He offered a goal for his actions that I applaud:

…I want every American to know that each action we take and each policy we pursue is driven by a larger vision of America’s future – a future where sustained economic growth creates good jobs and rising incomes; a future where prosperity is fueled not by excessive debt, reckless speculation, and fleeing profit, but is instead built by skilled, productive workers; by sound investments that will spread opportunity at home and allow this nation to lead the world in the technologies, innovations, and discoveries that will shape the 21st century.  That is the America I see.  That is the future I know we can have.

He built on a parable in the Sermon on the Mount to lay out a five-point program for building an enduring prosperity:

There is a parable at the end of the Sermon on the Mount that tells the story of two men.  The first built his house on a pile of sand, and it was destroyed as soon as the storm hit.  But the second is known as the wise man, for when “…the rain descended, and the floods came, and the winds blew, and beat upon that house…it fell not:  for it was founded upon a rock.”

We cannot rebuild this economy on the same pile of sand.  We must build our house upon a rock.  We must lay a new foundation for growth and prosperity – a foundation that will move us from an era of borrow and spend to one where we save and invest; where we consume less at home and send more exports abroad. 

It’s a foundation built upon five pillars that will grow our economy and make this new century another American century:  new rules for Wall Street that will reward drive and innovation; new investments in education that will make our workforce more skilled and competitive; new investments in renewable energy and technology that will create new jobs and industries; new investments in health care that will cut costs for families and businesses; and new savings in our federal budget that will bring down the debt for future generations.  That is the new foundation we must build.  That must be our future – and my Administration’s policies are designed to achieve that future.

Again, these are goals that are admirable and upon which most can agree.

Where I continue to part company with the Obama Administration is in its handling of the financial crisis. Obama explained and defended the bailouts of the banking system, but I found the defense disingenuous and unconvincing [my comments interspersed]:

The heart of this financial crisis is that too many banks and other financial institutions simply stopped lending money.  In a climate of fear, banks were unable to replace their losses by raising new capital on their own, and they were unwilling to lend the money they did have because they were afraid that no one would pay it back.  It is for this reason that the last administration used the Troubled Asset Relief Program, or TARP, to provide these banks with temporary financial assistance in order to get them lending again. 

Now, I don’t agree with some of the ways the TARP program was managed, but I do agree with the broader rationale that we must provide banks with the capital and the confidence necessary to start lending again.  That is the purpose of the stress tests that will soon tell us how much additional capital will be needed to support lending at our largest banks.  Ideally, these needs will be met by private investors.  But where this is not possible, and banks require substantial additional resources from the government, we will hold accountable those responsible, force the necessary adjustments, provide the support to clean up their balance sheets, and assure the continuity of a strong, viable institution that can serve our people and our economy.

Of course, there are some who argue that the government should stand back and simply let these banks fail – especially since in many cases it was their bad decisions that helped create the crisis in the first place.  But whether we like it or not, history has repeatedly shown that when nations do not take early and aggressive action to get credit flowing again, they have crises that last years and years instead of months and months – years of low growth, low job creation, and low investment that cost those nations far more than a course of bold, upfront action. 

Those who argue for an alternative to taxpayer-financed bailouts are, for the most part, not opposed to “early and aggressive action to get credit flowing again.” To the contrary, they argue that propping up “zombie” banks is counter to the goal of getting robust bank lending established. Even after the bailouts, the banks with impaired assets are going to be reluctant to lend. In any event, the second sentence is not logically implied by the first, i.e., it is a non sequitur.

And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – “where’s our bailout?,” they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.

Again, while it is true that bank capital can support multiple dollars of lending, if there is sufficient demand for the loans, bailouts are not the only way to improve the balance sheets of banks so that they have the capital required to support loans. Obama continues:

On the other hand, there have been some who don’t dispute that we need to shore up the banking system, but suggest that we have been too timid in how we go about it.  They say that the federal government should have already preemptively stepped in and taken over major financial institutions the way that the FDIC currently intervenes in smaller banks, and that our failure to do so is yet another example of Washington coddling Wall Street. So let me be clear – the reason we have not taken this step has nothing to do with any ideological or political judgment we’ve made about government involvement in banks, and it’s certainly not because of any concern we have for the management and shareholders whose actions have helped cause this mess.   

