The End of the Financial World as We Know It

By Michael Lewis and David Einhorn, The New York Times. Posted January 6, 2009.

It's hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn't give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity -- so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won't be able to do until they're confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.

Mr. Paulson must have had some reason for doing what he did. No doubt he still believes that without all this frantic activity we'd be far worse off than we are now. All we know for sure, however, is that the Treasury's heroic deal-making has had little effect on what it claims is the problem at hand: the collapse of confidence in the companies atop our financial system.

Weeks after receiving its first $25 billion taxpayer investment, Citigroup returned to the Treasury to confess that -- lo! -- the markets still didn't trust Citigroup to survive. In response, on Nov. 24, the Treasury handed Citigroup another $20 billion from the Troubled Assets Relief Program, and then simply guaranteed $306 billion of Citigroup's assets. The Treasury didn't ask for its fair share of the action, or management changes, or for that matter anything much at all beyond a teaspoon of warrants and a sliver of preferred stock. The $306 billion guarantee was an undisguised gift. The Treasury didn't even bother to explain what the crisis was, just that the action was taken in response to Citigroup's "declining stock price."

Three hundred billion dollars is still a lot of money. It's almost 2 percent of gross domestic product, and about what we spend annually on the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development and Transportation combined. Had Mr. Paulson executed his initial plan, and bought Citigroup's pile of troubled assets at market prices, there would have been a limit to our exposure, as the money would have counted against the $700 billion Mr. Paulson had been given to dispense. Instead, he in effect granted himself the power to dispense unlimited sums of money without Congressional oversight. Now we don't even know the nature of the assets that the Treasury is standing behind. Under TARP, these would have been disclosed.

THERE are other things the Treasury might do when a major financial firm assumed to be "too big to fail" comes knocking, asking for free money. Here's one: Let it fail.

Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed "too big" for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders -- perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.

This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992. And remember, the Federal Reserve and the Treasury have already accepted, on behalf of the taxpayer, just about all of the downside risk of owning the bigger financial firms. The Treasury and the Federal Reserve would both no doubt argue that if you don't prop up these banks you risk an enormous credit contraction -- if they aren't in business who will be left to lend money? But something like the reverse seems more true: propping up failed banks and extending them huge amounts of credit has made business more difficult for the people and companies that had nothing to do with creating the mess. Perfectly solvent companies are being squeezed out of business by their creditors precisely because they are not in the Treasury's fold. With so much lending effectively federally guaranteed, lenders are fleeing anything that is not.

Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we'll be in recession for some time to come. Our leaders have framed the problem as a "crisis of confidence" but what they actually seem to mean is "please pay no attention to the problems we are failing to address."

In its latest push to compel confidence, for instance, the authorities are placing enormous pressure on the Financial Accounting Standards Board to suspend "mark-to-market" accounting. Basically, this means that the banks will not have to account for the actual value of the assets on their books but can claim instead that they are worth whatever they paid for them.

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