Obama's Unsung Hero

A window opportunity to restructure America’s banking system

 

Copyright © 2008 by Michael Schemmann 1

 

When Barack Obama is sworn in as the United States’ 44th President on January 20, 2009, as Chief of the world’s most formidable Armed Forces with ultimate responsibility for the U.S. Treasury and its Federal Reserve System and Federal Deposit Insurance Corporation that by concerted action have just avoided a complete meltdown of the American banking system — still technically ruptured meaning “bankrupt” — Obama and the Democratic Congress have an historic opportunity to restructure the American banking system.

 

The president will start with a clean slate and preside over the finishing touches to repair the commercial banking system and most likely replace the man at the helm of the Treasury who willy-nilly helped him win the election by making the Bush administration’s dilemma front page news before convincing Congress to empower him to fix the blamage: Hank Paulson.

 

The $700 billion dollars authorized by Congress upon the urging of a hundred economics professors from Richard Arnould from the U of Illinois to Sidney Winters from the U of Pennsylvania, including Michael Boskin from Stanford, will not be enough to do the job because the total losses from the subprime lending debacle run into the $1.0 or more trillions. 2
Photo: Henry M. Paulson, Jr. courtesy of the U.S. Treasury

 

The proof of America’s banks’ bankruptcies from a financial reporting point of view based on generally accepted principles of accounting occurs when their equity commonly known as “capital” turns into negative equity, and on the whole by compiling all their balance sheets into one, that is what they did. Helping the stronger banks to absorb the weaker ones by giving them federal runds does not change the total picture a lot except to endear the Treasury to the survivors.

 

An analysis of Table 1 below shows the normal distribution: The banks' non-income producing assets (premises and other real estate, goodwill resulting from mergers and all other assets) are financed by equity (10% of total assets); deposits resulting from lending by double-entry bookkeeping (debiting customer’s loans receivables, crediting customer’s deposit accounts, creating "bank money" out of nothing) together with "borrowed funds" perfectly match the revenue generating loans and other financial assets (90% of total assets). Only banks can get away with low 9% capital-to-debt ratios because they are the fountains of money that drive our globalized economy. The problem for the private banks is that under the legal tender law, especially in turbulent times, only the central bank's high-powered money is legal tender for all debts, public and private, as is written on each and every U.S. dollar bill.

 

To this day, the write-downs by U.S. commercial banks on their U.S. sub-prime lending are about $600 billion with another couple hundred billions or a trillion left to do: "Take your time folks, help's on the way!" If we increase the “Allowance for loan & lease losses” shown as 89 billion dollars to the full one trillion dollars, the total equity capital will go down from $1.1 trillion to $633 billion dollars, or a low 6% of total assets (which is below the Basel II Capital requirements under the standardized approach which requires 8% regulatory capital). If we increase the subprime loan loss allowance to the full $1.5 trillion on the expectation of avalanche-effects on related industries, the banks’ total equity will be negative $267 billion, meaning the U.S. commercial banking system as a whole is bankrupt. However, Hank Paulson has just bought $250 billion of bank stock, and now we can see why! But let's go step by step.

Table 1 below is a combined balance sheet of all the assets and liabilities of the 7,282 U.S. commercial banks as reported by the FDIC for the year end 2007. 3

 

Assets and Liabilities of U.S. Commercial Banks

As of Year End 2007

(billions of dollars)

 

   Assets                                                                                   Liabilities and Equity

 

Cash & due from investments

 

482

4%

 

Demand & savings deposits

7,309

 

65%

Investment securities

 

1,591

14%

 

Borrowed funds

1,880

 

17%

Loans & leases

6,626

 

 

 

Subordinated notes

175

 

2%

Allowance for loan & lease losses

-89

 

 

 

Other liabilities

668

 

6%

 Net loans & leases

 

6,537

58%

 

   Total liabilities

 

10,032

90%

Other earning assets

 

1,514

14%

 

 

 

 

 

  Total financial assets

 

10,124

91%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Bank premises & equipment

