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Credit Crisis The Problem The Solution

Interest-Rates / Credit Crisis 2008 Mar 23, 2008 - 03:26 AM GMT

By: Fake_Ben

Interest-Rates Best Financial Markets Analysis ArticleFirst, we must understand the problem, which is fractional banking. The problem with fractional banking is that cash ALWAYS has to be less valuable than other alternatives. Otherwise, there is an immediate desire to deleverage (to get into cash), and the whole interconnected banking system, with all its counterparty risk, comes crashing down. We are seeing this problem now.

Because raising interest rates makes cash more valuable, the system is inherently biased towards needing and encouraging lower and lower rates. Look at the trend in interest rates ever since Volcker left office: it's down, down, down, a touch up, down, down, a touch up, down, down, down. 

The deleveraging problem could have happened in 1995 (the year Greenspan uttered the words “irrational exuberance”), 1998 (Long-Term Capital, the Russian debt crisis), 2000 (the dot-com bust), or many other times in recent history. That is why the Fed has been running scared for so long. For two decades, the Fed and government have fought deleveraging by encouraging more leverage (mostly by lower interest rates, but also by deregulation, the allowance of off-balance sheet vehicles and the overnight sweeping of checking account, etc.).

However, the leverage can't go on forever. At a certain point, the leverage becomes ludicrous. The excess credit drives asset prices up to a point where the earnings on these assets do not justify the risk of acquiring them (3% rental yield for an apartment whose value is supported by a clearly overleveraged banking sector???). You know something is wrong when the most respected banks are 32 times leveraged (does that even count all the off-balance sheet agreements, the derivates, and the effects from any mark-downs on the asset side???).

So basically, as I pointed out in August, the U.S. is the subprime lender of the world (along with Europe!). Our entire banking system was then and is now obviously bankrupt.

When an entire banking system is bankrupt there are two options:

1) Preserve the value of the currency and let the banking system crumble. Honor contracts and force bankruptcies. Purge the system of its excesses through a massive depression.

DOWNSIDE: Massive unemployment and a serious contraction in the economy.

UPSIDE: Faith in the currency is maintained, the banking system is cleansed, and many decades of healthy, long-term economic growth can be built upon a solid foundation. [NOTE: Your average economist erroneously believes that the Fed's inaction during the Depression was the problem. The real problem, as it always is, was the Fed's previous allowance in the 1920s of excessive credit growth. Because of this lack of understanding, your average economist is not inclined to ascribe any long-term benefit to the Fed's purging the system of its excesses.]

2) Change the rules of the game. Have an activist government try to prevent bankruptcies. There are many ways to change the rules of the game: The Fed can start to monetize and retire assets, such as mortgages, corporate debt, etc. Alternatively, the U.S. government can have the Fed monetize its debt, and use the new money for public works programs or simply send the money directly to citizens. Such a process of rules changing will be highly contentious because it will favor certain segments of society over others. It will be extremely political. [For example, if Congress sends checks directly to people, the banking system will cry: inflation. If the Fed recapitalizes banks with cash, the people will cry: bailout].

DOWNSIDE:A loss of faith in the currency, especially among foreigners, who hold the currency (and its implied liabilities) but do not get the benefits associated with monetization (the money is only given to U.S. citizens or U.S. entities). Given that 70% of the entire world's central bank reserves are in dollars, such a loss of faith could have dramatic consequences. All the benefits the U.S. received from decades of printing U.S. dollars and sending them abroad for goods could quickly reverse, and we could see trillions of U.S. dollars come home, quickly diluting their value and causing hyperinflation and a run by everyone (including U.S. citizens) into anything but U.S. dollars.

UPSIDE: Although uncertain, this option is thought to be more likely to preserve economic growth and employment. It is considered to be less painful.

Given that our national psyche was so scarred by the Great Depression (Option 1), I fully expect our politicians to go for Option 2. It will be interesting to see if Option 2 works out any better. It certainly did not for Europe before World War II, which is why their central bank is taking such a divergent approach.

Unfortunately, there is no free lunch. Excessive credit and leveraged were not only allowed to occur, but were the explicit policy of our government. Now we must choose a way to deleverage: either by a recession or by inflation. The trick is to deleverage in such a way that neither foreigners nor citizens lose faith in the system. Can that be done? We shall soon find out! It's going to be a wild ride.

