What It Costs You Personally to Bail Out the Banks

It's clear that the $700 billion TARP program won't be enough to bail out the financial system. Estimates of the total cost now run between $1 billion and as much as $4 billion. Let's cut it down the middle on the low side and assume the cost will be $2 trillion. There are around 300 million people in America. We'll guess that 200 million are taxpayers--kids and low income people don't pay federal income taxes. Divide $2 trillion by 200 million, and you'll find that your personal cost for bailing out the banks is $10,000. Of course, this is only a rough estimate, but it gives you an idea of what the bailout means to that person in the mirror. By contrast, the auto maker bailouts have, to date, cost about $125 per taxpayer. Even if we assume the total eventual cost of bailing out the auto companies triples, we're looking at $375 or so per taxpayer. In New York, home of Wall Street, it's not hard to spend $375 for dinner. Ask not what your country can do for you, ask whether you want to spend $10,000 to bail out the banks.

Financial Regulation for the Future

As the Obama Adminstration begins the process of reforming the financial regulatory system, the usual crew of columnists, commentators, pundits and bloggers are putting forth laundry lists of suggestions. Regulate credit default swaps, we are told. Formalize the derivatives markets, with centralized pricing processes like exchanges and centralized settlement and clearance functions. Tighten up capital requirements for financial institutions, and step back from the do-it-yourself risk-based capital requirements permitted under current international bank regulatory standards (which, in effect, allow financial institutions to largely decide for themselves how much capital to set aside; not surprisingly, they gave themselves higher grades for risk management than outsiders might have, with sad results that are all too familiar today). Establish prudent standards for mortgage loans, especially subprime loans, adjustable rate loans and any loan that may involve increases in monthly payments. Substantially increase the extent of governmental oversight of financial institutions, and make sure that hedge funds are covered. Make unequivocally clear what the heck Fannie Mae and Freddie Mac are and how much responsibility the federal government will have for their liabilities. Also make unequivocally clear what the major banks and their shareholders can expect from the government when a financial crisis hits. When Bear Stearns was too big to fail, but the much larger Lehman Brothers wasn't, it's no wonder that interbank lending evaporated last fall. Do something to definitively clean up bank balance sheets, like create a bad bank to buy toxic assets or nationalize troubled banks.

There is one point that may have been missed. It's important to regulate for the future. Like many generals, the regulators may be tempted to fight past wars. Almost all the suggestions for reform focus around past problems. These problems will be examined in depth as investigations are conducted. How things went wrong and how they could have been prevented will be analyzed in detail. Stringent regulations and controls will be instituted to prevent a repetition of the past. Enforcement actions, if warranted by the evidence, will be taken to emphasize the point.

But the past probably won't repeat itself. The securitization market for mortgages and consumer loans has largely evaporated, and you couldn't find a new CDO today if you wanted to. Credit default swaps aren't enticing with few creditworthy counterparties available and no centralized system of settlement and clearance. Liar loans and the like have left the scene as banks impose actual credit standards on borrowers because they can't sell loans to investors any more and therefore need to make responsible lending decisions. Almost all of the senior bank executives who wallowed in leverage are now pursuing other opportunities.

The most important task for financial regulators is to look for the battles that will be fought in the future. The financial services industry is second only to high tech in its capability for innovation. For perhaps the next five to ten years, banks and other financial institutions will be reasonably prudent, either because they will have learned their lessons or the government regulators peering over their shoulders will ensure that they learn their lessons. But, just as summer turns to fall and fall turns to winter, the financial services industry will seek to develop new products and services that will ease investor savings out of the scope of regulatory oversight and into another brave new unregulated world where profit margins are higher, executive bonuses are larger, and bureaucrats are scarcely to be seen. This is when the lunacy could begin anew. To guard against such a replay, regulators must not only change rules but also perspectives.

First, regulators should stay current with financial innovation. Congress put the regulatory agencies on the map to guard against the failings of markets. We know from the past 300 or more years that the financial markets cycle through booms and busts, and then more booms and busts. Another boom and bust is inevitable. How it will occur is presently unknown. But one can fairly predict that some time in the next few years, a 25-year old MBA or two will design a new financial thingamajiggy that will not be subject to government regulation and will catch on in the market. As soon as the higher ups in the big banks notice this development, their eyes will widen at the thought of grander bonuses and they will push this product to the edge of every imaginable envelope. Investor savings will be siphoned off into the great unregulated beyond and perhaps placed at far greater risk than investors realize. Bad things will happen, hair will be pulled, teeth will be gnashed, blame will be assigned and lives will be ruined. Regulators must be proactive in monitoring the development of financial products, and the ways in which they are used. Since the financial services industry is so highly innovative, regulators must make every effort to keep up with innovation; not after the fact but as it occurs. This can be done. It's simply a matter of gathering the information. The federal bank regulators and the SEC have examiners who can get up-to-the-minute information about bank activities. They and other regulatory staff should make it a priority to keep up with financial innovation and how new products are being used. Banks will grumble about giving potentially proprietary information to the government. But that's life. After the current debacle, that's a small price to pay for restoring investor confidence, and for the massive amounts of taxpayer dollars they have received and will receive.

