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Scary Financial Movie

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By David Ignatius
Sunday, January 25, 2009

Think of the financial crisis as a horror movie called "Toxic Waste." It has the same basic plotline as the "Alien" movies. There are deadly creatures hiding in the interstices of the financial system. At first, it looks as if these gremlins are just in "subprime" loans, but it turns out they're everywhere. They started by eating Lehman Bros. Now they're eating Citigroup. . . . They're eating Bank of America. . . . Eeeek!

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"Who you gonna call?" went the refrain of the movie "Ghostbusters." And that's the increasingly urgent question now, as Barack Obama confronts a financial crisis that could devour his presidency.

I put the problem to Eugene Ludwig, a former comptroller of the currency who has been warning about the seriousness of this crisis for nearly two years. His answer, worthy of the hero of my horror movie, is: "Fire away with your biggest artillery." Overdo it now, when it matters: To get the system's natural antibodies working again, stimulate the economy, not just with the planned $850 billion in new spending but with up to $2 trillion, if necessary. Where current financial rules are making the crisis worse, change them.

And most of all, get that toxic waste into a big holding tank (which in my movie will be lined with Kryptonite). Suck the nasties out of the private banking system and funnel them into a government-run structure where they can be slowly decontaminated. It's not a new idea: During the savings-and-loan crisis, this detox facility was called the Resolution Trust Corp. Now, as a shorthand, people are just calling it the "Bad Bank." By whatever name, it's time to create it.

How will the managers of the Bad Bank coax the gremlins out of hiding? With money, of course -- buying up an estimated $1 trillion to $2 trillion in toxic paper. Will the government overpay? Of course it will, especially at first, as it discovers fair prices for securitized debt for which there isn't now a functioning market.

This detox approach seems far more sensible than nationalizing the banks. The Treasury Department's actions over the past year have amply demonstrated that government officials can make dumb mistakes just as easily as private CEOs. Treasury pushed Bank of America to buy Merrill Lynch over a rushed weekend last September without any due diligence to discover the gremlins that were hiding in Merrill's trading book. Earlier, some at Treasury believed that Citigroup could rescue the financial system as Lehman was going down. That was dumb.

A look at Citi's latest financial report shows that the damage is concentrated in a few areas, even though the fear has become pervasive. The financial giant recorded a net loss of $18.7 billion for last year. The loss in North America was $24.6 billion, offset by gains elsewhere. And a chilling $19.9 billion in losses came from trading with big institutional clients; Citi lost only $3.6 billion on its consumer banking business.

Treasury Secretary Henry Paulson tried to stop the gremlins by giving the banks new capital through his Troubled Asset Relief Program, in the hope that the recapitalized banks would start lending again. But as the economy contracted and more loans went bad, the banks had to keep posting additional losses -- eroding their capital position by more than the government's new infusion. As financier Joe Robert says, it was like pouring water into a bucket that had a big hole in the bottom.

The watchword for the financial Ghostbusters has to be: Stop making things worse. In other words, stop policies that have perverse "pro-cyclical" effects, and make sure that everything is working to reverse the downward cycle.

Among the pro-cyclical policies we are now following are rules that force banks to add to their capital at the very time they should be allowed to draw it down. (That's one reason banks haven't been lending out their new TARP capital.) Ludwig suggests a "capital holiday" in which the current standards for "adequately capitalized" would, for the period of the downturn, satisfy the higher "well capitalized" requirements. That would help unfreeze the lending pipes.

Another pro-cyclical mistake is an accounting rule that forces banks to take big "mark-to-market" losses on assets they plan to hold to maturity, if those assets are judged to be "other than temporarily impaired," or OTTI in financial jargon. The OTTI rule is the gremlins' best friend.

"Once panic sets in, the death spiral can get out of control," warns Ludwig. The time to stop this horror movie is now. Obama should fire all the financial weapons he has, and soon.

The writer is co-host of PostGlobal, an online discussion of international issues. His e-mail address is davidignatius@washpost.com.


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