– Jonathan Ford is a Reuters columnist. The views expressed are his own –

Goldman Sachs wants to do its duty by the American people and give them their TARP money back. Some spoilsports have urged the government simply to say no because allowing the investment bank to repay the cash would make other banks look bad.

But this seems rather un-American. Why shouldn’t taxpayers get their money back if Goldman really doesn’t need it? The point to insist upon is that they get all of it back — and on commercial terms.

To be clear, that means not just the $10 billion of TARP-related preference shares the government subscribed for last autumn, but also the rest of the Federal assistance Goldman has received.

That includes the $29 billion of FDIC backed bonds that Goldman has issued at low coupons, without which — as Jon Unia observes in a snappy letter to the Financial Times on April 22 — it might have posted a first-quarter loss rather than a profit. Goldman has, as it points out, issued bonds without a guarantee since last autumn, so it’s not impossible. The full $29 billion would need to be refinanced on commercial terms. After all, either you’re a private sector player or you’re not.

Unia also observes that if Goldman wants to prepay the prefs, it should be charged by the taxpayer for the temporary loan of the Federal balance sheet. This, after all, is what a commercial lender like Goldman would do if the boot was on the other foot.

There is even a mechanism for it to happen. As part of any pref repayment, Goldman could be obliged to buy out the warrants it issued to the Treasury at the same time as the prefs at a price negotiated between the two. This payment could be the prepayment premium.

My suggestion would be that in any such negotiation Treasury Secretary Tim Geithner should select a Rottweiler of an adviser to act on the taxpayers’ behalf — one who could not be accused of being in Goldman’s pocket. Who could fill that role? How about Dick Fuld?

– James Saft is a Reuters columnist. The opinions expressed are his own

Treasury Secretary Geithner is all but admitting that U.S. banks are suffering not from market failure but self-inflicted collateral damage.

The U.S. Treasury on Monday detailed an up to $1 trillion plan to buy up assets from banks in partnership with private investors, using financing bankrolled by the government, financing that is only secured by the value of the doubtful assets the fund buys.

One portion will be dedicated to buying complex securities from banks employing capital contributed by private investors and the government topped up with funds borrowed from the Federal Reserve. A second portion will buy older securities that are, or were, rated AAA, using, you guessed it, more non-recourse funding.

But most interesting of all is a plan to buy whole loans, dubbed “legacy loans”, from banks but this time the private-public subsidized vehicle will get its leverage courtesy of Federal Deposit Insurance Corporation-guaranteed debt.

Notice that the ground has shifted subtly and the government is now talking not just about “toxic” assets but “legacy” ones. A legacy asset is, more or less, everything real estate related now on bank balance sheets.

These loans are not marked to market they are held to maturity, so no blaming the market here. They are nothing more than doubtful loans in the process of going bad as the economy implodes and the real estate they are collateralized with drops in value.

There is an almighty bust in the U.S. real estate market and it is blowing holes in bank balance sheets having nothing to do with securitizations.

It rather undercuts the argument that was advanced about earlier subsidy plans, that there was a “market failure” leading to hard-to-value complex securities being priced by the market at too little, below their fair “held-to-maturity” value.

The only uncertainty around a whole loan is whether the debtor will pay back the loan and, if not, what the collateral is worth. So there is no more deception about liquidity, market failure or anything else, only a naked subsidy to the banking industry, using the private sector as a pricing mechanism and cutting them in on the deal in exchange.

DEFINITION OF PRIVILEGE
So, will it work, and if it does how will this step influence the way banking functions down the road? Depends on what you mean by work, but it will doubtless take a tranche of lousy assets off of banks.

But as for creating confidence, I can’t see it. Firstly, investors will twig to the idea that the balance sheet issues are deep, and secondly, now that we are talking whole loans I think it’s clear that the $1 trillion is only a down payment.

That means the administration will need Congress to play along and fund another wodge of subsidy. That may be a tough sell, especially considering that the administration has bent over backward to keep Congress out of the funding loop, using the Federal Reserve and FDIC as funding mechanisms and thereby effectively arrogating the funding powers Congress is supposed to hold.

