Lesson 1: Central banks have learned that their knowledge of current and prospective developments of the economy is incomplete. They cannot know all that they would need to know to operate a perfect, large-scale model of the economy all of the time. The data they use are subject to repeated revisions, even for retrospective data, so the actions they decide to take are hedged because of uncertainty. As a result, especially since the disinflation of the early 1980s, central banks have tended to take small policy action steps. Because of lags in the effects of monetary policy action on the economy, central banks prefer to wait until an effect can be observed in the real world before taking further policy steps. The lesson here is central bank prudence in the magnitude and frequency of policy rate changes. This prudence ordinarily leads central banks to avoid aggressive and pre-emptive measures. Their knowledge is too uncertain to support big steps.

"Why a Dual Mandate is Wrong for Monetary Policy"
Anna J. Schwartz and Walker F. Todd
International Finance, 11:2, 2008

Since the last issue of The IRA was published, AIG (NYSE:AIG) discovered another $9 billion or so in unfunded liabilities, apparently linked to credit default swaps. The Fed began to sound out members of Congress about issuing debt. And the Governor of Illinois was arrested for a variety of felonies, including trying to profit from the sale of the Senate seat of President-elect Barack Obama.

We'd like to tell you that the US political system has reached a new low, but really we're reverting back to the pre-WWI norm of chaos and political corruption. For over a century Americans have convinced themselves that economic and political stability are givens no matter how stupid we as a nation act when it comes to matters of money.

That's why we believe that the new President needs to reconsider the composition of his economic team before the ravages of deflation do even more damage to the economy and public confidence. The future of the US economy stands on the edge of a knife. If the Obama inside circle does not start putting some new, competent faces in positions of authority in the economic team, the global economy could be locked into years of stagflation and US government could be in serious trouble next year, unable to fund itself.

We have to laugh at the thought of those fine public servants at the Fed board in Washington thinking that the reserve banks could issue debt near Treasury yields when other GSEs cannot. How does NY Fed 1s of '09 at plus 180bp to the one year sound?

Hello! When the central bank needs cash, you issue more currency. The bank of issue should never need to borrow dollars other than in short term money market operations. If rates are zero, then the reasonable limits of monetary policy have been reached. It's a matter of getting the zillions of dollars we have already created to come back into the markets. That should be the goal of policy, not attempting to replace dysfunctional markets.

The manifest statist, anti-market tendencies of Ben Bernanke and Tim Geithner should disqualify both of these men from future roles in the economic rebuilding effort, in our view. It's not that we hate economists, mind you. We love economists. We dine and go fishing with economists. But don't ever make the mistake of thinking that most economists are able to manage in the real world of risk and money. Both the Fed and Treasury should be acting as a market maker, encouraging and incenting private investors, not creating the bureaucratic structures we see multiplying around the financial market landscape.

What should we do? Two things: 1) The Fed should print money, not borrow existing dollars, until the Treasury TIPS  start to move up in yield, then Uncle Ben will know he's achieved the desired monetary goal; and 2), AIG needs to be put into bankruptcy and the US government should formally convert its preferred shares into common in the top three banks and assert control of these institutions, replacing board members and management as required. Then the world will know we are serious about dealing with the crisis.

Speaking of good candidates with actual market experience for heading a federal reserve bank or other government posts, we next feature a conversation with Eric Hovde, the Chief Executive Officer of Hovde Capital Advisors LLC. Hovde has worked on numerous bank acquisitions and sales, and now focuses his time on managing money. We spoke to Hovde last week by telephone from his office in Washington.

The IRA: Eric, thank you for taking the time to speak with us. Let's start with your view of the industry and then we'll go onto the bailout. You have an interesting perspective as investors in and operators of banks, as well as the M&A advisory business. What is the state of the banking industry today?

Hovde: Unfortunately it is in a very precarious position. Banks lent way to aggressively on ever-increasing asset values. And it wasn't just in the residential mortgage market, it was in the commercial property market as well. And that is a market that we see dropping rather precipitously over the next 12 to 18 months.

