A banking crisis is looming, and what has worked in the past is not going to work this time. The scale is global. The cost is enormous. There is no capacity to pay for it.
The banking (by which I mean the whole financial sector) meltdown is coming on quickly. It was a dry forest, as Treasury Secretary Henry Paulson said in last week's Senate Banking Committee hearing, that was vulnerable to the spark of the subprime mortgage crisis.
Bush is practicing his best Herbert Hoover, "Economic fundamentals are sound," and "Prosperity is just around the corner." It's working just as well as it did for Hoover. Of course, we'll need to see more blood on the ground before action is politically possible, that could occur in very short order. Leadership in the Democratic Party may have to take the virtual helm before the ship hits the rocks.
The country is in recession. That is not the crisis. Even though the Fed's rate cuts may be doing more harm than good, that is not the crisis. The bi-partisan stimulus plan won't do any harm, and it might even do some good, except for Democrats who now have co-ownership of a failing economy. But the recession itself is not the crisis.
The crisis is in credit markets. Credit conditions are continuing> More markets are freezing up. Banks are shinking their balance sheets. The result is hitting consumers reeling from loss of housing wealth, being felt in credit cards, student loans, municipal bonds as higher rates or simple unavailability of credit. Higher credit costs are exactly the opposite of the hope the Fed had when it lowered rates.
The culprit is the hit banks are taking to their capital reserves, and it's only getting worse. Mortgage resets have not seen their heaviest days, which means more securities are going under.
Here is the chart we ran last fall.
Commercial real estate is right behind. Defaults and foreclosures imply big new write-downs and further shrinking of bank balance sheets. Big banks are, at least in my mind, insolvent as they sit, or would be if they valued their toxic paper at its true value.
And everything is connected. The bond insurers are being split in half in order to maintain credibility for the municipals side of their operations. (Bond insurers have no purpose without their AAA rating. That is what they are selling to the A-rated counties and cities.) This may or may not reduce problems for counties and cities, who are seeing their tax revenues plummet. But one thing it is sure to do is send the other side of the business, the portfolio of toxic CDOs right to the bottom, taking with it as much as $150 billion more in bank capital.
We have to look for a way to salvage a stable commercial banking sector from this mess.
Of course, no fundamental change will occur until there is a lot more pain in a lot more places than there is today. The hurt has to penetrate everywhere and non-action is seen as simply acceptance of ruin. Presuming I am not so far out in front of the curve that I am swinging at a ball in the dirt, things could collapse quickly. Significant structural change in the financial sector may be called for sooner, rather than later, and history offers no workable models.
The most successful response was in the 1930s. Hundred of banks failed in the 1920s and 1930s. After the Great Crash, the country endured three and a half years of "Let the markets work," and "Prosperity is just around the corner," until FDR was inaugurated on March 4, 1933. On March 5, he declared a banking holiday to get examiners into each and every institution. Before the first day of summer, Congress had passed the Securities Act of 1933 and the Banking Act of 1933. The Home Owners Loan Corporation which we wrote about last week was in place creating stability in housing. Commercial and investment banking was separated by the Glass-Steagal Act. On the first day of 1934, FDIC insurance of depositors ended runs on banks.
Unfortunately over time the regulations put in place during the New Deal have come unwound. The most significant banking crisis since then was the Savings & Loan debacle of the 1980s, which ended with hundreds of billions of dollars in government subsidies bailing out insolvent institutions. This fiasco followed after Carter and Reagan deregulated an insolvent S&L sector beginning in 1980. Net worth at that time was minus $18 billion. Deregulation was supposed to give S&Ls flexibility to grow out of their mortgage base. Instead it instituted a Wild West of finance, which ended in a disaster ten times worse than the original problem.
Further deregulation under Clinton and his Treasury Secretary Robert Rubin repealed the Glass-Steagal Act and led to the Cowboy Capitalism of the 2000s, and too big to fail but to weak to work situation we have today.
The answer is not the Resolution Trust Corporation of the S&L days. That entity was designed as much to obscure the subsidy and the bailout as to protect the economy. But it could not work today, in any event, because this problem is tremendously larger than the S&Ls.
And not solving it means we have a liquidity trap. All economic actors hoard capital and everything shuts down. This is the doomsday scenario.
Yes, we need a return of the Home Owners Loan Corporation to provide stability to housing by purchasing the mortgage securities at deep discounts and getting people back in homes. Notice, this is not a bailout, but an attempt to put order in the market.
Yes, we need severe and strict new regulation to standardize mortgage, credit card and other loan products and to re-separate commercial from investment banking. But these are just the necessary conditions for a return of confidence and credibility to the sector.
We may well need also to somehow dismember these goliaths into workable consumer banking enterprises that have sufficient capital and a mandate to employ it.
That would take a lot of work. And leadership.
[FN: I apologize for not joining in the comments last time. Some glitch between my computer and the diary prevented me from viewing the comments.]