Thinking It Through

An Interview with Asher Edelman

What we’re not used to, and what we haven’t paid attention to, if it hits like a bomb, are the things that create what we saw in 2008 and which leave us with a very, very big stone to push up the mountain.

The two things I see that could put us back there very quickly are, first, the illiquidity of almost every form of debt at the moment. You can’t resell it. And by the way, this has nothing to do with Dodd-Frank, because before Dodd-Frank, we had 2007-2008. You can’t blame Dodd-Frank. Then, we have in that marketplace of no liquidity the second thing: derivatives portfolios in U.S. banks that, if you examine their backing, are greater than the GDP of the entire world and more than three times what they were in 2007. You have no liquidity, and you have all of this silliness going on, and you have the banks themselves who use it as a form of speculating. And regulators who don’t have a clue.

Until we have Glass-Steagall back, we will always have banks that prefer not to lend and use their capital to speculate. That will always be a drag on the economy and a risk to the economy. That doesn’t mean we’re going to get Glass-Steagall back, but banks should be in a position where lending is their main business. Investment banks and other forms of speculative vehicles, where the risk is to the shareholders and the bondholders, should be the people who play the other games. This isn’t the case with the banks today.

Free capital should not be used for speculation. Capital for speculation should be capital that earns some of the profits of the speculation, indeed most of the profits, and loses when the speculation loses. You should not have free capital to speculate with, given to the banks by both their depositors and the government.

You have to hope that Bernie Sanders wins in November, because otherwise the banks will go along on their merry way, and then when it really all hits, it will hit even worse. Bernie may not be able to get anything done, but I think there’s no one else in the race who has a program that might possibly work for this country.

OR: Do you think European banks are particularly vulnerable?

Edelman: There we get into the most interesting issue of all. I’ve dedicated time recently to considering the distressed debt in Europe. Generally speaking, the banks in Europe — the biggest, the smallest, the government ones too — have been in a business of cronyism for the last 25 or maybe 50 years, though they do not play derivatives games at the level that we do.

Let’s say I own a bank. Call it the Espirito Santo Bank, in Portugal. That bank is related to a string of companies, in total value (theoretically, because they’re all bankrupt now) larger than any other semi-private or private string of companies in Europe. Legally, I can’t actually lend to those companies, but I do that anyway through other routes. However, I have an arrangement with all the other banks in Portugal, or most of them. That arrangement is as follows. You, Mr. Government Bank, lend to my clients, and I will lend to the people who you can’t lend to, or where you’re up to the limit. We will have a handshake that will protect us.

Multiply that by six or seven major banks in a small country like Portugal, all doing that for each other. Now, imagine the central company group has a scandal or a swindle, and goes bankrupt. In that bankruptcy, 10 billion euros are missing, of which probably two billion euros were actually stolen, and the rest is lost. As a result, the institution in the center cannot wash the other hands, so they’re all sitting on bad paper. However, that happens in every country in Europe, and the cronyism is extraordinary. Now, it gets even more interesting. What do you do? Let’s say some of the bad paper was loans against real estate and this has been going on for 15 years — and then that real estate defaults. These banks don’t write off their defaults at all. They sit on them for two, three, four, five years. They don’t re-sell the debt at all.

But forget that for a moment. We now have foreclosed. Some of our other banking friends have defaults as well, on other pieces of real estate. We set up a holding company, and we dump all this real estate into the holding company. We declare whatever value the default was to be the value of the property in this holding company. So we have a holding company with, in many cases, almost worthless real estate: land, buildings that have no tenants anymore. And we’re carrying that effectively at par on our balance sheet, because we now own an equity interest in those holding companies.

That is not good capital from a reserve point of view, but our balance sheet still looks pretty cool. We look like we have equity and we have assets, and we don’t. This is the case throughout Europe. Now suddenly, the government comes along. In the case of Espirito Santo, they split it into a good bank and a bad bank and they put up more than four billion euros to rescue it. This money comes from the larger fund the E.U. set up to bail out Portugal.
That’s great, because they’re going to pay it back. They’re going to sell the “good bank,” and blah, blah, blah. The good bank is called Novo Bank. Some of these assets are carried at par. The loans are non-recourse and the collateral is worthless. Maybe, from a strategic point of view, it’s worth a million euros, and carried at 40. There are hundreds of such loans that are still on the books of Novo Bank.