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.
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 2 below reflects an increase in the allowance for loan losses to the full $1.5 trillion reasonably known and expected:
The technical bankruptcy of
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.
"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.
8th November 2008
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
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
6 Schemmann, Michael. 1991. “Money in
Crisis. A Solution for Paying Off Canada’s National Debt.”
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."