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Sunday, September 28, 2008

Nationalize or Bailout?

To Buy or to Bail, that is the question.

We do not have to buy "frozen negative assets." For much less taxpayers could
Nationalize the banks, clean up their accounts, and then sell them back to private enterprise. The taxpayers win. Go to Econospeak, find Peter Dorman’s essay “Plan B,” or go to the Financial Times and Martin Wolf’s article “Paulson’s Plan Was Never a True Solution,” Sept. 23, 2008, or go to Paul Krugman’s New York Times article of September 28, or Brad DeLong’s plan, or Nouriel Roubini’s plan at, or John Hussman’s plan at John Hussman Investments. It is complicated. Hussman's article really helped me. There are many who endorse nationalizing the credit system. Peter Dorman's also has a great idea. On September 28, 2008, the Congressional plan does not look right to me.

Sources of information:
Peter Dorman, Plan B
John Hussman, Open Letter to Congress
This American Life, The Giant Pool of Money

Swedish Banks Collapse in 1992
OK, Marjie, my sister, I'm in the mood to try to explain the Swedish bank failure of 1992. There was a real estate bubble in Sweden, it popped, and the banks found themselves with so many bad mortgages on their books that the entire bank system failed. Sounds like today. What the Swedes did is what Ralph Nader is now proposing. Nader uses the example of Chrysler Motors. Chrysler came to Congress for a bailout in about 1992. Congress instead took equity control or ownership of Chrysler. For the cash the government got stock and that means control of decisions. The government ran Chrysler for a while, then sold the stock to private money. Eventually the government pocketed a $400 million dollar profit.

In Sweden the government bought the banks, made the banks open their books with the bad loans in them. Government ran the banks, paid off the bad loans, then resold the bank to new investors.

How Investment Banks Work
Our financial investment banks are 3% owned by owners called shareholders or stockholders, that's the equity amount; 17% owned by creditors or bondholders; and 80% owned by depositors, called customers, who have a legal claim to x amount of interest on their deposits. That x amount are the banks liabilities. So is the interest to bondholders. When 3% leverages 100% that's called a 33 times leverage ratio. It's dangerous. If their investments go bad, then they can't pay the 97% their x amount of interest, a demand on profits, and they are forced to declare bankruptcy. Their emergency default plan is to get Secretary Paulson, former head of a Goldman Sachs investment bank and a man who had to place his $500 million savings in a blind trust before he could be appointed as Secretary of Treasury, to go Bush, Congress, the American public, and demand $700,000,000,000.00, no questions asked, no judicial review ever, no oversight. And do it now.

The John Hussman, Ph.D. Plan for Recovery
Here is the analysis of John Hussman, Ph.D. economist and president Hussman Investment Trust.
“It is difficult to believe that the U.S. government is contemplating taking on the bad assets of these institutions at probable taxpayer loss and effectively immunizing the bondholders (and shareholders) of these companies. . . . They are failing because 5% of the assets have gone bad and they over-stretched their capital. At the heart of the problem is “gross leverage” - the ratio of total assets taken on by the company to its shareholder equity. . . . The appropriate solution is not for the government to replace the bad assets with public money, but rather for the government to execute a receivership of the failed institution and immediately conduct a “whole bank” sale - selling the bank’s assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.

The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost. . . .

The stockholders and bondholders of the company itself should be the first to bear losses, not the public. That is the essence of what a free and fair market, and a responsible government would enforce. The investors in the companies that produced the losses should be accountable for them, and the customers and counterparties should be protected.”

Peter Dorman's Plan B
In Peter Dorman's "Plan B" (See he proposes a federal investment of $300 billion to fund a national central bank that would leverage 6 times to $1.8 trillion. (Morgan Stanley bank has a gross leverage ratio of 23.5, and failed banks had higher ratios.) It would buy failed banking and investment institutions, hedge funds, etc, and reconstitute their portfolios of bad loans, and then sell them back to private investors. Simple and direct. I think it superior to Hussman's "whole bank sale" method in that it would bring more transparency to the value of the bad loans. A bailout just perpetuates ineptitude, incompetence and greed.

