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Let the Banks Fail: Why a Few of the Financial Giants Should Crash

The finance industry still owns mountains of bad paper and must absorb these losses -- or else we'll face a very long recession.

So far, much of Washington’s ad hoc, ham-fisted response to the economic crisis has been based on the dictum that the financial institutions must be prevented from taking their losses.

That should come as no surprise. Big finance’s lobbyists have been all over the "bailout" (it should be bailouts, plural) from the very start, Wall Street pumped piles of cash into the elections — AIG, recipient of tens of billions in taxpayer largesse, ponied up $750,000 for both the Democratic and Republican conventions — and the whole thing’s been designed by "free-market" ideologues who came to Washington directly from Wall Street.

But the hard reality is that the institutions that created this mess have to take their losses — no doubt huge losses in many cases — if we're to have any chance of avoiding a deep recession that drags on for years.

Some will be wiped out in the process, but propping up firms that have massive -- and not entirely known -- quantities of so-called toxic securities on their books only delays the inevitable day of reckoning.

The rot has spread far beyond real estate, but that offers a nice concrete example of the danger of keeping Big Finance from taking its lumps. So far, their lobbyists have fought off attempts to force them to renegotiate mortgages, especially plans that call for writing down the value of the loans to reflect the post-bubble market. This is understandable. But the reality is that there are a lot of homes "under water" — that is, worth less than the value of their mortgages — and a lot of mortgages with "teaser rates" are about to adjust upward. Foreclosures only drive down the value of the whole market further -- who wants to pay today's fair value when two other houses on the same street are headed toward foreclosure and might be had for a song in a few months?

The justification for creating the big bailout honeypot for Wall Street was that banks are hoarding money, causing a "credit crunch" that's killing the whole economy. But that’s only true to a point; while financial institutions are holding cash, including, reportedly, those billions they gouged from the taxpayers, they appear to be doing so to protect their balance sheets, and in some cases, to fund mergers. The bigger problem -- one the bailout is hardly touching -- is that trillions in home equity and retirement accounts have vanished, and there aren’t a lot of people — or firms — looking to borrow money to buy stuff or expand right now.

Economist Dean Baker explains the dominance of the "credit crunch" narrative like this:

The media "largely ignored the growth of an $8 trillion housing bubble, by far the most important economic phenomenon of the decade. Now that it has burst and sent consumption plummeting, they are blaming the economic collapse on a 'credit crunch' instead of the more obvious problem that consumers just lost $6 trillion of housing wealth and another $8 trillion of stock wealth."

We hear a lot about banks not lending to one another these days -- another reason we have to buy up shares of their tanking stocks and guarantee their funky securities. But consider that as I write, a benchmark "interbank" lending rate (the LIBOR, if you care) is at its lowest point in history, meaning that banks aren’t, in fact, charging each other an arm and a leg for cash.

But, at the same time, William Prophet, an analyst at UBS, Switzerland’s biggest bank, told Bloomberg News that "the volume of loans apparently is still close to zero, and that hasn’t changed."  

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