The plan also hugely encourages moral hazard, as it leaves too big and too failed companies, boards and executives in place while providing them with a chance to climb out of the holes they have dug themselves. Not much of a lesson in accountability.

Writing in the Wall Street Journal, Secretary Geithner said the U.S. must strike a balance between promoting public trust and spending taxpayer cash to get the banking system functioning.

“This requires those in the private sector to remember that government assistance is a privilege, not a right. When financial institutions come to us for direct financial assistance, our government has a responsibility to ensure these funds are deployed to expand the flow of credit to the economy, not to enrich executives or shareholders,” he wrote.

It is just astounding that he even sees the need to remind us that free government money is not a right, and reveals much about the balance of power between him and those seeking handouts. And you simply can’t give a subsidy without enriching executives or shareholders, you can only hope not to do it too obviously.

Finally, don’t even begin to believe that concerns about government interference will leave the U.S. with few well qualified asset managers willing to commit their capital to the plan. New York and Connecticut are stuffed to the gills with asset managers who would crawl naked over hot coals to get access to cheap, non-recourse, long-term funding from the government.

That there are suggestions to the contrary is simply an attempt to try and influence the debate about government control over compensation at firms which accept taxpayer largess. A smokescreen within a smokescreen.

– 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 –

– James Saft is a Reuters columnist. The opinions expressed are his own –

Rather than vainly trying to refloat the shadow banking system, the U.S. would be better off grappling with the inevitable ultimate solution — debt destruction and inflation.

The common denominator of policies like the Term Asset-Backed Loan Facility (TALF) that was detailed on Tuesday, is that they try to solve fundamental problems with indebtedness by attempting to float asset prices high enough that they are back in proportion with the debt.

Even more, they use the same structures that worked out so poorly — highly levered hedge fund like vehicles and securitisation — but this time substitute government funding and leaves the taxpayer as main bag-holder if the deals go bad.

With up to $1 trillion, the TALF is designed to re-start parts of the securitization market such as auto, business and student loans. This followed the plan to avoid foreclosures and further house price falls by cutting borrowers, many of whom made silly borrowing decisions, a break on their interest rates.

Next up: a public-private plan to buy up toxic legacy assets from banks, which should be detailed in the next two weeks. Again, that program will provide government money at sub-market rates to investors to entice them to pay more than the market price for assets that would otherwise sink many banks.

The higher the leverage supplied the higher the price hedge funds and other investors will pay for doubtful assets. After all, like a Florida condo flipper, if the asset declines in value they can just walk away and throw the metaphorical keys at the Federal Reserve and U.S. Treasury.

“We want to make sure that the prices of the assets that are purchased reflect true market values that are not overpaid. So the idea between the public-private partnership would be that there would be both public and private money involved and that the pricing decisions would be made by private-sector specialists, not by public bureaucrats,” Fed Chairman Ben Bernanke told Congress on Tuesday.

“If the government is willing to provide longer-term lending, or leverage, there are many investors who presumably would be willing to buy under those circumstances who are unwilling to buy without the credit, without the lending they need to finance those purchases.”

I simply cannot reconcile the first part of that statement with the second. What do we mean by “market values” in a situation where the government provides financing not otherwise available? Vary the leverage and achieve any price you like.

LIVING IN A CASH FLOW WORLD

The TALF is slightly more defensible. There is a market failure when reasonably good credits can’t raise money under any circumstances. But before we try to re-start securitization and the shadow banking system, let’s recall what the problems were in the first place. For one thing the TALF relies upon imprimaturs from the credit ratings agencies which have been found wanting. That’s not yet changed, but government participation simply papers it over.

Even the obsession with banks almost seems beside the point.

“You won’t revive the economy through debt,” said Albert Edwards, global strategist in London at Societe Generale.

“Banks aren’t the problem, they are a symptom of the problem.”

