Why the White House and Congress won't break up the banks

There are plenty of good reasons to break up the behemoth banks -- just not good enough for Obama

By Robert Reich

Oct. 26, 2009

And now there are five -- five Wall Street behemoths, bigger than they were before the Great Meltdown, paying fatter salaries and bonuses to retain their so-called"talent," and raking in huge profits. The biggest difference between now and last October is these biggies didn't know then that they were too big to fail and the government would bail them out if they got into trouble. Now they do. And like a giant, gawking adolescent who's just discovered he can crash the Lexus convertible his rich dad gave him and the next morning have a new one waiting in his driveway courtesy of a dad who can't say no, the biggies will drive even faster now, taking even bigger risks.

What to do? Two ideas are floating around Washington, but only one is supported by the Treasury and the White House. Unfortunately, it's the wrong one.

The right idea is to break up the giant banks. I don't often agree with Alan Greenspan but he was right when he said last week that "[i]f they're too big to fail, they're too big." Greenspan noted that the government broke up Standard Oil in 1911, and what happened? "The individual parts became more valuable than the whole. Maybe that's what we need to do." (Historic footnote: Had Greenspan not supported in 1999 Congress's repeal of the Glass Stagall Act, which separated investment from commercial banking, we wouldn't be in the soup we're in to begin with.)

Former Fed Chair Paul Volcker, whose only problem is he's much too tall, last week told the New York Times he'd like to see the restoration of the Glass-Steagall Act provisions that would separate the financial giants' deposit-taking activities from their investment and trading businesses. If this separation went into effect, JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. And Goldman Sachs could no longer be a bank holding company.

But the Obama Administration doesn't agree with either Greenspan or Volcker. While it says it doesn't want another bank bailout, its solution to the "too big to fail" problem doesn't go nearly far enough. In fact, it doesn't really go anywhere. The Administration would wait until a giant bank was in danger of failing and then put it into a process akin to bankruptcy. The bank's assets would be sold off to pay its creditors, and its shareholders would likely walk off with nothing. The Treasury would determine when such a "resolution" process was needed, and appoint a receiver, such as the FDIC, to wind down the bank's operations.

There should be an orderly process for putting big failing banks out of business. But this isn't nearly enough. By the time a truly big bank gets into trouble -- one that poses a "systemic risk" to the entire economy -- it's too late. Other banks, competing like mad for the same talent and profits, will already have adopted many of the excessively-risky banks techniques. And the pending failure will already have rocked the entire financial sector.

Worse yet, the Administration's plan gives the big failing bank an escape hatch: The receiver might decide that the bank doesn't need to go out of business after all -- that all it needs is some government money to tide it over until the crisis passes. So the Treasury would also have the authority to provide the bank with financial assistance in the form of loans or guarantees. In other words, back to bailout. (Historical footnote: Summers and Geithner, along with Bob Rubin, while at Treasury in 1999, joined Greenspan in urging Congress to repeal Glass-Steagall. The four of them -- Greenspan, Summers, Rubin and Geithner also refused to regulate derivatives, and pushed Congress to stop the Commodity Futures Trading Corporation from doing so.)

Congress is cooking up a variation on the "resolution" idea that would give the Federal Deposit Insurance Corporation authority to trigger and handle the winding-down of big banks in trouble, without Treasury involvement, and without an escape hatch.

Needless to say, Wall Street favors the Administration's approach -- which is why the Administration chose it to begin with. If I were less charitable I'd say Geithner and Summers continue to bend over bankwards to make Wall Street happy, and in doing so continue to risk the credibility of the President, as well as the long-term financial stability of the system.

Wall Street could live with the slightly less delectable variation that Congress is coming up with. But Congress won't go as far as to unleash the antitrust laws on the big banks or resurrect the Glass-Steagall Act. After all, the Street is a major benefactor of Congress and the Street's lobbyists and lackeys are all over Capitol Hill.

The Street obviously detests the notion that its behemoths should be broken up. That's why the idea isn't even on the table. But it should be. No important public interest is served by allowing giant banks to grow too big to fail. Winding them down after they get into trouble is no answer. By then the damage will already have been done.

Whether it's using the antitrust laws or enacting a new Glass-Steagall Act, the Wall Street giants should be split up -- and soon.

-- By Robert Reich

Wall Street Voodoo

by Paul Krugman, NY Times, January 19, 2009

Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans.

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

The current buzz suggests, however, that policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward a compromise approach: moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” that would resemble the Resolution Trust Corporation, but without seizing the banks first.

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, recently tried to describe how this would work: “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?

What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value” purchases of toxic assets.

Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks.

Unfortunately, the price of this retreat into superstition may be high. I hope I’m wrong, but I suspect that taxpayers are about to get another raw deal — and that we’re about to get another financial rescue plan that fails to do the job.