A Bank Bailout That Works

The news that even Alan Greenspan and Senator Chris Dodd suggest that
bank nationalization may be necessary shows how desperate the situation has become. It
has been obvious for some time that a government takeover of our banking
system--perhaps along the lines of what Norway and Sweden did in the
'90s--is the only solution. It should be done, and done quickly, before
even more bailout money is wasted.

The problem with America's banks is not just one of liquidity. Years of
reckless behavior, including bad lending and gambling with derivatives,
have left them, in effect, bankrupt. If our government were playing by
the rules--which require shutting down banks with inadequate
capital--many, if not most, banks would go out of business. But because
faulty accounting practices don't force banks to mark down all their
assets to current market prices, they may nominally meet capital
requirements--at least for a while.

No one knows for sure how big the hole is; some estimates put the number
at $2 trillion or $3 trillion, or more. So the question is, Who is going
to bear the losses? Wall Street would like nothing better than a steady
drip of taxpayer money. But the experience in other countries suggests
that when financial markets run the show, the costs can be enormous.
Countries like Argentina, Chile and Indonesia spent 40 percent or more
of their GDP to bail out their banks. For the United States, the worry
is that the $700 billion appropriated for the bank bailout may turn out
to be just a small down payment.

The cost to the government is especially important, given the legacy of
debt from the Bush administration, which saw the national debt soar from
$5.7 trillion to more than $10 trillion. Unless care is taken,
government spending on the bailout will crowd out other vital government
programs, from Social Security to future investments in technology.

There is a basic principle in environmental economics called "the
polluter pays": polluters must pay for the cost of cleaning up their
pollution. American banks have polluted the global economy with toxic
waste; it is a matter of equity and efficiency that they must be forced,
now or later, to pay the price of cleaning it up. As long as the banking
sector feels that it will be bailed out of disasters--even ones it
created--we will continue to have a moral hazard. Only by making sure
that the sector pays the costs of its actions will efficiency be

The full costs of those mistakes include not just the $700 billion
bailout but the almost $3 trillion shortfall between the economy's
potential output and its actual output resulting from the crisis. Since
we are not forcing banks to pay these full costs imposed on society, we
should hear no complaints from them about paying for the much smaller
direct costs of the bailout.

The politicians responsible for the bailout keep saying, "We had no
choice. We had a gun pointed at our heads. Without the bailout, things
would have been even worse." This may or may not be true, but in any
case the argument misses a critical distinction between saving the banks
and saving the bankers and shareholders. We could have saved the banks
but let the bankers and shareholders go. The more we leave in the
pockets of the shareholders and the bankers, the more that has to come
out of the taxpayers' pockets.

Principles and Goals

There are a few basic principles that should guide our bank bailout. The
plan needs to be transparent, cost the taxpayer as little as possible
and focus on getting the banks to start lending again to sectors that
create jobs. It goes without saying that any solution should make it
less likely, not more likely, that we will have problems in the future.

By these standards, the TARP bailout has so far been a dismal failure.
Unbelievably expensive, it has failed to rekindle lending. Former
Treasury Secretary Henry Paulson gave the banks a big handout; what
taxpayers got in return was worth less than two-thirds of what we gave
the big banks--and the value of what we got has dropped precipitously

Since TARP facilitated the consolidation of banks, the problem of "too
big to fail" has become worse, and therefore the excessive risk-taking
that it engenders has grown worse. The banks carried on paying out
dividends and bonuses and didn't even pretend to resume lending. "Make
more loans?" John Hope III, chair of Whitney National Bank in New
Orleans, said to a room full of Wall Street analysts in November. The
taxpayers put out $350 billion and didn't even get the right to find out
what the money was being spent on, let alone have a say in what the
banks did with it.

TARP's failure comes as no surprise: incentives matter. Bankers won't
restart lending unless they have a reason to do so or are forced.
Receiving billions of dollars in bonus pay for racking up record losses
is a peculiar "incentive" structure. Bankers have been accused of
unbounded greed using hard-earned taxpayer dollars for bonuses and
dividends, but economists more calmly observe: they were simply
responding rationally to the incentives and constraints they faced.