Second, regulators should believe in themselves. In the past, attempts by a few regulators to assert authority over derivatives were met by, among other things, assertions that government bureaucrats couldn't understand such sophisticated products and would surely regulate them in a way that would hamper the markets. Some of these assertions even came from senior regulatory officials. Bureaucratic dumbness, if it exists, isn't an excuse to abandon governmental protection of investors, depositors and the financial system as a whole. Hire smarter government employees, if necessary. But the truth is that (a) the government has plenty of intelligent people who can understand complex financial products if they obtain enough information; and (b) very few people in the private sector truly understood these products, as is abundantly evidenced by the catastrophe that has resulted from their misuse. Government employees have sometimes achieved great things when they believed in themselves, worked hard, gave up evenings and weekends for the job, and refused to be held back by naysayers. Morale and zeal at the SEC have been lagging. While the stereotypical ultra-cautious, office-politicking, perks-obsessed, responsibility-avoiding, pension-awaiting bureaucrat is much too common way too often, there remains a cadre of committed public servants at the SEC who can, if given the opportunity, do the world a world of good. They have been crippled by a hostile White House, an unsupportive Congress, and the worst agency leadership in a generation or more. If they are given a chance to vindicate the public interest, they can and will. The financial regulators, including their leadership, must believe in themselves and in their capacity to do good. If they do, they will.

Third, to the Congress and the White House, start by healing thyself. The regulatory structure in the United States is meant to be independent of politics. Way too much for way too long, it has been anything but that. In the world of federal regulation, there is, separate from political considerations, such a thing as right and wrong, good and bad. Regulators must be allowed to call strikes when the pitch is inside the strike zone, regardless of who the batter may be. They must be allowed to quarantine those that could spread infectious disease, even if they are highly placed on Wall Street. One of the greatest impediments to regulatory proactiveness has been political pressure. Congress has a legitimate oversight function. But neither it nor the White House should protect the culpable, reckless or those that pose a risk to the financial system, and unfortunately one cannot say that the slate is clean in this respect. When the state police can write anyone, including the governor and the President, a speeding ticket, you'll have public safety on the highways. Things aren't different in the world of financial regulation.

Canaries in the Economic Crisis

You can find any economic prediction you'd like for the future. Some prognosticators predict the beginning of a recovery by the end of this year. Others predict another Great Depression. Most predictions fall somewhere in between. The truth is that all predictions are based on known information, and extrapolations made from known information. But the current economic crisis has been driven by largely unexpected developments that come out of the woodwork and pop nasty surprises. Note that we say "largely unexpected" because a few lonely voices decried the prevailing wisdom that real estate prices on a national level could never fall, and questioned the wisdom of extending the opportunity for home ownership to those those that could buy a home only by taking out mortgages they couldn't afford. The warning signs were there for those that were careful enough to look.

Now that we're in a deep recession, we're more concerned than ever about the future. It's impossible to make firm predictions, because there isn't enough firm information. There are, however, canaries that may give early warning of problems. Some are familiar; others may not be. Here's a not necessarily complete list of canaries.

U.S. real estate market. We all know about this one. It continues its destructive rampage. There are lots of foreclosures pending in the residential real estate market that and more are likely in the future. To make things worse, the commercial real estate market is now struggling, with a lot of construction projects in deep doodoo. Even rental properties may falter, since rents are starting to fall as the economy slows. This will lower the value of rental properties, and landlords that are heavily leveraged may find the going tough. The problems in this market run into the trillions of dollars. No amount of federal assistance or subsidy can turn this market around. The most that the federal government might accomplish is to soften the downturn. The U.S. real estate market is an important canary.

Europe. The Euro-block is in recession and its members are arguing among themselves about what to do. While they have a nominally unified monetary policy, they maintain individual national fiscal policies. Thus, they have a serious coordination problem. To make things worse, the specter of trade protectionism haunts Europe, as many nations appear to be growing fonder of the idea of trade barriers at their borders. Trade barriers were one of the critical factors in the 1930s that threw the world economy off the tracks and into depression.

