Categorized | economy

Top Ten Myths about the Economic Downturn*

*Special boring banking blog for boring blog readers. That’s you, bucko.

All joking aside, there’s a real reason why I’m blogging about the economy on an entrepreneurial and small business blog. It’s not just that economics matter, but business owners and consumers are making real and rational decisions based on the fear and nothing that fill our airwaves and newsprint. But you shouldn’t make any business decisions based on what people like Bill O’Reilly say and, since this crisis has brought out then Bill O’Reilly in even the best of us, perhaps we should be a bit guarded in what the Ann Coulter wannabes are screaming at us. (It’s not that the Bill O’Reilly wannabes and Ann Coulter wannabes don’t know what they’re talking about, like their real-life idols, and don’t have extremely valuable stuff for us to read, it’s just that when you raise the decibel level, it’s all about out-shrilling one another rather than rationality, that’s all).

In that spirit, let’s turn to our special banking edition and take on the poltergeist du jour of the right wing, the disaster to end all disasters, the liberal Freddy Krueger, Jason, Chucky, and Chucky’s Seed all brilliantly bowtied and beribboned in one socialist package, “bank nationalization.”

The government can’t manage banks.
This myth is so wrong on so many levels, it’s hard to know where to start. Yet conservative politicoes have been beating the-government-can’t-do-anything-right dead horse for so long, even liberal types agree that the horse is dead. So we have a banking bailout plan that contorts and contrives and confabulates desperately to avoid any possibility of a government “takeover” of banks while many economists, conservative as well as liberal, are saying that a government takeover of failing banks now will be considerably cheaper than the current Geithner plan and a government takeover of failed banks later.

When governments take over a bank

  • The government doesn’t “manage” the banks, it “owns” the banks. The bank managers manage the banks just like they do now.
  • It provides a potentially endless source of capital (because governments can tax, borrow, or print money) to either discharge all the securitized and guaranteed obligations of the bank, like deposits, or restructure the bank or thrift’s balance sheet and bring it back to health.
  • Shareholders and unsecuritized debt holders walk away with nothing, so bank nationalization does not mean welfare for all the starving children in the Hamptons.
  • While this may potentially give other banks’ shareholders the heebie-jeebies, thus drying up capital resources even more, nationalizing failed and failing banks in one fell swoop gets the nightmare over; it may reduce investor confidence, but not as greatly as the drip-drip-drip of bank failures and takeovers. It may, in fact, change the whole mass psychology of financial investors as they breathe a sigh of relief that their ownership stake in Wells Fargo or Bank of America wasn’t on the chopping block.
  • The government does not misallocate capital. It is true in countries where a significant majority of the financial system is controlled in perpetuity by the government that capital is poorly, inefficiently, and corruptly allocated. But in mature financial systems, government takeover is narrowly intended to either discharge the bank’s obligations or restructure the bank in preparation for a sale to private investors. As a result, the bank management is highly risk-averse, as befits a restructuring; government ownership of a failed or failing bank never results in home loans to the chronically unemployed or small business loans to the mentally incompetent.
  • The government does not prescribe or proscribe loans based on some social engineering thesis. In fact, a bank owned by the government that is being restructured is regulated by the government in pretty much the same way every bank is regulated — by capital requirements. Again, the government directors of the bank will be risk averse, but that is normal when a bank is being restructured.
  • The government — American, British, Swedish, whatever — brings a pretty flawless record in winding down failed banks and thrifts or restructuring failing banks or thrifts. The near-perfect track record of bank nationalizations over the last century in mature financial systems is easy to explain. I said it before: the government has a potentially infinite (or at least very, very large) source of capital at its disposal.
  • We’re already there, folks, so live with it. While Obama may say that bank nationalization is not compatible with American culture (what?!), the FDIC is taking over small banks at the rate of a couple per week. Missed that on the news, didn’t you? That’s because all eyes are on the big bruisers, like CITI and BofA. Not the corner banks that are, one by one, becoming the property of you, the taxpayer, and either being wound down or restructured for private sale.

    Here’s the situation. Three factors have contributed to the rapid decline in the financial health of many of our banks. The first, as I discussed earlier, was the uncertainty surrounding the actual risk of mortgage-backed securities which has rendered them unsellable. They’re still perfectly fine as securities (they are still generating revenues and, knock wood, haven’t lost their value), it’s just the price at which people are willing to buy them is not the price people are willing to sell them at. These are the so-called “toxic” assets that are “poisoning” our banking system. Now some banks have actually lost a significant amount of money on these securities; some are real losses (the securities have burned to the ground and are worth nothing) and some “paper” losses (the value of the securities has to be marked down to the market value of the security).

    Second, the normal sources of capital that banks routinely turn to have tightened up — or dried up entirely. Without capital sources, banks cannot lend out money because they don’t have the money to lend out. As any businessperson can tell you, if you’re not writing new business, you’re going out of business.

    Third, many regulated financial institutions are suffering from plain old defaults. It is perfectly normal in an economic contraction for borrowers to default at higher rates. Mortgages are a major culprit, but borrowers are defaulting at even higher rates on private label credit cards, standard credit cards, and even small business loans. These defaults are real losses for the financial institutions that hold these loan assets.

    These problems have created three types of banks: one type is headed for failure no matter what; another type of bank may fail if they don’t find new capital, but are likely to survive if they do, even if the economy worsens. Finally, the third type of bank, like Bank of America, is in perfectly fine shape and could probably muddle through without any extraordinary intervention. The Geithner plan intends to focus on the second type of bank: the ones likely to fail but probably won’t if the government injects money into the institution.

    That leaves the first class of banks, the ones headed for failure no matter what, as candidates for government takeover sometime in the future.

    Economists argue, however, that these banks should be nationalized immediately and that many of the banks in the second class should be included. In the long run, they say, this will be better for the economy and banking system.

    It is clearly impossible for the government to nationalize the entire banking system. In the end, however, it makes sense to grab the failing banks and close them or restructure them rather than throw money into a sinking boat.

    What does this mean for you as an enterpreneur or small businessperson? When the government nationalizes a failing bank, one of their objectives in restructuring is to get the bank lending again. Failing banks are bad for your business. They limit the availability of credit. While you don’t want government to systematically take over the entire financial system, you do want the mess to be cleaned up quickly rather than extended. The drip-drip-drip of bank failures means that credit will only drip-drip-drip until the system is cleaned out.

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