105

 

 

 

Perpetual preferred stock

5

 

0%

Other real estate

10

 

 

 

Common stock

36

 

0%

  Total real estate

 

115

1%

 

Surplus

738

 

7%

Intangibles

 

424

4%

 

Undivided profits

365

 

3%

All other assets

 

513

5%

 

Other capital

0

 

0

   Total nonfinancial assets

 

1,052

9%

 

  Total equity capital

 

1,144

10%

 

 

 

 

 

 

 

 

 

Total assets

 

11,176

100%

 

Total liabilities & equity

 

11,176

100%

 

 

Table 2 below reflects an increase in the allowance for loan losses to the full $1.5 trillion reasonably known and expected:


 

Assets and Liabilities of U.S. Commercial Banks

As of Year End 2007

(billions of dollars)

 

   Assets                                                                                   Liabilities and Equity

 

Cash & due from investments

 

482

5%

 

Demand & savings deposits

7,309

 

75%

Investment securities

 

1,591

16%

 

Borrowed funds

1,880

 

19%

Loans & leases

6,626

 

 

 

Subordinated notes

175

 

2%

Allowance for loan & lease losses

1,500

 

 

 

Other liabilities

668

 

7%

 Net loans & leases

 

5,126

52%

 

   Total liabilities

 

10,032

103%

Other earning assets

 

1,514

16%

 

 

 

 

 

  Total financial assets

 

8,713

89%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Bank premises & equipment

105

 

 

 

Perpetual preferred stock

5

 

0%

Other real estate

10

 

 

 

Common stock

36

 

0%

  Total real estate

 

115

1%

 

Surplus

-673

 

-7%

Intangibles

 

424

4%

 

Undivided profits

365

 

4%

All other assets

 

513

5%

 

Other capital

0

 

0

   Total nonfinancial assets

 

1,052

11%

 

  Total equity capital

 

-267

-3%

 

 

 

 

 

 

 

 

 

Total assets

 

9,765

100%

 

Total liabilities & equity

 

9,765

100%

 

 

The technical bankruptcy of America’s commercial banks can be helped or even "cured" by simply ignoring it and waiting a decade until the banks outgrow their losses through economic growth and the accompanying increase of the money supply. Hard-money won't like it; and one of the Fed's mandates might be violated. If turning a blind eye for lack of any other remedy had been an acceptable strategy (or non-strategy) as happened in Thailand 4   following the 1997 Asian financial crisis, then Hank Paulson shouldn’t have been so alarmist but could have opened another couple of discount windows at the Fed in order to get the central bank money into the banks and brokerage houses including Bear Stearns and Lehman Brothers.

 

The industrial revolution that got underway in the 1800s, the high degree of division of labor and the consumer society that resulted in the industrialized world and moving to the emerging economies of Asia is unthinkable without the liquidity provided by fiat money replacing the metallic currency. 5

 

One should note that the banks built their huge financial system virtually from nothing: Common Stock is a mere $36 billion; Perpetual Preferred Stock $5 billion that could or would have been contributed in kind or services rendered, or more likely as an accounting valuation difference called "goodwill" resulting from the many bank mergers that have taken place and are continuing (the small ones are leaning on the surmised strength of the big ones). Goodwill under U.S. GAAP is the excess of the consideration tendered (most likely in acquiring banks' own capital stock) and liabilities assumed over the inflated values of the identifiable net assets acquired. Goodwill is an intangible asset — $424 billion are reflected on the combined balance sheet.

 

The banks have been allowed to effectively usurp the Congress' sovereign power over money (Article 1 Section 8 of the U.S. Constitution: "To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures") by creating money out of nothing by double-entry bookkeeping (so called "bank money"). In England private country banks sustained themselves through their note issue that circulated as money until the Bank Charter Act of 1844 (7 & 8 Vict. c.32) conferred the exclusive right to print paper money (backed 100% by gold except in crisis) upon the Governor and Company of the Bank of England, the central bank of England.

