Too failed to live not too big to fail

March 16, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

The U.S. policy of keeping zombie financial institutions alive is so clearly failing that it is now attracting attack from inside policymakers’ circle of covered wagons.

The most interesting intervention in the banking debate in the past few weeks was an extraordinary attack by Kansas City Federal Reserve President Thomas Hoenig on what he termed a policy of “piecemeal” nationalization which leaves discredited management in place, repels new capital from the banking system and allows bad assets to fester rather than be cleared.

This is no academic who can be dismissed as having a poor grasp of the major systemic consequences of letting the big zombies fall, this is the man who has been a Fed president for 17 years and has a deep history in banking regulation, deeper and with more practical experience arguably than the people making the policies in Washington.

“If an institution’s management has failed the test of the marketplace, these mangers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached,” Hoenig said.

In short, it’s not an ideological attack on runaway market forces but a collection of sensible practical considerations that should limit the ideologically based decisions now being made.

And be in no doubt; administration policy as laid out by Treasury Secretary Tim Geithner, Fed chief Ben Bernanke and White House economic advisor Larry Summers has as its core a fervent commitment not to take into state control large insolvent institutions, preferring instead to essentially bear the risk and the cost without having a clear line of accountability for day-to-day bank actions.

They are in essence going down the route Japan took in the 1990s, keeping banks alive and hoping they will earn their way out of the capitalization hole. And, to be fair, the yield curve in the U.S. is a lot steeper than it was in Japan, meaning that banks will earn on the difference between their funding costs and the longer-term rates they charge customers.

But there is are quite a lot of opportunity costs built into that strategy, even if it is convenient in avoiding temporary public ownership of large parts of the banking system.

These costs may only make themselves apparent in retrospect, if we find ourselves in two years time with a struggling banking system that still can’t intermediate capital effectively. More likely those costs will become uncomfortably visible in only months. Despite protestations from Citigroup and others that they are producing profits, there is a real danger that the unpredictable and ad hoc way in which banking is being bailed out scares depositors and, more to the point, bond buyers and clients into withdrawing their money, business and credit from ailing banks.

That’s how this will play out, not by the U.S. administration suddenly going all five year plan on us, but being forced to step in by events caused partly by their own inability to inspire confidence.


That is the sad irony, in many ways it’s now a pretty good time to be a bank, only you want to be one without legacy assets. Somebody should be making fat margins, what with there being less competition and a steep yield curve.

But why on earth would you commit funds to the banking system when you have no credible view on how capital will be treated by government going forward. I’d be scared witless that my equity ends up being forced into making all sorts of lousy loans for political purposes, or that as a bondholder I am ultimately forced to take equity when the losses become too big for even government, or that I face competition from some zombie with government funding and non-economic marching orders.

None of these are avoidable problems. But what we could do is deal with them quickly, share out the pain transparently and move on. And just because some of the insolvent institutions are huge doesn’t mean they can’t be handled. As it stands the incentives for banks are to be too big to fail, and to be “independent” but pliable.

Hoenig points out that the Depression-era Reconstruction Finance Corporation at one point held capital in 40 percent of all U.S. banks but because it was aggressive in writing down assets to realistic levels and turfing out failed management was able to do it without any net cost to government or taxpayers.

But for that to happen we have to write down assets to their clearing price, not prop them up so that we can pretend we all still live in 2006. If you do that, banks and the economy have a chance, capital will return, loans will be made where they make sense and growth eventually will return.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —


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It scares me that I am so often in agreement with Mr. Saft’s philosophy of taking our medicine and moving on, as this is obviously not the political direction prevelant today, and therin lies the rub.
It is getting more and more obvious that this economic problem is a political problem with one side populated with those in political power, including the corrupted and corruptible, aligned with those recieving or needing public largess, versus individuals and businesss that did not get swept up in the prosperity via debt, leverage and inflation mania of the last thirty years, and upon whom the real burden of creating prosperity through productive labor, innovation in ideas and products and resource development, falls.
Government has not only learned how to bribe us with our own money, but they are quickly learning how to leverage the future to increase the size of the bribe. One wonders if we have crossed the line where creators of prosperity are outnumbered by manipulators and recipients.

Posted by Gary Leeper | Report as abusive

James Saft is right on the mark (again). The disproportion between the gargantuan sums this administration spends on trying to save banks and the crumbs it allocates to small businesses is nothing less than shocking.

Posted by YR | Report as abusive

The term zombie financial institution is fantastic whoever coined it. There is nothing inherently wrong with the concept of nationalization if we intend to regulate the marketplace so it is friendly to competition. I’m thinking that the situation has to be really messed up to make this radical maneouver necessary. I also think folks in the know are witholding information. These are sad times. I guess all we can really do is just carry on and make the best of things. People are comforted by tangibles. You don’t worry about going hungry if there are chickens in the back. But this kind of invisible monster that is large and pervasive is pretty terrifying. So maybe we should be getting back to basics. For me this means, if the guys in suits must spend our money, they can at least give us something right now in exchange. Give me a jar of honey, bowl of cereal, anything, something. Don’t just take the cash.

