"The Great Recapitalization"

While writing commentary on the events of our time I occasionally run across something that, by virtue of either its insightfulness or its absurdity, begs to be brought to the attention of as many people as is humanly possible. Edward Nelson's "The Great Recapitalization," which appears in the Federal Reserve Bank of St. Louis' Economic Synopses (Number 28, 2008), is such an item.

This brief (one page) article begins with an explanation of its purpose:

"On October 14, 2008, the U.S. Treasury announced a voluntary Capital Purchase Program intended to increase the flow of financing to U.S. businesses and consumers."

As I have commented in the past, there is probably nothing this side of Newton's Law of Universal Gravitation that is more mandatory than participation in a "voluntary" government program. Since there have been no published reports of a sudden "thawing" in the "frozen" credit policies of the nation's banks, it is probably safe to assume that the Capital Purchase Program has not been a model of short-term success.

"Under the program, the Treasury will inject capital directly into the banking system by purchasing senior preferred equity shares from certain depository financial institutions."

According to ProPublica, which is maintaining a "running total" of the cost of the Treasury's "capital injection," as of 22 December, 2008, a total of 210 banks were set to tap in to just under $200 billion of such government-provided cash. If that's an "injection" I would hate to see the price tag of a transfusion.

"Historical precedents exist... including the bolstering of bank capital with U.S. government funds by the Reconstruction Finance Corporation in the 1930s and the recapitalization of banks by governments in the Nordic countries in the 1990s."

Mr. Nelson is indeed correct in stating that these "precedents exist," but he fails to place those precedents in their historical context. Please allow me to correct that oversight.

The Reconstruction Finance Corporation was created by an act of Congress in 1932 for the express purpose of "making loans to banks, railroads, farm mortgage associations, and other businesses." What is not mentioned is that even the most rabid apologists of the New Deal will concede that the Reconstruction Finance Corporation, largely as a result of chronic underfunding and evidence of political favoritism, was a total failure. The use of the experiences of the "Nordic countries" as a precedent is also troubling.

As many financial historians such as Charles Kindlenerger (Manias, Panics, and Crashes, 5^th edition; pp. 142-143) have noted, the reason that those governments were forced to recapitalize their banking systems was that the banks were about to implode under mountains of write-offs on loans that had been made in the midst of a real estate "bubble" brought about by speculators that had caused property values to soar to heights that were far above the actual value of the mortgaged properties.

Does any of that sound familiar?

Mr. Nelson, along with those in charge of policy at every financial regulatory agency within the United States government, seems to have been of the opinion that "it couldn't happen here" because, after all, this is the good old USA and we're too smart not to learn from everyone else's screw-ups.. After citing a 2003 study from the San Francisco Federal Reserve Bank that had concluded "... the improvements in risk management offered by securitization, loan syndication, and hedging via derivatives instruments have helped banks shed unwanted risks...," he makes one of the greatest understatements of 2008:

"Recent financial turmoil has strained bank balance sheets and called into question previous opinion on how securitization would affect bank risk."

Securitization is the process by which assets of one type, such as mortgages, are "repackaged" and then sold as some other form of income-producing asset. As I explained in a recent posting, this is a good idea until something interferes with the underlying assets' cash flow. Then all Hell, not to mention a financial panic, breaks loose. This financial panic will almost invariably cause a stampede to the nearest voting booth where the public will demonstrate its ignorance of the fundamental issues at hand by voting the innocent out of, and the guilty into, elective office.

I could, of course, go on and on about this most recent attempt to bankrupt the national treasury but that would be redundant. Instead, I will make a final comment on today's subject.

It is well-known that intelligence can be inherited. Since we can assume that the lack of intelligence is also inheritable, it would appear that we have placed the responsibility for the well-being of the Republic into the hands of genetically pre-ordained idiots.