The IRA: Are you short any of these sectors synthetically or by shorting bank names with exposure in these areas? Or are you just watching?

Hovde: I tend not to address how we express our investment views and I do not like to be seen as "talking my book". However, we use synthetic instruments on a very limited basis. I do not have confidence in the CDS market from a number of different perspectives. As it pertains to the banking system, on top of the res and commercial sectors, you've got the corporate credit market where, again, the banks went out the credit spectrum, post 2003 to capture greater yield. We think that you are going to see a massive uptick in losses - both delinquency and non-accrual rates in the whole C&I book of the banking industry.

The IRA: So that is everybody, all banks large and small. So the little guys are going to basically catch up with the larger players in terms of loss rates on loans, but will still not have the drag from the trading book that dogs Citigroup (NYSE:C) and JPMorganChase (NYSE:JPM).

Hovde: The only difference you are seeing with the little guys, the smaller banks, is that you are either seeing institutions that have suffered huge extreme pain because they were way too leveraged to the res construction industry. During good times the res construction sector is the most profitable form of lending.

The IRA: So this sounds like Alpharetta, GA, where the housing market has collapsed. There have been several bank resolutions in GA already this year.

Hovde: Absolutely. Yet when times go badly it is the most unprofitable form of lending. So you have already wiped out a number of little guys that were concentrated on res construction lending. But in large part, the smaller players, the regional and community banks, are better positioned for one reason, they have a lot more capital than the financial behemoths. The OCC and the FDIC would not allow the little guys to go below a 6% tangible capital level and in many cases the regulators were putting pressure on you when you went below 7%. So, whereas Citi and a number of the big guys were able to take their tangible capital levels below 3%, at least the smaller cap guys had that capital cushion intact and I think it has been very beneficial to them to date.

The IRA: The irony of what you are saying Eric is that you are looking at notional or nominal levels of capital. We calculate Economic Capital or "EC" for all banks, the top three are at multiples to their Tier 1 risk based. Some are 4:1-such as for both C and JPM, for example. So not only did the OCC let the mega banks slide with respect to the nominal measures of tangible equity, but the risk weighted assets is off the scale as measured by EC is off the scale.

Hovde: Definitely. Both with respect to what the big guys were able to get away with respect to their securities books and their whole loan books, leverage that a community or even regional bank would never have been allowed to do. Not only do big institutions have far riskier assets on their balance sheets, but, at the same time, you have less reserves and less capital.

The IRA: OK, so here's the question we'll get mail about next week: compared with 1990-91 loss rates, do we do 2x in the next 12-18 months? Are we high or low on the projection of 2x the 2% charge-offs for the industry in that period and 3.5% for Citibank NA, a key benchmark for and outlier in the large bank peers in the US banking industry.

Hovde: I think without any question we'll do 2x that. And the thing I am tracking is the unemployment rate. [After this interview, the latest job numbers reported the worst monthly losses in decades. -- Editor] As you know, typically during epic periods of economic weakness, the unemployment rate and job losses are a lagging indicator. But right now it is a paramount indicator because if we do see job losses that are prolonged anywhere around a double-digit number, 10%, you basically put at risk every single credit card bank in the country. Who does that include? Citi, Bank of America (NYSE:BAC), JPM, Capital One (NYSE:COF), American Express (NYSE:AMX). You could essentially wipe out all of these guys.

The IRA: We've mentioned to a few people the RFI which came out in August from OCC, looking for technical responses regarding new data collection efforts for Shared National Credits, Basel II and monthly reporting of credit card data from the top 10 issuers. We're talking about gathering loan level data, more than 80 elements, including your FICO score, everything. All privileged data. There are 700 million active credit card accounts in the US, probably with more than three quarters of the assets in the top issuers. That tells you the future worry bead is credit card.