The problem is that asset prices are out of line with their ability to generate cash flow. Falling prices do impose a risk premium but the real issue, for stocks or for houses, is that their prices are not in the proper proportion to the debts they carry and to their ability to generate cash. That happened in part because of the shadow banking system and was a mistake.

So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.

University of Oregon economics professor Tim Duy thinks the U.S. will ultimately end its romance with financial engineering and get down to working through unsupportable debt the old-fashioned way — inflation.

“And therein lies the key to predicting when the Fed shifts gears; When Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth,” Duy writes.

“At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities.”

That is a dangerous and difficult to govern process, and the U.S. shows every sign of being willing to pay a very high price to avoid it.

But ultimately, the price will be too great and we will have to inflate and default in some mixture.

– 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. –

– Paul Taylor is a Reuters columnist. The opinions expressed are his own –

It works more like a sprinkler than a power hose, but the European Investment Bank has a role to play in preventing a financial inferno from sweeping across central and eastern Europe.

The trouble is that politicians have overloaded the European Union’s long-term lending arm with exaggerated expectations, calling on it like a fire brigade in every emergency, from saving credit-starved small firms to greening the car industry, combating the energy crisis and fighting climate change.

The need to serve many masters and focus on many priorities limits its impact, but the EIB now has more resources to back economic stimulus programs in the 27-nation bloc.

Philippe Maystadt, president of the Luxembourg-based bank, has received so many pleas for billions since the credit crisis struck that he starts by listing what the EIB cannot do.

It is not a central bank. It cannot provide liquidity. It cannot take equity stakes in banks and it cannot fund budgets. Its role is to finance investment projects that are aligned with the 27-nation EU’s policy objectives.

“What we can do is provide finance as intensely and rapidly as possible for investment. That’s what we’re doing (and) we aim to do more, better and faster,” Maystadt, a former Belgian finance minister, said in an interview.

The EIB plans to lend more than 7.5 billion euros to small and medium-size enterprises and local authorities in central and eastern Europe this year through local intermediary banks. That is three times last year’s volume, and on more flexible terms.

The bank has a triple-A credit rating because it is owned and backed by the EU’s solvent sovereign governments. So it borrows at cheap rates and lends the money on the same terms to clients who would otherwise have to pay far more to borrow.

Firms may now use the cash as working capital, for research and development and to buy patents and not just to buy goods.

The EIB is also working to address the special problems of eastern Europe. From Warsaw to Kiev, floating currencies have sunk against the euro, punishing hard-currency borrowers, while governments are struggling to raise funds as capital flows from parent banks in western Europe to eastern subsidiaries dwindle.

With the European Bank for Reconstruction and Development (EBRD) and the World Bank’s International Finance Corporation (IFC), Maystadt is looking to support banks in eastern Europe.

“For example one could imagine combining equity stakes from the EBRD with bigger credit lines provided by the EIB, using the specific instruments of each institution in a coordinated way to increase efficiency. If the EBRD comes in to reinforce a bank’s capital, it means we can lend more to that bank,” he said.

EU finance ministers agreed in December to raise the EIB’s capital by 67 billion euros to 232 billion euros so it can boost lending by 30 percent this year and in 2010 to help economic recovery. That is a stretch for the bank’s 1,400 staff.

The extra 15 billion euros a year will be targeted at SMEs, fighting climate change and speeding disbursements for projects in the new member states in central and eastern Europe.

Under EU rules, national governments or local authorities have to finance 35 percent of EIB-backed projects. The newcomers often lack the funds, especially during the credit crunch, so the EIB is also helping fund the local share.

However, the obligation to be even-handed among EU member states makes it hard to concentrate a large amount of lending on a few priorities or countries.

“It’s true we are an EU institution, so we have to work for all member states and our interventions have to be well balanced,” Maystadt said.

So far, the EIB has had no trouble borrowing on capital markets, but things could get tighter and more expensive as the bank raises its extra funds just as governments are tapping the market massively to finance national recovery plans.

That raises the question of whether the EIB could borrow from the European Central Bank, which is not allowed to lend money directly to member states.

