What is going on here?

Okay, if you caught me on Garland's show the other day then you heard me say that we have partially nationalized our banking industry, and many people aren't even aware of it. So I thought I'd take a couple of minutes to explain in case I was correct.

So last Monday, Secretary Paulson took the extreme step of forcing the nine largest banks in the U.S. to participate in the latest version of the bailout. As I remarked on Thursday, this never would have gotten through Congress due to all of the conservative's that are up for re-election this fall, as it is effectively nationalizing (partially) the banking system. You may have heard that the banks got good terms (this means the U.S. taxpayers got bad terms), that is indisputably correct. [By the way, that link is to an article written by extreme right-wing pseudoeconomist, Don Luskin - the irony is that he is typically screaming (literally) about limited government, laissez-faire, free market capitalism, etc... - here he tips his cap to Hank for stepping up big.]

Regardless, I think I got around to saying that it won't work, but I'm not sure if I actually said those words. I did say that Paulson's approach is flawed because he is doing nothing to separate the good banks from the bad banks. This is not about punishment (though I'm all for punishing those bankers that got us here), but about getting us in a position where our economy is able to move forward.

If you weren't aware, Japan has been dealing with similar issues for the past 15 years or so. One of the key criticisms of the Japanese policy decisions over this time has been that they have left too many bad loans on the books of the banks (it is also generally thought that they did not move quickly enough, nor with large enough fiscal (tax cuts and increased government spending) or monetary (lowering interest rates) stimulus).

Banks that made reckless investments in Mortgage Backed Securities (MBSs) and other financial innovations should be forced to bring them onto their balance sheets and shut down if that means that they are insolvent (meaning they don't have enough assets to pay off all of their liabilities). Paulson didn't even require them to stop paying dividends!

Let's list the reasons why this plan will not work (as outlined this past week, subject to change on a whim):

• Bad banks are still operating - none of the other banks really knows who is a bad bank and who is a good bank. This is a trust issue. Banks want to hold on to as much cash and other safe assets as they can, scared to lend even overnight to other banks because they may not pay them back.
  
• Paulson can force the banks to take the government's money (you may wonder why they wouldn't want the money, I'll discuss below), but he cannot force them to lend. There is some incentive for the banks to do something with the taxpayers money, they are paying 5% on it, but they are far better off paying down higher interest rate debt, or even worse if they are insolvent, "doubling down" on some other very risky assets (they either win big or lose big if they do this, but they are pretty much guaranteed to lose big if they don't).
• Businesses and consumers are rightfully bracing for a recession, possibly a long, dragged out Japanese style recession. Banks may finally come around and be willing to lend, but there needs to be sufficient demand for loans in order for any of this to get the economy going again.
• There is still nothing being done to affect the direction of home prices. Unlike many economists, I do not think that we should encourage government interference in housing markets. Any program that is designed to help people stay in their homes will only extend the pain that our economy is going to go through. It is very simple: you need first-time homebuyers in order to get the housing cycle started again. Anything that keeps housing prices too high, relative to incomes or rents will continue to price out those first-time buyers. Without that core demographic, the rest of us will have trouble finding buyers when we decide to move into a bigger house, or a smaller house (for those entering retirement), or making a geographic move. Anyway, just because I don't agree with it doesn't mean it won't happen, but it's not happening right now. So what? Well, as long as home prices continue to fall (broadly, obviously not everywhere around the country), the value of those MBSs continues to fall and the worse off the banks are that hold those bad assets.

Anyway, I can probably come up with a couple more problems with the plan, but we can sum it up with the idea that even if it works by some miracle, we are still enriching the same Wall St. criminals (at least morally bankrupt, if not outright criminal) that got us into this mess.

And to answer the question I posed above: why would banks not want "cheap" money from the Treasury? Well, good banks (seemingly like Wells Fargo, but I base that upon their response to the idea, not having any inside knowledge of their actual balance sheet) know they are good and don't really need this bailout. They are being forced to participate because Paulson doesn't want to only help the bad banks. Just helping the bad banks would guarantee that they would go bankrupt because there wouldn't be any more uncertainty about who to lend to, no more trust problems. That would be great for the economy (even if there was some short term pain - spike in unemployment, hiccups in the payments system, etc.) because we could focus on how to best move forward, rather than just continuing to put band-aids on the problem.