Hovde: It's interesting because you are raising another issue, namely FICO scores. I've always had a belief that when we get into a significant period of stress, FICO scores will turn to dust. FICO scores were a very nominal portion of credit created in the late 1980's and early 1990's. FICO scores were a byproduct of the 1990's and the 2000's. Many people who have 700 plus FICO scores are in those professions that are being wiped out at high speed today. I think that all of these FICO scores could end up to be a very poor indicator of future credit losses. Much like the rating agencies did a horrifically bad job, I would not be surprised five years from now to see people saying that FICO scores did a poor job on consumer loans.

The IRA: It is interesting you say it because the FICO was one of the early applications or misapplications of science to finance. The folks at Luwig VonMises Institute just ran a great reprise of his essay by Friedrich August von Hayek on The Pretence of Knowledge we have at the top of the previous issue of The IRA.

Hovde: No question. The whole financial services industry has lost the ability to underwrite credit on a piece by piece basis. We've moved to these macroeconomic models and quantitative statistics to try to derive whether something is going to be credit good or credit bad. In times of extreme stress, these quant models turn out to be pretty worthless.

The IRA: So think of what we can look forward to. First the institutional products and risk measurement methodologies, Basel II, have been attacked and decimated. Now the FICO score is going to likewise be undermined, something I'll bet many people don't anticipate or at least not in terms of the loss rates you are describing. The last bastion of credit scoring is the use of FICO for retail credit management. You could never charge enough of a fee on cards to actually administrate them actively in the way you are describing. Small town banks do that on cards, but not COF. As I always like to say, Martin Mayer taught us years ago there are no economies of scale in banking. Either you know your customer or you don't.

Hovde: Absolutely.

The IRA: What you are suggesting in terms of the impending demise of the FICO regime is another shocker. If you read the interview we did with Bill Janeway ('New Hope for Financial Economics: Interview with Bill Janeway'), what you are really saying is that the entire house of cards gets flushed. Upon what foundation do we rebuild the banking system? What is the new basis or the new hope for a credit regime for banks that can be leveraged?

Hovde: I think that the Fed and Treasury have to abandon this mistaken belief that they are going to resurrect the Street and its role in the credit creation machine. And they have poured so much of the Fed's balance sheet and so much of the Treasury's money down this hole called AIG to prop up GS and MS and Cs of the world. I think we would be much better off focusing federal monies on the regional and smaller institutions, build them up with new capital, because these banks have actual credit underwriting skills in their organization. They have less risk assets and more capital to begin with. I think credit creation is going to revert back to a model that looks like the pre-1980's, where the lion's share of the underwriting is done by local banks. It's going to be know your customer and you will need seasoned professionals to work as loan officers and credit underwriters to get credit going.

The IRA: Back to the future, isn't it? So given your cheery loss rate assumptions, we start to look like the bulls in the room. We've got to introduce you to our friend Nouriel Roubini. So our smiley faced assumption that Wells Fargo (NYSE:WFC) and USBancorp (NYSE:USB) are going to escape this tsunami of credit loss are going to be wrong?

Hovde: I don't think any of the major players will escape it. Do I think some had better credit culture? Yes, absolutely.

The IRA: Both WFC and USB are not afraid to say no to loans. WFC has one of the shortest overall loan exposure profiles of any large bank. We calculate that as loans plus uncommitted, because this is what they have to fund. WFC always comes in at or less than 100% of total assets because of its very low unused lines to total loans.

Hovde: There are some banks out there that kept their exposure in check by avoiding extremes. Then you have other banks where there were a multitude of different credit cultures. The res portfolio was toxic and the commercial was good because of who that chief credit officer was on the latter. Sometimes you have multiple C&I books in these big institutions with different management and production teams. Some institutions just had horrible credit cultures across the board.

The IRA: We have a credit card solicitation from WaMu we received just before the resolution and sale to JPM. Gonna keep this one as an artifact. Put it in the time capsule.

Hovde: Well you just described an institution that had horrible credit culture across the board. When things were melting down, they were still the cheapest credit in the market on the res side as well as on the multi-family side and on the commercial side! It's like they could never get the message. Either the guys at the top of WaMu could never figure out what the economy was going through and the credit loss cycle or they could not get the information down to the ground level because they didn't have the management systems to enforce what they wanted to do.

