Zombies that ate America

Major U.S. banks and securities firms are on pace to pay their people about $145 billion for 2009, a record sum that indicates how compensation is climbing despite fury over Wall Street's pay culture.

An analysis by the Wall Street Journal shows that executives, traders, investment bankers, money managers and others at 38 top financial companies can expect to earn nearly 18 percent more than they did in 2008 – and slightly more than in the record year of 2007.

– "Banks set for record pay," Wall Street Journal, Jan. 14, 2010

The American economy is not a zero-sum game. It is also not anything that can be reasonably considered a free-market economy. The reason that more than one percent of U.S. GDP went to pay Wall Street's bankers in 2009 is that the Republican and Democratic politicians have utilized the power of government to significantly distort the system for their benefit. While bank executives are reporting record profits for the zombie banks that appear to justify their enormous compensation, these reports are fraudulent and the profits are non-existent. Both are based upon false asset valuations and crazy derivative gambles disguised as financial investments. Banking executives are using the additional time given to them by the U.S. government and the Federal Reserve at the expense of American workers and U.S. taxpayers to recklessly loot the system before it breaks down again.

American businesses and taxpayers are not only being devoured by financial zombies, corrupt and foolish federal policies are forcing them to involuntarily pay for the privilege.

There is no doubt that the system is going to break down. This is not because it's based on fraud and pretense – although it is – but because it happens to be completely unsustainable. That $145 billion in banking industry salaries and bonuses is not only equal to one percent of GDP; it is also equal to 14 percent of all the post-tax corporate profits in America, according to the BEA's most recent report. Unless the plan is to convert the nation into a gigantic version of the Cayman Islands, where financial services and tourism make up the entire economy, this increasingly bizarre economic structure cannot possibly survive regardless of what Obama, the Senate, the House or the Federal Reserve attempt to do.

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Obama's embrace of Paul Volcker's plan to limit proprietary trading by financial firms is a good start, as is the idea of preventing banks from reaching a size where they are deemed too big to fail. But it is only start, and it is by no means enough to even begin solving the economic problem created by the short-sighted greed and arrogance of the zombie bankers. An easier and more effective way would be to end what Karl Denninger of the Market Ticker describes as "mark to fantasy." The only reason the banks are able to pretend they have made massive profits, the only reason they are able to pretend that they are solvent at all, is because they are allowed to claim artificially high valuations on the assets they are holding.

For example, if you have two mortgages, one for $200,000 and one for $25,000 on a house that is now worth $150,000, your house is said to be under water. The first mortgage is still worth something since it is a security claim to a real asset. But the second mortgage is worth nothing at all, even though the banks are still carrying them on their books at their full valuations. Since up to 50 percent of the six million expected foreclosures to come have second mortgages on them, this is a massive amount of phantom value that the banks are still counting. Even more phantom value exists because of the refusal of mortgage banks to foreclose on homes for which the owners are no longer paying their mortgages. They can't afford to foreclose on the homes in default because once the foreclosure takes place, the home must be valued at its actual value rather than its inflated phantom value.

There is a reasonable case for not always marking every asset to market, given the intrinsically subjective nature of value and the concomitant fluctuations of any salable asset. But that case does not include the transparently fictitious "mark to fantasy" custom that presently prevails.

I am deeply skeptical that Obama is threatening to take on the banks because he genuinely understands how they have badly damaged the American economy and planted the seeds of the destruction of the U.S. financial system. I suspect this is little more than political theater meant to bolster his disastrous poll numbers. No one knows better than Obama how he owes his presidency to John McCain's self-implosion for the benefit of the banks. But if Obama withdraws his support for Ben Bernanke, calls for an end to mark to fantasy, fires Tim Geithner and Larry Summers, and endorses Ron Paul's bill to audit the Fed, we'll know he's serious.

And if he is, then this attempt to put the interest of the American people ahead of the zombie bankers that prey upon them will mark the first thing he has done right in the last 13 months.