Rather, it is because we believe that preemptive government takeovers are likely to end up costing taxpayers even more in the end, and because it is more likely to undermine than to create confidence. Governments should practice the same principle as doctors: first do no harm.

I believe that Obama is sincere here, but I also believe that he has listened to and sided with advisors who have sold him one side of the argument, a failing in judgment that I attribute to his years at Harvard, where he gained an undeserved belief in the intellectual superiority of the the Eastern Scholarly Establishment, led by Harvard.  Notice that he says, “we believe that preemptive government takeovers …” He does not provide reasons and evidence, only belief to support his policies. Further, he mischaracterizes the situation when he says “preemptive government takeovers.” There would have been nothing “preemptive” in the takeover of Citigroup, Bank of America, and others that were realistically insolvent and only prevented from failure by the infusion of tens of billions of government funds and hundreds of billions of government guarantees.

Obama fails to provide answers to the thoughtful critics of his policies. Rather he mischaracterizes their arguments and rebuts the mischaracterizations. This is neither compelling nor honest. He continues:

So rest assured – we will do whatever is necessary to get credit flowing again, but we will do so in ways that minimize risks to taxpayers and to the broader economy.  To that end, in addition to the program to provide capital to the banks, we have launched a plan that will pair government resources with private investment in order to clear away the old loans and securities – the so-called toxic assets – that are also preventing our banks from lending money.

Obama doesn’t even attempt to answer the critics of his Private Public Investment Partnership (PPIP, or more accurately termed GASP – “Geithner And Summers Plan”), a sweetheart deal for investment banks and hedge funds that acts as a fig leaf for another trillion dollars of taxpayer bailout money.

Although I give Obama A’s and A-pluses on most of his actions and programs to date (including the stimulus package and budget), I give him between a C and D on his bank bailouts. My only hope is that Obama has said many times that he expects to make mistakes, implying that he is open to recognizing and learning from his mistakes. Let’s hope he recognizes this mistake sooner rather than later.

By now, almost everyone must know that in the last week the Federal Reserve and the Obama Administration fired coordinated bombshells at the financial crisis.

First, last Thursday the Federal Reserve announced major increases in asset purchase programs, adding $1.150 trillion to the total. The total included purchase of up to $300 billion of long-term Treasuries. The Fed also expanded the list of the type of assets it would purchase under its Term Asset-Backed Securities Loan Facility (TALF).

Before the financial community and the public had a chance to catch its breath, on Monday, the Treasury unveiled the next blockbuster. Both the FDIC and Treasury would combine with private investors to purchase toxic assets from banks.

In the FDIC program, the government would put up 92.5% of the money and private investors would put up 7.5% — but, here’s the catch, private investors would get 1/2 of potential profits from their 7.5% investment and be liable for no more than their investment. Who is responsible for additional losses? The FDIC, which in theory is underwritten by the banking sector — though if there are big losses, it seems likely that you and me, the taxpayers, will end up paying.

In the Treasury program, the government and private investors would put up equal amounts of initial capital, and then the government would lend the entity twice its initial investment. The entity would then bid for troubled assets from banks. The kicker here is that, once the entity has purchased assets, it will able to borrow against them from the Federal Reserves expanded TALF program; then turn around and buy more troubled assets, and so on. The private investor again may get to leverage its initial sum by 6 times or more, with losses limited to its initial investment. Who is responsible for additional losses? You know who. You and me, the taxpayers.

A key part of the plan is to amend the TALF, which was initially a Federal Reserve initiative aimed at purchasing new loans, with the objective of expanding new lending. The amended plan allows loans against existing securities that were “originally AAA rated.” Of course, many of those AAA mortgage backed securities are, as we are well aware, now junk. You can be sure that these are the ones the new rescue partnerships are going to pledge to the government first.