“This question hasn’t yet been posed,” Maystadt said. “For the moment we don’t call on the ECB. It’s a question that would have to be examined with the ECB. That hasn’t yet been done.”

Pressed to say whether the idea was topical, he laughed and fell silent.

– James Saft is a Reuters columnist. The opinions expressed are his own. –

U.S. plans for a public-private fund to buy up toxic assets are likely to amount to a fig leaf with which to hide subsidies to failing banks.

It is also, inevitably, an entirely new subsidy to outside investors, who by definition will only participate if they get better terms than now available in what we formerly thought of as the free market.

Treasury Secretary Tim Geithner last week announced the plan, which will provide between $500 billion and $1 trillion of financing to private sector funds which will use the money to lever up their own capital and make offers for complex and doubtful securities now clogging balance sheets. Further details are to follow.

But it’s likely the plan won’t work, if by work we mean come up with a believable price for these assets.

Banks won’t sell at market prices because to do so would make many fall over bankrupt. The U.S. can surely manipulate prices by providing cheap and plentiful leverage - sound familiar? - but that will be seen for what it is; a subsidy for the funds and the banks rather than a firm base to allow confidence to return.

As it is, there’s a standoff in markets as to how to price these assets. For the sake of illustration, let’s pretend that banks have a security marked on their books at 90 cents on the dollar, while similar securities change hands at 60 or 65 cents when bought and sold in arms length transactions.

The first thing to recognize is why the market and bank prices are so far apart for these assets, many of which are tied to real estate or consumer loans. It partly reflects uncertainty about how the underlying loans will perform given the poor economic outlook. But it also reflects the potential that assets will get cheaper still, that banks will become forced sellers later and so why commit your capital now as prices may well fall when banks disgorge.

It finally and powerfully reflects the fact that there is very, very little secure term funding at a reasonable price available with which to buy this stuff. That means you have to be a cash buyer with a long time horizon, meaning the return has to be pretty juicy.

The banks have a partly legitimate beef with what they see as a market failure and partly are applying self-serving valuations in order to avoid going bust. The assets may throw off more income than implied by market prices, in other words those returns to cash buyers may be a bit rich, but on the other hand these high carrying prices are very convenient for the banks which would fail if market prices were applied.

BETTER THAN PAULSON BUT STILL FLAWED

The earlier Paulson held-to-maturity plan was aimed at buying up these loans at higher than market prices, the justification being that there was a market failure and the government would actually make a “profit” on the deal.

That plan failed while the new one hopes to use private investors to set prices, thus justifying the numbers. It will avoid some issues, lessening the chances that banks just fork over the worst loans or that the auction is corrupt, but it won’t achieve a market price.

Imagine for a moment that you are a hedge fund manager and in your subjective view a security now held by a bank will generate a return of five percent over its lifetime at the price at which the bank is willing to sell. No deal.

But if the Treasury will lend you eight times your capital for five years at 2 percent, well then that works pretty nicely, at least from the hedge fund’s point of view.

Competition between funds for access to the leverage can improve the outcome for the taxpayer, but banks have to be willing to sell and won’t do it if it drives them under. The U.S. can and I fear will simply increase the amount of leverage it will give relative to capital until the returns to the funds are good enough to justify them buying the asset for a price that keeps the banks magically solvent.

Sound familiar? It should because that kind of leveraged speculation is everyone was doing until the summer of 2007. Only then they were doing it with money borrowed from banks, now they are doing it with taxpayer money. Actually, in retrospect it always was taxpayer money.

So, it’s a bit better than the Paulson plan, and maybe we want to spread subsidies across funds and banks to help soothe the problem. But will it work to restore faith in banks? I am not sure it is enough money to do that without getting a multiplying effect from the rest of us believing the prices. If the result appears to be fixed, that won’t happen.

– 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. For previous columns, click here. –

The U.S. Treasury Department on Tuesday unveiled a revamped financial rescue plan to cleanse up to $500 billion in spoiled assets from banks’ books and support $1 trillion in new lending through an expanded Federal Reserve program. But initial market reaction reflected investors’ doubts about the plan, with stocks falling around 3 percent after the announcement by Treasury Secretary Timothy Geithner.

