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Five Truths about the Banking Crisis

The first truth to understand about the banking crisis is that people don’t want you to understand it. You are supposed to trust in the judgments of the experts and give them whatever they are asking for, no matter what the cost or consequences. Just ignore the fact that many of these people are the same experts that failed to foresee or to prevent the problem in the first place.

Henry Paulson, the former treasury secretary, is one such expert. Throughout 2007 and most of 2008, he assured the public that the economy was strong, any subprime mortgage fallout was contained, the banking system was safe, and that there were no plans to recapitalize or rescue Fannie and Freddie.

Then, last September when multiple financial institutions were on the brink of collapse, he naturally took responsibility for his errors in judgment and inaction and resigned, right? Well, no. Actually he requested $700B more with virtually unlimited authority.

Of course it wasn’t exactly a request. Give me $700B right now or you get a massive financial collapse and the Second Great Depression. It almost sounds like a scheme cooked up by Dr. Evil. Did Paulson have some kind of doomsday device that he was ready to activate? Was the country really facing a financial meltdown?

We will answer that shortly and the answer may surprise you. Lets move on to Truth #2. This entire crisis was caused by widespread mismanagement throughout the financial industry.

Banks that loan money to borrowers who can’t repay don’t stay in business for very long — or at least they’re not supposed to. The same is true for investment managers that exchange good money for bad paper.

This may seem obvious, but there are still far too many weakly written articles that blame the financial failures on the bad economy or the weak housing market — as if banks couldn’t possible imagine that the economy might slow at some point.

Similarly, pointing the finger at credit rating firms or government regulators or auditors also misses the mark. Yes, all of these parties should have acted earlier to help prevent the crisis. But the situation wouldn’t even exist if not for the widespread irresponsibility of the people we trust to manage the world’s money.

Once the blame is assigned correctly, the ethics of the situation become very clear. Management needs to go, and the institutions they ran into the ground deserve to fail. But we can’t have hundreds of banks and financial institutions fail, right? Wouldn’t the economy drown in a sea of bankruptcies?

Truth #3: Banks can fail without endangering the economy. In fact, over 700 lending institutions failed during the Savings & Loan crisis in the early 1990s, and the damage was minimal.

Credit the Bush administration — not W. but his father. In 1989, he signed legislation creating a framework in which S&Ls could fail quickly, be removed from the marketplace, and then be replaced with healthy institutions.

The process was simple. If a financial institution couldn’t meet its capital requirements, the regulator declared it insolvent and shut it down immediately. At that point a government custodian (the Resolution Trust Company) took over the firm’s assets, inventoried and packaged them for sale, and auctioned them off to the highest bidder, usually another healthier financial institution.

If the RTC had difficulty unloading some assets (what we would now call toxic assets), it created innovative public-private sector partnerships to manage the risks and share the future profits.

When institutions were seized quickly, many still had significant assets that could be used to cover the losses and debts. But in the end it was a bailout, and the taxpayer was responsible for the final cost.

Which brings us to Truth #4: This current crisis almost certainly isn’t a trillion dollar problem, but we can certainly make it into one.

Let’s take a step back for a moment. If one year ago, someone had told us that the U.S. taxpayer would have to ultimately spend $500B to clean up the banking system and prevent a total collapse, we would have been outraged.

At this point we would consider ourselves lucky to get by so cheaply. Only $500 billion? And no depression? What a relief! The high price tags of TARP, the economic stimulus, and the dire economic projections have conditioned us to expect a final cost in the trillions.

The S&L crisis cost taxpayers $124B, and that was primarily the difference between what it took to pay insured depositors back and what was recovered from the failed institutions by the RTC. The cost may sound reasonable by today’s standards but was actually far higher than it should have been.

What happened was that in the early stages of the crisis, the scope of the problem was not well understood by the regulators and many insolvent institutions were allowed to continue operating. Often these institutions offered high-yield accounts to attract insured deposits and then proceeded to make more bad loans and investments.

The lesson is that the more quickly regulators act, the lower the losses are. Declare a bank insolvent the day that it first fails to meet capital requirements and the cost of the failure will be minimal. Keep it operating and give it more government guaranteed money to make more bad loans, and the final cost of the cleanup will skyrocket.

Now armed with our four truths, let’s go back to  Paulson and his ultimatum. Was the financial system really facing a meltdown? Yes, and it still is, but only because of his willingness to continue to provide taxpayer money and guarantees to banks and investment firms that created the current mess we’re now in.

The banking crisis could be solved today for the lowest possible cost if the Treasury would simply shut down insolvent financial institutions, auction off their assets, and repay depositors in full. There would be no damage to the economy aside from losses to investors in the financial institutions. In fact, the economy would be healthier and recover far more quickly if the banking and credit system were sound.

And there is no need for a full bailout. When AIG was taken over, its creditors received a nice Christmas present — its once precarious debt was now backed by the U.S. Treasury.

This prevented the chaos of the Lehman bankruptcy, a severe system shock followed by a legal mess that will take years to sort out, but there’s no reason that creditors in failed financial firms must receive 100 cents on the dollar for their claims. Only federally insured depositors should have that right.

Did Paulson know these four truths? Does Geithner? Perhaps they’re surrounded by too many Wall Street executives who are pleading for just a little more time and money to fix the mess that they created. Or perhaps they know that a financial crisis is the ideal environment for a dramatic expansion of the role of government in the economy.

One person who does know these truths is William Seidman. He was the chairman of the FDIC and RTC during the Savings & Loan crisis. At the age of 87 he is appearing in television interviews and writing editorials telling everyone that will listen that insolvent banks need to fail so that the system will survive.

My guess is that Seidman also understands Truth #5: Not all financial crises are created equal. When borrowers can’t pay their debts, you get a banking crisis, and as we’ve seen those are painful. But when governments can’t pay their debts you get a currency crisis, which is far worse. During Argentina’s recent currency crisis, the GDP fell by 10% in a single year, the unemployment rate jumped to 25%, and inflation hit 10% a month at one point.

We are nowhere near a currency crisis now. But the quickest way to get there is to borrow trillions of dollars and spend it on dubious financial rescue programs and stimulus packages that are unlikely to either rescue the financial sector or stimulate the overall economy.

Note: Jim Boswell contributed his expertise to this article. Jim is a former director of Price Waterhouse Coopers and a veteran of the S&L crisis. He and his team of analysts managed risk for the $400B Ginnie Mae portfolio amid the financial wreckage and received a Vice Presidential Hammer award for their accomplishments. I was lucky enough to be one of those analysts. His Wharton MBA and mid-western values and sensibilities are an invaluable resource for those looking to separate fact from fiction in these times.