[Nouriel Roubini's RGE Monitor has provided an excellent summary and brief analysis of the Geithner plan.]

Wall Street Wins!

The response of Wall Street, with a one-day rise on the Monday of the plan’s announcement of 7% in the S&P 500 and 18% in the S&P Financials indices, was ecstatic. The big bond investment firms fell over themselves with praise. This was what the financial community has been looking for, but almost giving up hope of getting: for the government to step in and buy all of the crappy loans on their books. The common estimate is that their are two trillion dollars of such junk held by banks. The government programs, not coincidently, have potential purchasing power of about $2 trillion.

If it works, and the street is currently betting it will, the plans will get the toxic debt out of the zombie banks, making them live once again, to the great benefit of the stockholders and option holders of the banks. Of course, the debt will go into the hands, primarily of the government; so if the plan doesn’t work, the economy doesn’t recover, and all of those bad mortgages, auto loans, and credit-card securities decline further in value, you and I will be left holding the bag.

And, of course, the big investment firms love the plan because they are going to be allowed to participate in buying up the bad debt with only small risk and big profit potential — to say nothing of getting to transfer their lousiest assets to the government. Bill Gross of PIMCO, the worlds largest bond company, has called it a “win-win” plan. It is a win-win plan for the investment community.

You Lose!

The Obama-Geithner plan is a lose-lose plan for you and me. We lose, first, because we as taxpayers are having to pony up almost all of the money to buy up the crappy assets that the financial community sold at very great profit to itself. The shareholders and bondholders of the financial community are getting the BIG bailout at our expense. If the plan fails, we are left holding the bag. Of course, the big financial firms will probably be forced into failure, too, but only after having transferred most of the bad privately-held securities into the hands of the willing government. This is bad public policy on multiple counts, not the least of which is the blatant inequity of it all.

But, what if the plan succeeds, as Geithner has clearly succeeded in convincing Obama that it will? You lose. The government will have succeeded in revitalizing the financial sector with the same players in charge. It will have turned the economy around by once again expanding leverage and debt, raising the burden of debt that for years has been depressing our real economic performance and individual well being. The chance will have been lost for transforming our economy away from pursuit of capital gains and financial aggrandizement toward focusing on meeting the real needs of our population and of the planet.

Obama Fails!

The current crisis, caused by financial excesses, offered the opportunity for us as a country to take away the dominant power of go-go finance and corporate exploiters. Instead of fundamentally rethinking and restructuring the political-economic management of our country, Obama has chosen to side with the entrenched power interests.

There are no outsiders in the inner circle of economic and financial advisors. All apparently come to their task with a mindset that big finance and big business are essential to the future of our country. Geithner was protégé of Larry Summers and Robert Rubin, both instrumental in the deregulation legislation that set the stage for the current crisis.

I am disheartened by this latest episode in the unfolding crisis not so much because of the unfairness of the latest plan but because of what it reveals about Obama’s core beliefs. The pressure that has been building around the financial meltdown has certainly required Obama to search within himself for the right answer.

There was no shortage of voices recommending that the failing banks be allowed to fail, to be restructured with government assistance, and the shareholders and bondholders be required to bear the results of their poor investment judgment. I have published many of these voices here. It seems highly likely that Axelrod, Plouffe, and Emanuel would have seriously challenged Geithner’s plan. Yet, in the end, when Obama had to decide, he supported a plan that is designed to make the financial sector as whole as possible, at huge cost to the government and, ultimately, us taxpayers.

From this episode, I infer that in matters of economics, Obama operates within the mindset of the prevailing economic paradigm of prosperity through continued growth in output, with little concern about what makes up that output.

For me personally, this is very sad. I had hoped, I realize now with little evidence, that Obama would bring a fresh perspective to managing our economy, one that would provide for rebalancing the economy as well as the distribution of income. It is not just who get the money (although this needs to change), but what as a nation we choose to produce and consume. To make changes in the latter, we need to redistribute political and economic power. In Obama’s actions on the financial crisis, there is no evidence that he saw it as an opportunity to accomplish some of this redistribution. This is not encouraging for the future.

