Wednesday, August 18, 2010

Financing the Recovery

The Dodd-Frank Financial Reform and Prevention of Self-Immolation Act
I haven't commented on the financial reform legislation as it finally came down the pike. Mostly, it was unobjectionable in the sense that it contains provisions that the banking industry agreed were needed to prevent itself from destroying itself so easily next time.

Think of the banking crisis which caused the Great Crater as being like a person strapping an explosive device to himself, going into a public area, and threatening to blow himself and everyone around to smithereens if the authorities don't come and help him take this thing off.

In that scenario, the new legislation is simply the banks agreeing not to strap explosive devices to themselves anymore, and, if they do, agreeing that the authorities can clear the square of others before they blow themselves up. Sounds OK, but you still wouldn't want such individuals hanging around your kids.

The one thing in the legislation that might put a crimp in the bankers' plans is the new Consumer Financial Practices agency: the banks assumed they could negate the power of that organization from the start, but there's a chance it could still be a problem for them, at least for a short while if President Obama picks Elizabeth Warren for it.

Unfinished Business

I commented at one point that the legislation was too silent on the subject of capital requirements for banks. It's clear now that there was a strategy there--this will be the province of the Bank for International Settlements (a/k/a Basel), and that the rules will be standardized across countries. That's really the only approach that will make sense--otherwise, the US banks would be penalized (or advantaged) vs. banks from other countries. There has been an agreement in principle on the new rules, which will be phased in slowly enough that their impact in restraining lending (requiring higher capital for a given amount of lending, for the most part) will not impede global recovery from the current downturn.

The other big time bomb strapped to public chests out there is Fannie/Freddie (FNMA and FRMC), the government-backed enterprises which insure huge quantities of mortgages, which are losing money hand over fist these days, presenting a potential new bailout issue. It appears to be either bail or jail--letting these organizations fail, or taking away their government backing, would have a catastrophic effect on the weak domestic housing market and simply can't be contemplated at the time.

The solution is pretty straightforward, and I'm sure they'll get around to it eventually. It would be called "recapitalization", and it would be quite similar to what was done through a consortium of banks in the '80's, when sovereign Third World debt volumes threatened to sink all the major banks. Here, the healthy loans in Fannie/Freddie (and there are plenty) would require a smaller amount of capital (using the new rules) once the bad loans are stripped off. Fannie/Freddie used to have rules which kept out the bad loans; they degenerated in the final years before the crisis, but not nearly as bad as some others. The bad loans on their books--a relatively small percentage but still a huge quantity--would be reworked, hopefully very creatively, and the effort put into them would eventually limit damage to something much smaller than what current estimates would suggest.

Where is the Love?

Where is the Loan,
You said was mine oh mine
Til the end of time
Was it just a lie
Where is the loan?

This should be a good situation: the banks are sitting on a ton of money; the companies that might borrow it are sitting on their own tons of money (which makes them great candidates for loans); neither banks nor companies can make enough just pussyfooting around with their piles (i.e., Treasury bills and the like).

What's needed is actually a FDR-style National Recovery Act kind of industrial and energy plan which the companies could rally around and put the system's money to work. The problem with this is all the TP hanging around gumming things up, but that problem isn't going away. The challenge of framing targeted investments to get the economy going (gradually) and moving in logical directions to assist our economic future is one that will have to be handled with a great deal of diplomacy. If it is handled properly (for example, "energy independence" to bring the conservatives on board; the promise of easy profits to get the companies falling in line), it can work.

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