Reviving Trust in American Banking and Governance

February 7, 2009

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

February 7, 2009

To:       Honorable President Barack Obama

Cc:       Honorable Vice President Joe Biden

Honorable Speaker Nancy Pelosi

Honorable Senator Harry Reid

Honorable Senator John McCain

Sub:     Reviving Trust in American Banking and Governance is necessary to expand the “Reach of Prosperity” and to Stabilize Society

Dear President Obama,

You have remarked that political leaders are not exclusively privy to the best ideas on governance.  This is indeed the best spirit of governance ever to emerge from a top leader anywhere in the world. If this continues to be the lodestar of your governance, the U.S. will change course to uplift competitiveness and expand the “reach of prosperity” needed for social stability.

How the Trust in Banking and Governance Erodes?

Historically, a lapse in governance of banks has lead to laissez faire practices, which bankrupt households and then devour the banks to cause a lasting financial depression.  This sequence of events unfolded before the Great Depression (GD) and again during the S&L crisis of the late 1980’s.  Why did the GD not recur due to the S&L crisis? 

Well, during the S&L crisis, new research emerged to show that foreclose of banks-with positive capitals below a minimum threshold capital-to-assets ratio-was optimal for taxpayers.[1]  Optimal bank foreclosure was antithesis of the prevailing dogma that markets could self-discipline banks without government oversight.  It was as if the custodians had learnt nothing from the GD to harbor the market dogma. 

Credit should go to the Congress to enact the optimal bank foreclosure rule in FDICIA 1991 and then to push for its adoption in BIS-Basle accords.  Widespread perception then ensued about the stability of banks and massive capital flew to USA that lowered the cost of capital, quadrupled the stock indexes and then expanded the reach of prosperity. 

How have we now lost investor confidence to face widespread financial gloom and doom? 

Banks virtually circumvented the optimal foreclosure rule (minimum capital requirement) by multi-tier leverage via off-balance sheet subsidiaries (SIV) with little capital on a consolidated basis to resort to their laissez faire practices with pseudo ratings of financial securities they issued to raise funds.  This paved the way towards bankrupting the American households in a pre-GD style. 

As a Federal Reserve economist, I pointed out in a top level meeting with Citigroup in 1994 how the SIV subsidiaries were diluting the minimum capital requirement severely.  The Federal Reserve officials present in the meeting were angry with me for raising this issue.  I inferred then that the Federal Reserve was not serving the best interest of taxpayers.  But when my papers on optimal bank governance rules were subsequently rejected because they did not square with the market-self discipline literature, I learnt that having me at the Federal Reserve was designed to muzzle my ideas on optimal governance to perpetuate laissez faire practices.  

No selfless researcher will use data generated by a regulated banking industry to infer about optimality of deregulation, i.e., about the efficacy of the market automatically disciplining banks even if they contravened the optimal bank foreclosure law by the sophistry of multi-tier leverage via off-balance sheet subsidiaries.  But the Federal Reserve has promoted precisely such research to convince the Congress about safety and soundness of the banking system following such sophistry and then to repeal of the Glass-Steagall Act in 1999. 

The Federal Reserve as well as the academy of finance and economics thus recreated the same pre-GD era laissez faire environment that had led to the GD.  We should not be surprised now about a recurrence of the GD.

The massive monetary infusion into banks (Federal Reserve’s $2.5 trillion and Treasury’s $400 billion) has not staved the deep meltdown.  It is because the laissez faire practices continue to devour weaker banks and households. 

The society has paid an enormous price for suppressing the real truth that optimal rules of governance are needed for prosperity amid stability.  This truth has emerged from selfless research.[2]  No selfish research or power could suppress the real truth.  The individual in me is truly redundant for such discourse. 

I left the Federal Reserve in 1995, but continued my perseverance to spell the truth about the necessity of optimal governance in simple English without complex economics-finance models so that the willing representatives of people (such as you) could decipher the sophistry and inefficacy of the laissez faire market dogma and the necessity of optimal governance for prosperity amid stability. 

The credit goes to you and other willing representatives to adopt optimal rules of governance like discontinuance of the “irresponsible” and “undisclosed” lending to hedge funds by federally insured banks.  Such steps have bared for good the inefficacy of the market dogma as well as the deleterious Ponzi Schemes centered in mega banks.   

Restoring Trust through “Safe Banking” 

To restore trust, governance and banking have to be based on truth.  A fundamental truth uncovered by selfless research is that “Safe Banking” is an optimal policy for governance.  Even market dogmatists grudgingly concede that my Safe Banking proposal is necessary to restore trust in banking and governance.  As a selfless researcher, I welcome other dominating optimal bank governance ideas articulated in plain English. 

