Giving the power to Wall Street

PHOTO: Wall Street Bull

The Obama administration, like the Bush administration before it, believes in the necessity of financial monsters like Citi, Bank of America and AIG. The proof is in their approach to fixing the credit and banking crisis.

On Friday, the details of Treasury Secretary Geithner’s plan to save the banking system were leaked. As others, like Krugman, have pointed out, the new plan is a lot like the one proposed by Treasury Secretary Paulson last year.

The crisis

Currently the big banks and related institutions, like AIG, are liable for a bunch of bad loans they gave out. They tried to hide the fact they were giving out these bad loans by selling them as a combo-deal with good loans using a system called collateralized debt obligations or CDOs. Here’s an explanation by Matt Taibbi:

 CDO is like a box full of diced-up assets. They can be anything: mortgages, corporate loans, aircraft loans, credit-card loans, even other CDOs. So as X mortgage holder pays his bill, and Y corporate debtor pays his bill, and Z credit-card debtor pays his bill, money flows into the box.

The key idea behind a CDO is that there will always be at least some money in the box, regardless of how dicey the individual assets inside it are. No matter how you look at a single unemployed ex-con trying to pay the note on a six-bedroom house, he looks like a bad investment. But dump his loan in a box with a smorgasbord of auto loans, credit-card debt, corporate bonds and other crap, and you can be reasonably sure that somebody is going to pay up. Say $100 is supposed to come into the box every month. Even in an apocalypse, when $90 in payments might default, you’ll still get $10. What the inventors of the CDO did is divide up the box into groups of investors and put that $10 into its own level, or “tranche.” They then convinced ratings agencies like Moody’s and S&P to give that top tranche the highest AAA rating — meaning it has close to zero credit risk.

Suddenly, thanks to this financial seal of approval, banks had a way to turn their shittiest mortgages and other financial waste into investment-grade paper and sell them to institutional investors like pensions and insurance companies, which were forced by regulators to keep their portfolios as safe as possible. Because CDOs offered higher rates of return than truly safe products like Treasury bills, it was a win-win: Banks made a fortune selling CDOs, and big investors made much more holding them.

The CDO system fueled the subprime mortgage market and the housing bubble because banks could now give out money to just about anyone, regardless of credit, to buy a house, then package things so it all looked like a safe bet. But when the smoke screen cleared, it was obvious that these big banks were giving out tons of money that they’d never get back. Teetering on the edge of insolvency, the banks stopped lending to people with good credit and the economy froze. Enter the taxpayer…

Bush/Paulson solution

The Paulson plan was to basically have the government buy these bad CDOs from the banks. The trouble is, if the government buys the bad debt from the banks at what they are worth now, the banks are still bankrupt. So Paulson’s plan implied that the government would overpay for the bad debt on two assumptions, 1) that the debt was undervalued by the market and 2) if we overpayed it was worth it to save the economy. His plan wasn’t very popular, and so it was scrapped in favor of buying stock in the bad banks to keep them in business despite their bad debt. But what’s also important is who got the money. Enter Taibbi again:

Another member of Congress, who asked not to be named, offers his own theory about the TARP process. “I think basically if you knew Hank Paulson, you got the money,” he says.

This cozy arrangement created yet another opportunity for big banks to devour market share at the expense of smaller regional lenders. While all the bigwigs at Citi and Goldman and Bank of America who had Paulson on speed-dial got bailed out right away — remember that TARP was originally passed because money had to be lent right now, that day, that minute, to stave off emergency — many small banks are still waiting for help. Five months into the TARP program, some not only haven’t received any funds, they haven’t even gotten a call back about their applications.

Obama/Geithner solution

Unfortunately Paulson’s plan didn’t work (credit was still frozen and the banking system teetered on the edge of collapse), so now the new guy, Geithner, has brought us back to square one, where the US Government (with taxpayer money) will buy bank bad debt at inflated prices on the assumption that it’s actually worth more than anyone is willing to pay for it. To price the debt they propose have an auction which Yglesias describes here:

The crux of the matter is that “toxic assets” will be put for sale at auction, in which the bidding will be done by private parties but whoever buys the asset will have their downside risk mitigated by the fact that the government is actually putting up the bulk of the money as a silent partner in the venture. The odds are strong that this will lead to banks being able to sell their assets for more than they’re really worth. This is the basic dynamic of an auction. Ten people guess what something’s worth, and whoever’s guess is highest “wins” the auction. As per the winner’s curse, this usually means that the “winner” of the auction is someone who’s guessed too high. The fact that the government, rather than the bidders, will be bearing most of the risk further encourages the bidders to guess too high. Consequently, the winner of the auction will stand a small chance of making a bunch of money and a large chance of losing a small amount of money. The government will stand a small chance of making a bunch of money and a large chance of losing a bunch of money. And the banks selling the assets will stand a large chance of making a bunch of money.