“For all the rhetoric that this is a new plan, they’ve done nothing but rehash and expand the old procedures,” said Steven Ricchiuto, chief economist at Mizuho Securities USA.

Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York, said details of a proposed public-private investment fund for mopping up toxic bank assets were “very vague”.

“It sounds like for this public-private investment fund they are still exploring a range of different structures for the program or seeking input from market participants,” he said. “That’s the the kind of stuff we heard on TARP One and suggests that given all this time they still don’t have anything very specific nailed down.”

James Ellman, president of Seacliff Capital in San Francisco, criticized the proposals. “Investors want clarity, simplicity, and resolution. This plan is seen as convoluted, obfuscating, and clouded. We know that Geithner was able to overrule many other Obama administration people, and said we should not be tough on bank equity holders or bank management. So equity holders got a better deal, and it’s still not a good deal.”

Do you have confidence in Geithner’s plans? Debate the announcement below. We’ll update this post with fresh comments from analysts and other market participants as we get them.

– James Saft is a Reuters columnist. The opinions expressed are his own –

Why not just play by the existing rules and rescue the economy, rather than the banks and their foolish shareholders and counterparties?

The choice for the Obama administration comes down to this: pay a subsidy to weak banks and reward failure and self-dealing or shut them down and start over again.

Because it doesn’t want to run the banks, and who can blame it, my bet is that the U.S. government will go the subsidy route, but it would be wrong.

A better idea is nationalization of the banks that can’t function combined with fresh capital for lending, perhaps in new institutions or newly managed ones built from the wreckage of the failed.
As Nobel prize winning economist Joseph Stiglitz points out, the United States has an existing process to deal with failed banks.

“You have to have a certain amount of capital and if you don’t have enough capital you are going to be shut down. We have a legal framework and we should use that legal framework,” he said in an interview on Saturday at the World Economic Forum in Davos.

“What you need to do is carve out the narrowest thing that you need to carve out to preserve the payment mechanism. We are engaged in re-writing the rules and the question is: ‘For whose benefit?’”

Both bondholders and derivative counterparties — people who entered into a contract with a bank for payment if certain external things happened, such as the default of a third party — look to be the big winners in preserving the existing banks.

I would also be very interested to see where the cash from bailouts of banks and their complex international obligations flows. It seems to me pretty possible that in rescuing banks, you are bailing out their derivative counterparties, channeling cash to many people and institutions who were speculating, who took risks on the strength of the bank counterparties they were using but who had no contract with the U.S. government for these risks to be insured.

Many of them inevitably will be abroad and some may be unsavory. The political fallout could be huge.

The argument in favor of this particular bailout is that, as we saw in the aftermath of the Lehman failure, the knock on effect will magnify the impact of the crisis. But really, this is about how you want to take your pain, and who will bear it rather than how much.

NOT BAD BANKS BUT DEAD BANKS

And it’s not just that wiping out failed institutions would be fairer, it would also be more successful. So long as house prices are falling, efforts to prop up banks through insurance will very likely be swamped by future losses.

Let the FDIC or Federal Reserve take over the weak and even, as Stiglitz has proposed, take a big chunk of the money you would otherwise spend and use it to capitalize a new bank or several new banks with clean balance sheets. Those banks could take $150 billion or so and leverage it very easily but conservatively, thus allowing for more than a trillion of new credit. Keep management at arm’s length from government and sell it back to the private sector in three years or so. They won’t be best banks the world has ever known, but they will beat the ones we have now hollow.

In the meantime the bad assets of failed banks could be managed separately, in much the same way the Resolution Trust did with assets of failed savings and loans.

There is also an elegance in the barbell proposal of Nassim Nicholas Taleb, the author of “The Black Swan: The Impact of the Highly Improbable,” to nationalize the banks, limiting them to utility functions like payments and simple deposits, but twin them with an utterly unregulated sector with no recourse to government insurance or support of any kind.