In addition, the U.K. is reaching a critical point in its economic crisis. The pound has fallen dramatically in the last few months (losing over a third of its value against the dollar in the last six months), and the U.K.'s largest bank, Royal Bank of Scotland, is on the verge of being nationalized. The U.K. real estate market is more leveraged than the U.S. real estate market (hard to believe, but U.K. lending standards were extremely lax). With its economic growth in recent years derived to a large degree from financial services (although not so much today), while its manufacturing sector declined, the U.K. is caught in a bad place with almost no way to turn around.

Russia is another worrisome canary. The ruble is under enormous stress, with oil prices having fallen as they have. The Georgians are breathing easier, since Russia must now focus on its economic problems. One suspects that the recent Russian natural gas embargo of the Ukraine (which resulted in natural gas shortages in many parts of Europe) was motivated in part by the need for Russia to boost its revenues from energy sales by any means possible. To maintain "harmony" with Russia (we use the term advisedly), European nations may have to pay it subsidies in the form of higher energy prices. That, in turn, would push Europe's economy farther down the slippery slope. And the ruble could be devalued. That would destabilize the financial markets at a time when they can hardly stand more instability.

American companies do a lot of business in Europe--or not. Watch European economic trends because they could portent trends in the U.S.

Japan. Japan has the second largest economy in the world. Although we tend to see it as an aggressive exporter, Japan actually imports a lot and has recently run trade deficits. Although oil accounts for a large part of Japan's imports, Japan does buy a lot of consumer goods from other countries. The Japanese economy is sliding down the slippery slope, and its government is scrambling as fast as the Obama adminstration to develop a stimulus package. However, the Japanese government, in spite of almost 20 years of economic stagnation, has never been able to develop an effective stimulus policy. If Japan keeps sliding, it will import less from the rest of the world.

China. China has the world's third largest economy (having just surpassed Germany). The Chinese government has announced a stimulus package that, in proportion to its national economy, is larger than the Obama administration's proposal. This measure may help stabilize things in China. But don't count on it to do much for the U.S. economy. In dynastic China, the government stockpiled grain in years with good harvests, and released grain from the imperial graneries during famines. Today's nominally Communist government in China is simply following in the tradition of its imperial predecessors. The people will be fed, and social harmony will be maintained. But the barbarians outside China are on their own. Notwithstanding its image as an export nation, the Chinese import a fair amount from the U.S. (things like agricultural products and scrap that's used as raw material for manufacturing). If China's economy keeps slowing, U.S. exports there will fall.

Oil Prices. The price of petroleum is a wild card. It's leveled off in the high 30s and low 40s. That's a damn sight better than $147 a barrel, where it was in mid-2008. A drop in the price of oil (and other energy sources) provides a direct stimulus right to the consumer. The nice thing is that much of this stimulus comes out of the pockets of nations that are hostile to the U.S. and might use oil revenues to do injury to the U.S. If oil prices keep dropping, that will be good for the economy. But, if they rise again in the spring, as some predict, expect an adverse impact on an already chastened consumer.

U.S. manufacturing. U.S. manufacturing is the quietest canary. But it may be the most important. In times past, the manufacturing sector played an important role in leading the economy out of recessions. A recent exception was the 2002 recession, from which recovery was achieved in no small part by ultra-easy Federal Reserve monetary policy. We know today that easy money doesn't produce a lasting recovery. Indeed, one reason why banks aren't lending now is because they bought into the whole easy money thing the last time around, and made a shipload of bad loans that plague them--and us--today. Current government policy might prevent panic and collapse. But it's unlikely to produce recovery. Manufacturing may be just about the only game in town. Keep an eye on it as an indicator of future trends.

Barack Obama: Buy on the Rumor, Sell on the News

Today, Barack Obama was sworn in as the 44th President of the United States. The Dow Jones Industrial Average closed at 7949, or 1676 points below the 9625 level where it closed on Nov. 4, 2008, the day he was elected. That 17% percent drop shouldn't be taken as a negative reflection on President Obama. It's really variant of the stock market following the old adage of buying on the rumor and selling on the news. Buying on the rumor is a way to profit from hope. Selling on the news--in this case, recent negative financial reports from major banks and business corporations--is what you do when reality looms.

Reality is that the banking system still harbors hundreds of billions and perhaps trillions of dollars of losses. The real estate and credit crunch losses of last summer have been supplemented by more broadly based losses resulting from the recession. Many different companies in many different industries are now hurting, and banks will probably be measured by the size of their loan loss reserves as much as by their earnings (or losses). Even though the banks have written off hundreds of billions of dollars already, new losses are springing up like the heads of the Hydra.

