The financial markets didn’t seem to be listening while Barack Obama was kicking off his presidency with a pledge to “begin again the work of remaking America.” As Obama spoke, the share prices of America’s biggest banks were plunging toward 20-year lows. Wizardly prognosticator Nouriel Roubini of New York University said the U.S. banking system is “effectively insolvent.” In Britain, the government advanced a plan to completely take over the Royal Bank of Scotland, which faces 2008 losses of $40 billion or more – a move some think Obama will have to make with regard to some of America’s landmark banks.
Obama’s inauguration speech drew some sharp distinctions between his own plans and those of his predecessor, George W. Bush. But the ongoing banking meltdown may end up requiring a lot more of the same medicine that Washington has already been administering.
[See why there's a bright side to the ongoing bank bailouts.]
There’s no doubt that the Bush/Paulson financial rescue plan was an ad-hoc effort that shifted course several times. It was set up last September to purchase unsellable toxic securities that were wrecking the banks’ balance sheets. Then it morphed into direct investments in the banks themselves, with lots of new lending to the banks from the Federal Reserve on the side, to get credit flowing again.
Many Democrats in Congress now want to see bailout money steered away from the big banks, and directed at individual homeowners at risk of losing their homes. Obama, however, may soon find that he has little choice but to keep capitalizing the banks, just as Bush was doing.
[See why there's nothing new about this recession.]
This would be good for the economy but bad for bank investors, which is why the markets greeted President Obama with a 5-percent plunge in the S&P 500. What’s most important right now is that the banks continue to function, and return as quickly as possible to something that looks like normal lending. From the economy’s perspective, it doesn’t matter who owns the banks. But when the government buys a stake in a public company – or increases a holding it already has – the existing shares get diluted and fall in value. So shareholders lose money.
While reacting to grim news about mounting bank losses, the stock markets are also anticipating further government bailouts (“investments,” if you prefer) to keep Citigroup et. al. solvent. That's why they fell so sharply on Obama's first day.
[See why Obama needs to be Superman to achieve his economic goals.]
Obama would dearly love to spend the remaining $350 billion of bailout money on something that feels like a fresh start. But banks are the circulatory system of the entire economy, and if they’re not healthy, nothing else works. If the banking meltdown continues, it will sharply reduce the value of money invested in infrastructure or clean energy or schools or anything else. Investments pay off when money is reinvested and you get more than a 1-for-1 return on the dollar. But if banks aren’t lending and there’s no credit, you can’t do that.
It’s infuriating that Citigroup made so many bad investments that it would have collapsed by now without $45 billion in government aid. And that Bank of America, recipient of another $45 billion in taxpayer loans, failed to understand how deep Merrill Lynch’s problems were when it bought the investment bank last September, forcing it to go hat-in-hand to Washington.
The outrage over all this may intensify, since both banks may still need more federal help to get through a rising tide of credit-card and consumer-loan defaults. Others banks could follow. But we may soon learn that all that trial and error at the Treasury Dept. over the last four months actually accomplished something: It provided Obama with a rough blueprint for how to manage a lousy problem.