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Saturday, April 4, 2009

Why Obama should nationalize the banks

Dear Mr. Obama, March 26, 2009

Why you should nationalize the failed banks

This letter tries to persuade you to lift the low income group in our nation, and stop the hemorrhage of public money going to the wealthy bankers. The New Yorker magazine keeps a file of “Letters We Never Finished Reading.” The first letter begins with the words, “Dear Fathead . . .” This is not that type of letter.

In 2006 the net worth of the entire U.S.A. was estimated at over $50 trillion, according to the Federal Reserve report “Currents and Undercurrents” by Arthur Kennickell. Between 2001 - 2007 the combined net debt of the U.S.A. --- including consumer, government and corporate debt --- grew from $27 trillion to $49 trillion, a $22 trillion or 81% increase in net indebtedness in seven years (according to the Flow of Funds report from the Federal Reserve). Of the $22 trillion increase in indebtedness, $18 trillion originated from financial corporation debt. This was the Credit Default Swap market.

It is very obvious that the size of the American economy could never generate that much genuine business loan activity. Another species of loan had to be created, and it was the Credit Default Swap market, an unregulated insurance business, better understood as a gambling casino. According to Frank Partnoy, business law professor at U.C. San Diego, it serves as a ballast against unwise investments, but there is no reason that government should not require full transparency of its shadowy valuation. An article in the MultiNational Monitor by Robert Weissman details the regulation needed in this area, March, 2009.

When the subprime housing mortgages began to default in late 2007 it caused the tail to wag the dog, according to Partnoy, that is, the value of the mortgages was much smaller than the mountain Credit Default Swaps tied onto the mortgages. They were tied on as gambling stakes in a casino market that has no contractual connection with the underlying values. As in a cock fight, the value of the wagers exceeded the value of the cocks.

We have no business committing tax revenue to the losses of this insane casino, nor offering non-recourse loans to anyone to entice them to buy up this junk.
A non-recourse loan is essentially a gift of money to the holder of the loan if the loan goes bad, becomes uncollectable.

Writing at, on March 27, 2009, one professional economist offers a companion to the Obama plan:
There is one bailout bill waiting for some action. The Los Vegas casinos are hurting. I know: boo hoo. How could the government bail them out? They could lend me money to gamble. I will be obligated to share my winnings with the government, but they agree that I do not have to repay the loans if I lose. So, I would stand to gain a great deal with little risk.

How is my casino plan different from the present plan of creating a market for "legacy" [Isn't that nicer than saying toxic] assets, other than that financial firms will have to put up a wee bit of their investment.

The best we can hope for from Obama would be to continue to embarrass himself with the obsequiousness toward rich and powerful in such a way as to spark a massive protest comparable to the 1960s. Let's stop dithering. Any takers?

Another economist at had this to say,
Remember that old Gary Larson cartoon in which two scientists are standing before a blackboard crammed with math? One furrows his brows and says he has doubts about Step 3. Standing apart from all the Greek letters and operators above and below it, Step 3 says, “And then a miracle occurs....

I believe that Mr. Geithner should leave your cabinet. He seems committed to betting other people’s money, our tax dollars, on the wrong horse, over and over again. Furthermore, it is unconstitutional for the executive branch to commit revenues without the approval of Congress. A growing popular disapproval and consensus feels that these Credit Default Swaps are non-enforcable contracts that amount to pure gambling.

Another economist, Peter Dorman, writes about setting up an independent government financial entity, bypassing the “negative frozen assets” or “toxic” or relatively worthless assets fictitiously insured by AIG, held by major banks, hopefully to be purchased by PIMCO and other private investors.
Incidentally, there are two routes to public banking. The most direct, which I have advocated in this blog since last September, is to simply set up the system from scratch right now and capitalize it with funds redirected from bailouts. I admit there are loose ends to be dealt with, especially having to do with resolving the international obligations of the existing system, but that’s to be expected with any program. The second route is to hang onto the existing banks after nationalizing them. I have argued against this idea, since it would put the liabilities of these institutions on the public ledger. Perhaps this downside could be reduced by giving the banks’ creditors and counterparties a Paulson-style haircut, but this strikes me as very difficult to pull off, and, at the limit, it simply converges with the “good new (public) bank” proposal I have been pushing.

So: (1) This is a fantastic article by Jamie. [James Galbraith’s article “No Return to Normal” in the Washington Monthly, March 19, 2009, posted at] I hope it is widely read and discussed. (2) I think we need to be willing to go a little further on the financial front and to take more account of how economically interwoven our world has become.

James Galbraith, "No Return to Normal"
James Galbraith is highly skeptical of the Geithner-Obama plan, saying in part,

Geithner's banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it's a number between five hundred billion and one trillion.")

The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.

That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner's plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.

Delay is not innocuous. When a bank's insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution-nomenklatura privatization, as the Russians would say-through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

I’m going to make this essay a little longer because the James Galbraith piece is so good and important any reader at this point should read more of his essay.
A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt's ambition exceeded anything yet seen in this crisis:

[Roosevelt's] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war-from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA's power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. Borrowing and lending-mortgages and home construction-contributed far less to the growth of output in the 1930s and '40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn't overcome until the war ended.

And to conclude with Galbraith:
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
I encourage to read the entire Galbraith essay at, March 19, 2009.

Pressing Problems and Inequality
Our nation has pressing problems far more important than the solvency of billionaire hedge fund managers and their cohort, whom you are so intent on protecting. Nationalizing the banks seems at this point to be the most rational and efficient solution to the financial system meltdown. Let the chips fall, as it were.

The driving force for this unpleasant mess has been the 30 year growth in inequality, since Reaganomics took hold. This period has seen the top one percent of households double their ownership share of the nation’s property. The lower half of the U.S. households own 2.5% of the nation’s wealth, while the other half own 97.5% of it. For every one dollar owned by half the other half owns 39 dollars. When comparing the bottom half, 58 million households, with the top one percent, 1.1 million households, the ratio is one dollar owned by the lower 50% to 668 dollars owned by the top one percent. The top one percent own more than the bottom 91% of households, or 3 million people have a net worth equal or greater than that of 273 million people.

You were elected to relieve the tension that inevitably is created when resource allocation is so unequal or disparate. Many pressing social problems grow out of this misbalance of resources, and you were placed in your position of authority and power to adjust this gross imbalance. Your years of work in the Chicago neighborhoods of poverty should make you keenly aware of this injustice. Presently the annual income of the top one percent exceeds the income of the bottom 60%, and if rewards are to be justly allocated according to sacrifice, then this is a gross imbalance and a serious social injustice.

Throwing tax money at the financial casino is immoral, in my view. I think you should be able to cut the losses, nationalize the failed banks, re-regulate the entire system, and move on to solving the problems of those who do not eat well, have no place to sleep at night, can’t afford healthcare, childcare or education.
We elected you for that job, not to wipe up the stupid mess of stupid gambling addicts. We are with you and support you.

Yours truly, Ben Leet in San Leandro, California

About the subprime tail wagging the Credit Default Swap dog listen to Terry Gross’s conversation on Fresh Air, NPR, March 25, 2009, with Frank Partnoy, law professor at U. C. San Diego. See economics professor Jack Rasmus’ article “Epic Recession Revisited” about the explosion of financial corporation indebtedness from 2001 - 2007 at For details about U.S. wealth distribution see the aforementioned Federal Reserve report, Currents and Undercurrents. For details on the distribution of annual national income see State of Working America, 2006/2007, page 79. Regarding the collapse of the financial sector read MultiNaitonal Monitor, March 2009, Robert Weissman, Thomas Donahue.

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