Reality is that the mortgage mess and credit crisis have morphed into a general, widespread recession. Unemployment is rising rapidly, not only in financial services and real estate-related industries like construction, but also in manufacturing, retailing and many small businesses. Things in Europe and Asia are, if anything, sliding faster than they are in the U.S. The U.K. is moving toward an expanded bank bailout. The Euro is dropping sharply against the dollar. Russia's ruble is under enormous stress. Japan's export-based economy may be shrinking at an annual rate in the double digits. China's government is implementing a stimulus package that, proportionately speaking, is larger than President Obama's stimulus proposal.

President Obama's stimulus package may give the stock market a lift (or not, if the news from the real economy continues to be bad). Whether it provides lasting support is a different question. The devil is in the details. Two basic things must be done to turn the economy around long term. First, federal fiscal policy should focus on encouraging productive economic activity. Production is the heart of any industrial economy. For much of the past 10 years, federal policy has been to boost real estate prices, counting on rising values to induce consumers to buy more homes (fueling the construction, finance and related industries) and to spend their home equity (fueling retail activity of all sorts). But, bottom line, this was just a speculation in commodities prices--in this case, the price of real estate instead of tulip bulbs. Except that at the peak of the frenzy, real estate and tulip bulbs amounted to the same thing--assets whose value depended on finding increasingly foolhardy buyers. No economy builds true wealth by trying to inflate asset prices. Doing so only results in price bubbles that painfully burst. Many oil producing nations have boom-bust cycles because they are too dependent on petroleum prices. The U.S. will be unable to establish sustainable economic growth if it continues its dependency on real estate prices. We need to focus on producing more things that can be sold domestically and overseas.

The second essential step is to establish a functioning financial system, one that manages and invests savers' money in reasonably prudent ways without creating systemic risk to the entire economy. It should be doable, but recent history is disheartening. Wall Street made massive amounts of money in the short term by creating huge risks for other people's money in the long term. What we need is a new Wall Street. The Obama administration and new Democratic Congress will endeavor to achieve that through increased regulation. It worked in the 1930s and could work again. After all, the unregulated derivatives market was the source of most of the trillions of dollars of losses that bedevil banks today. Market forces have also imposed reform. The most successful firms in financial services today are the plodders: the purveyors of index funds and low cost target date retirement funds. The tortoises beat the hares.

Note that we said restoring production of goods was the first step to recovery, and that salvaging the financial system was second. That's because you can't have a sound financial system unless you have a sound underlying economy. The Bush administration's policies of throwing unlimited quantities of cash at every financial institution in sight have failed to revive lending because the banks want borrowers that are creditworthy. And there are many more creditworthy borrowers when underlying economic conditions are strong, than when the economy is riven by layoffs and bankruptcies. The financial system is, in the final analysis, an adjunct to and service industry for the real economy. We can't become economically healthy if our economy is based on banks shuffling paper around (Iceland's recent collapse is Exhibit A in this respect).

Many observers viewed the yellow-gold dress Michelle Obama wore to the Inauguration as a symbol of hope and optimism. Maybe so. It certainly wasn't Republican. The real symbol of hope and optimism was the election of her husband, a nonwhite man, as President of a majority white nation. America today remains perhaps the only nation in the world that is truly based on democratic principles, rather than tribal or ethnic ties, or arbitrary borders left as an unfortunate legacy of European colonialism. The brightness of America's freedoms has attracted numerous talented and ambitious people from around the globe, whose energy and abilities provide a synergistic boost to its economy. America has a flexibility and capacity for innovation, improvisation and creativity that is unmatched anywhere else. Changes are good that ten or fifteen years from now, our economy and financial system will be quite different from what they are today. But chances are also good that they'll work, because that's America.

Why It Would Make Sense to Nationalize Banks

Today's government bailout of Bank of America (Part Deux? Part Trois?) illustrates why nationalizing the troubled major banks would make sense. Beginning with last spring's acquisition of Bear Stearns by J.P Morgan Chase, heavily subsidized by the United States, until today's just-another-$20 billion-bailout of Bank of America, it's become clear that we have already nationalized the financial system's losses. The government does not, however, control what the banks are doing. When credit is badly needed to boost the economy, the banks aren't there for us. When a serious restructuring of the financial sector is needed, little progress is seen. Yes, there have been some emergency consolidations. But, when the Merrill Lynch acquisition started going sour on Bank of America, B of A went back to the table--the one where the government sits--and asked for, and got, a larger welfare check. The Bush administration nationalized the financial system's losses in order to stabilize it. However, the financial system hasn't been stabilized; and credit remains frozen.

The major banks and other major financial institutions have become latter day Fannie Maes and Freddie Macs: institutions where private parties get the profits and gains, and the public takes the losses. This assymmetry of profits and losses undermines free enterprise dynamics. Fannie and Freddie failed to manage their risks properly, because they and their investors figured, correctly, that Uncle Sam would bail them out if they were reckless.