Posted by Don | Report as abusive

US Fed and Treasury officials feel that throwing Money at the problem can fix it. No proper analysis was conducted to identify why Risk assessments of Banks failed and the speculative Financial Instruments that brought the Banking Industry to its knees. If the problems were correctly identified better solutions could have been applied. It was also the responsibility of the Government to incorporate covenants for usage of Bale out Funds.
Secondly if Banks are too big to fail the Government must step in to split the larger Banks into more manageable units. Also Banks need to change their staffing policies and should hire only those Finance Professionals with atleast 5 years experience in running Brick and Mortar Businesses. It is time for current lot of Investment Bankers to be pensioned so the Industry can be rebuilt on the bedrock of conservatism. Banking can no longer be irresponsible to its fiduciary obligations. To expect the Government to continue being charitable in the face of Public criticism,is being too hopeful. Too me this whole charade of Bale outs looks like a game of “blind mans bluff”.

Posted by F.Daruwala | Report as abusive

I have my doubts about this. I agree that the management of these TBTFs need to be fired in disgrace. I fear that the TARP was designed to save the Corporate Aristocracy from that embarrassment and not to “save” our economy. We are seeing the backlash as the current administration tries to put conditions on the bailout. These Zombie Corporation’s top management is spending their time trying to figure out how to get around the new rules instead of running the business at hand. Of course they do not run the business. They are the elite our corporate industry support in gracious lifestyles for little or no return on the dollar. Today those that bellied up to the TARP bar but have not taken any freebies yet are opting to not indulge because the new rules limit the compensation management can leach off the failing corporation. They should have failed and been allowed to be broken up and sold through bankruptcy proceedings. The scare tactics regarding the lost jobs was really about the upper management losing their jobs. Who ever bought up the companies would have had to hire people. The auto industry would have been the same. You don’t buy an assembly plant and not hire people to run the plant. In fact, I still think the auto industry should be allowed to fail so we can get fresh blood injected into the US auto industry. Their innovations in fuel efficiency and for getting off of foreign oil have been non-existent. In 20 years they have not improved fuel efficiency except for the hybrid which is going to be a maintenance nightmare. For the last 20 years this industry has passed over effective plug and go alternatives and I am not talking about battery driven vehicles that can only go, at best, 40 miles on a charge.

The People of the US have been scammed by Industry collusion facilitated by the Corporate Aristocracy to keep the US dependent on oil as well as to enrich themselves through greed in the housing industry where “creative” financial instruments were unceasingly pushed upon the public while Rating Institutions rated these instruments as sound investments. In no way should our tax proceeds or our national debt be used to reward these “Captains of Industry” who through their greed and arrogance failed not only their company but the American People.

Posted by B.Free | Report as abusive

There are many complex elements to financial machinations this complex and global in scope. This is a spherical challenge in both cause and possible repair and solution to the losses. The truth is illegal instruments were sold to the rest of the world in an overt fraud; and to what end: our economy has been damaged; but look at the Euro, look at the Pound, these great nations have also been severely damaged by this shameful practice of selling valuless derivitives. This is a case of financial snake oil, pushed on the world by slick salesmen. In order to deduce the truth, look at who is prosecuted; many of these people will never see an open Court of Law.

That reveals a painfully obvious conclusion.

Look at Iceland. I truly hope that the very smart people in charge right now can stop the bleeding, and right the course of this country. This is the United States. The american people will take alot and they will turn the other cheek. But they will draw the line at the complete destruction of the american way of life.

They will rise.

Posted by phoenix1 | Report as abusive

I have enjoyed reading through the comments. I knew we had smart people out there that see it right. Too bad they aren’t our elected officials.

Posted by wupta | Report as abusive

As long as cabinet level posts and their underlings are filled with people like Hank Paulson and his role in securing TARP, which his former employer Goldman Sachs benefited from handsomely, the questions of conflicts of interest will remain. The notion that players from industry need to be the ones in charge of government oversight is flawed.

Clearly Big Business did not do what was good for business. Neither did government or it’s regulators. For all the success we have had, we could have done just as well by pulling names out of a hat. What is more disturbing is each successive administration recycles the same group of people to fill regulatory posts.

It is probably high time for some new blood. We have ignored the academic community for decades regarding climate change, health care and host of other concerns facing civilization. So far they have been right. It is academia that educates our leaders and the very least they present a greater diversity of thought than the same old group thinkers and cronies who have lead our nation for decades. Their voices should be heard. S should that of the common man.

It is becoming painfully apparent that appointments to government are less and less viewed as opportunities to serve and have become positions of privilege for the ruling elite. If you believe I am suggesting we are becoming a banana republic, I urge you to draw your own conclusions.

