Buying Bad Debt to Return Bank Solvency

Let’s begin with a hearty laugh…a big guffaw…

We don’t hear much from Tom Friedman anymore. But we still have Paul Krugman, Ben Bernanke and Tim Geithner.

It was the latter who had us in stitches yesterday. Here’s the report from Bloomberg:

The US financial system is in better shape than it was before the recession and is well placed to provide the funding needed for the economic expansion, Treasury Secretary Timothy F. Geithner said.

“The core of the American financial system is in a much stronger position than it was before the crisis,” Geithner said today during a Bloomberg Breakfast with reporters in Washington.

US banks had net income of $87.5 billion in 2010, the highest since 2007, the Federal Deposit Insurance Corp. said today. The Standard & Poor’s 500 index has jumped 64 percent since March 2009, and corporate bond spreads have narrowed.

“We can say with much more confidence now that the US banking system and the US capital market are much more likely to be in a position to finance the capital needs that come with a recovery,” Geithner said.

Oh stop it, Tim. How much more can we take?

Hold on… Let’s take a few deep breaths.

Now, how did that work again? The banks were shown to be insolvent during the crisis of ’07-’09. They had too much bad debt and not enough capital. And now they’re healthy, right?

Well, what happened to the bad debt? Most of it was backed by real estate. Did real estate go up? It didn’t?

Then, what happened to make the bankers rich again?

The Fed bought their bad debt – about $1.25 trillion worth. But not only did it relieve the banks of their mistakes, it also connived with the US Treasury, now run by the aforementioned Geithner, to make sure the bankers made a lot of money. The Fed lent to them at next to zero interest rate. Then, the US Treasury borrowed the money back at 4%. Even a banker could make money with that deal.

But wait, there’s more…

Government deficits and money printing may mean eventual ruin to a nation’s finances, but they do wonders for the financial sector. Free money is great for the people who get it first, in other words.

It’s like milk. Wholesome and fresh initially, it soon begins to turn. You can pass it along for months. You can pretend it is still good. But don’t open the carton!

The banks were able to use this free money from the feds to rebuild their balance sheets. Tim Geithner now pronounces them “solid” and “healthy.”

But wait… This is the same man who watched over them, from his post at the New York Fed, before the crisis of ’07-’09 too. He thought they were solid and healthy back then too.

They weren’t. It’s true they are in better shape now. But only because the sour milk is now in the Fed’s refrigerator…

Yes, dear reader. The trick of modern financial management is merely to turn little problems into bigger ones…passing along the bad stuff to larger and larger groups. Individual banks were broke. Now, the Fed is broke. And the US government too.

Individual banks were going broke…so they put the credit of the US central bank at risk to save them. And who stands behind the Fed? The US government.

When the crisis hit, the bankers looked at each other. They sized each other up. Who’s broke? Who’s solvent? They quickly decided not to accept Bear Stearns’ credits or to deal with Lehman Bros. as a counterparty. Then, the feds stepped in…refloating the whole sector on a sea of dollars, US government bonds and the full faith and credit of the US government.

Now, the whole system is in jeopardy.

By the way, Tim. You want to know how an economy really works? You want to know why you can’t engineer a real recovery by adding more debt to a debt-drenched system?

You don’t?

Well, we’re going to tell you any way. Here’s Ludwig von Mises, writing in the 1930s:

Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.

Yes, and the “recovery” engineered by Bernanke and Geithner is built on quicksand.

In a real recovery, people have jobs. In a phony one, they don’t.

Since last June, reports Mort Zuckerman in The Financial Times, employers added a paltry 284,000 jobs, net. Not enough to keep even with population growth. In January of this year there were actually half a million fewer people working than there were in June of 2009.

“The decline in unemployment to 9% is illusory, because half a million discouraged workers stopped looking for jobs.”

And now…

“Oil price surge puts fragile US recovery at risk,” reports the FT.

Of course, you read it here first. Ben Bernanke forced up oil and food prices. This thighbone was connected to the knee bone of uprisings in the desert…which led to the leg bone of even higher oil prices.

And now, the “recovery” that Ben Bernanke wanted so badly is threatened by his own reckless and futile policies.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning