Tim Geithner's Black Hole
Pity Barack Obama's economic advisers. The blogs are now demanding their scalps, and Treasury Secretary Tim Geithner and his colleagues face a nasty dilemma: There are no solutions to the banking crisis without extraordinary political and financial risks. Thus, they have adopted a three-pronged approach, delay, delay, delay, in the hope that somebody comes up with a breakthrough.

Here's the problem: Today's true market value of the U.S. banks' toxic assets (that ugly stuff that needs to be removed from bank balance sheets before the economy can recover) amounts to between 5 and 30 cents on the dollar. To remain solvent, however, the banks say they need a valuation of 50 to 60 cents on the dollar. Translation: as much as another $2 trillion taxpayer bailout.

That kind of expensive solution could send the president's approval rating into a nose dive. Consider: $2 trillion is about two-thirds of the tax revenue the federal government collects each year.

The logical alternative -- talk show hosts' solution du jour -- is to temporarily restructure or nationalize the banks and leave taxpayers alone. Remove the toxic assets, replace management and cut the too-big-to-fail financial dinosaurs into smaller, nimbler entities. Then reprivatize these smaller banks and let the recovery begin.

Oh, if it were that simple. I suspect Obama's advisers would like nothing more than to dismantle an irresponsible firm such as Citigroup. They are afraid to do so, for one reason: All the big banks are connected to a potentially lethal web of paper insurance instruments called credit default swaps. These paper derivatives have become our financial system's new master.

The theory holds that dismantling a big bank could unravel this paper market, with catastrophic global financial consequences. Or not. Nobody knows, because the market for these unregulated financial derivatives, amounting potentially to over $40 trillion (by comparison, global gross domestic product is now not much more than $60 trillion), is the financial equivalent of uncharted waters.

Geithner has reason to be terrified. He was part of the Henry Paulson-led team that underestimated the devastating global-contagion effect of the collapse of Lehman Brothers. Geithner won't make the mistake of underestimation again.

Geithner also knows that the mood in Congress has changed. Were a global financial brush fire to break out as a result of bank restructuring or nationalization, today's populist Congress might just let it burn. Congressional anger is likely to intensify when policymakers realize that credit default swaps demand a stream of premium payments like a life insurance policy, not just a payment due at termination. And recent signs indicate that firms such as Citigroup, in recycling their taxpayer bailout funding, may have helped other financial firms, including some in Europe, meet these payment obligations.

In addition, Geithner worries that because the troubled insurance giant American International Group (AIG) is a conduit for the banks' use of credit default swaps, a collapse of AIG (as an unintended consequence of dismantling the big banks) could be catastrophic. AIG's more than 300 million terrified holders of insurance-related investments and pension funds, who have investments totaling $20 trillion (U.S. GDP is $14 trillion), could suddenly rush for redemptions -- the equivalent of a run on a bank. Geithner would face a worldwide insurance collapse to accompany his global banking collapse.

Or again, maybe not. Nobody knows.

Here's another likely Geithner fear -- that Congress forces the banks' bondholders to take a hit. So far, only stockholders have lost out because of the banking crisis. One reason for the fragility in the credit default swap market of late is that markets fear that bank bondholders, who today are protected even before U.S. taxpayers, could soon see their status change. The worry is that if even bondholders are put at risk, U.S. and foreign investors alike would stop financing all corporate America. The administration says that won't happen, but market participants believe (probably correctly) that this White House can't control Congress.

So our Treasury secretary has no choice but to talk of bank stress-testing and other tactics to buy time before the big bank bailout. Notice that the president's budget already contains a contingency fund of up to $750 billion for a future bank bailout -- a politically shrewd number that roughly matches the size of the Paulson bailout. The true cost is likely to be two or three times as much, unless some last-minute intellectual breakthrough -- a tax holiday for derivatives? -- arises.

The Obama team needs to remember that we got into this mess because of a lack of financial transparency. It's time to tell the American people what the stock market already knows: that the path to recovery will probably be expensive and politically unpopular, perhaps explosively so. This dire situation could take us all down, which is why Obama should name a proven, world-class problem-solver who is not from Wall Street as his bank workout czar. James Baker, the former Republican secretary of state and Treasury secretary, comes to mind. Other possibilities: former Democratic senators Bill Bradley or George Mitchell. Perhaps the White House should name a team.

In the end, at least one thing is certain: Our present position is unsustainable. The longer we delay fixing the banks, the faster the economy deleverages, the more credit dries up, the further the stock market falls, the higher the ultimate bank bailout price tag for the American taxpayer, and the more we risk falling into a financial black hole from which escape could take decades.

David M. Smick is a global financial strategist and the author, most recently, of "The World Is Curved: Hidden Dangers to the Global Economy."
Unbelievably, this whole problem emanated from Congress exempting the CDS market from the gambling provisions which enabled 2 parties with no interest in either side of the debt being able to make a bet on the fate of a creditor. It was always insane. Normally insurance requires a party to an insurance policy to have an insurable interest. If this basic rule of insurance had been maintained this would never have occurred. Just another example of Congress doing something they didn't understand and the rule of unintended consequences rearing its ugly head. Most people won't read this or try to understand it. So we will do it again at some time in the future. Its suicide bombing by another name.
Posted by: Omoter Speaking for Boskone7794 2009-03-10