February 3, 2009

What to Do about Banks

In a way, one good bank solution is simply to continue existing strategies, with an emphasis on resolving which banks are solvent.

Consider -- if you have Washington Mutual branches in your city, you may have noticed they are still there and still in business. They just have different owners. We can trust our current process for handling insolvent banks -- it works well.

When TARP investments were initially injected into banks, the main objective was to stop the accelerating general bank run.

Enough time had passed before TARP that many of the worst actors -- CountryWide, Washington Mutual, IndyMac, Bear Stearns, Lehman -- had been removed or absorbed. The initial necessity to let market discipline take out the worst actors had been accomplished, and when Wachovia was taken out it began to look like enough had been done in terms of an object lesson and it was time to begin the recapitalization.

There is no fundamental reason why the whole previous plan isn't still a good approach, but there is a reality that some banks that looked ok, like Bank of America, were not so ok. In Bank of America's case, the late acquisitions of CountryWide and especially Merrill began to weigh down this previously strong bank, showing that it's never too late for mismanagement during a crisis.

At this point, we (literally all of us US taxpayers) are now on the hook for Bank of America's choices, which complicates what could otherwise be such a simple proposition:

Let them fail, and let FDIC, with taxpayer money, reimburse the depositors to the FDIC limit.

At this point though, we've already put big money into many remaining banks, so....

....it's time to consider what FDR did shortly after taking office in the midst of a continuing bank crisis more severe in some ways than we face now, but not so much more severe in other ways.

He weeded out the bad banks and created a convincing guarantee of the remaining "good" banks, ending the bank crisis in 1933. This was one of FDR's greatest successes.

We could do the same now.

We won't need a general bank holiday, as some work has already been done. The step here for us now is to investigate which banks are really too close to the edge, and put them into the arms of the FDIC a little sooner.

Essentially, we'd just make the FDIC uptake process more aggressive and put in the taxpayer dollars the FDIC will need as determined during the examination phase.

What are the presumptions about house prices (or commercial real estate, etc.)? Exactly that the bubble in the Case-Shiller price graph(s) will be erased fully, so that prices return to levels of the year 2002 (this accounts for inflation). We can then simply extrapolate defaults from current trends. This will yield a reasonable prediction of the near future cash flow value for mortgage backed securities and their derivatives. Similar principles can be applied to commercial real estate, and using trend extrapolation can even be applied to credit card lending, etc. Some banks will then be clearly insolvent, by more than a few percent of their nominal assets. These are rounded up and sent to the FDIC.

The political way to present this is we are fulfilling the FDIC promise we have made to each other as a nation. It's money we are paying ourselves.

And then, once more bad banks are removed, we can recapitalize the survivors in proportion to their assets at market value, thus proportionally favoring the stronger banks -- adding more lending power to those lenders that have shown better management. When a bank's assets are of high quality, it then proportionally receives *more* new capital, not less. We want to put loan decision making into the hands of better decision makers.

As to how to recapitalize, in addition to the proportional-to-asset-market-price principle, taxpayers must gain ownership stakes in exchange for their money, like any stockholders naturally have. Stock is a perfectly fine method.

The percentage of taxpayer ownership that results is less relevant than simply the fact that taxpayers aren't victims in a transfer of wealth. No. Something a little more just happens.

Taxpayers are the investors. They have voting rights, which could be administered by a congressionally-appointed board. Their shares can gradually be sold at a profit, 5 or 10 years from now.

Instead of a taxpayer rip off, we have a taxpayer investment.

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