The Bank Charter Act did not prevent the creation of bank deposits by the private banks. The English country banks that had sustained themselves on the interest on their private note issue used by merchants as the circulating medium, found a way around the ban to create "money". Instead of issuing notes, they simply began to credit their customers' deposit accountx, creating their money that way, leaving it up to the customer to distribute it by cheques writing, so that the Bank of England's banknotes (the "cash") in circulation were reduced to a fraction of the nation's money supply; and that is still the situation today ($600 billion Federal Reserve notes, two-thirds of which are circulationg in other countries as a surrogate currency, versus $5 trillion plus bank money). Keynes (1913) in Indian Currency and Finance laments:

 

"In England, of course, bankers immediately set themselves to recover the economy and elasticity which the Act of 1844 banished from the English system by other means; and with the development of the cheques system to its present state of perfection they have magnificently succeeded." [Cheques today have been replaced by more efficient electronic impulses.]

 

Now the U.S. commercial banks are illiquid because their own created bank money is no longer transferable to transact the nation's 300,000 payments and $1.5 trillion plus per day through the banks' own Clearing House Interbank Payments System (CHIPS), requiring the Treasury and Fed to put their high-powered central bank money into the system, now is the time to take back their private-mint money power by paying off at least a part of the burgeoning $11 trillion national debt instead of giving it to the private commercial banks who created their own dilemma. 6

 

The global financial crisis came in waves. The first wave came after the big French bank BNP Paribas suspended three investment funds worth 2 billion euros  because "it was impossible to value certain assets in an uncertain market" resulting in an instant freezing of the affected markets and immediate counter action by the European Central Bank by "pumping 95 billion euros into the banking sector". 7 “There is nothing more nervous than a million dollars,” as the saying goes.

 

The second wave came in the form of a credit crunch, the third by a complete halt in interbank-accommodations during “Black September” when Hank Paulson engaged in high-stakes poker by teaching Lehman Brothers a lesson and letting them fail causing a world-wide meltdown of securities and their derivatives, the fourth wave.

 

There may be a fifth wave looming on the horizon from trillions of dollars of imbedded derivatives and their losses waiting to be taken on the banks’ balance sheets. 8 The banks with the involvement of AIG have written some $65 trillion in CDSs (credit default swaps).

 

The European Union and international accounting standard setters, succumbing to political pressure, are loosening mark-to-market rules that the banks and their brokers have been enforcing rigorously on margin accounts. The IASB is easing fair value accounting, allowing banks to reclassify financial instruments as long-term investments held to maturity "in certain ways  that would keep price falls from hitting profits", even reverse previous write-downs taken after the effective date of July 1, 2008, and so massage their so called “statements of financial position” that accountants must continue to audit. 9

 

Financial engineering and the “quants” of Wall Street and the rating-agencies-created- models that gave rise to SIVs that brought the respected discipline of finance and art of risk management into ill repute based on their blind faith and over-reliance on highly complex mathematical formulas that may work in physics. 10

 

Capitalism is characterized by risk-taking, enjoying the gains, and suffering the losses but not socializing them.

 

Almaty, Kazakhstan

8th November 2008

 

See comments received

 

1 Michael Schemmann is a professional banker by training, former corporate loan officer of a Canadian chartered bank, a Certified Public Accountant in the State of Washington, and Director for Asia of the IICPA (www.iicpa.com), and an accounting instructor at Kazakhstan Institute of Management, Economics and Strategic Research in Almaty.

2America will need a $1 trillion dollar bail-out” - Kenneth Rogoff FT London 18 September 2008; “Credit crisis could cost nearly $1 trillion,  IMF predicts – International Herald Tribune online 8 April 2008.

