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Why little Timmy Geithner is afraid of big bad Liz Warren

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As reported on HuffPost last week, Treasury Secretary Timothy Geithner has expressed opposition to the possible nomination of Elizabeth Warren to head the Consumer Financial Protection Bureau.

As John Talbott reported, one can assume that Geithner, being very close to the nation's biggest banks, is concerned that Warren, if chosen, will exercise her new policing and enforcement powers to restrict those abusive practices (at our commercial banks) that have been harmful to consumers and depositors.

Certainly the new financial reform bill is continuing to attract enormous lobbying action from these banks. The reason is simple. The bill has been written to put a great deal of power (as to how strongly it is to be implemented) in the hands of its regulators, some of which remain to be chosen. The bank lobby will spend millions to see that Warren, the person most responsible for initiating and fighting for the idea of a consumer financial protection group, is denied the opportunity to head it.

But this is not the only reason that Geithner is opposed to Warren's nomination.

Geithner sees the appointment of Elizabeth Warren as a threat to the very scheme he has utilized to date to hide bank losses, thus keeping the banks solvent and out of bankruptcy court, and their existing management teams employed and well-paid.

As Kenneth Rogoff explains in his new book, This Time is Different, most crises are preceded by a boom or bubble period in which asset classes, such as homes in this case, reach unsustainable pricing levels. The main driver of most of these asset bubbles is loose bank lending in which banks offer money to asset buyers on very liberal terms, thus guaranteeing that asset prices will inflate abnormally. Eventually, all bubbles burst, and in the worst cases we are led into financial crises. The banks make things even more difficult because as prices fall, the banks end up with substantial increases in problem loans.

To deal with this increase in problem loans, the banks typically pull back on all lending, not just lending in the affected sector. The banks, now primarily concerned with their own survival if they wrote off the problem loans, literally stop almost all new lending, thus driving the economy into a deep recession. Naturally it is difficult to sustain economic activity when there is no credit being supplied by the banking system! instead of lending to businesses and consumers, the banks shift their investments to very safe instruments like US Treasury securities. The result is a risk-free cash flow that over time eventually repairs the banks' balance sheets by increasing their profitability and thus restoring their book equity.

Typically, during crises, the Federal Reserve also lowers interest rates and the cost of bank borrowing so as to make this risk-free profit spread to banks even greater. In the current financial crisis, the Federal Reserve has lowered interest rates to almost zero percent per annum thus assuring that the banks can profit enormously by doing almost nothing, not lending, and sitting on risk free Treasury investments. While good for the banks, one can see how damaging this lack of credit extension can be to an economy trying to recover from an economic crisis.

What is most damaging about this approach to an economy attempting to recover from a recession is that it ensures that the policy of tight money from the banks will continue for some time. Time is what is needed most, for the banks to earn their way out of their loan losses and insolvency problems -- if they decide not to quickly write off the bad loans, which is, quite apparently, going to be their choice.

In Japan, after their banking crisis of 1994, it took more than a decade for the banks to repair their balance sheets and resume normal lending, thus retarding economic growth for decades. And this is exactly the plan that Geithner and Larry Summers have proposed for the current crisis. If you remember, Hank Paulson, the Treasury Secretary at the time, had announced that the $700 billion TARP funds would be used to buy toxic assets like bad mortgage loans from the commercial banks. But this never happened and now the amount of bad bank loans has increased into the trillions. Immediately after receiving authorization of the funding for TARP from Congress, Paulson reversed direction and decided to make direct equity investments in the banks rather than using the TARP funds to acquire their bad loans.

So where are the trillions of dollars of bad loans that the banks had on their books?

They are still there. The Federal Reserve took possession temporarily of some of them as collateral for lending to the banks in an attempt to clean up the banks for their supposed "stress tests." But as of now, the trillions of dollars of underwater mortgages, CDOs and worthless credit default swaps are still on the banks' books. Geithner is going to the familiar "bank in crisis" playbook and is hoping that the banks can earn their way out of their solvency problems over time -- so the banks are continuing to slowly write off their problem loans but at a rate that will probably take decades to clean up the problem.

And this is where defeating Elizabeth Warren's nomination becomes critical for Geithner. For Geithner's strategy to work, the banks have to find new sources of profitability in their business segments to balance out their annual loan loss from their existing bad loans in an environment in which they continue to suffer new losses in prime residential mortgages, commercial real estate lending, sovereign debt investments, bridge loans to private equity groups, leverage buyout lending and credit card defaults.

The banks have made no secret as to where they will find this increase in cash flow.

They intend to soak their small retail customers, their consumer and small business borrowers, their credit card holders and their small depositors with increased costs and fees and are continuing many of the bad mortgage practices that led to the crisis (ARM's, option pay deals, zero down payments, second mortgages, teaser rates, etc). American and Banking Market News reports this week that the rule changes in the financial reform bill may lead banks to start charging fees that had essentially disappeared from the industry early in the new millennium -- such as fees for not meeting minimum balance requirements on a checking account, or reinstituting fees for certain online banking transactions that are currently free, or charging to receive a paper statement, or to talk to a live teller, as Bank of America's CEO has recently proposed.

However, it is exactly these types of unwarranted fees on small consumers and poorly designed products that Elizabeth Warren would certainly fight against as head of the new consumer finance protection group. And it is why Tim Geithner sees her as so threatening. For unless the banks are allowed to raise fees and charges on their smaller consumer customers, Geithner's and Summers' scheme for dealing with the banking crisis by hiding problem loans permanently on the banks' balance sheets will be exposed for what it is: an attempt at preserving the jobs and stellar incomes of current bank executives -- at the cost of dragging out this recovery needlessly for years into the future.

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)
 

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Back in the 50s, I lost my entire life savings in ... by Paul from Potomac on Friday, Jul 30, 2010 at 11:14:44 AM
I think that the financial industry is ahead of th... by Bruce Morgan on Friday, Jul 30, 2010 at 11:38:03 AM
Reducing production while raising prices will drai... by Margaret Bassett on Friday, Jul 30, 2010 at 2:53:43 PM
Geithner has never been for the consumer. He was i... by Dennis Kaiser on Friday, Jul 30, 2010 at 3:24:01 PM
is at what interest rate reasonable lending ends a... by Paul Magill Smith on Saturday, Jul 31, 2010 at 11:30:26 AM
Hi Richard--- Great essay! I think all Americans s... by Elizabeth Hanson on Saturday, Jul 31, 2010 at 10:05:51 PM
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