By Robert Kuttner
October 6, 2008 | Prospect.org
It is now increasingly clear that the Paulson approach will not solve the financial crisis. The damage that has been done to America's financial system will not cured by having the Treasury purchase dubious bonds, even $700 billion worth. It extends to a basic collapse in credit markets, a run on the stocks of banks with a melting away of bank capital. The crisis has now extended to European banks, and is rapidly becoming a worldwide calamity.
The crisis also destroys the basic business models that have proliferated in the past decade -- of having financial intermediaries invent ever more obscure securities that allow ever greater levels of pyramiding. It is the unwinding of this larger model that is causing the deeper collapse, and not merely a lack on confidence in certain exotic bonds backed by mortgages of depressed value. Hedge funds will be next, causing wider losses.
The Paulson plan will take weeks to implement, and markets are already declaring a resounding vote of no-confidence. As I and others have been urging, the Democrats were mistaken two weeks ago to think they had merely to build on the Paulson plan, as if it were the only available approach. But it is not too late to devise a more robust strategy right now. That is what the Democrats in Congress and Obama's top financial team should be doing, well before the election.
In ordinary times, there is a transition of nearly three months between the presidential election and Inauguration Day. This time, with the utter failure of Paulson's approach and the irrelevance of George W. Bush, the moment for Obama's leadership begins November 5 -- and his team should be working with the Democratic leadership (and sentient Republicans) now. Legislation should be ready November 5, and it should be enacted by the lame-duck Congress, which does have a majority of Democrats. Signing the legislation could be Bush's one decent legacy.
After Election Day 1932, the lame duck president, Herbert Hoover, tried to co-opt President-elect Roosevelt into a Hoover-style bank rescue. But Roosevelt insisted on starting anew. It cost the country five precious months (in those days, the new president did not take office until the following March.) This time, Obama needs to begin leading immediately, or the crisis will deepen by January 20.
Specifically, we will need a plan for a much more straightforward re-capitalization of banks. Three decades of deregulation have ruined much of the financial system. Paulson-style patches will not put Humpty-Dumpty back together.
First, the government will need to take over many large banks, get rid of bad assets (and bad actors), recapitalize banks as necessary with public funds, and sell them back to the private sector over time, perhaps keeping an equity share. George Soros has proposed one good way of accomplishing this.
Worst case, this could cost as much as two trillion dollars, but even that is less than 15 percent of one year's GDP. It is far preferable to watching a financial crash turn into a second great depression, which could easily happen if government stays on its present policy path. But there is still time to head a depression off -- if government acts fast.
Second, government should refinance distressed mortgages directly, instead of hoping that buying up mortgage-backed bonds will somehow trickle down to homeowners. The government's borrowing rate is very low. Refinance every at-risk owner-occupied house, and the stabilization will trickle up. The one agency with the competence to handle this is the FDIC, which should get additional funding and staffing.
Finally, radical re-regulation is in order. With the federal safety net being extended to every major category of financial institution, examination and supervision should be extended along with it. We need to extinguish exotic financial engineering in favor of plain vanilla finance, in which banks take in deposits and make loans, and the value of assets can be understood by examiners. Investment banks, for their part, need to get back to their knitting of underwriting stock issues. Leverage ratios of 30-to-one, which have been standard for hedge funds, private equity companies, and investment banks, need to be prohibited, as they are for commercial banks. This is nothing but gambling, with taxpayers picking up the losses. Likewise entire categories of speculative financial inventions, such as credit default swaps. High-rollers can be redirected from Wall Street to Las Vegas, where the assets the risk are their own.
The core principles for a total overhaul can be found in a prescient speech delivered last March 27 by one Barack Obama. You owe it to yourself to read it. Obama, his advisers, Barney Frank, Chris Dodd, Nancy Pelosi and Harry Reed need to get busy -- right now.
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