Today, the managements of the major banks have similar incentives. They're under relatively little pressure to face the music and truly write off their losses There's always a chance Uncle Sam will help them out. Another government bailout program might improve the value of some of the bad assets on their balances sheets, or even purchase them from the bank, thereby boosting management's bonuses and stockholdings. They don't seem to notice that all the government bailouts to date--which came with a price tag now running in the trillions--haven't turned things around. If they don't bear the losses, they don't have to notice.

Thus, bank managements have every reason to avoid hard decisions and put off painful, but needed restructurings. At the same time, the government doesn't run the banks and isn't making the tough decisions, either. No one's in charge and nothing definitive is being done to clean up bank balance sheets. Granted, Citigroup has just announced plans for a restructuring. But have they truly made the hard, hard decisions? Or do we think that they might ask Uncle Sam for at least a few tens of billions more before all is said and done?

Nationalizing troubled major financial institutions would clear things up. The government would be in charge, which would mean it's responsible. It would have to find solutions. Having both the responsibility and authority would give it the incentive to do just that. Don't assume the government would get it wrong. Government officials have done a pretty good job after nationalizing Fannie and Freddie--we know that because Fannie and Freddie are no longer in the news. Mortgage loans have become harder to get; but it's actually good thing that borrowers now need more than a pulse in order to qualify.

Nationalization also paves the way for crippled banks to be recapitalized by private investors and eventually returned to the private sector. How? Because the government could turn the bank around and make it an attractive investment. Right now, the government is taking preferred stock in exchange for bailout money because it doesn't have control of the bank and preferred stock gives it the potential to secure some gains for the taxpayers. But the government's taking preferred stock discourages private investors from infusing capital, because they might be diluted by a subsequent government bailout. If the government nationalizes a bank, cleans it up and gets it back on its feet, private investors would have a much easier time buying the bank (or at least its good parts), at a price that could be fair to everyone. The bad parts of the bank would have to be held by the taxpayers, but they're on the hook for the losses anyway. Restructurings along these lines are already happening with AIG and IndyMac, which were nationalized last fall.

The financial sector won't recover from its current disfunction until its balance sheets are cleaned up. What's clearly unacceptable is more of the Bush administration's ad hoc, back of the envelope, 70-yard Hail Mary pass style policy, carefully tailored to its 2:00 a.m. perception of whatever the problem might be. Sometimes, after they announce a policy--such as the use of TARP to buy toxic assets--they then decide, in the full light of day, to back away from it. A few months later, buying toxic assets has returned as the policy du jour. The width of ties doesn't change as quickly. The current mixed private-public financial sector, whose balance sheets are opaque even on sunny days with clear skies, seems condemned to a slow, agonizing death of a thousand quarterly writedowns. Only animal torturers would enjoy what's going on. Nationalization shouldn't be forever. Nationalized financial institutions should be privatized, in whole or in part, as soon as is reasonably feasible. But to restore the financial sector's health, someone has to take charge, make the tough calls and administer the tough love. The only realistic candidate is the government, and we might as well get on with it.

A Proposal for the Economic Crisis: Establish New Banks

Officially, the federal government claims that very few banks have closed. If you're talking about formally chartered banks, that's true. Even if you count the close calls, like WaMu and Wachovia, which were acquired by other banks before they could collapse, the number of bank failures is relatively contained.

The reality, though, is that there has been a major collapse of the banking system. The securitization industry was a de facto banking system, which has almost totally disappeared as a result of the mortgage mess. This was multi-trillion dollar line of business, and provided a large part of the credit given to American consumers and industry. Scared straight by the disaster in the securitization market, large banks for all practical purposes no longer actively lend. They might retain existing loan relationships, but are often reducing credit lines for existing customers. New extensions of credit are very difficult to get, and usually are made only if the loans can be sold to the federal government. Banks themselves don't like to lend if they have to hold the credit risk on the loan.

Today, Federal Reserve Chairman Ben Bernanke said in a speech in London that more bank bailouts may be needed. This, on top of President-elect Obama's $800 billion plus stimulus package. Bernanke said banks might need capital infusions, and the federal government might have to buy toxic assets (the original purpose of Henry Paulson's TARP program, which he subsequently backed away from but perhaps should have implemented).

Let's face the facts: the banking sector has become a black hole that is soaking up taxpayers' money with no end in sight. It's obvious that the Fed and Treasury Department don't know how bad the problem is, nor do they know the magnitude of the taxpayer relief the existing banks might need. It's also obvious that the banking sector isn't about to return to real lending any time soon.