Only Safe Banking can prevent moral hazard (blackmailing of taxpayers and investors) to restore the trust in American banking governance. [3] This is vital to preserve dollar’s reserve currency status.

Government interference in business, especially banking, makes a society very inefficient.  But top creditors-bankers have shaped policy to maintain government protection/interference in banks by propagating that (a) the federal deposit guarantee and (b) continuance of failed big banks through continual capital infusions are necessary to prevent systemic risk.  This has perpetuated moral hazard, which means that banks could continue to employ little capital to undertake huge leveraged bets to usurp any profits as hefty bonus and to transfer huge losses to taxpayers when bets failed.  This happened during the S&L crisis of 1989.  That is when I started my research on the latent causes of banking crisis and financial depression.  My subsequent research led me to “Safe Banking” to avoid moral hazard, which I had communicated to the US Congress in 2003 but was bulldozed. 

Pure market proponents, those who are selfless, should embrace my Safe Banking policy because it eliminates deposit insurance and government interference in banks.   Selfishness obviously dictates market dogmatists-bankers to seek protection through deposit insurance and too-big-to-fail policy.  This maintains freedom to take highly leveraged risky bets to usurp any profits as bonus and to blackmail taxpayers to replenish banks with new money when such bets fail. 

The current meltdown offers a great opportunity to the taxpayers and to the government representing taxpayers to offer a new charter for safe banks and universal banks. Under this charter:

1.      No bank will have deposit insurance. 

2.      Safe banks will invest only in government securities and be subjected to government monitoring for minimum capital and executive pays. 

3.      Universal banks will be free to have any amount of capital and any type of investment. 

4.      Only highly capitalized universal banks can win the trust of investors. 

5.      Thinly capitalized universal banks will not survive and so will not exist.

6.      There will be no moral hazard risk and cost to taxpayers.

7.      Universal banking will be very efficient without implicit or explicit government intervention.

8.      Efficient universal banking will make the nation competitive and win the trust of investors worldwide.

9.      Safe Banking will obviate huge costs to taxpayers due to failing regulatory agencies. 

During the Great Depression, federal deposit insurance was introduced to win the trust of depositors in banks.  But the federal insurance did not prevent recurrence of depression.  Depositors are not worried now.  But large investors have lost trust in bank debt and equity.  They seem to have lost trust in governance because of reckless guarantees which are panic-driven and not credible.  Such guarantees will eventually lead to a failure of Treasury securities. 

The government has willy-nilly adopted my Safe Banking proposal by guaranteeing Money Market funds and by encouraging merger between Morgan Stanley and the investment banking business of Citigroup.  The guaranteed Money Market funds are almost like my safe banks.  The other banks are already universal banks except that they are yet to be weaned away from government protection via deposit guarantee and too-big-to-fail policy.  This can be done by transferring all banks to government conservatorship without the Fannie-Freddie $1 warrant mistake and with a transparently announced plan to not confiscate private debt and equity.  

Government conservatorship for banks may not be necessary if insured deposits can be smoothly transferred to Money Market funds or explicitly chartered safe banks by any insured depositor who desires to do so.  For example, any JPM Chase depositor who does not want to transfer from this bank can choose to do so but he would forfeit the federal guarantee.


My proposal sounds outlandish.  But this will very likely raise enormous trust in banks like JPM Chase, Goldman Sachs and Morgan Stanley after these banks are weaned away from federal deposit insurance and too-big-to-fail policy and investors believe that the government will no longer intervene.  All financial institutions should be subjected, however, to any new rule for optimal governance of securities markets. 

The charter of Fannie Mae and Freddie Mac should optimally remain as government sponsored entities because, as mortgage aggregators across the economy, they diversify the mortgage loan risk pool and lower the cost of raising debt and equity capital backed by such low risk loan pools.  The risk of Fannie Mae’s mortgage loans has remained significantly less than that of the commercial banks, especially during the crisis.  Only a government charter of Fannie and Freddie can keep the economy’s mortgage interest rate low.  Only Fannie and Freddie can offer competition to other banks in the mortgage business to keep the cost of housing low.  Other banks would obviously like to eliminate the government sponsored charter of Fannie and Freddie so that they can raise their mortgage interest rates usuriously.  But this will lead to a breakdown of the home mortgage market, thwarting the presidential goal (people’s mandate) of expanding the reach of prosperity amid stability.  In fact, the current crisis deepened when the other banks tried to eliminate Fannie and Freddie after short-selling the GSE stocks.  Selfishness and greed has aggravated the current crisis.  The academic curricula on maximization of the utility of own wealth should be urgently amended.

Backbone of the System

Rulers (politicians and bureaucrats) have been generally swayed by the top creditors-bankers without questioning how credits are being generated.  Top creditors are the major sources of funding of the rulers.  But how is the credit generated? 

