money which is available for use in this plan is $350 Billion. That is nowhere close to being enough for the banks so that they can avoid bankruptcy. The only thing this does is to buy time. It buys time for these worthless assets to go up in value again, and that is the only way that the banks can remain in their current forms.

Will the assets recover the value that they used to have? Absolutely not. Using the analogy of the house in the ghost town again, the ghost town would have to turn into a boom town in just a few months. I’m not aware that something like that has ever happened.

To simplify things quite a bit, you could say that one of these bank assets is made up of 1,000 houses in a low-income area of Cleveland (where the sub prime crisis is extremely severe).

By now, all of them will have lost at least 50% of their value, 200 of them will have been torn down, and 500 of them are empty (and the empty ones have lost 80% of their value due to looting and other things).

If each house were worth $20,000 in the beginning, the bank asset would have been worth $20 million. After the value destruction that I outlined above, the face value of the asset would be only $5 million. In addition to that, such an asset is priced based on the future expectations of it, which I need hardly mention are not good. Hence, nobody wants to buy it, and it is in fact worthless.

This decrease in value from $20 million to $5 million in a short time is the essence of the banks’ problems. In many cases, the situation is far worse than what I have described above, but I’ll try to keep it simple for now.

Hence, this bailout, like the other ones, is totally misguided and has no prospects of working. Why are they doing this anyway? Because the prospect of nationalization is too ideologically offensive to American politicians. Nationalization would lead to all the shareholders losing their money, and the bank executives would be fired.

Several banks will have to be nationalized sooner rather than later anyway, regardless of further bailout attempts. As I said, the reason for this is simple: the value of the bank assets will not go back up. I don’t favor nationalization because I think that would be too wasteful and expensive, but instead, I favor the creation of new banks, as I wrote in January.

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


an average patriot said...

We should liquid all failed banks and start over with new ones. Bailing them out is worthless except in furthering the bankrupting of America started by Bush.

Obama's package will not work either. The second great depression is just starting and will dwarf the great depression in every respect and remember what got us out of it. Not the new deal but WW2!

Anonymous said...

Obama has to explain to people like me (who are saddled with debt) how this bailout will help me.

I am not an engineer or in construction. So, this massive government spending, won't help me or will it?

My problem is debt and I also just got laid off -- so, basically, I am not spending or buying anything that is not an essential good (i.e. I pay my rent and buy food and that's it).

If I don't get a job soon or get a job that pays less, this stimulus, will not help me because I'll still be left struggling to pay off my debts, while the banks get to wipe their debt off with MY money.

it's doesn't make sense at all.