There is no way for the public to know how unclean the banking system's balance sheets are. Yet, an economic recovery depends heavily on a renewal of lending. Federal deficit spending might stimulate the economy for a while. But it isn't the self-sustaining kind of commercial activity that is crucial to a healthy economy. That requires a revival of lending. What we need are new banks. With pristine balance sheets, new banks would not be hampered by toxic assets and could lend based on reasonable credit standards. Their managements would not be concerned for career reasons about having to take write downs for bad decisions they made a few years ago, and would not need to hoard capital to cover losses from those bad decisions.

New banks would necessarily be small, which would mean they would naturally focus on consumers and small businesses, two groups of customers that have been squeezed out by existing banks. Small, new banks would be community oriented, and their localized knowledge would allow them to be more flexible with the smaller borrowers that default. New banks, being small, would not be too large to fail, so they wouldn't need the massive, unending bailouts that the mega-banks now receive.

Some of the second $350 billion tranche of the TARP money could be set aside to facilitate the formation of new banks and credit unions. This would involve the federal government holding an equity position in the new banks and credit unions, at least for a while. But better that than ever increasing federal equity positions in the too-large-to-fail banks.

As the new banks become established, they might well begin buying branches and facilities of existing troubled banks. In this way, banking resources could be transferred from poorly managed institutions which, in taking public assistance, have surpassed every welfare queen in America, to banks that might actually use those resources to benefit the real economy. If this slow motion process of restructuring the banking industry is taken far enough, the remnant troubled institutions might be allowed to fail (thereby turning off the spigot at the Fed and the Treasury), without seriously disrupting the real economy. That would be a good thing. When Sweden had a financial bubble burst in the early 1990s, it instituted policies along these lines, of forming new banks and allowing some troubled banks to fail. Its economy staged a good recovery.

The Fed and Treasury are spooked by the fallout from their decision to let Lehman collapse, which freaked out the financial markets and forced them to bailout the entire U.S. financial system. But they apparently have no strategies, policies, programs or proposals other than further bailouts regardless of cost. This must end; taxpayers, who do not have limitless resources, cannot indefinitely provide the existing financial system with a limitless line of credit. Banking isn't like an elementary school soccer game where score isn't kept. Banking is part of the free enterprise system and ultimately the score must count or the government has undermined free enterprise (and treated bankers like they're elementary school kids; but perhaps we should stop here because this analogy might be hitting too close to home).

Let's remember that the goal is to save the country, not the banks. To get around the black holes that existing banks have become, taxpayer money should be used to establish new banks and credit unions with clean slates for balance sheets. Then, credit might flow again to the real economy, and the entire society begin to prosper anew.

Let the Investor Beware, Part Deux

Like a horror movie mummy rising from a sarcophagus, the legal doctrine of caveat emptor has re-appeared in the financial markets. Caveat emptor--or, let the buyer beware--harks back to the English common law brought to North America by colonists. It placed the responsibility of evaluating a purchase (of a horse, a farm or an investment) on the buyer. The seller, for the most part, only had to refrain from actively engaging in fraud.

As the American economy grew larger and larger, and the financial markets became more complex and national in scope, the legal responsibilities of sellers grew. In particular, after the 1929 crash, the federal government adopted securities laws that reversed the roles of buyers and sellers in the stock markets. Suddenly, it became the responsibility of the seller to disclose to the buyer all sorts of information. The buyer no longer had to figure out what might be hinky about an investment. The seller had to disclose the hinky features. In the vastness and anonymity of the 20th century's stock markets, this role reversal made sense. A hardworking store owner in Cedar Rapids had little or no ability to figure out whether or not a chemical company in New Jersey or an insurance company in Connecticut was a good investment. The companies had most or all of the relevant information, while the potential investor or depositor had essentially no way to get access to it. If we were to have vibrant capital markets, the sellers of the investments would have to ensure the provision of accurate information.

Similar increases of regulation occurred in the banking industry. The federal government, as the insurer of bank deposits, insisted on all sorts of limitations on the risks that banks took as the price of boosting depositor confidence. The depositor no longer had to beware of the bank.

However, like any industry, the financial services industry shifted activities away from the regulated arena. It saw greater profitability where it would face fewer restraints, and went for the gold.

If we look at the areas in the recent financial crisis where the greatest losses occurred, they were in largely unregulated arenas. The mortgage-backed securities market and the derivatives market (especially for credit derivatives) almost entirely fell outside the scope of federal regulation. The losses there ran into the trillions. These markets amounted to a shadow banking system, where activities and risks received no oversight by federal banking regulators, and disclosures to investors were not generally reviewed by the SEC. This shadow banking system has almost entirely collapsed, just as the recognized banking system collapsed in the early 1930s. The trillions being spent or loaned by the Federal Reserve and Treasury Department (via its TARP program) are primarily devoted to combating the aftereffects of the collapse of the unregulated part of the banking system.