The credit is the difference between the price of (mental and physical) labor and the cost of living of an individual.  The recent hefty bonuses paid by losing and bankrupt banks show that many top creditors have simply gouged the prices of their labors.  The price of labor is thus not always based on begetting value for society.  It is based on the ability to inflict moral hazard (blackmailing) risk on taxpayers.  Many other creditors like doctors offer globally competitive services of immense value to society.  But they perhaps charge significantly more than the value of service they render because of artificial barriers to entry into their profession. 

In any case, the total credit of an economy must equal the debt laden on the borrowers.  This means that the borrowers ultimately prop the creditors and rulers.  The financial meltdown has made this truth transparent. 

The creditor-debtor relationship is necessary and vital for a society.  For example, the young need to borrow from the old who save over time for retirement.  Only when usury creeps into this relationship, catastrophic financial meltdowns occur to shrink (through painful depressions) the quantum of credit to the level of repayable debt. 

Modern usury has taken the form of (a) cannibalization of savings and incomes of the vast majority by a few advantaged custodians of the system, and (b) artificial inflation in food and energy prices by hedge funds taking highly leveraged bets with funds borrowed from the taxpayer insured banks to keep the interest rate high.[4]  I have argued in previous memos how such sophistry could successfully fool the Federal Reserve’s Monetary Model.

A Simmering Catastrophe

The prevailing wisdom (in academia, government and real-world) barely a year ago was that lowering the interest rate would crash the value of dollar.  My analysis then was antithesis of this wisdom and my prescriptions were thus outlandish: (i) to stop lending privately-held hedge funds from the taxpayer insured banks, and (ii) to lower the interest rate simultaneously.  The government followed these steps because, as Prime Minister Gordon Brown conceded in a Washington Post column, the financial problem was rooted in undisclosed and irresponsible lending.  After these steps were adopted, inflation vanished, commodity prices collapsed, and dollar appreciated despite lower interest rates, as presaged in my arguments.  This definitely expanded the reach of prosperity as the vast majority of consumers now face significantly lower food and energy prices.  The dollar has rallied due to a short-covering or repaying of the dollar loans made by the hedge funds. 

The reason for revisiting the above analysis is that the dollar may have reached a transient peak and may hereafter fall precipitously if quantitative easing and deficit spending continue unabated.  Hedge funds may have almost repaid their dollar loans.  At least they no longer face the danger of being called to reduce margin debt balance.  The necessary deleveraging may have led to stability of most, if not all, hedge funds.  This is my best inference based on the nature of market gyrations.  If this is true, any further quantitative easing or deficit-spending can be calamitous to dollar’s value. 

Quantitative easing should be already causing consternation among creditors including global central bankers.  One would expect that quantitative easing may induce the creditors to take risky bets as the value of their dollar holdings falls.  I believe this will happen.  But the creditors may not be motivated to take risky bets within USA.  It is mainly because USA is not a globally competitive production center at this juncture due to the exchange-rate differential with many emerging market currencies.  Hedge funds and other creditors including central bankers are more likely to pull their dollars to invest in commodities and emerging markets where production is more efficient (less costly).  

Dollar’s fall with respect to the emerging world currencies may be desirable for relocation of the manufacturing base back to the U.S., but this may not happen any time soon because the demand has slowed everywhere.  Falling dollar is thus not a great recipe to revive American manufacturing.  If excessive quantitative easing is made, a falling dollar will only lead to runaway inflation in the prices of American imports, despite lower demand. 

Options are limited.  The stimulus package should, therefore, be kept efficient to produce globally competitive goods and services especially energy and food.  The government and big corporations may need to be made more efficient by lowering wages without reducing the payrolls.  Banking sector reform should pave the way for rebuilding the trust of international investors in the American financial system.  Healthcare, higher education and defense should be made more efficient (less costly).       

Necessary Components of Stimulus Package

A stimulus package is urgently needed to smooth the painful rebalance of credit with debt without much expectation for a boom.  We need debt relief for households facing foreclosure and lower mortgage interest rates for all.  Building the broadband, modern electric grid and renewable energy are also very important and urgent to enhance American competitiveness.  I feel happy that such items enumerated in numerous previous memos have found prominent place in the package being considered at this moment. 

Another item I had dreamt since 2003 is to divert the vast human talent from the finance sector towards teaching of mathematics in elementary and secondary schools.  At least a million finance professionals, who are very good in math, can be absorbed in moderately good paying jobs in numerous elementary and secondary schools around the country.  This should be a major component of the stimulus package.  Most students dread about math soon after elementary school.  It is because the emphasis in math in American elementary schools is almost nonexistent.  But my family tradition shows that a child’s interest in math can be cultivated efficiently only at the elementary level.  Math is very necessary to build skills in engineering and information technology.