3 Federal Deposit Insurance Corporation. Historical Statistics on Banks at www2.fdic.gov/hsob/

4 Schemmann, Michael. 2007. “MBA Handbook 2008.” “Restructuring Banks from Their Liability Side”, pp. 169-70, referring to the Colm-Dodge-Goldsmith Plan imposed by the American Military Government on Germany in 1948, and to a study by Bangkok Bank’s Research Department, “Commercial Banks in Thailand 2004”.  —   “Paper money was used in China two thousand years ago; and the fitting name of flying money was given there to bills of exchange at least a thousand years ago.” (Marshall, Alfred. 1923. “Money, Credit, and Commerce. London: Macmillan, reprinted 2003 New York: Prometheus Books, p. 420, fn. 2.

6 Schemmann, Michael. 1991. “Money in Crisis. A Solution for Paying Off Canada’s National Debt.” Vancouver, BC.  ISBN 0-9695712-0-8

7 BBC News. "ECB moves to help banking sector," August 9, 2008 at http://news.bbc.co.uk/1/hi/business/6938425.stm

8 Big Picture. An under the radar "FASB Bombshell: FAS 140 to Eliminate QSPEs" eliminating the concept of QSPEs (qualified special-purpose entities), "The migration of exotics to the balance sheet may be inevitable", "FT pegs the dolar amount at $5 trillion," at http://bigpicture.typepad.com/comments/2008/06/fasb-bombshell.html  June 4, 2008.; and FASB Chair's speech "Lessons Learned, Relearned, and Learned Again from the Credit Crisis—Accounting and Beyond"  of  September 18, 1988 at http://www.fasb.org/news/09-18-08_herz_speech.pdf

9 Wall Street Journal, "Money & Investing," October 20, 2008 (cover story), but "UBS refuses to flatter results by using rule change" because the effects must be reported and investors can see through them. (Financial Times of London, "Companies & Markets", November 5, 2008, p. 2.

10 Derman, Emanuel. 2004. "My Life as a Quant - Reflections on Physics and Finance." New York: John Wiley & Sons, Inc. referred to in the International Herald Tribune, the global edition of the New York Times, "Wall Street innovation gone wild. Assessing  risk took a back seat on Wall Street", 5 November 2008. The author is a professor at Columbia University. He comments on the failure of risk management, as cited in the IHT: "The quantitative models typically have their origins in academia and often the physical sciences. In academia the focus is on problems that can be solved, proven and published – not messy, intractable challenges."

Comments received:

November 8, 2008

Nice article. However, contrary to your opinion Hank Paulson is a nice guy he is the stooge for the greedy Wall Street bankers who commanded their old plea of too big to fail and the effects thereof when it really was to save their jobs, perks, monster salaries, and bonuses not just the banks but Wall Street people with whom they now have become fully integrated. Whereas, selectively they picked off some to the benefit of the giants who have become even bigger. Thus, there are now essentially only four banks left — Citigroup, JP Morgan, Bank of America, and Wells. Ironically, they have created a situation that even further reinforces the too big to fail concept.

It would have been much cheaper for the government to buy back the defaulted mortgages and sell the houses to qualified buyers at low interest rates. Meanwhile bankrupt the banks, and since they can't or won't lend money in this recession environment and bar or restrict their ability to create their "soft money" and replace it with hard [central bank — Federal Reserve] money. Given the financial and energy crisis this is the opportunity for the government to provide the money to rebuild the public and private infrastructure, like they did during the [Great] Depression, for the new industries with the non-interest bearing hard money. It didn't have the economic effect then as much as it could now, because it was four years before the programs were started, whereas now it is short-lived.

Moreover, such a move could lead to the requirement you recommend to separate their clearing function from their lending function, which could prevent them from creating soft money by restricting their lending to actual, savings or CD deposits and Fed Bank loans under rigid percentages tied to economic and inflation situations.

The King had a great idea, he just didn't keep control, and ever since the boys have had their way because of the power they control over every community and indirectly the governments. One of my axioms... is "If you don't control it, it will control you." You can substitute anything or anyone for 'it', and still have a truism.

A corollary to this is a response of Willie Sutton, a famous bank robber during the big '30s Depression when asked why he robbed banks, "'cause that is where the money is".

I could get off on a whole dissertation on capitalism, free enterprise, competition and regulation, but would digress from the urgency addressed in your article.