James Galbraith: Due Diligence Damn it.

Although part of this article deals with the New Deal, the latter parts deal with lessons for the present situation. According to Galbraith the Geithner plan does not include due diligence and thus could very well cost the taxpayer whopping losses without showing much benefit in terms of getting banks to loan more money.


From: TPMCafe Book Club
Due Diligence, Damn It

By James K. Galbraith - February 13, 2009, 6:14PM
Rauchway's book is an exceptionally valuable pocket summary of the major actions of the New Deal. It solves a big problem for those with small pockets: how to keep enough facts at close hand to answer, with authority, all the anti-Roosevelt nonsense and disinformation in circulation these days.
But Rauchway is also very good on Hoover. He is especially good on the illusions and self-delusions of the Depression's first years. Chief among these was the optimism, the ritual statements that things would soon get better, that prosperity is "just around the corner." This false optimism we don't hear expressed so much today; President Obama knows to avoid it.
But false optimism is, nevertheless, still present. It has become a mental habit. It is institutionalized and embedded in the professional economic forecasts, notably the official baselines of the Congressional Budget Office. These cannot admit the possibility that we are at the start of a new Depression, because there is no similar experience in the statistical record on which they draw. It will take time, grim experience, and determined argument, before the President and Congress come to grips with this.
A second feature of the Hoover years was his desire to revive credit, lending and the operations of the banks. There was a touching faith in the institutions that had brought so much prosperity in the 1920s. And the people who had enabled the boom were in no position, mentally or politically, to admit their errors and change their views.
So it is today, obviously. The new Treasury, like the old one, remains in a Hoover mind-set, fixed on the chance of a top-down solution that would, in a phrase we hear constantly, "get credit flowing again." The idea is to stuff the banks with money, in the hope that they will burst and the manna will rain down.
But banks are not moneylenders! They do not need money, in order to lend! Banks create money. And they do it, when they want to. They lend, in other words, when there is a reason to lend. And not otherwise. The testimony of the bank chiefs yesterday made this very clear.
Or to put it another way, credit is not a flow. It is a contract. It requires a borrower as well as a lender. And the borrower must be both optimistic and solvent. These are the conditions that are not met today, and that cannot be met by stuffing money into the banks.
FDR realized two things. First, that the banks were bust. They had to be closed, reorganized and rebuilt. And second, that credit would revive only if the balance sheets and business prospects of the borrowers -- that is to say, of the American population -- were restored. The first he accomplished immediately. The second took through World War II, which (through victory bonds) massively recapitalized the American family. Meanwhile, for nine years New Deal spending kept Americans fed and economic activity alive.
What Secretary Geithner needs to do is, is assign teams to examine the banks. He must do this, before taking the fatal step of guaranteeing their assets. Examination, as in, look at the loan tapes underlying the mortgage-backed securities. Look at them. This is called "due diligence." Or, not buying a pig in a poke.
It will become clear that the banks either (a) do not have the loan tapes, and hence can say nothing about the quality of the underlying mortgages, or (b) where they do have the loan tapes, that sub-prime securities are deeply infected by fraud and misrepresentation.
We know this, because of the losses already incurred, and some evidence from inspections that have actually occurred.
When this becomes plain, it will be clear that there is no upside to these assets. They cannot recover. They are, essentially and for the most part, doomed to default. Therefore it is wrong to speak of the taxpayer "assuming the risk." The Treasury is proposing to take on a sure loss, thus to make a massive transfer to bank stockholders and incumbent management. With no effect on the balance sheets of the American public - and therefore no chance that credit and credit-fueled economic activity will revive.
That, so far as I understand it, is the economics of the Geithner plan.
Perhaps the Treasury has a clear and persuasive answer to this argument. But if they do, they have not made it. And their constant use of a bad metaphor - "credit flow" - raises grave doubts. Does the Treasury team really understand, in a way that clearly separates the public interest from that of the bankers, the situation we are in?