“They rigged the game. We pay them for their profits, there is no clawback so their incentive is to hide the risk they are taking,” he said in an interview in Davos.

“Which is why eventually, (speaking) as someone who loves free markets, a total nationalization of the part of the business that requires insurance and does clearing and payments needs to happen.
“I am angry with U.S. policy. What we had is exactly the opposite of socialism, they got TARP to pay their bonuses and to take more risk.”

It is true that if you let large banks go down and don’t bail out their counterparties many other banks may fail, including banks outside the United States. Mitigating that –  and that’s the best we can hope for — will take coordination, but those failures don’t change the basic issue.

Who has a call on the resources of the state and whose claims should take priority? I don’t think it ought to be derivative speculators, shareholders or bondholders. Get in line.

– 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. For previous columns by James Saft, click here.  –

– Mark T. Williams, a professor in the Boston University School of Management’s Finance & Economics Department, was a former Federal Reserve bank examiner in San Francisco and Boston. The views expressed are his own. –

Washington is doling out more than $1 trillion to banks, a hefty capital commitment putting taxpayer money at risk. Meantime, Congress is moving to expand financial sector oversight and the Federal Reserve Bank is likely to take on this additional duty.

As the government’s financial involvement increases, the Fed must be ready for this expanded role. Unfortunately, the current fleet of Fed examiners is in way over their heads. I should know: I used to be one.

The root cause of the financial crisis has been bank driven. Under the Fed’s watch, Wall Street wizards were allowed to concoct, sell and speculate on risky credit-related products. In addition to monetary policy, the Fed has an important duty to maintain a safe and sound banking system. Although this supervisory role is well understood, banks still overdosed on risk — not overnight but over time. This significant risk trend was missed by the Fed and its examination force.

In maintaining safety and soundness, bank examiners are the first line of defense. They are the foot soldiers, the Fed’s eyes and ears. The examination process includes physical sampling, on-site visits, and executive interviews, culminating in a formalized bank rating and written report. These ratings are an important risk measurement and provide a bank’s financial health scorecard. The Fed does not make these ratings public but uses these to assemble lists of the weaker banks that need further attention and oversight.

Data from bank examination reports are also used to evaluate longer-term risk trends on a local, regional, and national basis. As the Fed conducted on-site examinations, it is difficult to imagine how they missed this growing credit storm. The Fed could have quickly put the brakes on risky lending practices, reduced the number of bank failures and better protected the financial strength of this vital industry.

The Fed missed spotting the risk because many of its field examiners lacked the needed sophistication, training and measurement tools. While the bets being placed by regulated banks grew in size and complexity, Fed examiners were ill-equipped to adequately measure, monitor and report on these risks.

This growing gap in examiner knowledge and skills provided greater opportunity for banks, armed with generous bonus plans and sophisticated models, to overindulge in risk.

The banking industry continues to consolidate. In the last 25 years, the number of U.S. commercial banks has declined from over 14,000 to approximately 7,300. This significant trend has caused greater concentration of risk as more assets are being controlled by fewer banks. One botched Fed examination at a major bank can have much more far reaching implications than just 20 years ago. In addition, recent strategic miss-steps by major banks, such as Citigroup and Bank of America, have obliged more day-to-day surveillance and stressed an already wobbly examination force.

The on-going financial crisis has also forced investment banks, such as Goldman Sachs and Morgan Stanley, to adopt commercial banking status. As a result, the Fed now has a new type of “risk-taking” animal to tame and put under regulatory oversight. Unlike commercial banking, investment banks historically have taken more risk and used more leverage in seeking profits. The Fed must quickly and thoughtfully retool its examiner force so it can better carry out the critical role of maintaining a safe and sound banking system.

With significant taxpayer money on the line and more slated to be released, Fed examiners in today’s marketplace must better protect our investment as well as keep banks from inflicting financial harm to themselves and to the broader economy.

To upgrade Fed examiner capabilities, there are four critical areas which needs fixing:

1. The Fed must immediately hire more specialized bank examiners to provide better risk training and establish adequate incentives so the best will be encouraged to stay.

