The U.S. financial system is effectively insolvent

I have said before that a systemic response is necessary to deal with the present banking crisis in the United States. This crisis has nothing to do with subprime assets and little to do with things like predatory lending. Those are issues that populists will use to prosecute the scapegoats we are likely to see down the line. The crisis has everything to do with low interest rates, zero regulation and a credit bubble of monumental proportions.

The banking system of the United States is effectively insolvent. Buying up $700 billion in assets is not going to solve this basic fact. A systemic response is needed. If we do not address these issues, we may see significant dead-weight loss as many institutions fail.

After Lehman Brothers was allowed to fail, on Sep. 16th I said the following:

As I survey this situation in serene tranquility away from market turmoil, I realize that I am very troubled by how the Lehman Brothers bankruptcy was handled. In my estimation, it was like putting the cart before the horse – allowing a financial institution to fail before you have worked out a mechanism of how to deal with that failure.

This one action will expose the global financial system to enormous additional risk.

Hank Paulson at the U.S. Treasury and Ben Bernanke at the U.S. Federal Reserve wanted to avoid the moral hazard of supporting the acquisition of a failed institution with government funds as it had done when JP Morgan Chase bought Bear Stearns. Therefore, Paulson and Bernanke were both fairly adamant about not offering any backstops for a Lehman Brothers takeover.

This is the principal reason both Bank of America and Barclays decided not to pursue a takeover of the firm. And this is also the reason Lehman Brothers failed. Had the U.S. government offered guarantees on Lehman’s debt, Barclays or Bank of America would have bought Lehman Brothers. In fact, I reckon BofA would have preferred to buy Lehman Brothers over Merrill Lynch as the price tag was much lower.

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong.

They were wrong for three principal reasons:

  1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.
  2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.
  3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.
Lehman’s bankruptcy: putting the cart before the horse?

I believe I have been proven right as all of the chaos we are now seeing is a direct result of the chain of events resulting from Lehman’s bankruptcy. But, I say again, the time for adhoc partial proposals is over. What we need now is a comprehensive solution. And this is NOT what we are getting from Congress.

Last Tuesday I warned:

Paulson’s plan is a trap
Whether you like Paulson’s plan or not, Paulson has been very crafty in making his proposal. He is obviously a good negotiator because he has anchored the discussion around a false set of goals. Congress, which had been unable to present its own proposal, will probably take the bait and use this proposal as a baseline from which to craft legislation, rather than start from scratch with their own initiative.

Moreover, it remains to be seen whether this proposal will ultimately cost a measly $700 billion. Experience with Iraq War funding proposals and the history of Japan’s experiences after their property bubble burst tell us that this is the first of many handouts that will be requested. And once the first request is passed, it will be very difficult for legislators to admit that the handouts were not money well spent. So, additional handouts are likely to pass as well.

If Congress allows this plan or some other remedy like it to pass, it will have confirmed its uselessness to the American citizenry. Just as with 9/11, Congress will have allowed the executive branch to usurp powers that are constitutionally held in the legislative branch. Therefore, in the end, when this proposal ends up costing much more than $700 billion, I will hold Congress to blame more than the Bush Administration.
The $700 billion Paulson Plan is dead on arrival

And indeed events are unfolding according to script, with Congress taking Paulson’s proposal as a baseline from which to craft legislation. This is lazy and incompetent. If America wants to know what a real comprehensive bill looks like, we should look to Sweden, Finland, and Norway for the answer. But, as markets move very quickly, we could have entered debt deflation by the time Congress gets the will to act.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.