Even if the banks had not poured out the money in bonuses as we were
pouring it in, they might not have restarted lending; they might have
just hoarded it. Recapitalization enables them to lend. But there is a
difference between the ability to lend and the willingness to lend. With
the economy plunging into deep recession, the risks of lending are
enormous. TARP did nothing to require or create incentives for new
lending, focusing instead on cleaning up past mistakes. We need to be
forward-looking, reducing the risk of new lending. Just think of what
new lending $700 billion could have financed. Leveraged on a modest
ten-to-one basis, it could have supported $7 trillion of new
lending--more than enough to meet business's requirements.

Flawed Attempts to Restart Lending

Policy-makers have been flailing around, trying to figure out how to get
lending restarted. It is not hard to do--if the government bears all or
most of the risk. The Federal Reserve is, in effect, making major loans
to America's corporate giants, giving them a big advantage over
traditional job creators, America's small- and medium-size enterprises.
We have no idea if the Fed is doing a good job of assessing risk and
whether interest rates commensurate with the risks are being charged.
Given the Fed's recent record, there is no reason for confidence. But
there is a consensus that whatever the Fed is doing, it is not enough.

The Obama administration has floated a number of ideas, from buying the
bad assets and putting them into a "bad bank," leaving it to the
government to dispose of them; to providing insurance to the banks; to
assisting private investors (like hedge funds) to buy the bad assets,
presumably by lending to investors on favorable terms. Because of the
lack of details, the market greeted the Obama administration's
announcement of its so-called plan with dismay. As this article goes to
press, we can only guess that the administration's plan will be an
amalgam of several of these ideas. The devil is in the details, and
without the details we can't be sure how things will turn out.

An early idea floated by Paulson was for the government to buy the bad
assets from the banks. Naturally, Wall Street was delighted with this
idea. Who wouldn't want to offload their junk to the government at
inflated prices? The banks could get rid of some of these bad assets
now, but not at prices they would like. Then there are other assets that
the private sector wouldn't touch with a ten-foot pole. Some of them are
liabilities that can explode, eating up government funds like Pac-Man.
On September 15 AIG said it was short $20 billion. The next day, its
losses had grown to some $85 billion. A little later, when no one was
looking, there was a further dole, bringing the total to $150 billion.
Then on March 1, the government agreed to another $30 billion in
taxpayer money for AIG--the fourth intervention in less than six months.

Paulson's original proposal was thoroughly discredited, as the
difficulties of pricing and buying thousands of assets became apparent.
More recently a variant of this proposal, which involves government
buying garbage in bulk, was broached. But the major difficulty with
determining prices of toxic assets, whether singly or in bulk, remains:
pay too much and the government will suffer huge losses; pay too little
and the hole in the banks' balance sheets will still seem enormous,
requiring another bailout to recapitalize the banks.

Most variants of the "cash for trash" proposal are based on putting the
bad assets into a bad bank (advocates of the plan prefer the gentler
term "aggregator bank"). But the banks holding only good assets would
likely be short of cash, even after taxpayers had vastly overpaid for
the trash. The hope is that the banks would then find private funds to
further the recapitalization, though one suspects that the sovereign
wealth funds, to whom many turned a little while ago, would be less
interested, having been so badly burned before.

I believe that the bad bank, without nationalization, is a bad idea. We
should reject any plan that involves "cash for trash." It is another
example of the voodoo economics that has marked the financial
sector--the kind of alchemy that allowed the banks to slice and dice
F-rated subprime mortgages into supposedly A-rated securities. Somehow,
it is believed that moving the bad assets around into an aggregator bank
will create value. But I suspect that Wall Street is enthusiastic about
the plan not because bankers believe that government has a comparative
advantage in garbage disposal but because they hope for a nontransparent
bonanza from the Treasury in the form of high prices for their junk.