The IRA: Well banking is about communication and control, isn't it? The classical rating community has been synthesizing the CAMELS data from the public data as we do. But it is clear that the FDIC is going further with resolutions. They are taking "outlier" institutions out and resolving them based on projected losses.

Hovde: Yes. However, you can't do anything with just the public data. What we are seeing is a huge differential between banks that are being aggressive and serious about moving through their problem loans and those which are not.

The IRA: Yes, some look better today than their numbers suggest, while noiser banks may actually be righteous. So you agree there may be some false positives among the outliers in the high loss rate banks?

Hovde: Prime example: Marshal & Ilsley Bancorp (NYSE:MI). If you look at their credit data, it does not look good. But most people in my business know that MI has been the most serious and aggressive bank in resolving their problem loans. MI is pushing the assets to the curb, getting the assets sold, taking the hit and moving on. It has a strong credit culture plus it had the capital to begin with to take the hits. Where other banks were playing every game in the book and just keep extending and restructuring to keep the problem off, praying and hoping things will turn around.

The IRA: I am just looking at them on The IRA Bank Monitor professional terminal. MI's score is 3.7 vs. 1.5 for the industry. Capital, lending capacity and efficiency at or below the 1995 baseline for the entire industry, which is excellent. A 0.8 Efficiency Stress score vs. 1.1 for the entire industry is very impressive for a bank this size at this point in time. The pain you describe in terms of losses are clearly visible in the ROE and Default scores. Does MI survive the tough triage rules for "Sheila's List?"

Hovde: Every other major player in AZ is playing games but for MI. MI is cleaning house aggressively. Of course, if you take that approach you will see a spike up in loss rates and ROE degradation, but this is the smart approach because when you start going into an economic down cycle one of the most important things you can do is identify and workout your problem assets as quickly as possible. If you think that asset prices are going to collapse, put those assets to the curb and get rid of them. Ultimately if you get aggressive with your borrowers, you get a hold of whatever cash they have left whereas the other banks won't, and, most importantly, you get the assets moving…

The IRA: Into strong hands. This is what we call the Prime Solution. Get the money and the assets into stronger hands.

Hovde: Exactly. Going back to what I said before about the community and regional banks like the MIs of the world, this is where the Congress and the Treasury should focus their money and their resources in the Obama Administration. The large banks will have to be restructured and broken up. The smaller, better capitalized and funded institutions are the buyers of these assets. Remember, when you take over a foreclosed property or other assets resulting from a default, the cost of ownership is a huge issue. That's why it is almost always better for the lender to sell the assets into the market. It's not just servicing. It is real estate assets management, taxes, everything.

The IRA: We took an aspiring young real estate mogul to see one of the biggest players in the New York real estate industry back last May thanks to an introduction of a dear friend. The lawyer is the deal broker and confidant to every major builder and tenant in the city. So he looked over the young man's resume and noticed that he was working in the Hamptons building McMansions as a project manager for a small developer, doing everything. Then he smiled and opined: "Kid, you got a job, which is good. Keep it. I see you want to do development. There isn't going to be any development in New York once the current projects are complete. Nothing. Change the word "development" into "management" or "restructuring" on this resume. Then you'll have a lot of takers." Good advice from a very smart man, who also predicted the downfall of Lehman and the rest, including GS and MS. This was before their mutation into regulated banks.

Hovde: One of the problems that is rapidly approaching is commercial real estate mortgages. Res mortgage are the largest asset class in the banking system. Commercial real estate mortgages are the second largest asset class in the banking system. Unfortunately much of the underwriting sins that started in the res market in 2002 crept into the commercial sector as well by 2004 and 2005, plus you never dealt with the massive excess inventory surplus of commercial office space post the Internet boom. Because financing costs became so low, real estate values kept shooting up and builders kept building more. So you have a national vacancy rate of 15%, which is moving higher every quarter. I think you are going to see major losses coming through the commercial real estate books of the banking industry.