Given that we are on the inevitable path to changing the rules of the game (Optioin 2), my proposed solution is that it should be done in a clear, unified, upfront and immediate manner. We need to get people to understand the problem and solution quickly. If it is done in piecemeal fashion, markets will gyrate wildly as they have been doing (“We're headed for a major recession, sell everything” one day, followed by “The Fed will sink the dollar to prevent recession, go to commodities and stocks” the next day). Such wild gyrations are likely to cause a loss of faith in the system (“It is rigged,” “It's impossible to make money without knowing the next move out of Washington.”) Every time a minor solution is proposed, the market rallies sharply. But the market soon realizes the solution is not working and goes back downward, forcing politicians to come up with yet another solution. Given the enormity of the problem, the solution should be comprehensive from the start.

The real question to answer is: to whom does the new money the government will create go first? The banking sector or the people? A select group of people or all people? My take is that the only way to put together as comprehensive a deal as is needed is to be totally fair. Send each and every American, regardless of age, indebtedness, health, or any other measure, a check for $30,000. It's a one-time thing. Get the Fed to monetize the Federal government debt that will be created to issue the checks.

The Federal debt should have an infinite term and 0% interest (meaning it will always be on the government books, but never needs to be repaid). Will such a plan hurt the dollar? Probably. But maybe not. Will it be inflationary? Yes, but a lot of the money will be used to pay off debt, which will help deleverage the banking system and decrease money supply. Basically, what you are talking about is a plan to repartition the assets of a bankrupt banking sector in as painless a way as possible. But you are doing it in a creative, comprehensive, and quick manner, without having to run everything through the bankruptcy process.

I doubt such a plan would get very far, especially as all the people of Wall Street and all the establishment economists would fight it (mainly because it would be an equitable distribution of the value held by the banks, and it would --- in relative terms --- disempower the rich and make those less fortunate less beholden). However, it might be the only option for the banking class, and the best way to avoid a total collapse of the system. Through this solution, the banking sector may emerge better off than other alternatives.

While my solution is highly imperfect, I do believe it is the least worst compared to others. And it certainly is the most just.

By Charles Zentay

FakeBen is a blog to monitor the Fed and its actions and encourage community participation. At FakeBen, we believe that the Fed policy of the last two decades has created a credit bubble as large as that created in the 1920s. This bubble will lead to either inflation, a recession, or both.

We believe that the Fed's policy of lowering interest rates to encourage more credit creation is misguided, will eventually lead to 0% interest rates, and will not solve the long-term problem, which is too much credit relative to GDP.

Copyright © 2008 by Charles Zentay. All rights reserved.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Do your own due diligence.

Fake Ben Archive

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


26 Sep 08, 15:31
using retirement accounts to solve credit crisis

About your idea of $30,000 for each person from the fed... what if the fed allowed anyone to remove any amount of tax-deferred retirement account (e.g. 401K), as long as they immediately use it to pay off debt.

Wouldn't this also accomplish similar positive ends?

11 Oct 08, 23:50
Solution to recession

There is a good direction towards a long-term solution to this problem. Go to : It talks about the solution in US govt.'s targeted spending in national asset creation. happy reading.

04 Nov 08, 16:57
us bailout

Do you have any idea how much it would cost to supply the entire U.S. population with 30,000 dollars each?

30 Dec 08, 15:03
People helping each other

Agreed with changing the rules of the game and letting the banking industry crumble (or at least redefine itself).

I just found out about this idea on

Basically is people helping each other by lending money without intermediaries. Pretty neat idea.

Jerry Baldy
21 Aug 09, 21:25
Credit Crisis partial solution

February 23, 2009

Welcome to "A Better Tomorrow". This blog will provide an evolving discussion of the macro economic crisis we in America face today. We will define the crisis in general terms and we will suggest solutions as the main platform of the blog, we will also make comments on responses to the situation in the mainstream press at times and we will request reader input into this page in all areas of discussion. If at any time you wish to contact me, please feel free (my name is Jerry Baldy and my e-mail is

Let us begin

The situation we have is an economy that produces approximately 11 Trillion dollars annually of GDP and has approximately 70 Trillion dollars in debt and growing (about 10 trillion already spent (accumulated budget deficits) and about 60 trillion promised in the form of Baby Boomer Social Security, Medicare and Medicaid obligations. There is no way the economy itself can support 70 Trillion dollars of Debt. In addition, the economy presently is in a severe contraction due to both governmental and banking mismanagement and corruption. This current set of circumstances has resulted in HUGE government bailouts (700 Billion Tarp, Paulson/Bush banking system bailout and 797 Billion Obama economic stimulus package and 500 billion for current budgetary considerations).Thus adding 2 Trillion to the 70 trillion aforementioned with more to come.