If the government takes over banks that don't meet the minimum capital
requirements, placing them in federal conservatorship, then these
pricing problems are no longer important. Under this scenario, pricing
is just an accounting entry between two pockets of the government.
Whether the government finds it useful to gather all the bad assets into
a bad bank is a matter of management: Norway chose not to; Sweden chose
to. But Sweden wasn't foolish enough to try to buy bad assets from
private banks, as many in America are advocating. It was only under
government ownership of the entire bank that the bad bank was created.
Norway's experience was perhaps somewhat better, but the circumstances
were different. Given the complexity and scale of the mess Wall Street
has gotten us into, I suspect we will want to gather the problems
together, net out the derivative positions (something that will be much
easier to do under conservatorship and a significant achievement in its
own right, with major benefits in risk reduction) and eventually
restructure and dispose of the assets.

More recently, another idea has been put forward: the government would
insure bank losses. By removing the risk of loss, the value of these
toxic assets automatically increases, improving the banks' balance
sheets. Bankers love this idea. The government can give them a big
insurance policy at a small premium. Politicians love this idea too:
there is at least a chance they will be out of Washington before the
bills come due.

But that's precisely the problem with this approach: we won't know for
years what it would do to the government's balance sheet. Six months
ago, what the banks told us about their losses going forward was totally
off the mark. AIG had to revise its losses by tens of billions of
dollars within days. Real estate prices might fall only another 5
percent, or they could fall another 25 percent. With the insurance
proposal, neither the government nor the banks have to admit the size of
the hole in the banks' balance sheets. It's another example of those
nontransparent transactions that got Wall Street into trouble.

Even worse, the insurance proposal exacerbates incentive distortions--it
moves us from a zero-sum world into a negative-sum world, where
increased taxpayer losses are greater than Wall Street's gains. The
insurance proposal may even inhibit banks from restructuring mortgages,
worsening the problem that gave rise to the crisis in the first place.
If they restructure the mortgage, they have to book a loss. If they keep
the mortgage and things get worse (the likely scenario), the taxpayer
picks up most of the downside risk; but if things get better and prices
improve, the banks keep the gains.

Still worse are proposals to try to enlist the private sector to buy the
trash. Right now, the prices the private sector is willing to pay are so
low that the banks aren't interested--it would make apparent the size of
the hole in banks' balance sheets. But if the government insures
private-sector investors--and even makes loans at favorable
terms--they'll be willing to pay a higher price. With enough insurance
and favorable enough loan terms, presto! We can make our banks solvent.

But there is a sleight-of-hand here: go back to the zero-sum principle.
The private sector is not going to provide money for nothing. It expects
a return for providing capital and bearing risk. But its cost of capital
is far higher than that of government. The losses are real, and the
private sector won't bear them without full compensation. This means
that the amount the government is likely to have to pay in the end is
all the greater.

This proposal, like so many others emanating from the banking community,
is based partially on the hope that if banks make things sufficiently
complex and nontransparent, no one will notice the gift to the banking
sector until it is too late. It appears as if they are at last getting
the high market prices that they hoped they would get all along. But it
would be a misnomer to call these market prices, since the government
has taken away the downside risk. This proposal has, of course, the
further advantage of drumming up support from the hedge funders, who so
far have not received any of the TARP bonanza.

There is an underlying problem facing all these proposals: the hole in
the banks' balance sheets is bigger than the $700 billion Congress has
approved--and much of what has been spent so far has been wasted. So the
financial wizards are turning to tried and true gimmicks--the same ones
that got us into the mess. One strategy is to hide the costs in
nontransparent accounting (easier under the insurance proposal). The
other combines this trickery with the magic of leveraging and pretends
that leveraging carries no risk. The government sets up a "special
investment vehicle" using, say, $100 billion of TARP as the "equity." It
then borrows another $900 billion from the Fed--which in rapid
succession has been tripling and quadrupling its balance sheet. Of
course, in doing so the Fed is risking taxpayers' money--but without
having to ask permission of Congress. At best, this is a deliberate
circumvention of democratic processes.

Is There an Alternative?