The tens of billions that Bernie Madoff apparently stole are a drop in the bucket compared to the mortgage and derivatives losses. But even his fraud seems to have originated in a largely unregulated corner of the securities market. Although the facts of this scam remain to be fully revealed, it would appear that virtually all of the victims were well off individuals or institutional investors. They would probably have been considered "accredited investors" (i.e., a category of investors deemed capable of taking care of themselves and therefore not needing the extensive protections given to regular investors). In other words, the concept of accredited investors is premised on the doctrine of caveat emptor. Accredited investors have access to hedge funds and other investments that may be more profitable than ordinary investments like mutual funds. The tradeoff for them, though, is less governmental protection, as well as potentially greater financial risk. Many accredited investors accept this bargain, because they want the profit potential of hedge funds and other alternative investments. They have to remember, though, that to a much greater extent they are on their own.

While regulators may have failed to uncover Madoff's shenanigans as quickly as we'd like, we should remember that his victims voluntarily invested in a less regulated sector of the markets. Regulators should bear responsibility for their failures, but investors should bear responsibility for their failures.

Sadly, there probably won't be much that can be done to recompense Madoff's victims. And taxpayers will probably lose shiploads of money bailing out the banking industry for mortgage and derivatives losses. We (and especially the new adminstration and new Congress) should think about the future, by filling the regulatory gaps. We shouldn't expend a lot of effort commiserating with bankers distraught over the burdens of increased regulation. The astronomical size of the losses in question call for an expanded victims' rights program in the financial markets. While regulation should be reasonable and well-tailored to addressing the problems at hand, rolling back the cold hand of caveat emptor would be a good way to begin the healing process.

The Economic Crisis: Are the Inmates in Charge of the Federal Asylum?

One indication of insanity is irrational behavior. A memorable antiwar movie from the late 1960s, King of Hearts (starring Alan Bates and Genevieve Bujold), depicts a British soldier in World War I who finds himself in an abandoned French town, searching for a German time bomb that will blow up the town. He inadvertently opens the door of the local insane asylum. The inmates escape and take up their lives in the town. One of them is a barber, who gives his customers shaves and haircuts, and then pays them. We won't tell you how the movie ends. But this one is worth renting or buying if you want an entertaining exploration of the boundary between sanity and insanity.

There is evidence that lunatics have taken over federal economic policy. Let's look at some of the irrationality.

Ultra Low Interest Rates. The Federal Reserve's ultra low fed funds rate target (and discount rate) are meant to stimulate economic activity. But banks aren't lending because they don't consider anyone creditworthy any more. So interest rates that could slip beneath a snake's belly don't have a stimulative effect. But they severely penalize savers and retirees who depend on interest income. The U.S. needs to boost its savings, to have capital to fund the government's deficits. But the government ensures meager rewards for savers, while taxing those rewards as ordinary income. (By contrast, capital gains, which are scarcer than hens teeth in today's financial markets, are given preferential tax treatment.) Retirees who see the interest on their hard-earned savings evaporate are hardly going to run out to the nearest mall and give the economy a consumption-driven boost. The wealth effect goes into reverse when your investment income dries up. Ultra low interest rates also push down the dollar, which increases the price of oil and gasoline. This must be the push me-pull you kind of stimulus.

Combating Deflation. The federal government is shoving as much borrowed and printed money as possible into the economy to, among other things, reduce the potential for deflation. Deflation, we are told, is bad because consumers will wait for prices to drop before buying, thereby reducing spending. And repayment of debt becomes more burdensome if the borrower must repay with deflated dollars. But these broad propositions overlook the fact that not all deflation is bad. If consumption of a particular item cannot be deferred, deflation is good, because lower prices will stimulate more consumption. For example, it's hard to defer most purchases of food, electricity, and gasoline. If prices of these items fall, that gives consumers more discretionary income for other purchases (or to repay their debts faster). But the Fed's tsunami of liquidity doesn't differentiate between the prices of goods where purchases can be deferred and those that cannot. Thus, all these free-floating dollars could set the stage for serious inflation, and perhaps sooner than we'd think. The recent deflation in gas prices is a darn good thing, and some deflation in food prices would be welcome.