The IRA: It is important that you raise this issue of commercial overhang because a lot of people thing we went into a recession with a tight commercial market, that everyplace was mid-town Manhattan of say two years ago. We've been talking to our colleague Josh Rosner about phantom inventory for some time. And we see it in Torrance where IRA is headquartered. As and when prices firm, huge inventory will come to market.

Hovde: You clearly see this in Orange County, where the official vacancy rate is 16%. However, if you factor in the "shadow space," you can easily add 10% to that.

The IRA: We were just in Orange County earlier this year for the Financial Service Roundtable. On the way out to Dana Point, there was another mall around every bend and another condo development balanced on the hills above.

Hovde: This is why retail is going to be the worst hit sector of the real estate market. Commercial office overall is going to be bad, but retail space is going to be devastated. The epicenter for the retail devastation will probably be Las Vegas.

The IRA: Oh? How appropriate. Is this due to falling traffic or other factors?

Hovde: Not only will nobody be going to Las Vegas, but in Vegas, everybody ended up drinking their own KoolAid: if they build it, they will come. Las Vegas developers were adding this year and next year 35% more retail space than had existed before and it was not like Vegas was under-retailed before. So, even if the economy held together they were going to have massive problems in Las Vegas. Now with the economy in trouble, airline passenger traffic falling off a cliff and the casinos in trouble, it is going to be absolutely devastating to every retail property in Vegas.

The IRA: So I guess you agree with our view that a couple of the larger banks such as C and JPM are going to be explicitly controlled by the government by sometime next year? Treasury shall dispense with the idiocy of preferred equity "investments" standing behind the existing common shares and assume the place of owner-in-fact.

Hovde: I think that is more than likely.

The IRA: So what do we do with a C or JPM once they are formally nationalized? Run them for a while and then sell the pieces? I don't see any prospective buyers.

Hovde: That's the thing. I had to laugh and chuckle when people talked about a buyer for C. The few banks that could have done that deal where themselves in such trouble that they could not do it nor would they want to. What has to happen is that these troubled companies need to be placed into conservatorship and then broken up into pieces. I don't understand why the Treasury and the Fed continually want to create larger and larger institutions that are going to create even bigger systemic risks to the global markets.

The IRA: It is all that the Fed and Wall Street gang in control of Treasury know to do. The likes of Hank Paulson or Timothy Geithner, who we just challenged to a public debate by the way, cannot conceive of the pre-crisis Wall Street banks not being the center of the world. But in economic terms that change has already occurred, the public reckoning is just delayed. But don't you think that once resolved via a receivership, the assets or C or JPM could be sold piecemeal?

Hovde: Yes, maybe not branch by branch, but certainly state-by-state or by region or country. We used to do that back at the RTC where a group of 15-20 banks would make a consortium bid for a larger failed bank and they worked very effectively. Somebody like USBancorp (NYSE:USB) could buy the California operation of C. A strong player in the Southeast, the Northeast, etc. Then you deal with the various international operations and sell those off piece by piece.

The IRA: We suspect that the financial reality of C's above-peer loss rate profile will eventually force such a strategy. So it does not sound like you are a big fan of the bailout to date. Is that a fair statement? Did Lehman have to go bankrupt?

Hovde: Yes. Look, it is a ridiculous question. You could not prevent Lehman from going bankrupt unless the US government was prepared to absorb a couple of hundred billion in losses. Lehman was a toxic waste dump. The bond holders are going to receive something like 10 cents on the dollar. When people like Dick Fuld say it was short sellers, he is wrong. Short sellers had nothing to do with it. The simple fact is that every buyer went in, looked at the books and records, and if it had been the case that the firm was just suffering from a depressed stock price, they would have scooped it up in a heartbeat. No, nobody bought it because it was a toxic waste dump.