Cardinal principles of Governance

The efficacy of the stimulus package or any subsequent government program should be assessed by the following complementary principles:

1.      Incentives to increase production of globally competitive goods, services and ideas.

2.      Flow of monetary resources to the effective producers through new jobs and restructuring of existing jobs if feasible, for example, in government.

3.      No subsidy, directly or indirectly through guarantees for certain values of bad bank assets.  Subsidies rarely trickle down.  Subsidies generally impoverish the vast majority of effective producers while enriching the subsidized non-producers.  Lawmakers are tempted to grant subsidies/earmarks because it is easier to collect political contributions.  But the latest election shows that the vast majority, hurt by the current system, can contribute massively to a leader willing to serve their interests.  More importantly, subsidies have made the system unstable.  Bankers have their representatives in the governments to push for such subsidies to cover their failures and enormous compensations.

With profound regards,

Sankarshan Acharya

PS: Two major events have unfolded after this memorandum was sent and posted here. These events are as predicted in the memorandum. (1) Today, China has stated that it would seek guarantee from the US about its holdings of US Treasuries. (2) Today, China also committed $20 billion to invest in Brazilian Aluminum company. See the Bloomberg News posted below.

[1]Acharya, S. and J. F. Dreyfus (Journal of Finance 1989): “Optimal Bank Reorganization Policies and Pricing of Federal Deposit Insurance.”

[2]Acharya, S. (Pro-Prosperity.Com 2009): “Value of Selfless Research.”

[3]Acharya, S. (Journal of Risk Management in Financial Institutions 2008): “Safe Banking to Avoid Moral Hazard.”

[4]I have argued about this in my 2005 book and several memos.  I am humbled by the accuracy of my prediction about the modern usury when inflation and interest rates were high and executives were collecting massive compensations. 

The rise and (almost) fall of America's banks
Sunday February 8, 8:11 am ET
By Stevenson Jacobs and Erin Mcclam, Associated Press Writers

Pen-and-paper tellers to a global catastrophe: Tracing the rise and (almost) fall of US banks

These days, you can roll up to an ATM at the grocery, the pharmacy, the gas station, the hardware store, the office, even the ballpark. You can check your Bank of America balance on your iPhone. You can text Chase, and Chase will text you back.

That's banking today: It has grown from an almost quaint relationship between teller and customer into a massive, dizzyingly interconnected network that touches almost every adult in this country.

And right now, the federal government -- working without a road map, and without a net -- is putting together a plan to keep U.S. banks from collapsing.

Not just to get the banks lending again. To keep them alive.

The government is expected to announce Monday a plan that analysts expect will include lifting soured mortgage assets off selected banks' books, possibly along with guarantees against other losses and maybe more direct injections of cash.

Financial industry experts say it is a matter of choosing the best of several options, none of them very palatable.

And no one knows for sure what will work because nothing like this has happened in living memory.

Getting it wrong could trigger a replay of what happened after Lehman Brothers collapsed last fall -- the stock market in free fall, seizure of the credit markets, ripples of layoffs. Perhaps even a run on other banks -- so many customers rushing to pull out their cash that it would make the bank run in "It's a Wonderful Life" look like, well, a feel-good holiday movie.

"The banks are at a terrible junction," says Robert Reich, a labor secretary under President Bill Clinton. "The bottom is falling out. Almost every area of the credit markets, we're finding people unable to repay their loans. That means many banks are basically insolvent."

"If one big bank implodes," he says, "the reverberations could be endless."

So how did we get into this mess?

And how do we get out?

Washington and Wall Street are still playing the blame game. But most financial experts agree that a cocktail of bad economic policies and lax government oversight led lenders, borrowers and investors to take huge risks.

Greed and recklessness trumped fear and reason, and they led banks to the brink.

To understand how the things went awry this time, go back a couple of decades, to a time when you could walk into your hometown bank branch and speak to a teller who knew your name and kept a pen-and-paper record of your mortgage.

Banking was a simpler affair, and a no-nonsense one: If you didn't make enough money to qualify for a loan, you didn't get one.

But in the 1980s, falling interest rates and loose lending standards opened banking to the masses.

Credit was cheaper, and the government pushed to make more Americans homeowners. The housing boom was on.

Banks and savings and loan associations, or S&Ls, spread across the country offering cheap, 30-year mortgages. By 1980, banks had $1.5 trillion in outstanding mortgage loans, more than double the amount from 1976.

It was, says Eugene White, an economics professor at Rutgers University and an expert on the Great Depression, all about the government's postwar policy of selling a "piece of the American dream."

"But by doing that, we forgot about the risks," he says.