Supporting Asset Prices. Official denials notwithstanding, it's clear that the Bush administration and Congress have acted to support stock prices. The incoming Obama administration is hinting at supporting real estate prices. Government subsidies of this nature inevitably cause misallocation of society's resources. We have invested way too much money in real estate. Much of it was borrowed money, and we are paying a painful price for this misallocation. No lesson has been learned, however, as the Fed, Treasury, Congress and White House all jump whenever the stock market tells them to jump. Government prescribed asset prices will either cost the taxpayers a mint, or provide speculators with undue profits (take a look at federal agricultural price supports, or the time in 1992 when hedge funds smacked down the British pound). The government should focus on providing a safety net for the unemployed and those in need of health insurance; and stimulate economic activity. Let the market set asset prices; that's what the market does well and the government does poorly.

Lack of Change. Too many of the Obama administration's appointees were close the scenes of the crimes leading up to the economic crisis. Their actual or potential involvement in past governmental failures or disappointments casts doubt over their ability to be effective in official positions and in the freshness of their thinking. One form of insane behavior is repetitive self-destructiveness. We want Barack Obama to succeed. This country badly needs a successful President. Repetitive self-destructive policy making isn't conducive to success.

Prediction for the Financial Markets in 2009

If you look at a few financial websites, you'll read that the stock market will dip at the beginning of this year, and then recover, ending the year above its current levels. Or you'll learn that the markets can be expected to rally at first, only to drop off sharply in the second half of the year. Or you'll be told that the markets will rise, drop and then rise again. Or that they will drop, drop some more and then drop even some more.

We would predict that almost all the predictions will be wrong. Of this we are certain. And here's why.

Governmental and political action will have greater impact on the financial markets than anything else in 2009. Consumer demand will stagnate. Business investment will be muted. Bank lending, these days, is almost an oxymoron. The only show in town is the government--or more precisely, the governments of all the world's economic players. And almost nothing is as unpredictable as government action or inaction, and their consequences.

We can expect some sort of big stimulus package from the Obama administration. But will it work? Comparable measures in Japan in the 1990s were ineffective; and there are many similarities between the U.S. today and the Japan of 12-15 years ago. Massive losses were sustained in the real estate and stock markets. The government avoided making the financial sector face up to and write off all its losses. Consequently investors felt constrained not to invest in banks whose balance sheets were opaque (on the accurate assumption that the banks were actually insolvent). Unemployment was rising rapidly even while the social safety net was increasingly strained. Consumers avoided unnecessary spending, and saving became the order of the day. Japan also had a strong export sector. Consumers in other nations, especially America, did much to prevent a collapse of the Japanese economy. The U.S. does not have as strong an export sector today, and the continuing volatility of the dollar and disappearance of trade financing threaten to cripple America's export industries.

The Obama stimulus package should focus on assisting and strengthening the real economy. Between TARP and the Federal Reserve's money printing presses, the financial sector has soaked up enough trillions of taxpayer dollars. The money flooding into the financial sector isn't finding its way into the hands of consumers and businesses. It's time to disintermediate the financial intermediaries and put money directly into the real economy. A large degree of stimulus by the U.S. government shortly after the 9/11 bombings in 2001 did prevent the U.S. economy from nosediving into a major recession, although the Federal Reserve made the horrendous mistake of not withdrawing the extra liquidity it provided quickly enough, producing the real estate and credit bubbles that have now devastated the U.S. financial sector. It's just possible that the Federal Reserve's measures, plus TARP and the Obama stimulus package, might revive the U.S. economy. But we'd predict that the Fed won't have the guts to withdraw the extraordinary levels of liquidity it's now providing, because no one likes to take away the punch bowl just as the party really warms up, even though astronomical hangovers will be the alternative.

Even the best efforts of the U.S. government, though, can be confounded by international developments. Other nations are throwing up trade barriers, by trying to weaken their currencies, raise tariffs, subsidize their industries and slow the movement of imports off their docks. In a time of recession, national protectionism is a game of musical chairs. When the music stops, there won't be enough chairs for everyone. Indeed, in the worst case scenarios, there may not be chairs for anyone. But political pressures within each nation force its government to protect its own citizens, even if the overall worldwide effect is to worsen the recession. Thus, the best efforts of the Obama administration may be undermined by other nations. In the mosh pit that will be the world's economy in 2009, there's no way to predict how things will go for anyone.

So what does an investor do? Stay diversified. Okay, diversification didn't work in 2008, when virtually all asset classes fell in value. But any investment strategy will sometimes fail. Unless you believe in Bernie Madoff, you won't find an investment strategy that doesn't involve losses sometimes. Diversification is like capitalism--it's imperfect, but better than the alternatives. Today, you should think about being more conservative, keeping some dry ammo in the form of extra cash. Use this cash opportunistically when good potential investments pop up. Meanwhile, concentrate on that New Year's resolution to lose the love handles, and you'll have a way to get something positive from 2009.