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In Goldman Sachs We Trust

 September 16, 2008 12:00 PM

For reading on our trip, we chose Galbraith's commentary on the Great Crash of 1929 quoted above. Reading this book again after nearly 25 years is a rather chilling experience. Change the names of people and securities, and the dates, and the account of Galbraith could be published in a newspaper today describing the fall of Bear, Stearns, Lehman Brothers or Merrill Lynch (NYSE:MER).

And our favorite chapter: "In Goldman Sachs We Trust," a scathing comment by Galbraith on how the masters of the universe at Goldman Sachs (NYSE:GS) sponsored trusts such as Blue Ridge and Shenandoah, speculative Ponzi schemes that made the market collapse of October 1929 far worse than it would otherwise have been.

There has been a huge amount of commentary on the fall of Lehman, the fire sale of MER and the impending demise of AIG (NYSE:AIG). In each case, we see firms that are arguably still solvent, but increasingly illiquid. Driven into panic by a noxious combination of leverage, fair value accounting, hedge fund bear raids and incompetence in Washington, all manner of financial institutions are now on the defensive.

Some observations:

First, the demise of the GSEs and now the monoline investment banks, those dealers not affiliated with a commercial bank, may be considered the appetizer and soup courses of this dismal meal. The main event now approaches, namely how Washington will deal with the impending illiquidity of some of the nation's largest depositories. Led by wounded soldiers like Washington Mutual (NYSE:WM), there are many US banking institutions that are under stress but still solvent, and require only additional capital to see themselves through the next 2-4 quarters of loss. Once the private markets are able to estimate the likely peak loss rates of such institutions, then a flow of new capital can and should enter the system to recapitalize these banks.

The question is, how to get from here to there without forcing some of the largest, most visible banking industry names into an open and very messy liquidation that can only further erode the public trust in our banks and the governmental agencies charges with their safety and soundness. Does anybody really believe that the market for Treasury and agency debt would survive the collapse of a major bank or another primary dealer? Let us not forget that AIG is a primary dealer.

Second, we as a nation need to distinguish between our free market rhetoric and the financial reality forged over more than three quarters of a century since the Great Depression. Commercial banks are GSEs, as our friend Alex Pollock at AEI likes to remind us. Just look at the liabilities of commercial banks and count the federal guarantees and subsidies that make banks appear profitable and liquid.

Watching our friend Larry Kudlow and other American conservatives beat their chest and profess undying loyalty to the goddess of free market discipline is all fine and well, but the fact remains that we live in a largely socialized economy. Since the 1930s, when we substituted government regulation for personal responsibility when it comes to ensuring bank safety and soundness, Americans have lived in a system where financial institutions are already supported by government guarantees and liquidity facilities. The public/private business model of US commercial banks is the best example of that Depression-era compromise which was struck between the traditional American ideal of free market discipline and the outright communism advocated by many of the New Dealers who surrounded FDR.

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