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Play by The Rules, Close Failing Banks

James Saft

Why not just play by the existing rules and rescue the economy, rather than the banks and their foolish shareholders and counterparties?

The choice for the Obama administration comes down to this: pay a subsidy to weak banks and reward failure and self-dealing or shut them down and start over again.

Because it doesn't want to run the banks, and who can blame it, my bet is that the U.S. government will go the subsidy route, but it would be wrong.

A better idea is nationalization of the banks that can't function combined with fresh capital for lending, perhaps in new institutions or newly managed ones built from the wreckage of the failed. As Nobel prize winning economist Joseph Stiglitz points out, the United States has an existing process to deal with failed banks.

"You have to have a certain amount of capital and if you don't have enough capital you are going to be shut down. We have a legal framework and we should use that legal framework," he said in an interview on Saturday at the World Economic Forum in Davos.

"What you need to do is carve out the narrowest thing that you need to carve out to preserve the payment mechanism. We are engaged in re-writing the rules and the question is: ‘For whose benefit?'"

Both bondholders and derivative counterparties - people who entered into a contract with a bank for payment if certain external things happened, such as the default of a third party - look to be the big winners in preserving the existing banks.

I would also be very interested to see where the cash from bailouts of banks and their complex international obligations flows. It seems to me pretty possible that in rescuing banks, you are bailing out their derivative counterparties, channeling cash to many people and institutions who were speculating, who took risks on the strength of the bank counterparties they were using but who had no contract with the U.S. government for these risks to be insured.

Many of them inevitably will be abroad and some may be unsavory. The political fallout could be huge.

The argument in favor of this particular bailout is that, as we saw in the aftermath of the Lehman failure, the knock on effect will magnify the impact of the crisis. But really, this is about how you want to take your pain, and who will bear it rather than how much.


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And it's not just that wiping out failed institutions would be fairer, it would also be more successful. So long as house prices are falling, efforts to prop up banks through insurance will very likely be swamped by future losses.

Let the FDIC or Federal Reserve take over the weak and even, as Stiglitz has proposed, take a big chunk of the money you would otherwise spend and use it to capitalize a new bank or several new banks with clean balance sheets. Those banks could take $150 billion or so and leverage it very easily but conservatively, thus allowing for more than a trillion of new credit. Keep management at arm's length from government and sell it back to the private sector in three years or so. They won't be best banks the world has ever known, but they will beat the ones we have now hollow.

In the meantime the bad assets of failed banks could be managed separately, in much the same way the Resolution Trust did with assets of failed savings and loans.

There is also an elegance in the barbell proposal of Nassim Nicholas Taleb, the author of "The Black Swan: The Impact of the Highly Improbable," to nationalize the banks, limiting them to utility functions like payments and simple deposits, but twin them with an utterly unregulated sector with no recourse to government insurance or support of any kind.

"They rigged the game. We pay them for their profits, there is no clawback so their incentive is to hide the risk they are taking," he said in an interview in Davos.

"Which is why eventually, (speaking) as someone who loves free markets, a total nationalization of the part of the business that requires insurance and does clearing and payments needs to happen. "I am angry with U.S. policy. What we had is exactly the opposite of socialism, they got TARP to pay their bonuses and to take more risk."

It is true that if you let large banks go down and don't bail out their counterparties many other banks may fail, including banks outside the United States. Mitigating that -  and that's the best we can hope for - will take coordination, but those failures don't change the basic issue.

Who has a call on the resources of the state and whose claims should take priority? I don't think it ought to be derivative speculators, shareholders or bondholders. Get in line.

Reuter's Note: At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist.

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