Then came the bust. Unable to pay their mortgages, homeowners and businesses began defaulting in droves. Deliquencies soared, triggering the savings and loan crisis, battering the stock market and prompting a huge, taxpayer-financed bailout.

Sound familiar?

Fast forward to today. Not exactly an example of lessons learned.

Some ingredients of the S&L mess, such as cheap credit, loose lending standards and weak oversight, also are part of the current debacle. But two new trends -- the rise of the global banking behemoth and the packaging of debt into securities that investors could buy and sell -- made this meltdown unique.

And much worse.

In the span of a decade, Citigroup, Bank of America and JPMorgan Chase, once bread-and-butter providers of free checking accounts, grew into international banking conglomerates that buy and sell stocks and manage assets for fees.

The "universal bank" model, which took hold in the late 1990s, changed the face of global finance. And it linked Main Street with Wall Street in a way never seen before.

Banks themselves became ubiquitous in American life. From 1995 to 2008, the number of bank branches grew from 81,000 to 99,000. Over the past decade, the number of ATMs swelled from 187,000 to 406,000.

These banks lured first-time homeowners, many of whom believed housing prices would go up forever, with attractive lending rates and lax requirements. Bad credit, no credit -- it seemed almost anyone could get a mortgage loan.

But instead of holding on to the loans themselves, a modern version of the old pen-and-paper model, the banks bundled them into securities and sold them to investors across the globe.

In a flash, a mortgage for a home in California or Florida could be sold to a hedge fund in London or Singapore -- a huge shift.

In the old days, credit had been based on the borrower's ability to pay back the loan.

"But now it was based on the lenders' ability to securitize the loan and sell it," says Barry Ritholz, a financial analyst and author of "Bailout Nation: How Corrupt Money Shook Wall Street." "That is absolutely unique in the history of finance."

Sure, the risks were big. But so were the rewards.

Using vast sums of borrowed money, Goldman Sachs, Morgan Stanley and other investment banks bought and sold mortgage-backed securities and other complex financial products, reaping astronomical profits that helped pay for outsized bonuses for executives.

In 2006, Goldman Sachs turned a $9.4 billion profit, the highest in Wall Street history. The bonanza netted chief executive Lloyd Blankfein a bonus of $53.4 million, more than any other Wall Street CEO for that year.

That was followed by the $41.4 million pay package received by Morgan Stanley CEO John Mack, who led his firm to a profit of more than $7 billion of profit in 2006.

But the good times didn't last long.

When the housing market began to decline in 2006, subprime loans -- those made to people with the worst credit -- were the first to self-destruct. That caused massive financial losses at the big banks and claimed the first casualties of the financial crisis.

Then, early last year, Bear Stearns, a venerable 85-year-old investment bank, began to teeter.

The bank suffered huge losses tied to subprime securities. Its stock plunged, and investors raced to pull their money. Bear Stearns was bought by JPMorgan for a meager $10 a share in a government-brokered fire sale.

Six months later, the crisis spread to Lehman Brothers, a 158-year-old investment bank that helped finance America's railroads. And, this time, the government decided not to step in.

Lehman collapsed in the biggest bankruptcy in U.S. history. Immediately, banks around the world, seized by fear, stopped trusting almost anyone, and lending, the lifeblood of the economy, dried up.

Seemingly overnight, two of the biggest names in global finance were gone.

To the even greater alarm of most Americans, the stock market went haywire. The Dow Jones industrials, in what amounted to a slow-motion crash, plunged 2,400 points over eight straight trading days in October. By late November, retirement accounts were cut almost in half.

To many observers, the big banks broke one of Wall Street's cardinal rules: Be greedy, but be greedy over the long term.

"They forgot their instinct for self-preservation," says Lisa Endlich, author of "Goldman Sachs: The Culture of Success."

This January, the government took over six failed banks, including three on a single day. Last year, it took over a total of 25.

When it happens, the government swoops in and try to minimize disruption. Recently, it has tended to close banks on a Friday and achieve something close to business as usual by Monday morning, arranging for other banks to take on the assets. ATMs have kept working, and people have had access to their cash.

So far, most of the failed banks have been relatively small, many with assets only in the hundreds of millions of dollars. But what would happen if one of the nation's big banks, the kind that manage hundreds of billions in assets, went down?

"That would probably cause a complete meltdown of the American financial system," says Andreas Hauskrecht, an associate professor of money, banking and finance at Indiana University.

After the financial crisis accelerated last fall, the government increased the limit for the amount of bank deposits it will insure for individual depositors, from $100,000 to $250,000, effective through the end of this year.

And while few Americans have to worry about keeping anything bigger than that in the bank, the government could eliminate the limit altogether and insure all deposits regardless of size if a huge bank, such as Citigroup or Bank of America, were to fail, says Jim Wilcox, a professor of financial institutions at the University of California at Berkeley.