The IRA: Right and Barclay's bought the broker dealer clean out of the bankruptcy. Thus the real question is why the bond holders and equity holders of Bear Stearns were spared. What lever did the boys at the Bear have over JPM and the Fed that they were allowed to escape? Seen from today, they got a great deal. But Barclays bought the only thing of value at Lehman, namely the people.

Hovde: Exactly. The only thing of value at Lehman was the people. Look at their commercial real estate book. It was all B Piece or Mezz finance or bridge finance loans. These types of loans will be destroyed in a weakening economy. They were fraudulently lying, in my view, about loans on Lehman's books as well. They had a loan called SunCal. They had written it down from $1.4 billion to $1.1 billion. At a $1.1 billion, SunCal is a property developer in Orange County, they were valuing land lots in the Inland Empire of California at something over $15,000 per lot whereas today you'd be hard pressed to give these lots sell these at $2,000 a lot. There was nothing left at Lehman to save. This is one of my problems. The Fed and Treasury are desperately on the hook trying to save GS, MS and C…

The IRA: You mean with the capital infusions and loss sharing agreement with C?

Hovde: Yes. This could be an open-ended liability for the Treasury and taxpayers, which is ironic because these large banks are not going to be the key players moving credit through the system in the future.

The IRA: Exactly. If we don't drive the good money in terms of deposits into strong banks, the economy will be dead in the water for years. So then you agree with our view that Bear, AIG should all have been put into bankruptcy? BTW, the small FSB and Lehman's loan servicing unit are still sitting in the bankruptcy last time we looked.

Hovde: Yes, of course. Going back to the Bear Stearns scenario and how poorly they handled that event has had repercussions on the entire series of events that followed.

The IRA: Well, the Fed and Treasury were inconsistent. Bear was saved, Lehman was not and the markets were surprised, the definition of a systemic event. Duh! Didn't Ben Bernanke and Geithner understand that the entire market saw Bear as a precedent?

Hovde: No only that, but what they did was by allowing the Fed of New York to get put on the hook for $29 billion in assets from Bear and allowing the common stock holders to walk away with not just $2 per share but get renegotiated to $10 per share. Further, they did not pull Jimmy Cayne out of the building and prosecute him, which just further reinforced the Greenspan Put that the Fed is here to just bail you out Wall Street of its problems. As a result, look at the lack of actions that Dick Fuld and Lehman took. Nothing. Did C collapse its dividend? No, they kept paying huge dividends to shareholders.

The IRA: In a resolution the FDIC could possibly claw back those dividends. Another happy thought.

Hovde: Yes. Dick Fuld at Lehman tried to maximize the highest value for Neuberger & Berman, valuations there were unattainable. He did not raise anywhere near enough equity because he did not want to suffer the dilution. All of the CEOs on Wall Street thought "Oh, the Fed's here to take care of us." If they would have allowed the shareholders of Bear Stearns to be wiped out, clipped the bond holders, and allowed regulators to take a tough line as we did in the late 1980s, you might not have the crisis of confidence that exists today. In the 1980s, every CEO of an institution where the government had to put up money was led out of the building in handcuffs by the federal marshals and in half the cases prosecuted. The decision-making on Wall Street would have radically changed that day.

The IRA: Totally agree. Yet Bernanke and Geithner refused to do that. They refuse to do their clear duty under the law to restore confidence in the banking system, seemingly because of their political and personal ties to these major Wall Street firms.

Hovde: Look the same economic team that lit this fuse and let this fuse go 12 years ago is now about to come back into power. The same economic team has been floating around through the Clinton Administration, the Bush Administration and now is driving the Obama economic program. It is stunning to me that we are not seeing a wholesale switch-out of these Goldman Sachs participants or their protégés who have driven US economic policies for a good 12 years. It is amazing that they are still in place and still being put into positions of power.

The IRA: Well, it is not really so amazing. As our friend Bob Feinberg likes to remind us , there is only one party in Washington. And he predicted all of this buy the way. So who would you like to see at Treasury?

