Standing on the brink — of a fresh financial start

November 18, 2010

The opinions expressed are the author’s own.

For the past several years, governments around the world have been trying to avoid dealing with excessive debt, shrinking revenue and economic activity. The main approach has been for governments to lend their credit rating and cash to help banks and public sector entities paper over the problem, in the hope that a rising tide of economic activity will lift all boats.

Unfortunately, the efforts by the Federal Reserve and other monetary authorities to “reflate” asset prices and economic turnover have failed. The reason for this failure is a basic one, namely that once nations reach a certain level of indebtedness, each marginal increase in debt and/or the supply of fiat money has less and less impact. In the U.S., for example, the velocity or turnover of the money supply has fallen because the free flow of credit and related economic activity has been withdrawn.

The chief result of the temporizing approach to the crisis taken by the leaders of the G-20 nations has been to delay the day of reckoning and erode the credit standing of the member nations. First Greece, then Ireland and next likely Spain have been left insolvent due to efforts to prop up equally bankrupt commercial banks.

But now with the citizens of sovereign states from the Germany to California rejecting bailouts and cuts in government services, the day of reckoning is coming for the banks and creditors. But therein lies the path out of hopelessness and toward national renewal.

If you consider that the average price of a home in the U.S. has fallen by more than 25% from the peak levels of the housing boom, the fact of insolvency among our largest financial institutions is no big surprise. Indeed, one of the reasons why this writer has been so bearish on the situation facing the largest banks is that something like half of their assets are tied to housing — more if you include loans sold to investors.

The Fed has been attempting to reverse this large drop in asset values with a variety of expedients, but unfortunately the courts are open every day. Even as the U.S. central bank has used quantitative easing to artificially support asset prices in the securities markets at the macro level, the fact of liquidation and resolution is slowing eroding the capital of the biggest banks.

Likewise, as I wrote in an earlier piece for, “Bernanke conundrum is Obama’s problem,” the fact of financial insolvency makes the largest banks unwilling to refinance American homeowners, adding further deflationary pressure and thwarting Fed efforts to increase the velocity of money in the U.S. economy.

Earlier this month, Ambac Financial Group, a leading insurer of municipal bonds, was forced to file bankruptcy because claims by holders of residential mortgage backed securities (RMBS) were slowing eating away all of the company’s capital. The response by Treasury Secretary Timothy Geithner has been to try and paper over this situation and, once again, bail out the largest U.S. and European banks. The holders of RMBS with Ambac guarantees may get nothing if Secretary Geithner prevails (see “Ambac, CDS and Geithner: It’s AIG All Over Again,” The Institutional Risk Analyst, November 16, 2010).

So what is to be done? The first thing that Americans must do is to accept that the level of home prices, GDP, velocity and other indicia are not going to return to pre-crisis levels for many years to come. Once we accept this reality, then restructuring and recapitalization will become the obvious if painful choice. When I am speaking on the banking industry, I tell the audience that the task ahead is like cutting off a few fingers with a kitchen knife. The bad news is that it will hurt like hell. The good news is that the fingers, eventually, will grow back.

The Obama Administration needs to change direction and to embrace restructuring and national renewal instead of the current policy of extend and pretend. The same factors that drove Ambac into bankruptcy are working on Bank of America, Wells Fargo, JPMorganChase and will eventually force a restructuring. The sooner we start the process, the sooner the U.S. economy will recover.

Indeed, I expect that the Obama Administration will eventually, reluctantly be forced to invoke the powers under the Dodd-Frank law and restructure the top-three U.S. banks. This will be near-total losses for equity holders and haircuts for creditors, but the end result will be a solvent bank that is smaller, profitable and able to again lend.

It is important for Americans to remember that bankruptcy and liquidation are necessary steps to national renewal and economic stability. The Founders of the United States embedded bankruptcy in the U.S. Constitution for precisely this reason. The Founders knew that prolonged uncertainty and a lack of finality when it comes to insolvency was bad for society, thus they commanded Congress to create federal bankruptcy courts.

Having been through a personal restructuring a decade ago, the end result of five years of civil litigation, I do not make the recommendation of embracing restructuring lightly. But restructuring and liquidation of debt allowed me to rebuild my life. Each time that a family looses a home to foreclosure, that tragedy creates an opportunity for another family to make a fresh start. When a bank is restructured, the creditors lose money, but the bank is then able to support economic growth. And when an individual declares bankruptcy in the U.S., our Constitution provides the right for fresh start.

By speeding the process of resolving bad debts and restructuring viable companies, the U.S. courts are moving forward with the process of national renewal even though our politicians have not yet found the courage to lead the way. I suspect that this, too, is going to change and very soon. No amount of talk and obfuscation in Washington can prevent the process of liquidation underway on Main Street. Before long, the fact of renewal and restructuring at the micro level will be visible at the macro level as well, and that is good news.


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This needs to happen soon, and get interest rates back up to earn some money for savers.

Posted by 123Rock | Report as abusive

Not sure but nothing is looking good anymore.

If you are prepared you may survive,

Posted by SHTFMILITIA.COM | Report as abusive

Unfortunately the behaviour of Central Banks and their Governments worldwide have and continue to sucker in new victims to the ‘recovery’ ponzi scheme.

The fingers that will become severed will parhaps belong to retirees and their expected but substantially reduced pension payments. While the fingers will, ‘as you suggest’ grow back, the retirees will not be around to benefit.

Boy is this going to hurt.

Posted by tonydd | Report as abusive

Retirees are fine. They have DEFINED benefits that you can’t cut off. And they won’t be around to…. pay off the public sector debts.

Posted by threeRivers | Report as abusive

It would be very helpful if you posted your thoughts on what might be the signs that said restructuring was close. I’d like to know when to short these banks.

Posted by ginunn | Report as abusive

Chris, You understand the banking position but you do not seem to understand Main Street and the lack of personal income from productive enterprise.

It isn’t just the banks that are insolvent, it is the entire country in aggregate. This has come about from a long process of international corporations moving the productive jobs off shore. Lots of reasons for this but in total, there now is not enough real income from productive labor within the US to pay its bills on a personal, local, state or federal level.

Restructuring the banks is just ONE piece of a very broken puzzle. Even if they could lend, there aren’t enough qualified borrowers to pay back the entire debts we have taken on and a majority for consumption and not productive enterprise… even at 0% interest. You need to back up some and look at the entire picture.

Posted by economicminor | Report as abusive

[…] Chris Whalen: Standing on the brink — of a fresh financial start (Reuters) […]

Posted by Frontrunning: November 29 « Finance Blog | Report as abusive

I don’t normally comment on blogs.. But nice post! I just bookmarked your site

Posted by Anna | Report as abusive