Opinion

The Great Debate

First 100 Days: Fix the banks

January 23, 2009

morici– Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. The views expressed are his own. —

For every new president, campaign promises and inaugural idealism must give way to the hard choices that measure the mettle of their leadership.

Now Barack Obama must act pragmatically to fix the banks or the economy will sink under their weight.

Banks continue to suffer losses on bonds backed by failing mortgages, credit cards and auto loans, and questionable corporate debt. To assist, the Treasury has used TARP funds to purchase capital in healthy and deeply troubled banks alike; however, no one can calibrate how high bank losses will go, because no one knows how far housing prices will drop and how many loans will ultimately fail.

The Obama Treasury could put a floor under bank losses, through government guarantees on their bonds, or by creating an aggregator bank that purchases those securities from banks altogether.

Guarantees would give the banks profits on bonds whose underlying loans are mostly repaid, and shift to taxpayers losses from those bonds whose loans are mostly not repaid. That would require additional large subsidies from taxpayer to the banks.

An aggregator bank, however, could turn a profit. It could purchase all the commercial banks’ potentially questionable securities, at their current mark to market values, with its own common stock and funds provided by the TARP. Then the aggregator bank could balance profits on those securities whose loans pan out against losses on securities whose loans fail.

An aggregator bank could perform triage on mortgages. It could work out those whose homes can be saved with some adjustments in their loan balances, interest rates and repayment periods; foreclose on mortgages for homeowners who could not meet payments with reasonably concessions; and leave other loans alone.

Commercial banks acting alone cannot accomplish triage as effectively, because individually they can have little effect on how much housing values will fall. In contrast an aggregator bank, holding so many mortgages and working in cooperation with Fannie Mae and Freddie Mac, could have a salutary impact on housing values. It could put some breaks on falling home prices.

Beyond toxic securities, policymakers need to fix what got banks into this mess. The 1999 repeal of Glass-Steagall permitted the creation of financial supermarkets, like Citigroup, that combined commercial banks with investment banks, brokerages, and the bizarre universe of hedge and private equity funds.

Those nonbank financial firms are run by salesmen and financial engineers that don’t understand long-term commitments as bankers to borrowers with solid incomes and sound business plans.

Investment bankers, securities dealers and fund managers, essentially, get paid commissions on sales and for betting other peoples’ money on arbitrage opportunities. They put together people that have money with those that need money, and those people that can’t bear risk with those that can.

In contrast, commercial bankers, historically, had skin in the game—bank capital and a fiduciary responsibility to depositors. They were paid salaries, not commissions on the volume of loans they wrote or bought from mortgage brokers to package into bonds. They expected to be fired if their loans prove imprudent.

To investment bankers and securities dealers, it does not matter how risky a loan is, because they can always bundle it into a bond to sell it off or insure it with a swap. That’s nonsense, as we have learned. Adopting that thinking commercial banks got stuck with too many loan-backed bonds and buying swaps that were not backed by adequate assets.

Commercial banks need to be separate and more highly regulated. The ongoing process of breaking up Citigroup and placing its banking activities into a separate entity should be replicated at other Wall Street and large regional banks.

Freed from toxic assets and the complications of affiliations with financial institutions having other agendas, commercial banks could raise new private capital and make new prudent loans as President Obama’s stimulus package lifts consumer spending and business prospects.

Such approaches would disappoint those who champion unbridled free markets but Wall Street’s financiers have abused the opportunities offered them by deregulation to the peril of the nation.

President Obama needs to craft solutions that address the world as he finds it not as intellectuals tell him it should be.

Comments
4 comments so far | RSS Comments RSS

Bill Clinton signed the 1999 repeal of Glass-Steagall due to his dubious ties with America’s big banks. Therefore, he bears a huge responsibility in the current financial meltdown. He should be investigated for it. Of course, that will not happen.

Posted by Immanuel Toledano | Report as abusive
 

Before fixing the banks, the bankers should be “fixed.”
Bankers do not take risks; they only underwrite risks. Those, who take risks, are not bankers, and it follows that they should not be employed by banks.
Bankers use prudent judgment – they are not driven by greed.
Bankers should submit to tests of competency as doctors, lawyers, CPA’s do, and held to the highest standards of competence and integrity, and be held responsible for acts of incompetence and malpractice.
Bankers should submit annual personal financial statements to their supervisory authorities.

 

That’s not a bad idea Ugo…They should be held to even higher standards as it is not their money they are risking or gambling away, but an actual person’s life savings perhaps;that cannot be looked at or treated as a piece of paper. I think it’s safe to say that the careless and greedy Wall Street bankers will not survive once this is all over with and we have set new rules, regulations and boundaries. Also the CEO’s of large corporations and their pay, accountability and responsibility is in dire need of being addressed.

Posted by Damian Palmares | Report as abusive
 

I have always liked the idea of a “bad Bank” to clear off the balance sheets. I even suggest such somewhere else on these pages. The only thing that I would add is that the bank should make its acquisitions by auction. Secondary to that is to make sure that the new value flows through to the borrower and perhaps have a special capital gains tax if recapture, even progressively, any potential increase in values.

Posted by Glen | Report as abusive
 

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