Rationalize The Banks!

Leaks in the media indicate that the banks are about to inhale another helping of taxpayer dollars. This round is likely to be considerably larger than the $350bn they swallowed in the bail-out last October.

The
leaks from Obama administration officials without names suggest that
the money will provide a further subsidy to bank executives and
shareholders and may not even resolve the banks' financial crisis. In
other words, the banks may yet come back for more.

The rumored plan is for the government to buy up hundreds of billions of dollars of bad debt from banks and place it in a "bad bank". The bad bank would then resell these assets for whatever price it could get from private buyers.

The
basic problem with this sort of plan is that it requires that the
government overpay for the bad assets. If we just pay Citigroup, Bank
of America and the rest what their assets are worth, then they would be
bankrupt. They have taken enormous losses on these assets. If they had
to own up to their losses, it would wipe out the capital of many, if
not most, of the banks in the country.

Recent estimates from Goldman Sachs and Nouriel Roubini put the cumulative losses to the banking system at around $2tn.
There is a lot of room for guesswork in such estimates, but there can
be little doubt that this number is in the right neighborhood.

We
are in the process of losing $8tn in housing bubble wealth. Most of
this will be absorbed by homeowners, but if just 10% of this loss
accrues to banks, that would be $800bn. In addition, banks have lent
$3tn to support a bubble in commercial real estate. If one third of
these more speculative loans go bad, and half of that loss is incurred
by banks, that gets us another $500bn. Add in $200bn each in losses on
credit card debt, car loans and small business loans, all of which are
now far shakier because borrowers no longer have home equity as a
backdrop, and you get to the $2tn neighborhood.

This $2tn loss
compares with bank capital of just $1.4tn, a large portion of which is
rapidly disappearing "goodwill". In other words, the losses to the
banking system will almost certainly vastly exceed its capital. This is
why the banks need to tap our wallets.

If we go the bad bank
route and pay too much for bad assets, then taxpayers are effectively subsidizing bank shareholders, who would otherwise be wiped out, and
bank executives, who would otherwise be looking at big pay cuts or
unemployment.

But it gets even worse. There is no reason to
think that the bad bank route will be sufficient for resolving the
banks' problems, at least not in round one, because they may not come
clean with all their bad assets.

It is important to remember
that these banks are run by people who could not see an $8tn housing
bubble. It is likely that they still don't know the full seriousness of
their problems. (The same can be said of Treasury secretary Tim
Geithner and national economic adviser Larry Summers, the bad bank's
designers.)

Many of their loans have not yet gone bad - for
example, underwater mortgages that are still current. The bad news on
these loans will come when homeowners have to make short sales, which
could leave banks with losses of $100,000 or more per loan. This means
that the bad bank created under this plan will have to be an ongoing
business, handing out more taxpayer dollars for the banks' junk over
the next several years.

There is a simple alternative, which
can be called "bank rationalization" in order to avoid the "n" word.
Under this scenario, the government would take possession of insolvent
banks. This is not interference with the market. It is the market.
Bankrupt banks go out of business, but due to their importance to the
economy, we can't let them be tied up in bankruptcy proceedings for
years.

Dealing with the matter all at once can both allow for a
quicker fix to the financial system and also ensure fairer treatment of
bank creditors. First, the shareholders of bankrupt institutions must
be forced to eat their losses. However, we may not want to honor all
the debts of the banks at 100 cents on the dollar, which has been
current practice.

While the government has guaranteed most
deposits, it has not guaranteed the bonds and commercial paper of the
banks, nor their commitments on credit default swaps (CDS) and other
derivative instruments. If it takes possession of all the bankrupt
banks at once, it can apply a uniform policy. For example, it could honor bonds at 90 cents on the dollar or only pay off full CDS
obligations to those who actually own the bond that was being insured
against default.

To force banks to own up to insolvency, bank rationalization can apply punitive terms to banks that fail
subsequently and allow their creditors to hold bank executives
personally liable for their losses. Such rules would lead to more truth
telling from our bankers.

In short, bank rationalization is
both much fairer and better for the economy than the bad bank plan. If
only the people who missed the housing bubble can be forced to recognize this fact.