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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.  
mortgage resets
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.]

Originally posted to DemandSide on Mon Feb 18, 2008 at 08:27 PM PST.

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Comment Preferences

    •  bush's position is untenable but, (2+ / 0-)
      Recommended by:
      mayan, DemandSide

      you need a better point than this...

      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

      nice cogent diary though

      please pardon the poor keyboarding, i can never decide which two of my ten thumbs to use, so hopefully some of you are fluent in Typo

      by TAPayne on Mon Feb 18, 2008 at 08:32:10 PM PST

      [ Parent ]

    •  The Real Problem Is Inner-City Mortgage Fraud And (4+ / 0-)

      greedy Banker types...

      The "New Deal" Regulations became unwound because of several very public movements to get unqualified buyers into housing, which in itself opened up the door to FRAUD on a massive scale.

      Add in the bankers greed, booking paper profits on risky securities, and you have a recipe for disaster...

      And it IS NOT a one-Party problem, either.

      BOTH parties pushed policies that made this possible.

      •  Greed has no political party. n/t (0+ / 0-)

        "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

        by bobswern on Mon Feb 18, 2008 at 10:17:21 PM PST

        [ Parent ]

      •  Helping the poor own homes? (1+ / 0-)
        Recommended by:

        Should there be policies to help the poor own a home instead of paying someone else's mortgage payment?

        The new rules have thrown the baby out of the bathwater.  You will see more reports about people who can buy an affordable house being turned away because they can't meet some of the strict and ridiculous rules such as spending an extra $1,000 for pre-home buying counseling, and having at least six months of mortgage payments in the bank.

        Many people now are forced to pay more in rent than they could pay in mortgage if they bough an affordable home.

  •  Well... (4+ / 0-)

    we should just put McCain in then...He's had plenty of experience with a serious banking crisis with his old band, The Keating 5.  

    "We're all working for the Pharoah" - Richard Thompson

    by mayan on Mon Feb 18, 2008 at 08:34:32 PM PST

  •  Democrats have zero political courage. (3+ / 0-)

    good luck!

    We don't have time for short-term thinking.

    by Compound F on Mon Feb 18, 2008 at 08:37:57 PM PST

    •  Banking sector has too much power in DC. (1+ / 0-)
      Recommended by:
      Stranded Wind

      This crosses party lines. The regulations are there. The will and the means to enforce them are not. Essentially, it's just too freakin' late. That ship sailed years ago. It's going to be very, very, very ugly.

      "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

      by bobswern on Mon Feb 18, 2008 at 10:21:19 PM PST

      [ Parent ]

  •  Obama or Clinton? (0+ / 0-)

    Silly goose, you did a nice, substantial diary instead of a candidate thingy, and now you have just eight comments.

     Obama or Clinton: go, ponder, and come back with a diary favoring one of them, or if you're particularly creative see if you can inflame supporters of both candidates with one shot :-)

  •  On this, McCain is a bigger Hoover than W is (1+ / 0-)
    Recommended by:

    McCain disdains government intervention in the markets even more than W's crowd.  It is possible McCain will flip-flop on this during the general election campaign, but his record suggests that he would let the markets play this out while the government stands on the sidelines.  In other words, the Hoover approach to financial crisis.

    So this is how liberty dies -- with thunderous applause.

    by MJB on Mon Feb 18, 2008 at 11:16:45 PM PST

  •  richardson (0+ / 0-)

    really disappointed me when he bragged about being the only pro-growth democrat.  Laffer endorsed him too.

    Another sad thing is that I wonder if either presidential candidate will act on their promise to put human rights (including decent pay) and environmental concerns into trade agreements.  I'm kinda skeptical.


    by siamesewonka on Tue Feb 19, 2008 at 12:15:51 AM PST

  •  Two points about the mortgage crisis (1+ / 0-)
    Recommended by:

    1)After the tech bubble burst and the downturn of 2001, Greenspan and the banking/mortgages/RealEstate industry from California to the east went on a mission to extend the housing bubble beyond its normal life.

     There was a deliberate attempt to marry the "do away with unnecessary regulations" with the mortgage underwriters to extend and boost the lending and  price inflation to recover wealth that was missing in other parts of the economy. A housing bubble that should have peaked at 5 to 6 years was boosted to 8 plus.  It was artificial and encouraged in spite of the pyramid scheme it represented.  

     Federal regulators (political appointees)and others were cheerleading the new rules climate, non enforcement, non investigations.  The creation and expansion and offloading of CDO's and credit swap growth to unmanageable or uncontrollable size was encouraged and allowed to run unchecked.

     We will see a bust because there is no precedent in reining in a bubble of this size. No controls in place, no feeble attempts now after the fact can save these institutions. Fundamentally, they are insolvent.  4% or 6% currency reserves are not enough to cover the run that is coming.  Even the Fed is mainly borrowed money. There are no large reserves.

     So we will see a bust, and then an attempt to reconstitute. Instead of bandaids and partial fixes for some of the sectors, we should look at what we want for survival of the households, and what the shape of the post crash banking should look like.

     That is where the real leadership needs to be, if the Democrats dare to do it.

    www no, The Economic Populist. Ignorance is Blitz, not Bliss

    by Pete Rock on Tue Feb 19, 2008 at 09:06:42 PM PST

    •  The poor will never own homes (1+ / 0-)
      Recommended by:

      The mortgage crisis has brought disastrous results for the poor to middle class citizens who dream of owning a home.  While many people foolishly bought more house than they can afford, with new rules in place, poorer people can no longer own a home because of strict requirements on income and at least six months of mortgage payments in the bank.

      Now home ownership will be left to people who can actually afford it and then they can rent it out to people who can't afford it.

      I recently bought an extra home and I now have a poor family paying me $200 more than what my mortgage payment is!  I'll eventually have renters put money into my bank account each month until I sell the house in a decade and reap their fruit.  

      They told me they can't make enough to meet the new rules.  Their loss, my gain.  While Bush signed the law, the Democrats should be the one to blame for forcing poorer people to rent for their entire lives.

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