Like Paulson’s with plan, Geithner is striving to maintain the integrity of the current top heavy banking system. Both were about funneling money to the ailing Wall Street behemoths rather than strengthening the smaller banks which didn’t bet their businesses on subprime mortgages, but are nonetheless struggling because of the economic downturn.

It’s all who you know

It doesn’t take a crazy conspiracy theory to understand why our government is expending so much taxpayer money to save the banks that are ‘Too big to fail.’ Paulson was the CEO of Goldman Sachs, and Geithner was the head of the NY Fed which arranged the bailout of Bear Stearns. They have an understandable bias toward their buddies on Wall Street. Then of course there is the Democratic Congress that’s awash in Wall Street money. They aren’t likely to raise too much of a ruckus about bailing out their top campaign contributors.

If the Obama gamble works

The Geithner plan may surprise us and end up saving the day. For the time being. The trouble is that the ‘too big to fail’ banks will remain in command of our economy, this time fueled with even more of a guarantee of public money. Knowing that future failures mean a bailout, why won’t these banks start gambling again in search of higher profits and astronomical bonuses? That’s what financial nerds call moral hazard.

What should have been done

Because of bank deregulation in the 1990s (pushed by Republicans and Democrats) banking institutions were allowed to get bigger and take on more risk. That led us to the situation we’re in now, where a handful of struggling companies are able to depress our entire economy and practically hold our government hostage for bailout funds. Any long term solution should involve breaking up this oligopoly so no institution is ‘too big to fail’ and taxpayers are never again called upon to save the hides of enormously wealthy bankers who gambled away our national financial security. Unfortunately, that’s not what Obama is doing. In the end he may have to break up the big banks, but it seems that will only be a last resort after having handed over more and more public money to the privileged few on Wall Street.

Flickr photo of Wall Street Bull by Christopher Chan

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If you get a chance, read Matt Taibbi’s Rolling Stone article in full.

4 Comments

  1. Chris

    I will not be posting tomorrow… I figured this post makes up for a few days 🙂

  2. Ian

    Its a difficult situation. I think that the accusations of Paulson playing favorites are a little lacking in substance. They might be true but there isn’t much concrete evidence here to back it up. While some of it is curious as to why he saved some banks but not others, I can’t claim to understand the interconnectivity of it all to say which bank is more important than another. A congressman chooses to remain unnamed and spout off about this. That’s not really a credible source, unfortunately. You have to take everything said by a politician and run it through a filter based on their political party to try and understand their motivation behind what they say. For example, we know the GOP is only remembering their fiscal responsibility when they aren’t in power.

    I do like the idea of breaking up the big banks. No company should be so large that its failure could jeopardize the country’s entire economy.

    I think it is acceptable to have a generally slow recovery from this crisis. Everyone seems to want to solve it now and have everything go back to being OK. They want the Dow back to where it was. Well the Dow never should’ve been there. We should be having safe economic growth so that the end product economy is more stable. I don’t see why the government (a.k.a. the taxpayers) should necessarily take up toxic investments. Perhaps they could temporarily take them off the banks’ hands with the stipulation that a certain fraction of all the banks profits go towards repaying the government, perhaps with slight interest to account for inflation. This could take some time to clean up completely, but it would allow the banks to start moving credit again while not needing to worry too much about paying the loan back quickly. Of course, a bank receiving government funds should also have some extended oversight on things like CEO pay.

  3. JM

    I agree with Taibbi. Oh, and Chris too.

    I think the evidence of favoritism is in how the firms were treated – Bear Sterns was allowed to fail but Sachs was saved. Wall St pays for the election of most of these people – why would they put that money up if they didn’t expect anything in return?

    I suggest Chris use a new photo as well.

  4. Ian

    How is that proof of anything? Maybe Bear wasn’t crucial enough, or maybe it happened at the wrong time. This is just political hackery unless you have something more substantial to go on except “Jimmy got a cookie but I didn’t! You love Jimmy more!” arguments.