Fed examiners need to show a strong aptitude and understanding of the risk-taking activities which now drive bank earnings. The Fed should hire from the very institutions it regulates. In the last decade, the flow of hiring has been primarily from the Fed to such banks, which has further eroded the strength of the national examination force. In addition, adequate incentive systems need to be put in place to minimize the brain drain and insure that the best examiners have financial incentives to stay.

2. The Fed must tighten regulation and leverage-ratio requirements of investment bank-related activities.

Recent financial losses, including such high profile bankruptcies as Lehman Brothers, the shot-gun marriage of Bear Stearns to J.P. Morgan, and the continued financial harm inflicted by Bank of America’s ill-conceived acquisition of Merrill Lynch division, reinforce the danger of using excessive leverage. The Fed needs to re-examine its position on what is acceptable leverage and provide clear policy.

3. Compensation schemes at commercial and stand-alone investment banks must be re-evaluated with tighter oversight and linkage to overall ratings.

Bank-derived compensation systems can reinforce good as well as destructive behavior. The Fed should take a more active role in better identifying when incentive systems are positively aligned or when they encourage excessive risk taking.

4. The Fed must provide tighter regulation oversight on bank prime-broker operations.

Many commercial banks offer prime-brokerage lending services to unregulated, high-risk hedge funds. Up until recently, this business segment has grown substantially. There are more than 6,500 hedge funds in the U.S. that control more than $1.2 trillion. A bank can only be as strong as its customers. Given that the hedge-fund industry is looking shakier every day, the Fed must strengthen its expertise in regulating and tightening up lending standards in the prime-brokerage areas of its member banks.

By focusing on these four areas, stronger Fed examination staff and oversight will strengthen our banking system and go a long way toward protecting your $1 trillion bet.

– John Kemp is a Reuters columnist. The views expressed are his own –

The international system of bank regulation, epitomised by the Basle II process and the light-touch principles-based regulation of Britain’s Financial Services Authority (FSA) has comprehensively failed.

In too many instances, light-touch principles-based regulation with an emphasis on banks’ internal risk controls turned out to be no effective regulation at all.

Former Fed Chairman Alan Greenspan was the most prominent proponent of this approach, which relied on the profit-maximising self interest of financial institutions to limit risk-taking to prudent levels.

In this view, bank leaders themselves could be relied upon to manage their institutions prudently — after all bankruptcy is not in the interest of shareholders. Previous bank failures (such as Barings) were the result of failure to measure risks properly, or failures of internal communication and control.

So the job of regulators was to set out principles and ensure banking institutions had adequate internal systems and controls, then allow senior management to ensure the overall level of risk was prudent.

This reliance on internal risk-management systems has proved to be a huge error. As Greenspan himself noted recently, bank leaders had not acted in the careful manner he had expected when he pushed for them to be freed from the old, more restrictive regime.

As a result, credit control will be much more intrusive in future. As noted in a companion column, there is renewed interest in some form of overall credit policy to limit the quantity of credit (and debt) within the economy and ensure it is consistent with macroeconomic stability.

But intensive contra-cyclical credit controls will only work if they are imposed on a broad range of institutions and on a worldwide basis — otherwise the banking system will arbitrage between regulators, and business will be booked in the jurisdiction with the “lightest touch”.

This is precisely what happened in the last decade, when the FSA, and the Commodity Futures Trading Commission (CFTC) in the United States, arguably led a race to the bottom among regulators to offer the most generous regime in the hope of creating a competitive advantage for their home jurisdiction and winning more business.

So any new credit control instruments will need to be implemented on a multilateral basis and agreed through the Basle Committee on Banking Supervision, in tandem with the Madrid-based International Organisation of Securities Commissions (IOSCO).

The Basle Committee’s updated Capital Accord (Basle II) has already been rendered moot even before it has been fully implemented. Basle II’s decision to allow banks to rely on their own complex internal risk control systems when judging how much regulatory capital they need to hold now looks quaint. Of the three pillars in Basle II — (1) capital requirements, (2) supervisory review, and (3) market discipline — the third now looks wholly outdated, and elements of the first and second need substantial re-working.

