Analysis: House panel probes the ‘science’ of bank insolvency

Exclusive analysis for FinReg21 by Darrell Delamaide 

When a relatively obscure congressional subcommittee wins recognition from a fledgling journalistic operation that has neither a print nor an online outlet, the event does not garner a lot of headlines. 

So few people took note earlier this week when the Investigations and Oversight subcommittee of the House Science and Technology Committee received one of the first Investigative Governance Awards from the ProPublica newsroom, an experimental group founded by former Wall Street Journal managing editor Paul Steiger to provide investigative journalism outside of an established newspaper or magazine. 

The award, one of four in different categories, was for the panel’s work last year in documenting the failure of a government agency affiliated with the Center for Disease Control to properly protect Katrina victims from high formaldehyde levels in trailers supplied as emergency housing by FEMA. 

Subcommittee chairman Brad Miller (D-N.C.) proudly noted the award for the panel’s report on “Toxic Trailers – Toxic Lethargy” when he opened a hearing Tuesday on a different kind of toxicity – the “toxic assets” held by banks that led to a worldwide financial meltdown. While banking may not seem to fall under the purview of a Science and Technology subcommittee, Miller reminded the audience that economics is known as the “dismal science” and he had convened four well-known economists to discuss “the science of insolvency.” 

The hearing aimed to pin down the what, when and where of insolvency, and what that should mean for policy. “Many credible economists are not persuaded when regulators peek into the black box of banks’ assets and liabilities and declare that there is nothing to worry about,” Miller said. It was those same regulators, he noted, that “not that long ago told us that any problems in the financial sector arising from mortgage defaults would be easily ‘contained.’” 

The question of whether the banks are insolvent has driven much of the debate about the bailout. The answer lies in the valuation of the banks’ assets and whether losses on those assets exceed bank capital. Many economists, including some of the witnesses at the hearing, have argued that the banks are technically insolvent and are “zombie banks” or “dead men walking” because the toxic assets, if properly valued, would wipe out their capital. 

The hearing did not, however, produce any black-and-white declaration of insolvency. Among the four economists testifying were three left-leaning experts who have been publicly skeptical of the administration’s assessment of the banks’ health and the government’s approach to the bailout. 

Jeffrey Sachs, who directs the Earth Institute at Columbia University, agreed with the arguments of the Federal Reserve and the Treasury Department that the short-term problem was one of liquidity that the emergency measures successfully dealt with. But, Sachs continued, the administration has no policy in place to deal with the longer-term problem of recapitalizing institutions with impaired capital. We will only be able to realize over time which institutions these are, and what consequences the capital impairment will bring, he said. 

Any resolution authority for seizing and unwinding large financial institutions, Sachs said, should have the four hallmarks of FDIC receivership – shareholders and bondholders should be the first to absorb losses; taxpayers should get value in return for their participation; the process should be transparent, and it should be speedy. 

The government’s proposed program for removing toxic assets, the Public-Private Investment Partnership, or PPIP, “fails on all counts,” Sachs said. It is unfair, not transparent and too expensive for taxpayers, he said, and should be abandoned if, as the government’s stress tests of the banks seemed to indicate, this type of subsidized aid is no longer needed to stabilize their situation. 

Sachs’ condemnation of PPIP won agreement from two other witnesses – Simon Johnson, professor at MIT and former chief economist of the International Monetary Fund, and Dean Baker, director of the Center for Economic Policy Research. 

“The science of insolvency has failed,” Johnson said. The government’s bailout has created the wrong incentive for bank executives – it has taught them that it’s all right to “tunnel” money out of these institutions and take high risks because the government will save their banks, their jobs and their compensation. 

The government failed to be as strict with U.S. banks as the IMF would have been in any country where it was called in to deal with a financial crisis. A truly tough stress test would have been administered, management would have been removed and banks would have been immediately recapitalized. 

Johnson, who is also a fellow at the Peter G. Peterson Institute for International Economics, has been quite vocal in his blog, BaselineScenario.com, that allowing the banks to “muddle through” with impaired capital will dampen economic recovery and could lead to a “lost decade” of slow growth similar to that experienced by Japan in the 1990s when it refused to take bold action with its ailing banks. 

Dean Baker contended that the banks could not argue that there was no market for their toxic assets or that they will be worth more at a later date. Such assets are being routinely sold by the FDIC as it unwinds smaller banks, he said. “There is little reason to believe that the current market prices for these assets are unreasonably low and that they will be selling for substantially higher prices in the foreseeable future,” Baker said. 

And yet this premise is the basis for the government’s policy of holding back and letting the banks value the assets at much higher prices than can be currently fetched in the market. The Financial Accounting Standards Board buckled under government pressure to relax the “mark-to-market” rule, enabling the banks to avoid massive writeoffs that would, in fact, have rendered them insolvent. 

Even the more conservative witness on the panel, David John of the Heritage Foundation, was not willing to say the government’s approach was the right one, though he contended it could be. The stress tests may not have been tough enough, he said, but they accomplished what they were intended to do – distract the market from worrying about banks going bankrupt “in the next 15 to 20 minutes.”