James Galbraith has made another effort to get this message across — interestingly in the European media rather than the New York Times, where it properly belongs. The beginning of the Der Spiegel article is below, with a link to the entire article.

US ECONOMIST JAMES GALBRAITH

Financial Crisis Caused by a ‘Culture of Complicity’

While the world talks about new ways to save struggling banks, there are a handful of economists who think some banks shouldn’t be saved at all. American economist James Galbraith told Manager Magazin that it might make more sense to break them up and start over.

Manager Magazin: Professor Galbraith, you suggest that banks that suffer from bad assets should simply be declared insolvent, instead of rescuing them with taxpayers’ money. Why?

What should be done with the world’s ailing banks?

James Galbraith: We need a correct assessment of the degree of losses suffered by a bank which is functionally insolvent. But as long as the old management is in place, there are no incentives to cooperate in the evaluation you need to make. That’s the first problem.

The second problem is: When a bank is insolvent, the incentives for normal banking practice disappear. They become perverse. The incumbent management has good reason to gamble excessively and to make capital losses. This is because it appears that the regulators could soon close down the bank.

Beyond that, if the situation for the bank is truly hopeless or if the management is truly corrupt, then the incentive is to loot the institution, to take as much money out of it — e.g. in the shape of bonuses and dividends — before the true state of the books is discovered.

More

Here is a nifty graphic display of relative magnitudes of different sums of money. You see, when talking trillions, we are talking BIG.

What does one TRILLION dollars look like?

All this talk about "stimulus packages" and "bailouts"…

A billion dollars…

A hundred billion dollars…

Eight hundred billion dollars…

One TRILLION dollars…

What does that look like? I mean, these various numbers are tossed around like so many doggie treats, so I thought I’d take Google Sketchup out for a test drive and try to get a sense of what exactly a trillion dollars looks like.

We’ll start with a $100 dollar bill. Currently the largest U.S. denomination in general circulation. Most everyone has seen them, slightly fewer have owned them. Guaranteed to make friends wherever they go.

Click on the $100 bill to see the rest of how many of these we need to get to a trillion dollars. It is amazing and dismaying!

The Wall Street Journal story goes into depth. For those that can follow it, it provides a fascinating education on how these supposedly sophisticated organizations badly mispriced risk, and how other predatory financial concerns took advantage to reap billions in profits (which would not be realized if the government had not stepped in with taxpayer money to make the bets good).

I can see no public justification for making whole gigantic gambles on the failure of the U.S. economy. When gamblers are dealing with gamblers, caveat emptor should certainly apply. Bailing out the losers so they can pay the winners provides no public benefit.

Here is the article in full. It is worth trying to work your way through it.

Hedge Funds May Get AIG Cash

Some Bailout Money Is Set Aside to Pay Firms That Bet Housing Market Would Crater

By SERENA NG

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages. AIG has put in escrow some money for at least one major bank, Deutsche Bank AG, whose hedge-fund clients made bets against the housing market, according to a person familiar with the matter. The money will be released to the bank if mortgage defaults rise above a certain level.

In essence, while the U.S. government is busy trying to prop up the housing market — by trying to limit foreclosures, among other things — it is simultaneously putting up cash that could be used to pay off investors who bet housing prices would tumble and many mortgage holders would default.

It’s unclear how much government money might eventually flow to hedge-fund investors. Overall, the government has committed up to $173.3 billion to bail out AIG. Of that amount, AIG’s housing-related bets have cost U.S. taxpayers some $52 billion.

The investment strategies involved are perfectly legal maneuvers. Still, the losses show how AIG strayed from its core business: selling standard insurance policies to businesses and individuals to protect against everything from fires to lawsuits. "AIG’s financial-products division went heavily into the business of speculation, and its gambling debts are what taxpayers are paying off right now," said Martin Weiss of Weiss Research, an investment consultant in Jupiter, Fla.