No one has ever lost money in an account insured by the Federal Deposit Insurance Corp. But no one has ever seen a bank that size go under, and news of a giant bank's downfall would probably touch off a panic in which even depositors with money in safe banks rush to get it out.

But there's a bigger economic problem: Other lenders, which hardly trust everybody these days anyway, would stop trusting anybody. Businesses, unable to borrow money day to day, would fail, with worldwide consequences.

It doesn't take an economics degree to realize that would be nothing short of catastrophic for the economy.

"Not to say there's not good aspects of letting someone fail," says Robert G. Hansen, senior associate dean at Dartmouth College's Tuck School of Business. "But the short-term costs of inflicting that punishment to everybody are really high, and I don't think the Obama administration has the stomach for it."

Already, the new administration is treating the Lehman failure as a lesson. Treasury Secretary Timothy Geithner suggested at his confirmation hearing before Congress that the feds would not let another big bank go down.

"Lehman's failure was enormously complicated, an enormously complicated set of events," he said. "It didn't cause this financial crisis, but it absolutely made things worse."

So what now?

Financial experts don't expect the United States to go the way of Iceland, where a collapse of the banking system last month threw the tiny country into turmoil and toppled the goverment.

What keeps them up at night is a scenario closer to that of Japan, which bungled its own bank bailout in the 1990s and limped along during a "lost decade" of anemic economic growth and high unemployment.

To prevent that, the Obama administration must choose the best of several difficult options, or a combination. The emergency medicine prescribed by the last administration -- flooding the financial system with billions of federal bailout dollars -- hasn't worked. If anything, banks are sicker.

One idea under consideration is the creation of a government-run aggregator bank, or a "bad bank," that would buy up hundreds of billions of dollars in banks' toxic assets. The government also may decide to pump more money into banks and offer billions in dollars in guarantees against future losses.

But no single fix is seen as a magic bullet, and financial experts say the government is quickly running out of lifelines.

"The longer they wait, the more damage there is to the economy and the more it will cost taxpayers," says Frederic Mishkin, an economics professor at Columbia Business School and a former member of the Federal Reserve Board.

In theory, the government-run bad bank would buy soured debt that's gumming up the banks' books and clogging the flow of credit. That could shore up banks' base of capital, soothe investors and get banks lending again.

But in practice, it's far from simple.

For starters, no one -- including the banks themselves -- knows how much these assets are worth. The complex nature of mortgage-backed securities, credit default swaps and other contaminated products has made investors too afraid to touch them.

Pricing them is tricky, to say the least.

If it pays too little, the government risks forcing banks to record huge losses on their books, potentially putting them out of business and wiping out shareholders. If it pays too much, it risks shortchanging taxpayers by hundreds of billions of dollars.

"It's a can of worms," says Sung Won Sohn, an economics professor at California State University, Channel Islands.

The forensic nightmare of appraising these bad assets forced the Bush administration to abandon the idea in the early days of the bailout. With the markets spiraling lower, there simply wasn't enough time.

And even if the government figures out how much to pay for the assets this time, the question is how much to buy.

Goldman Sachs estimates the government would need to shell out $4 trillion or more to absorb all the banks' troubled mortgage and consumer debt.

How big is $4 trillion? It's more than one-third of the economic output of the United States in a year. It's more than twice as big as the first federal bailout and the coming economic stimulus combined. Just look at all those zeroes: $4,000,000,000,000.

Another vexing issue: Who would be in charge of poring over the banks' books and valuing the assets? Experts say the people best qualified to do that are the same ones who created the faulty products -- Wall Street bankers and other investment professionals.

That prospect makes some financial observers queasy.

"We're asking the same people who got us into this mess to get us out. These are the guys who buy airplanes and decorate their offices for a million bucks," says Bill Seidman, a former chairman of the FDIC who ran the government bailout during the savings and loan crisis.

Seidman and others are calling for an alternative rescue plan that they say would avoid the pitfalls of past efforts: a short-term nationalization of the banks.

To many people, that very thought is an affront to the free-market system, more Argentina than America. But that's exactly what the U.S. government did in the S&L debacle of the 1980s.

With Seidman at the helm, the government-run Resolution Trust Corp. took over failed S&Ls and sold off their depressed assets -- repossessed homes, offices, cars, planes and even artwork. Any institution needing help had its management fired and its shareholders wiped out.

During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700 failed thrifts. Then it sold the cleaned-up S&Ls back into the private sector.

The cost to taxpayers? About $125 billion to $150 billion by the time the bailout was completed in 1995, which was about 2 percent of one year's gross domestic product at the time.