Ultimately the fate of any society rests with the people and not it’s leaders. Our society must get past it’s dogmatic divisions and unite around the issues that beg for the collapse of civilization.

Posted by Anubis | Report as abusive

I think it was John Lennon who best described the current feeling of many Americans.

Help, I need somebody
Help, not just anybody
Help, you know, I need someone

Posted by Mick McCall | Report as abusive

There is obviously an opportunity here for new banks to form. The only difficulty will be extracting the value out of the failing banks so that this can be injected into the new entities and leave the sick carcasses behind with their ailments.

Where is the new wave of entrepreneurs who could pull this together? Or has the recent climate stifled all forms of enterprise and leadership?

Posted by Cornelius Nienaber | Report as abusive

Hi: I for one believe the Zombies have to fall. Thats how the US has always operated. Let the weak fail and the rest grow stronger as we did in the Airline Industry and others.

One radical thought though – After finding what AIG did with their money. Why not cancel all the CDS deals outright and only honor those where the buyer/seller has a genuine exposure and was not a punter. This way the guys who had exposure and bought the CDS cover is covered and the guy who bought the CDS – cover on the neighbours house and burnt it down and claimed insurance is penalised. Though dont know how far this is legally permissible..but what the heck.. change the law.


Posted by Athoo | Report as abusive

Some excellent comments…. just picking up on the retention of discredited management, it makes me shudder when I hear so called banking “elders” stating that bonuses need to be paid otherwise top staff, their decision makers, would leave and go elesewhere; surely that is what is required, let them leave, realise what they have caused outside their greed bubble and join the job seekers.
You don’t rebuild with the same bricks that have already failed.

Posted by Jonesy | Report as abusive

If I take pain killers to shield myself of the pain, I run the risk of starting to believe that I am ok when in fact I am just masking the advice my body is giving me to stop doing whatever originated the pain in the first instance. After all these pain killers (cash injections on a gargantuan level) the pain will come back and will be much worse as we will have believed that it had gone away and started doing those things that brought it about in the first place. If a building is collapsing, you take all the people out and let it finish collapsing or even better aid it by pushing it down and leaving space for a new one to be built. Same thing happens in forrests when a big tree falls.

Posted by Robbie | Report as abusive

There might be solace in punishing the entities causing this situation but really folks do you think we have time to organically create whole new institutions replacing those that have roots aeons deep? To instantly clone relationships that survived and prospered while on opposite sides of two world wars. Would be nice, but the notion is infantile. We need to learn, with the collapse of religious morality, there will be very little internal restraint within organizations, this year’s plan is the sole mantra. Ethics are optional. Better I think we become better lion tamers or husbands of whatever particular species you are using. Do not however waste effort in expecting the animals to clean up their act…
Oh, when lion tamers get eaten is it the lions’ fault?

Posted by Crikey McGregor | Report as abusive

I have yet to see discussion of the 800 LB gorilla, namely the displacement of sustaining manufacturing, goods and services in the developed world, to the BRIC nations. The collapse of ’our’ institutions is a sympton and, regardless of the media witch-hunt, only a symptom. All that we had in the Western Democracies we have now duplicated elsewhere at a staggering level of redundancy. Of course each of the BRIC nations have a right to grow their economy I just cannot get my head around the notion we have them do so by giving them ours. Seems China just happened overnight? Not a pennyworth of thought went into this at our end until it was too late.
More simply put: my mortgage with you would not be toxic if I still had my job!

Posted by Crikey McGregor | Report as abusive

Good article except the part about returning to growth. There are already 6 billion people on the planet and we are entering peak oil. The world is huge but it is still limited therefore a model based on never ending growth is guaranteed to fail eventually.

Posted by Joe | Report as abusive

We are simply trying to reinflate the growth bubble. Mr. Saft, you are correct again. Pumping printed dollars into financial institutions in order to keep assets valuation up near 2005/2006 levels sounds like a modest loss people could live with. Reality couldn’t be further from the truth. These types of policy measures seem at best desperate if not deceptive.

It is clear that corruption and greed are pervade the entire U.S. political/economic system. The U.S. government’s response was initially to make whole (indemnify) the victims of our unregulated business arrangements abroad. This has restored a good deal of confidence around the globe. However, Wen Jiabao has certainly made his concerns regarding U.S. credit worthiness public amidst the backdrop of public anger by U.S. taxpayers responsible for footing the cost of filling a seemingly bottomless pit with dollars.

Karl Marx’s observations on the banking system couldn’t be more contemporary. The lessons we could learn are being ignored by the elite in favor of maintaining the Dollar as the world’s reserve currency and the dubious benefits that accompany that. It is clear to me our government wants to return to the path of inflation, the vehicle with which wealth is stolen from a society. Just look around, how many cannot afford to go movies , eat out, buy clothing, new automobiles or simply repair them. How many lost their homes and now live in tent cities? The economic model of perpetual growth is unsustainable.

Posted by Anubis | Report as abusive