October 02, 2008

No Banker Left Behind

Well, it looks like the house is about to pass a $700B boondoggle. They say this is necessary to “bail out” the mortgage mess, and if they don’t do it that the capital markets will lock up and it will rain frogs etc. This is all BS.

A bunch of people, from bankers on Wall Street, on down to homeowners on Main Street, took too much risk. They were happy when everything went up. A lot of Bankers made a lot of money, a lot of homeowners saw great paper gains, often borrowed against those paper gains, or maybe even sold their homes and realized gains (like I did). However, anything that goes up that fast will come back down. The Banks that took huge bonuses out for the Execs, instead of keeping it in the bank for a rainy day, are now upside down. The homeowners who borrowed against their paper gains are now upside down. By upside down I mean that their liabilities exceed their assets. They are “insolvent”.

What happens when you’re insolvent? Your equity (stock) value goes to $0, the creditors now have preference for your assets over the equity holders, and since you can’t pay the creditors you go through bankruptcy. This is how a free market works, in fact it’s an improvement over the debtor-prisons of old. You go through bankruptcy, life sucks for about 7 years, your record is effectively expunged and you move on.

For Harry Homeowner on Main Street who owes $200k more on his house than it’s worth, bankruptcy is the best possible thing for him. How many average guys can save $200k in 7 years? Also, given overinflated home prices right now, it might cost $4k/mo to own a house that costs only $2k/mo to rent (another reason that home prices need to come down). So, not only would he get a $200k gift but he’d also save more over the next 7 years on top of it.

For Big Bad Bank that screwed the pooch, this isn’t as much fun for them. As Harry, above, defaults on his loan, the bank is put in an even worse situation. But that’s good! The sooner the bank’s board of directors decides that the bank is insolvent and that the creditors have preference over the assets, then bankruptcy can begin for these mismanaged banks. Then NEW banks can spring up to take their place.

Think the old banks are full of smart guys? We just proved they’re not. They’re not good at math (lower division science classes have a lot more math than any MBA program), they’re not the only ones who understand these “complex” transactions, they mostly just have the contacts. These kind of contacts are the kind that when you screw up, you can find a buddy to pick up your stinky asset for you. In return, you’ll pick up one of his stinky ones later and neither of you have to write anything down. This is exactly the type of old-boy network that needs to evaporate. These contacts, although valuable to the individuals who have them, have negative value to the system.

Remember how they used to fight forest fires aggressively until they realized that all the deadwood just built up and made for a less healthy forest now and for worse fires in the future? It’s the same thing here. Think you need to rescue the 100 year old banking institution? No you don’t, it’s full of deadwood. Over paid, “fireproof” executives who would never get cleaned out otherwise need to be cleaned out. Mismanaged divisions need to disappear. Programs with poorly reviewed risk profiles need to be reviewed and cut.

If the taxpayers *really* need to put $700B into the system, then put it only into new banks. Give the system a chance to clear out all the tools who decided that they could privatize gains and socialize risks. All the execs whose institutions collapse will have a bankruptcy on their records, will have a hard time getting D&O (Director and Officer) insurance, and will have a harder time raising money to manage in the future.

If you want a guaranteed return, buy T-Bills. The T-Bill rate (currently 1.72% APR) is the only rate that us, the taxpayers, are willing to give you. If you want 20% returns then guess what, there’s a good chance you’ll lose it all. In fact, mathematically speaking, you should lose it all about 1 out of 5 times while chasing a 20% return.

There’s no free lunch, unless/until, of course, we pass this bill. Then we’re buying lunch for all of Wall Street, with no banker left behind. Even the bad ones.

Posted by rick at 07:11 AM