Barack Obama, Arugula Populist – Jan 25, 2010

So what do you do when you have to face the reality that, one full year into your administration, when you are idolized around the world, you have towering majorities in both houses of Congress, you were elected on a mandate for change and yet with all that going for you, you a) can’t get your signature legislation passed, and b) one of the safest Senate seats in the country for your party just went to the opposition in a convincing drubbing, won by a little known candidate who said he was going to stop your top priority?  What do you do?
You change the subject, that’s what you do.
That’s why all of a sudden, we are treated to the unfamiliar sight of Barack Obama, Populist.  It seems that all those little people, the ones who cling to their guns and religion when times are bad, are the people he needs now, and what better way to appeal to them than to bash Wall Street?  (Incidentally, I’m wondering how all those smart New York financial types, who supported Obama with tens of millions of their unconscionable riches, are feeling about their investment these days.)  Obama angrily insists “we’re going to get every dime back” of the bailout money.  Well, yes, these were loans, not gifts, and the funds that were not loans were equity stakes that the government took in banks like Citibank.  So of course the government is going to get paid back.  That’s what banks do, is to borrow money and pay it back – that was the case long before the President started stamping his foot about it.  I would be more concerned about the fact that Congress is planning to use the TARP program like a revolving line of credit, so when the banks pay it back with interest (as many have done already) Congress finds something else to spend it on instead of returning it to the Treasury and reducing the deficit.  It is a congenital defect with Congresspeople, particularly acute among Democrats although clearly both sides are susceptible, that they can’t look at incoming money without a reflex move to spend it.
Obama has also announced a petulant little bank tax, which supposedly is to punish banks and at the same time build up a fund to defray the costs of a future bailout (the risk of which they plan to regulate away).  The thing Democrats just don’t seem to understand, despite decades of incontrovertible evidence, is that companies do not pay taxes.  They merely collect the money for the taxes from their customers, their employees, and their shareholders and pass it on to the government.  So whatever the purpose of this tax, its effect will be to make life harder and more expensive for those folks out there clinging to their guns and religion who just found their mortgages are more expensive.  Way to go, Mr. Populist!
The big idea that Obama floated this week is his so-called Volcker Plan, which is essentially a return to Glass-Steagall, to effectively convert all deposit-taking institutions into safe little operations like the old Bailey Building and Loan, and make sure that there is no taxpayer backing of those reckless greedy bankers who want to go out there and engage in (gasp! horrors!) proprietary trading, or worse, (double gasp!!) invest in hedge funds.  Now tell me, is it not the case that Congress has been working on a financial regulation plan for the better part of a year, they have had hearings, there is legislative language that has been put together and the sausage is in process (remember the financial consumer protection agency, the squabbles over who gets to regulate what, all that)?  And along comes Mr. President, keen to be seen surfing the same monster wave that Scott Brown rode in on, to say, “Never mind all that!  Let’s do this!  We got to rein in the banks!”  And as you might expect, the idea is not well thought through or even coherent.  As I understand it, the White House web site as a two-page set of talking points about this, rather than a serious analysis-driven proposition.  It’s a reflex.
Now, I believe that there is merit in the idea that taxpayers should not pay the freight when somebody goes out and does something stupid, like leverage up his company 34 – 1 and then put all the proceeds in structured investments the true risk of which he can only guess.  That guy, and his financiers, should be wiped out.  But does this plan even approach that kind of bracing cold wind of financial discipline?
Think of it this way:  if all the banks that take consumer deposits stayed with simple businesses like mortgages and small business loans, would we have avoided this mess?  Remember that the first wave of the crisis occurred when Bear Stearns crapped out.  Not only was that not an FDIC-insured institution, but its business, employees, contracts et al were only kept alive because Bear was merged into JP Morgan – one of those insured banks!  That would probably not have been possible under the Volcker Plan.  In the wake of this, the Fed tried to calm nerves by telling all the surviving investment banks that they too could borrow at the emergency window, previously a privilege only for commercial banks.  Now even the high-flying Masters of the Universe could get rescue funding if they needed it.  Thus does the government step in to say, “I don’t care what the rules say, when we need to prop up the financial world, prop we will.”
