The Bank Rescue

In the near term, the plan would provide financing to buy $500 billion of banks’ bad assets — and possibly up to $1 trillion over time. Most of the financing would be in the form of low-cost government loans and loan guarantees for private investors who buy the troubled assets.

The first assumption is that those battered assets will recover handsomely, thus allowing the government loans to be repaid with interest. There has, however, been no independent assessment of the assets or their underlying collateral, so there’s no way to know that they will recover by much, if at all from their beaten-down state.

The Times has reported that investors are currently offering 30 cents on the dollar for certain toxic assets. Banks are unwilling to sell at that price, but that doesn’t mean the offer price is too low. It may only indicate their fear that taking such losses might render the banks insolvent. With government subsidies, investors will presumably offer a price that is more to the banks’ liking. But that, in turn, could expose the government to big losses. Government loans are huge compared with the sums that investors must put up, so even a modest decline in the value of the purchased assets would endanger repayment of the loans.

Even if we assume that the assets do increase in value, allowing the government to be repaid, there are still unsolved problems.

Successful sales will rid banks of some of their toxic assets, but not necessarily all or even most of them. To restore the banks to health, the sums expended would have to be enough to balance the banks’ assets and liabilities, and provide a reasonable cushion to resume lending and absorb future losses. No one knows with any certainty how much that is, though some estimates put it north of $2 trillion, much more than what the administration is contemplating.

And even if you assume that the sums put up by the government are enough to cleanse the banks entirely, restoring the banks to health by throwing money at them — even with a sheen of private capital — would not be fair. It would be one big transfer of wealth from the government to bank investors. That would be better than an apocalyptic crash, but it is a near complete socialization of losses, with little value flowing to taxpayers.

A better way would be to base the rescue on current reality, not assumptions about the future. What would an examination of the banks’ assets reveal about their value? What is the size of the hole in the banking system? In the absence of good-faith measurement, taxpayer-financed purchases of bad assets could court huge unnecessary risks.

In other banking crises, both in this country and abroad, resolution of a systemwide problem has sooner or later involved separating solvent banks from insolvent banks. In the end, there is no getting around firing the executives at failing banks, acknowledging the losses, wiping out the shareholders and then deciding how the government can best restructure the institutions. The Obama administration has yet to explain why its approach is better than that.

Toxic Bank's Assets

The Obama administration has finally come up with a plan to deal with the real cause of the credit crunch: the infamous "toxic assets" on bank balance sheets that have scared off investors and borrowers, clogging credit markets around the world. But if Treasury Secretary Timothy Geithner hopes to prevent a repeat of this global economic crisis, his rescue plan must recognize that the real problem is not the bad loans, but the debasement of the paper they are printed on.

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.

Ever since humans started trading, lending and investing beyond the confines of the family and the tribe, we have depended on legally authenticated written statements to get the facts about things of value. Over the past 200 years, that legal authority has matured into a global consensus on the procedures, standards and principles required to document facts in a way that everyone can easily understand and trust.

The result is a formidable property system with rules and recording mechanisms that fix on paper the facts that allow us to hold, transfer, transform and use everything we own, from stocks to screenplays. The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity. To bring derivatives under the rule of law, governments should ensure that they conform to six longstanding procedures that guarantee the value and legitimacy of any kind of paper purporting to represent an asset:

- All documents and the assets and transactions they represent or are derived from must be recorded in publicly accessible registries. It is only by recording and continually updating such factual knowledge that we can detect the kind of overly creative financial and contractual instruments that plunged us into this recession.

- The law has to take into account the "externalities" or side effects of all financial transactions according to the legal principle of erga omnes ("toward all"), which was originally developed to protect third parties from the negative consequences of secret deals carried out by aristocracies accountable to no one but themselves.

- Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant "underlying assets."

- Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.

- Governments can encourage assets to be leveraged, transformed, combined, recombined and repackaged into any number of tranches, provided the process intends to improve the value of the original asset. This has been the rule for awarding property since the beginning of time.

- Governments can no longer tolerate the use of opaque and confusing language in drafting financial instruments. Clarity and precision are indispensable for the creation of credit and capital through paper. Western politicians must not forget what their greatest thinkers have been saying for centuries: All obligations and commitments that stick are derived from words recorded on paper with great precision.

Above all, governments should stop clinging to the hope that the existing market will eventually sort things out. "Let the market do its work" has come to mean, "let the shadow economy do its work." But modern markets only work if the paper is reliable.

Government's main duty now is to bring the whole toxic environment under the rule of law where it will be subject to enforcement. No economic activity based on the public trust should be allowed to operate outside the general principles of property law.

Financial institutions will have to serve society and fully report what they own and what they owe -- just like the rest of us -- so that we get the facts necessary to find our way out of the current maze. They must begin learning to put on paper statements about facts, instead of statements about statements.