 European Pressphoto Agency

An AIG spokeswoman declined to comment, as did a spokesman for the Federal Reserve Bank of New York.

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

It is not known which hedge funds made those bets with specific banks. However, several large funds made big, ultimately profitable, wagers that mortgage defaults would increase.

Many of the assets AIG insured were tied to subprime mortgages. The deterioration of those high-risk mortgages, along with AIG’s own financial woes, forced the insurer to put up billions of dollars in collateral, mostly to the banks that were its trading partners. AIG sold protection on securities backed by physical assets, as well as on positions almost entirely backed by other financial bets.

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to "sell short" — or bet against — securities backed by mortgages to questionable borrowers. These hedge funds entered into trades with investment banks. The banks then used a complex set of financial maneuvers to pass on some of the risk of those trades to AIG and other insurers.

The transactions meant that AIG was wagering that the U.S. housing market would remain robust. With housing markets now in free fall, the hedge funds stand to collect money from their bank counterparties. AIG is, in turn, compensating the banks.

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn’t easy.

So at Deutsche, the German bank’s securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker "START," short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds’ bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer’s own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, "AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space," says a senior investment banker whose firm bought credit protection from the insurer.

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

 

Click to See Full Chart

If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won’t be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor’s. They’ve since been downgraded to "junk" status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named "Abacus" and also insured by AIG Financial Products, according to people familiar with the matter.

These pools were made up of credit-default swaps tied to individual mortgage securities. AIG had to post collateral to Goldman when the assets dropped in value. Some of this money, too, could go to hedge-fund clients of Goldman.

From mid-September to the end of last year, AIG and the government paid $5.4 billion to Deutsche and $8.1 billion to Goldman under credit default swap contracts the insurer had written.

A spokesman for the German bank said, "Our exposure to AIG was well-collateralized and hedged." A Goldman spokesman also said his firm’s exposure was collateralized and hedged.

Write to Serena Ng at serena.ng@wsj.com

Printed in The Wall Street Journal, page A1

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved

More

• Congress Looks to Tax to Recoup AIG Bonuses
• AIG Bonuses Spur Taxpayer Outrage
• Q&A: The AIG Bonus Controversy

The chart compares European indices of credit default swaps (those notorious credit instruments that provide insurance against a bond losing value) for general corporate bonds (red line) with those for bonds of financial corporations (blue lines). These indices indicated the cost of purchasing such insurance.  Both have risen sharply in the last month, indicating the market perception of increased risk of default; but note how much greater has been the rise in the financial bond index, to a level above the index for general corporate bonds. The analysts point out that this crossing has occurred only twice before — when Bear Stearns was absorbed and Lehman Brothers went bankrupt. It is also worth noting well that the financial index is well above its prior highest level.

According to the Bloomberg article, my perception of the risk of bank bond defaults is becoming widely shared:

“We’re seeing the start of the next leg of the crisis and that’s going to be financial bondholders taking a haircut as lenders default,” said Mehernosh Engineer, a London-based strategist at BNP Paribas. “There’s been a perception that banks’ senior bondholders are untouchable but that’s going to change.”

Bondholders take a haircut in a restructuring when they agree to a reduction in the par value of their securities. Indexes gauging the performance of bank bonds have signaled deteriorating prospects for the securities this year as lenders grapple with $1.2 trillion of writedowns and losses, and the threat of nationalization.

The premium (relative to Treasury) yield demanded to hold the lowest-rated bank bonds has risen by 10 percentage points since the end January is a staggering 34.5 percentage points! Despite U.S. continuing U.S. government denials, the market clearly is anticipating major defaults of bank bonds.

When I went shopping for non-financial bonds last week, I found that 90 percent of all the bonds offered for sale on two different "offer books" were bonds of major financial institutions. Clearly, there were a lot more wishful sellers of financial bonds than there were buyers. This is not the time to own bonds of financial corporations unless you know what your are doing and willing to bear very high risk.