The stuff really hit the fan with the sudden evaporation of Lehman Brothers later that year.  This time, for reasons the world has yet to learn, the Feds did not ride to the rescue and the firm went belly up.  Another investment bank, not guaranteed by the FDIC.  And what happened?  Well, first of all, both Merrill Lynch and Morgan Stanley, among the last remaining of the large investment banks, were shotgunned into merging with deposit-insured institutions – again, something that would not have been possible under Glass-Steagall.  More importantly, when Lehman went bust, they defaulted on lots of very short-term loans they had taken out, the kind of overnight stuff that is the lifeblood of modern finance.  And with those defaults, the unthinkable happened: money market funds, which are not government insured but which sell themselves as being as good as cash, suddenly were not.  Those funds who had bought Lehman paper actually found they could not repay their investors dollar for dollar.  Then the roof fell in.
When something as rock solid as a money market fund is suddenly risky, when one investment bank is allowed to fail when others are forced into mergers, when suddenly nobody had confidence of the value of their securities – mortgage-based in particular – then everything freezes up.  Financial firms can’t raise overnight money because nobody trusts the paper.  Nobody will make a price on broad categories of assets; banks and investors holding those assets have to write them off as worthless and decimate their capital base to cover the losses.  Banks, investment banks, and other market professionals become suddenly wary of trading with each other, because nobody knew if their counterparty was the next Lehman.  Liquidity dries up, markets become desiccated and cease to function properly.  Asset values fall.
Now, how much of that would not have happened if Obama has his way and prevents banks from proprietary trading?  Given that he does not propose to include investment banks or other financial institutions in that scheme, it probably all would have followed a similar if not identical course.  Because you don’t have to be a commercial bank taking in FDIC-insured deposits to be too big to fail, and effectively carry a government guarantee (they learned that lesson with Lehman).  Look at AIG.  Over a hundred thirty billion.  And that money will not come back for decades, if ever.  As long as these big guys trade billions back and forth each day with each other, the failure of one is a calamity for all.  The Economist uses the metaphor of a group of mountain climbers, roped together.  If one of them falls off the mountain, they all could go along for the ride.
So the Volcker Plan will not actually prevent another version of the Great Panic of 2008.  What it would do is put our commercial banks at a critical competitive disadvantage vis a vis similar firms in other countries, who are not subject to the same restrictions.  Not only that, but if banks stick with bread and butter businesses like mortgage lending and small business loans, they will become more risky, not less, as they will have very little diversification of businesses, and the markets they lend in are notoriously cyclical.  There was a good reason that banks were permitted to forage further afield – it was the outgrowth of the last real estate crisis, in the early ’90’s, after which banks made the case that broader business lines made them less prone to concentrated losses that threatened their viability.  Well, that didn’t work too well, either, but that doesn’t mean it was better back then.
I think one simple way we could prevent this kind of mess again would be to require all mortgage-originating institutions to retain a significant portion of each loan on their own books, perhaps as much as 20%.  In one stroke, it would put a stop to the willy-nilly, throw-me-the-money, liar loans and no-doc specials that really fueled the balloon.  It would return the simple task of evaluating a credit risk to those closest to the borrower, and would also probably put some discipline into the borrower, as their local banker would be less willing to let them take out a low-teaser-rate loan if they couldn’t afford the later ratchets.  It probably would have made mortgages harder to get, and more expensive.  In retrospect, that is exactly appropriate.  That one small change would have made a huge difference.
(sigh),  But that’s just so much common sense.  Instead of that, look for more populism at the State of the Union address.  That voter anger is a rich vein; as implausible as it may seem for Mr. Arugula, he’s going to try to tap it.
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