Big Numbers in Perspective
That $700 billion bailout amount is equal to 5% of the annual national product, GDP (in Sweden they paid 4% to get out of their mess), and equal to about 22% of the annual federal budget. It is also the amount we have paid for five and a half years of war in Iraq. The war is expected to cost $3 trillion. There are $50 trillion in national assets, $14.2 trillion in annual GDP for 2008, $3.3 trillion in annual federal budget, and soon there will be $11.3 trillion in national debt, up from $6 trillion when Bush came into office. Too many numbers, but maybe you get a picture.

How the Mortgage Market Went Biz-zerk
What I think happened is now the most important part. Capitalism is like a game of chicken. You are looking to float a scheme that looks good on the surface, but is flawed. Such is the case with bundled mortgages, called CDOs, collateralized debt obligations. You sell the idea, people invest, you hold your position until you guess that the last fool has invested, then you jump out.
I'm of the opinion that the "negligence" of bank presidents ran this game, fully aware of the shoddiness of their CDOs. Warren Buffett called CDOs "weapons of mass financial destruction." Everyone knew that. They knew.

I heard a program on KALW from This American Life, and they traced the whole process back and forth. The show’s title is called The Great Pool of Money, and it was aired in May, 2008, available on the web for listening. And I listened to it over again.

Mortgage companies were creating and re-selling crappy mortgage loans. They called them Nina loans, meaning, No Income No Assets. One example on the show I can summarize quickly: "Hey buddy, you want a loan for $540,000? Sure. Have you got a job? Sure. Here's the money." That was on the program. They never checked on mortgage applicants incomes.

Then they aggregated the loans into bundles, slicing and dicing them up so that no one knew who owned the mortgage. One small company in upper Manhattan, small buyer of CDOs, had interest in 16 million different mortgages. If there are 70 million home owners, and three quarters have not paid off their mortgages, then there are 53 million outstanding mortgages. This company had a fractional piece of a 30% of U.S. mortgages. This bubble got bigger as mortgage brokers became more brazenly reckless. The bundles were rated by Moodys and Standard and Poors as AAA, the top-most risk free loans. They discovered later that they were analyzing them wrong, but that came later. Of course, the rating agencies were being paid by the investment banks to rate the CDO bundles.

The mess was insured by AIG, who really went out on a limb, but hey, they wanted to make a profit, and what the hell, and now ......taxpayers nationalized that company for $85 billion.
One year prior to costing the taxpayers $85 billion dollars the CEO of the company stated that under no reasonable scenario could his company fail. !! (See Gretchen Morgenson's article in the New York Times, September 28, 2008)

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007

Poison in the Water Bottles
Now, no one wants to buy the mess. And none of the banks will loan to each other. Paul O'Neil, Bush’s first Secretary of Treasury, made the analogy of having 12 bottles of water on the shelf, and you know that one of them has poison in it. What do you do? You throw them all out. That is the source of the credit freeze up that Bush warns against. Banks will not loan to banks because there is poison in the loan portfolios of all the banks. Also the default rate added to the inflation rate is about 11%, and that’s a high interest charge. The real estate market is down. Perhaps 8%, or 5 million, of U.S. mortgage holders and second mortgage holders in a two year period are going to declare bankruptcy, or give up their loan, foreclose, and there is no one to buy the house at its inflated value. Bankruptcies are slated to double in 2008 from last year.

If you are still here, Sweden, bought out the 3% shareholder stake, kept the 17% bondholders happy, and serviced the 80% customers. Paulson does not want the shareholders to take their consequences. Nor does Bush, McCain, Bernanke. And Obama? We’ll see. Nader of course saw it coming some years ago.

On the other hand economists like Paul Krugman, Martin Wolf, Brad DeLong, Peter Dorman at Econospeak who presented a “Plan B” on that web site, Nouriel Roubini at
have endorsed the plan to nationalize the insolvent companies.

Well, this is my imperfect analysis, but I draw it from an article by John P. Hussman, Ph.D. who runs a financial advisory firm. He posted his solution, I downloaded. Now you have it. It is confusing, isn't it. I know if a professional economist looked at it he would shake his head. But not just at my analysis. There are really creative people working on this, and many other problems. I am optimistic. But enough! Send this to someone if you dare.

"Love is its own excuse for being." Meher Baba

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