Considering the circumstances there will be some appetite for future Treasury issuances in the short run and mid term (the additional two Trillion referred to above). But the longer range appetites ( reserves for Baby Boomer obligations of Social Security, Medicaid and Medicare) for U. S. Treasuries are more questionable and undoubtedly will be more, much more, expensive with yields paid by American taxpayers much higher and revenues received by American tax payers much lower. At some point perhaps there will be a currency devaluation. I never thought I would say that. Unless we devise a plan that will satisfy world markets that Americans can successfully address this Financial Crisis and the massive inflation that could follow in a sustainable way, very unpleasant consequences will occur. We need a plan that is based in reality not the program we are engaged in now, IT WON’T WORK.

Suggested Partial Solution

Fed/Treasury Partnership &

Direct Fed/Treasury Economic Stimulation:

A successful solution will require an understanding that a significant Federal Reserve and Treasury Department partnership is mandatory (a Keysian/Friedman partnership).

This Partnership is critical because the economy is fragile and continues to weaken and cannot grow us out of this set of circumstances. Further, confidence has been essentially lost in all governmental institutions and elected representatives with the possible exception of the Fed and Treasury.

The Treasury Department ( with Tim Giethner’s leadership along with Larry Summers and Paul Volker’s experience and intellectual horsepower) teamed with the Federal Reserve (with Ben Bernenke at the helm) have the human resources and balance sheets to lead us back to the path of prosperity. The Feds balance sheet should be used in a manner that maximizes monetary policy while utilizing the Treasury department as a partner temporarily until this Crisis has been resolved and a sustainable Economic policy is in place.

An example of this would be for the Federal Reserve Bank and the Treasury Department to partner. This partnership would be represented by a model that consists of equal contributions of 30 year U.S. Treasury Bonds Principle and Interest. These contributions would be the engine of the partnership supporting troubled commercial banks loan activity. The partnership would serve as a guarantor of the new loan activity for qualified banks and would be called the Fed/Treasury Partnership. The Fed/Treasury Partnership would have two functions the first would consist of contributed Treasury bond principle for use in stabilizing troubled banks and the second would be contributed Treasury Bond interest used for other Fed/Treasury purposes (discussed later). For the first part of the Fed/Treasury Partnership to be successful the bank in question must be free of toxic assets. To accomplish this, the troubled bank would quarantine all of its toxic paper. Proceeds from toxic paper would be used as a further cash infusion and/or a set aside for additional capital requirements into the bank. The troubled mortgage/other assets themselves would be would be left unadjusted, no Mark to Market valuations. Toxic asset valuations would remain at their cost basis on the banks books and would be represented on the balance sheet as troubled assets to be worked out. Asset valuation would take place at a more tranquil time and environment and be market driven. With this treatment of toxic assets completed a clean bank emerges to work with.

With the bank now clean of toxic asset effects the Fed and Treasury representatives can determine and guarantee (thru the Principle portion of the Fed/Treasury Partnership contribution) a sufficient amount of new loan activity to obtain stability and/or profitability. This will be expensive as the Partnership is guaranteeing virtually all new loans and will do so for a sufficient amount of time for bank recovery. Management of the partnership model “Principle Portion” should be managed by Federal Reserve Bank representatives. By the end of the Fed/Treasury Partnership intervention the bank will be profitable and in a better position to dispose of toxic assets in a reasonable market driven fashion. The problem banks will survive. The toxic assets will be sold in the free market. The bank will finally be removed from the Fed/Treasury Partnership umbrella to lend again and prosper. This process can and should be used in a Federal Reserve Bank Partnership with foreign Central Banks and /or appropriate foreign government agencies. This model can be very useful as global portal linkage in addressing the global aspects of the financial crisis.