Hovde: I would have liked to see Paul Volcker, but at his age he may not have wanted to take on that responsibility. I would have reached out away from Wall Street and gone into the broader banking industry. Somebody like a Richard Kovacevich, Chairman of Wells Fargo or John Allison at BB&T (NYSE:BBT). I would have reached out into the commercial banking world who understands the banking system and the capital markets.

The IRA: I would have rather had Paul O'Neill again than another Wall Street politician like Geither. People don't understand that Paulson is a politician too, not really a deal guy. Paulson, don't forget, was a protégé of Haldeman and Ehrlichman during the Nixon Administration!

Hovde: The Street hated O'Neill because he would not play their game. They belittled him and destroyed his reputation and used their bullhorn to knock him out. O'Neill understood the need to protect the government's finances and to impose new risk controls on Wall Street.

The IRA: Given your earlier comments about the likely forward loss rate scenario for the banking industry, do you think the coming economic crisis will be sufficiently bloody to break the corrupt grip of Wall Street in Washington?

Hovde: Yes. The grip of Wall Street is still embedded and locked. But what will ultimately happen is that just as the Republicans have been wiped away in this election cycle, the Democrats will be decimated in the next two election cycles. People are being told in the broad economy that we are spending all of this money to help you and save your job and allow you to get that year-end bonus. And it's not. People are going to start waking up to the reality that hundreds of billions in public funds have gone down a hole. The animosity and anger among the public toward elected officials if going to be intense. Whoever is in power is going to pay for that. So the Republicans deserved what they got and you will start seeing that animosity direct toward Democrats in the next two elections cycles.

The IRA: Show trials perhaps? You spoke very eloquently the other day about Danny Wall, the former RTC official who led some innovative solutions to the S&L crisis in the 1980's but was ultimately vilified. You said that Bernanke, Geithner, Summers et al could face a similar fate due to the political concerns you just outlined. Could you elaborate?

Hovde: When Congress starts taking heat from their constituents, even if they themselves were completely complicit in creating the mess or in the mistaken ways of prevent or addressing the mess, Congress' first act will be to grab the people in the Obama Administration and at the regulatory agencies, and pull them in front of congressional committees. And they will tar and feather those individuals. Now the story on Danny Wall is relevant here. Danny Wall was the long time assistant to Senator Jake Garn (R-UT), who was the head of the Senate Banking Committee. When the Federal Home Loan Bank Board's Ed Gray left, he was appointed to the position. This is right when the S&L crisis was starting to develop and we started to see losses in the Texas market. So what Congress said was that we don't want to take losses or appropriate money to FSLIC, the S&L deposit fund, so go out and use tax credits to clean up the mess. We'll allow you to use tax credit to convince wealthy investors to come in and recapitalize these institutions. So Danny Wall went off and did precisely that and executed what I see as some of the smartest government rescues of the S&L crisis. The SouthwestPlan provided capital loss coverage, yield maintenance, but also left the assets in the private sector. They brought into the industry people like Lew Ranieri, the Bass Brothers, Ron Perelman, and a lot of other private investors.

The IRA: Could we do that now? Is this approach viable?

Hovde: I think you could absolutely do that now. In fact, that is probably the way I would have approached this whole problem when it comes to the banks by providing capital loss coverage to entice private capital to come in and get rid of some of these poor managers and recapitalize the industry in a substantial way.

The IRA: But of course Congress soured on the use of tax credit and private investors making a profit.

Hovde: At first the Congress loves the idea because the Southwest Plan was not costing them any money. However, when USA Today and the Wall Street Journal and all of the major newspapers around the country started reporting about these big tax credits going to super wealthy people. So what happened? Congress pulled Danny Wall back to Washington and they grilled him, and tarred and feathered him, and destroyed his reputation and destroyed his career. I think Ben Bernanke, Tim Geithner and the other people at the Fed and Treasury better be very careful about the decisions that they are making. A lot of the decisions they are making are very independent of Congress. When things get bad enough and hot enough, the Congress is going to want to point the finger of blame.

The IRA: Such is the way of any democracy. Thanks Eric.

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