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Wipe the Slate Clean and Start Over

News reports indicate that President Obama is considering a “bad bank” system to address the problem with “toxic assets” on the books of financial conglomerates.  The problem with this approach is that: 1) what price do we pay for these “toxic assets” and 2) it preserves and protects shareholders with taxpayer money.  We need to start over and wipe the slate clean.  This would be very painful but it is better than dumping trillions of dollars into a system that is broken beyond repair.

Bad Banks

The “bad bank” concept was discussed in September 2008.  It involves a governmental entity, probably the FDIC (Federal Deposit Insurance Corporation), purchasing the “toxic assets” from financial conglomerates.  The theory is by removing these assets from the financial conglomerates books would free them up to start lending again.  This sounds good in theory but this faces significant problems.

What do we pay for such “toxic assets”?  The “market” says they have very little value or are worthless.  The purchase of these assets would be a direct subsidy to the financial conglomerates and taxpayers would be left holding the bag.  This would be extremely expensive and will not guarantee that banks will start lending.

Why should taxpayers assume the risk that was created by financial conglomerates?  The “bad bank” idea preserves and protects shareholders and possibly executive management.  This creates a moral hazard in that if there are no consequences to taking risks and making poor decisions then what lessons are learned from this crisis. 

Wipe the Slate Clean

We should wipe the slate clean and start over by restarting the economy with a streamlined and smaller financial system.  In the end, we must have a financial system that is smaller, more transparent and less complex.  We must have a financial system that creates wealth out of real assets and not paper or thin air.  The proposals below would be extremely painfully to a broad segment of our country (including me) but may be the fairest way to deal with this crisis.

1. Require full disclosure of financial conglomerate assets.  Financial conglomerates have “off-balance sheet” assets that are not publicly reported.  Require a complete audit.
2. Based on full disclosure determine if financial conglomerates are solvent (asset values are greater than liabilities) or not.
3. Create an entity similar to Resolution Trust Corporation (RTC) that will sell the assets of those financial conglomerates that are insolvent.
4. For those banks that are solvent.  Lower the minimum capital requirements imposed on them by bank regulators.  I know this seems risky but what can we do at this point.
5. For those financial conglomerates that are solvent, they must be made smaller through changes in laws governing financial institutions.
6. For those solvent banks that need a capital infusion then taxpayers must receive a true “market” investment in return and not the one that former Secretary Paulson structured.  This has to be a true last resort and banks must know that there is a price (including more oversight) to pay for the capital infusion.  This while dilute the interests of current shareholders but too bad.

The above proposal addresses the problem with financial conglomerates.  The following proposal addresses the troubled mortgages and involves the beginnings of a newly restructured mortgage system which would be modeled after the Danish System of mortgage finance.  Restructuring our mortgage system would require legislative and regulatory changes.

1. Refinance and modify all existing troubled mortgages in such a way that loan principal cannot exceed current market value of the homes.  This should prevent “negative equity”.  It is an artificial price support but this could help the housing market.  Refinance these loans to a fixed rate loan with a guarantee similar to FHA loan.
2. These new loans would be funded by a standardized bond issued by loan originators.  The new standardized bonds would be of equal size, identical cash flow and same maturity as the mortgage.  This is the concept of “Principle Balance” and which is very important in the Danish system.
3. Fannie Mae and Freddie Mac could be the first loan originators under this plan.

This would be the beginning of changing our home mortgage system.  It would entail significant changes and many monied interests would not be happy.  But that is too bad since these same interests got us into this mess. 

One big question remains: what to do with the securities that were created by slicing and dicing up the cash flows from the trouble mortgages?  Are they just written off as a capital loss?

There is not enough space on this page to go into details.  The most important point of this discussion is that our current economic system and financial system must change.  It is obvious that our current system is not sustainable.  “Bad bank” theory is just preserving this irreparable system.