Firms often get into trouble--accumulating more debt than they can
repay. There is a time-honored way of resolving the problem, called
"financial reorganization," or bankruptcy. Bankruptcy scares many
people, but it shouldn't. All that happens is that the financial claims
on the firm get restructured. When the firm is in very bad trouble, the
shareholders get wiped out, and the bondholders become the new
shareholders. When things are less serious, some of the debt is
converted into equity. In any case, without the burden of monthly debt
payments, the firm can return to profitability. America is lucky in
having a particularly effective way of giving firms a fresh
start--Chapter 11 of our bankruptcy code, which has been used
repeatedly, for example, by the airlines. Airplanes keep flying; jobs
and assets are preserved. Under new management, and without the burden
of debt, the airline can go on making a contribution to our society.

Banks differ in only one respect. The failure of a bank results in
particular hardship to depositors and can lead to broader problems in
the economy. These are among the reasons that the government has
provided deposit insurance. But this means that when banks fail, the
government comes in to pick up the pieces--and this is different from
when the local pizza parlor fails. Worse still, long experience has
taught us that when banks are at risk of failure, their managers engage
in behaviors that risk losing even more taxpayer money. They may, for
instance, undertake big bets: if they win, they keep the proceeds; if
they lose, so what?--they would have died anyway. That's why we have
laws that say when a bank's capital is low, it should be shut down. We
don't wait for the till to be empty. Because the government is on the
hook for so much money, it has to take an active role in managing the
restructuring; even in the case of airline bankruptcy, courts typically
appoint someone to oversee the restructuring to make sure that the
claimants' interests are served.

Usually, the process is done smoothly. The government finds a healthy
bank to take over the failed bank. To get the healthy bank to do this,
it often has to "fill in the hole," making up for the difference between
the value of what the bank owes depositors and the value of the bank's
assets. It's no different from an ordinary takeover or merger, except
the government facilitates the process. Typically, in the process,
shareholders get wiped out, and often the government and/or private
investors may put in additional money.

Occasionally, the government can't find a healthy bank to take over the
failed bank. Then it has to take over the failed bank itself. Usually,
it restructures the bank, shutting down many of the branches and lending
departments with particularly bad track records. Then it sells the bank.
We can call this "temporary nationalization" if we want. But whatever we
call it, it's no big deal. Not surprisingly, the banks are trying to
scare us into believing that it would be the end of the world as we know
it. Of course, it can be done badly (Lehman Brothers, for example). But
there are far more examples of it being done well.

The current situation is only slightly different. There are few healthy
banks to take over the very many unhealthy banks, and the banks are in
such a mess--and the economy is in such a downturn--that we don't really
know how much money would be needed. We don't know if claims by
depositors are greater than the value of assets, and if so, by how much.
The banks may claim, If we hold the assets long enough, and if the real
estate market recovers, and if our recession isn't too deep or long,
then we can meet all our obligations. We are "solvent." We just can't
get the cash we need.

Those are big ifs. That's why governments typically make judgments based
on market values. Right now, the suspicion is that the banks don't meet
their capital requirements with current market values, let alone the
market values in the future, as real estate prices continue to fall and
the downturn gets worse. (If banks don't have enough capital, we would
give them short notice: either come up with additional capital, or you
can't continue to operate as you are. We either find someone to take you
over, or we run you, restructure and sell.)

The banks obviously don't want the government to play by the rules. They
want to delay the day of reckoning. They want what is called
forbearance. They say, Allow us a little slack now, because we are
fundamentally sound. Of course they would say that. Of course banks
claim that market prices underestimate true values. We learned the hard
way in the S&L crisis, however, that delay is very costly. We are on
track to learn that lesson again.

The Obama administration seems to be proposing a way out of this muddle:
we will "stress test." We will see how well you fare. If you pass the
test, we will help you get out of your temporary difficulties. Stress
testing involves using mathematical models to see what happens under
various scenarios. The banks were supposed to have been stress testing
themselves on an on-going basis. Their models said everything was fine
and dandy.

We know those models failed. What we don't know is whether the models
the administration will use will be any better. Will they use the old,
failed models? We have been told that it will take time to do the stress
test, and while we wait, will we pour more money into failing
institutions, with good money chasing bad, ever widening our national
debt. We know, too, that the worst-case scenarios that will be used in
the stress test are nowhere near the worst-case scenarios that some
economists are depicting--implying that even banks that pass the stress
test may need more funding down the line.

