Sunday, April 04, 2010

What Should Have Happened With the Bailouts and All That

What should have happened?

I have written before about our government’s foolish, wrongheaded and sometimes corrupt responses to our ongoing economic crisis. I have described how I think their measures have actually made things worse, not better.

So far it’s been a difficult year for us Cassandras. Nowadays people seem somewhat pleased, if not downright optimistic, about business and economic news. Hiring is up (even if unemployment is unchanged). The Dow Jones is creeping towards 11,000. Large and influential companies declared substantial profits for all of 2009. Housing prices are holding steady and inflation doesn’t seem to be eating anyone alive. Could we have turned the corner?

I do not disown my previous pessimism. I’d rather double down at this point. I think it beneficial to also take a little time to describe what our government was actually trying to do to revive the economy, and whether those efforts have paid off. This will help me illustrate for you all my belief that we are actually in worse shape now than we were during the dark times of 2008 and 2009.

If you recall those dangerous days in the summer of 2008, there was a great deal of fear and insecurity surrounding the collapse of one of the world’s most powerful investment banks. Lehman Brothers (which had existed since 1850 and had almost $20 billion in net revenue in 2007) went from hale & hearty to bankrupt & broke in just a few months. Lehman’s problem wasn’t that they were evil or that they were greedy, but rather that they were stupid. The bank’s assets were not worth anywhere near what they (and everyone else) had thought they were worth when they bought them. With worthless and nonproductive assets Lehman would not be able to meet their obligations to creditors and shareholders, and the company had to declare bankruptcy.

This collapse was a frightening event, and affected a lot more than just Lehman’s shareholders, because people knew that the sorts of things that Lehman owned a lot of (complex instruments known as Credit Default Swaps, or CDS’s) were also owned by the other big investment banks on Wall Street. Investors realized that Lehman’s demise prefigured the rapid demise of EVERY SINGLE OTHER BANK on Wall Street, organizations such as JP Morgan, Goldman Sachs, Citigroup, and pretty much any other big bank you have heard of. In September 2008 all of these banks were technically insolvent, their assets absurdly worthless.

This was the situation facing our leaders in Washington. They decided that these banks were too important to the economy to be allowed to fail (thus they received the moniker “Too Big to Fail”), and that those banks should receive all the support that our government had the ability to give them. This support came in two crucial ways:

1. First, our government gave trillions of dollars to these various banks to plug the gaping holes in their balance sheets. They did this through methods that you have probably heard of such as the enormous TARP bailout, and also through methods that are more obscure, like comparatively enormous interest-free loans from the Fed, government guarantees of bank liabilities, and even some peculiar backdoor bailouts that were disguised as other things so as to not upset the public.

2. By the spring of 2009 it was clear that our trillions of $$$ were not enough to fill the hole created by the banks’ foolish incompetence. Therefore the US Financial Accounting Board (called FASB) was pressured into changing one of the accounting rules that corporations are bound by. Banks would now be allowed to pretend that their assets were actually worth what they paid for them, rather than recognize that they were now almost worthless. This was intended so that the banks would have time to sell off these bad assets, or recognize the loss in value, over a longer period of time rather than all at once.

So that’s what our government did. Here is what was SUPPOSED to happen as a result:

Since they were allowed to make-believe that their assets had value, the banks didn’t have to be in a huge hurry to solve the problem. They could take all the free money from the government and strengthen their operations, and use the cash to cover the losses from their bad assets, and progressively return their companies to good health. Their stock value would go up, they’d be able to issue more stock, and get even more money to smooth their path.

(Incidentally, one of the most crucial things these banks were also supposed to do was lend their money. This is the main reason they were allowed the tag of “Too Big to Fail” – because people believed that, once rescued from the brink of disaster, these companies would lend or invest their money to homeowners, small businesses, other banks, and anyone else that was a good risk. This free flow of credit is viewed by many influential economists as being very, very important for a healthy economy; and the banks were viewed as being crucial for that flow of credit.)

That’s what was supposed to happen, but that isn’t what actually happened.

What actually happened is that the investment banks took all the free money from the government and became giant casinos. They never lent the money (except back to the government, which is worth a blog post in itself). They made risky investments, played the stock market, and declared enormous profits. They took these profits and, rather than sell or write down the bad assets on their balance sheets, they pretended that those things weren’t even there and instead gave themselves really big bonuses. Goldman Sachs, for instance, gave its employees over $15 billion in bonuses.

So here we are, coming up on two years later. These Too Big To Fails are in exactly the same boat they were in September 2008. Nothing has changed, except now we’ve churned through trillions in public $$$ with nothing to show for it – money we may wish we had when the next inevitable crisis hits. The banks’ ability to pretend that they are viable institutions is not infinite. The only thing keeping them in business from day to day is our government’s implicit promise to protect them no matter how stupid or wasteful they are. As soon as that guarantee is ever in doubt, there will be a painful day of reckoning.

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