Seidman believes a similar plan has the best chance of success. And he claims it would cost taxpayers far less because the government wouldn't have to buy bad assets or inject more money into troubled banks.

Instead, the government's expenses would be largely limited to the cost of cleaning up the seized banks and selling them back into the private sector, Seidman says.

"If we don't do it, we risk staying right where we are -- pumping more money into insolvent banks and keeping them alive at the expense of healthy ones," he says.

That's what happened to Japan, which injected billions of taxpayer dollars into the banking system and spawned a legion of "zombie banks" -- financial institutions that take government money but don't lend it out.

Nationalization isn't a sure thing either.

In the S&L days, the government recouped some taxpayer money by selling the physical assets of the banks, things like real estate and cars -- not the hard-to-value paper assets held by banks today.

That wrinkle makes it much harder for the government to follow the RTC strategy, says Jonathan Macey, deputy dean at Yale Law School and the author of a book about a government bailout of Sweden in the 1990s.

"We're not talking about valuing buildings and dirt," Macey says. "This is quite a bit different."

In other words, it's uncharted territory once again.

AP Business Writer Madlen Read contributed to this story.

Chinalco May Invest $20 Billion in Rio Debt, Mines (Update1)

By Brett Foley and Ambereen Choudhury

Feb. 11 (Bloomberg) -- Aluminum Corp. of China, the nation’s biggest producer of the metal, may invest as much as $20 billion in Rio Tinto Group to gain more access to commodities, a person with knowledge of the matter said.

Chinalco, as the company is known, is in talks to buy bonds that will convert into Rio shares and purchase stakes in Rio mines, the person said, declining to be identified as the details aren’t public. An announcement is planned for Feb. 12 when Rio publishes its annual earnings, the person said.

Rio last week said it was in talks with Chinalco to raise cash by selling notes and parts of some units to reduce its $38.9 billion of debt. Chairman-elect Jim Leng quit last week, after less than a month, because of a disagreement over how to cut debt at the company, which is also considering a broader share sale.

“Rio would get the cash they need and Chinalco would get greater access to the natural resources that they need,” Tobias Woerner, an analyst at MF Global Securities Ltd. in London, said yesterday by telephone. “Unless you think the China story is over, Chinalco are going to need those resources and this deal would deliver them at a potentially more attractive rate than only a year ago.”

Rio gained 2.5 percent to A$50.17 at 1:21 p.m. Sydney time on the Australian stock exchange, outperforming bigger rival BHP Billiton Ltd. which fell 3.1 percent. Rio’s shares have slumped 16 percent since BHP withdrew its $66 billion takeover offer in November. BHP has risen 38 percent.

Asset Sale

Aluminum Corp. of China Ltd., Chinalco’s listed unit, dropped 0.5 percent in Hong Kong trading at 10:27 a.m. local time, and rose 7.6 percent in Shanghai.

Rio’s London-based spokesman Nick Cobban declined to comment when contacted by phone yesterday. A spokesman for Chinalco in London, who asked not to be identified, declined to comment. Lu Youqing, spokesman and vice president at Chinalco, didn’t pick up his mobile..

London-based Rio, which plans to sell assets and cut jobs and spending to lower debt by $10 billion this year, said Jan. 28 it was considering a rights offer to help reduce debt. It has debt of $38.9 billion after buying Canadian aluminum maker Alcan Inc. in 2007.

Chinalco may be interested in Rio’s bauxite and alumina assets at Weipa, Gove and Yarwun in northern Australia, Credit Suisse Group’s Sydney-based analyst Paul McTaggart wrote yesterday in a report. Bauxite is an ore refined into alumina, which is used to make aluminum.

Largest Holder

Chinalco, which is state-controlled, became Rio’s largest shareholder last year after acquiring a 9 percent stake. A possible sale of more stock to Chinalco may be blocked by the Australian government, UBS AG analysts led by Glyn Lawcock said in a report this week. Australia may limit ownership under the Foreign Investment Review Board regime to 15 percent, the analysts said in a report.

Western Australia wouldn’t stand in the way of Chinalco increasing its stake in Rio, Premier Colin Barnett said in an interview. Chinalco got approval from Australian treasurer Wayne Swan in August to raise its stake in Rio from 9 percent to 11 percent. It would need to reapply to increase the stake beyond that level, Swan said.

To contact the reporters on this story: Brett Foley in London at; Ambereen Choudhury in London at

Last Updated: February 10, 2009 21:57 EST
China Needs U.S. Guarantees for Treasuries, Yu Says (Update1)

By Belinda Cao and Judy Chen

Feb. 11 (Bloomberg) -- China should seek guarantees that its $682 billion holdings of U.S. government debt won’t be eroded by “reckless policies,” said Yu Yongding, a former adviser to the central bank.