Gradually America is realizing that we must do something--now. We
already have a framework for dealing with banks whose capital is
inadequate. We should use it, and quickly, with perhaps some
modifications to take care of the unusual nature of today's problems.
There are several ways we can proceed. One innovative proposal (variants
of which have been floated by Willem Buiter at the London School of
Economics and by George Soros) entails the creation of a Good Bank.
Rather than dump the bad assets on the government, we would strip out
the good assets--those that can be easily priced. If the value of claims
by depositors and other claims that we decide need to be protected is
less than the value of the assets, then the government would write a
check to the Old Bank (we could call it the Bad Bank). If the reverse is
true, then the government would have a senior claim on the Old Bank. In
normal times, it would be easy to recapitalize the Good Bank privately.
These are not normal times, so the government might have to run the bank
for a while.

Meanwhile, the Old Bank would be left with the task of disposing of its
toxic assets as best it can. Because the Old Bank's capital is
inadequate, it couldn't take deposits, unless it found enough capital
privately to recapitalize itself. How much shareholders and bondholders
got would depend on how well management did in disposing of these
assets--and how well they did in ensuring that management didn't overpay

The Good Bank proposal has the advantage of avoiding the N-word:
nationalization. Some believe a more polite term, "conservatorship" as
it was called in the case of Fannie Mae, may be more palatable. It
should be clear, though, that whatever it is called, the Good Bank
proposal entails little more than playing by longstanding rules, a
variant of standard practices to deal with firms whose liabilities
exceed their assets.

Those who say the government cannot be trusted to allocate capital
efficiently sound unconvincing these days. After all, it's not as though
the private sector did a very good job. No peacetime government has
wasted resources on the scale of America's private financial system.
Wall Street's incentives structures were designed to encourage
shortsighted and excessively risky behavior. The bankers were supposed
to understand risk, but they did not understand the most elementary
principles of information asymmetry, risk correlation and fat-tailed
distributions. Most of them, while they may have been ethically
challenged, were really guided in their behavior by the perverse
incentives they championed. The result was that they did not even serve
their shareholders well; from 2004 to 2008, net profits of many of the
major banks were negative.

There is every reason to believe that a temporarily nationalized bank
will behave much better--even if most of the employees are still the
same--simply because we will have changed the perverse incentives.
Besides, a government-run bank might spend some time and money teaching
its employees about risk management, good lending practices, social
responsibility and ethics. The experience elsewhere, including in the
Scandinavian countries, shows that the whole process can be done
well--and when the economy is eventually restored to prosperity, the
profitable banks can be returned to the private sector. What is required
is not rocket science. Banks simply need to get back to what they were
supposed to do: lending money, on a prudent basis, to businesses and
households, based not just on collateral but on a good assessment of the
use to which borrowers will put the money and their ability to repay it.

Meanwhile, there needs to be an orderly plan for disposing of the old
bad assets. There is no magic in moving them around from one owner to
another. In some countries, government agencies (often hiring private
subcontractors) have done a good job of selling off the assets. Other
countries (including some hit in the East Asia crisis a decade ago) have
had an unfortunate experience, bringing in investment banks and hedge
funds to dispose of their assets. These institutions simply held them
for the short time it took the economy to recover and made a huge
capital gain at the expense of the country's taxpayers. To add insult to
injury, some even took advantage of tax havens to avoid paying taxes on
those huge profits. These experiences suggest caution in turning to
hedge funds and other investment firms.

Every downturn comes to an end. Eventually we will be able to sell the
restructured banks at a good price--though, one hopes, not one based on
the irrational exuberant expectation of another financial bubble. The
notion that we will make a profit from the bailouts--which the financial
sector tried to convince us were "investments"--seems to have dropped
from public discourse. But at least we can use the proceeds of the
eventual sale of the restructured banks to pay down the huge deficit
that this financial debacle will have brought onto our nation.

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