Some form of Basle III will be needed to buttress the contra-cyclical credit instruments which national regulators and central banks will deploy to manage the credit cycle and limit debt to GDP ratios to more safe levels.

Basle III needs to settle on an agreed range of credit instruments and credit-creating institutions that will be subject to regulation, how regulation will be applied on a counter-cyclical basis, the respective roles of supervisors and bank management, and how to ensure against regulatory arbitrage.

BANK REGULATION AND MONETARY POLICY
The failure of Basle II process bank regulation at multilateral level has been matched by failure among national regulators. The events of the last 18 months have demonstrated that a credit-fuelled banking crisis cannot be contained within the financial sector and has potential to destabilise the rest of the economy severely. Credit policy is a matter of macroeconomic strategy, not just financial regulation.

If credit expansion has the potential to destabilise the real economy, and the liabilities of much or all of the financial system are contingent liabilities of the central bank and the finance ministry as lenders of last resort, then the quantitative control of credit is arguably too important to be left to a financial regulator, such as the FSA or the U.S. Office of the Comptroller of the Currency (OCC) and U.S. Office of Thrift Supervision (OTS).

Quantitative credit control needs to be brought within the remit of the central bank, so that credit expansion can be adjusted in tandem with interest rates (and indirectly in response to changes in government fiscal policy) to ensure internal, external and financial balance simultaneously.

While banking regulators may still have a “tactical” role in supervising prudential management and risk controls within individual institutions, the “strategic” role of limiting credit extension across the financial system as a whole to a safe level is too important, and properly belongs to the macroeconomic managers at the central bank.

Recent regulatory trends have seen institutional responsibility for financial regulation dispersed across multiple institutions, and separated from monetary policy at the central bank. This trend may now have to be reversed.

A more consolidated and intensive approach appears inevitable. Proposals to combine the various US regulators or at least to give the Fed over-arching responsibility as a super-regulator for the financial system have received widespread support, though the details of institutional reform have yet to be agreed.

In the United Kingdom, the wisdom of separating financial regulation from the Bank of England and passing responsibility to the FSA is increasingly questioned. The need for a lender of last resort support to a wide range of institutions, and the macroeconomic consequences of a widespread debt crisis, have pushed the Bank of England back into the heart of financial regulation.

If a new instrument for controlling the quantity of credit is eventually implemented, it will probably have to be managed out of the central bank. The FSA may retain responsibility for the prudential supervision of individual banking institutions, but the overall framework of control will need to be set by the central bank.

EMERGING REFORM AGENDA
If proposals for regulatory reform are to stand any chance of being implemented, they will need to move beyond a sterile debate over market-led discipline and innovation versus stodgy heavy-handed state regulation.

They will have to recognise that collective action problems and moral hazards in the credit creation process make some form of quantitative control essential. The system needs to achieve a financial balance alongside internal balance and external balance, and for that it needs to develop a third instrument, credit policy, alongside the traditional monetary and fiscal policies.

Credit policy will need to act directly on the volume of credit created, and amount of risk, independently of its price, which is the province of interest rates and monetary policy.

It will need to be contra-cyclical and apply to a broad range of institutions to be effective.
It must be dynamic, capable of being modified as the financial system evolves and pioneers new ways to circumvent the existing controls.

It must also be applied on a multilateral basis to prevent the type of regulatory arbitrage which occurred in the late 1990s and 2000s.

The Basle Committee is the most promising forum for reaching agreement. But Basle III will need to be developed much more quickly than Basle II, which took more than a decade, has still not been implemented fully, and risks becoming a stillborn historical curiosity, a monument to an age which has passed.

That suggests Basle III should focus on a much simpler set of credit control instruments, and eschew complexity in favour of a blunter but more effective approach. Crude but effective safeguards may be preferable to interminable arguments and theoretical elegance.

– 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.