The Interest Portion of the Fed/Treasury partnership model will be used to support strong banks (banks not suffering from toxic assets) to generate a more balanced and healthier overall banking system. Management of the interest portion of the partnership model should also be managed by Federal Reserve Bank representatives. The result of the interest portion of the Fed /Treasury partnership model would be to effectively expand strong banks product lines and profitability. This is accomplished by the Fed/Treasury partnership utilizing the model's on-going revenue stream (interest portion of the model) to underwrite new business Loan programs or Credit Card programs, asset purchase programs and other product line expansion that emerge as part of recovery. Other Product line expansion possibilities from the Fed/Treasury partnership on-going revenue stream (interest portion of the Fed/Treasury model) could be to allow mortgage warehouse lines for Jumbo’s mortgages, non-conforming mortgage loans or to purchase asset backed securities. Further product line expansions would include supporting Municipal Bond issuances nation wide and finally support our shadow lending industry (very important as this industry provides approximately 45% of all loan activity in the country). These and many other potential partnership activities would have the beneficial effects of generating confidence and attracting private capital back to the Capital Markets at an efficient cost basis.

These suggestions would begin the credit thawing process and would have a calming effect on financial markets. In addition to previously mentioned benefits of using the Fed/Treasury Partnership another important use is the Fed/Treasury Partnership is supporting Bank to Bank Lending. This could be a very, very important contribution of the Fed/Treasury partnership.

In addition to freeing up Credit Markets, instilling Investor confidence and reinvigorating asset securitization and eliminating the need for immediate Mark to Market accounting for toxic assets and reinstituting a secondary market for non-conforming mortgage loans (Jumbo’s and other collateralizations) and supporting Bank to bank lending while supporting the Municipal bond markets, Corporate Debt Market fluidity and reinvigorating the Shadow Lending Industry the model can be modified to stimulate the lower economy directly.

Direct Fed/Treasury Economic Stimulation:

Direct Fed/Treasury Economic Stimulation Program will be similar to the Fed/Treasury Partnership (described above). Both the Fed and Treasury will contribute 50% of partnership requirements into a model. These contributions will consist of both the Treasury and Fed contributing 30 Yr. U.S. Treasury Bonds, Principle and Interest into the model. However, one difference is that this stimulus would go directly to the lower economy and augment the work of the Fed/Treasury partnership in stabilizing and balancing the banking system.

Another difference is only in Interest Portion proceeds of the model are used as the program guarantee. The Principle Portion of the model is NEVER used. A further difference is this program is a for profit program for the Federal reserve bank. A fee structure, payment schedule and program time line will be established as part of program architecture with the Treasury managing the program.

One example of program use would be for the Direct Fed/Treasury Economic Stimulation Program to directly guarantee toxic loans sitting on troubled commercial banks books that have been quarantined. This would be a great help to the loan workout process as well as the banks mark to market problems. In addition, loans made by thrift banks that participate in the national Jumbo and/or non-conforming mortgage program financed by the Fed/Treasury Partnership (referenced above). This guarantee would encourage thrift institutions (thru stimulus program guarantees) to provide refinance and purchase credit to individual borrowers while the Fed/Treasury partnership encourages commercial banks to provide additional warehouse lines to thrift institutions. This approach would have the effect of creating seamless financing available for housing purchases and mortgage refinance activity, creating greater confidence and jobs in the mortgage, Construction, Real Estate and related service industries. Finally, this stimulus would minimize troubled bank losses of quarantined assets and help to stabilize the countries Real Estate price structure.

Another example would be for the Direct Fed/Treasury Economic Stimulation Program to directly subsidize small and medium size commercial (FDIC) banks not involved in toxic asset activity through direct loan guarantee programs designed for specific industries as determined by the treasury and Fed. This would make credit more available to a variety of small, medium and large businesses while creating confidence and jobs. Further, this program could be expanded to direct commerce lending with the amount, nature and duration of support determined by an industries or local economies as needed. In total the Direct Fed/Fed Treasury Stimulus would maximize the work of the Fed/Treasury partnership while supporting the growth of small business. The combination of these two initiatives is intended to augment current fiscal and monetary policy while lending flexibility to the crisis management plan now in place.

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