The U.S. “should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way,” Yu, who now heads the World Economics and Politics Institute at the Chinese Academy of Social Sciences, said in response to e-mailed questions yesterday from Beijing. He declined to elaborate on the assurances needed by China, the biggest foreign holder of U.S. government debt.

Benchmark 10-year Treasury yields climbed above 3 percent this week on speculation the government will increase borrowing as President Barack Obama pushes his $838 billion stimulus package through Congress. Premier Wen Jiabao said last month his government’s strategy for investing would focus on safeguarding the value of China’s $1.95 trillion foreign reserves.

China may voice its concerns over U.S. government finances and the potential for a weaker dollar when Secretary of State Hillary Clinton visits China on Feb. 20, according to He Zhicheng, an economist at Agricultural Bank of China, the nation’s third-largest lender by assets. A People’s Bank of China official, who didn’t wish to be identified, declined to comment on the telephone.

Clinton Talks

“In talks with Clinton, China will ask for a guarantee that the U.S. will support the dollar’s exchange rate and make sure China’s dollar-denominated assets are safe,” said He in Beijing. “That would be one of the prerequisites for more purchases.”

Chinese Foreign Ministry Spokeswoman Jiang Yu said yesterday that talks with Clinton would cover bilateral relations, the financial crisis and international affairs, according to the Xinhua news agency.

U.S. government bonds returned 14 percent last year including price gains and reinvested interest, the most since rallying 18.5 percent in 1995, according to indexes compiled by Merrill Lynch & Co. Concern that the flood of bonds would overwhelm demand caused Treasuries to lose 3.08 percent in January, the steepest drop in almost five years, Merrill data show. The yield on the benchmark 10-year U.S. Treasury has risen to 2.80 percent from 2.21 percent at the end of last year.

Blackstone Loss

China’s loss of more than $5 billion from investing $10.5 billion of its reserves in New York-based Blackstone Group LP, Morgan Stanley and TPG Inc. since mid-2007 may increase its demand for the relative safety of Treasuries.

“The government will be a net buyer of Treasuries in the short term because there’s no sign they have changed their strategy,” said Zhang Ming, secretary general of international finance research center at the Chinese Academy of Social Sciences in Beijing. “But personally, I don’t think we should increase holdings because the medium- and long-term risks are quite high.”

Bill Gross, co-chief investment officer of Pacific Investment Management Co., said on Feb. 5 the Federal Reserve will have to buy Treasuries to curb yields as debt sales increase. U.S. central bank officials said Jan. 28 they were “prepared” to buy longer-term Treasuries.

“The biggest concern for China to continue buying U.S. Treasuries is that if Obama’s stimulus doesn’t work out as expected, the Fed may have to print money to cover the deficit,” said Shen Jianguang, a Hong Kong-based economist at China International Capital Corp., partly owned by Morgan Stanley. “That will cause a dollar slump and the U.S. government debt will lose its allure for being a safe haven for international investors.”

Currency Reserves

China’s foreign-exchange reserves, the world’s biggest, grew about $40 billion in the fourth quarter, the smallest expansion since mid-2004 as an end to yuan appreciation since July prompted investors to pull money out.

The world’s third-biggest economy grew 6.8 percent in the fourth quarter, the slowest pace in seven years. Policy makers cut interest rates by the most in 11 years and announced a 4 trillion yuan ($585 billion) economic stimulus plan in November to spur domestic demand.

Yu said China won’t channel its reserves toward stimulating the economy because its trade surplus is sufficient to fund any import needs. China’s trade surplus was $39 billion in December, the second-largest on record.

A decline in reserves “isn’t likely because of China’s huge twin surpluses,” Yu said. China “should diversify its reserves away from U.S. Treasuries if the value of China’s foreign-exchange reserves is in danger of being inflated away by the U.S. government’s pump-priming,” he said.

Linking Disputes

China may try to link trade and currency policy disputes to its future investment in Treasuries, said Lu Zhengwei, an economist in Shanghai at Industrial Bank Co., a Chinese lender partly owned by a unit of HSBC Holdings Plc.

U.S. Treasury Secretary Timothy Geithner accused China on Jan. 22 of “manipulating” the yuan to give an unfair advantage to its exporters in the global market. The currency has dropped 0.16 percent since the start of this year to 6.8342 per dollar, following a 21 percent gain since a peg against the dollar was abandoned in July 2005.

“China can also use this opportunity to get a promise from the U.S. not to make inappropriate requests on bilateral trade and the Chinese yuan,” Lu said. “We can’t afford more yuan appreciation as the economy is facing a serious slowdown.”

To contact the reporters on this story: Belinda Cao in Beijing at; Judy Chen in Shanghai at

Last Updated: February 10, 2009 23:03 EST