Sec. Geithner (a former Gold/Sacks exec and Paulson protégée) has proposed a "bad bank" solution to the insolvency of the financial sector. Similar to the original TARP proposal, the taxpayer funded bad bank would go around buying up toxic assets from the financial institutions with our money. Our bi-polar politicians tend to divide the solution set into: 1) a (bad) socialist "nationalization" solution like they used in Sweden, or 2) the TARP/bad bank type of (good) public/private "partnership" like they tried in Japan's lost decade. Let’s look at something deeper than just the labels in the debate.
Wall Street's negative reaction to Geitner's approach isn't caused by the talking head's "lack of specifics", it's because this is a BIG problem, far larger than his puny $350B:
The total size of the US banks asset problem is $2 Trillion, a much larger amount than the Geithner plan addresses. In addition, there are foreign banks that hold $1 Trillion of troubled US assets. The market knows this and that is why the Geithner plan fell so flat. There is no way to fairly value the problem assets. Either you kill the banks or you cheat the taxpayers. This has always been a fatal flaw of the Bad Bank approach.
So the Bad Bank solution is going to require the Treasury to print up 2.5 Trillion Dollars, just like Mugabe does. Murdock’s WSJ thinks that nationalization is the "other N-word" and is predictably in favor of socializing the RISK through the bad bank approach but would leave the rewards in management's private hands. They predicts dire consequences if we don't:
By not adopting the good bad-bank solution, the system remains as corrupted as before. The bad assets will continue to suck resources out of the economic system in the form of zombie borrowers, misallocation and mis-pricing of capital, public sector debt, and budget deficits.
There seems to be at least three major issues in the bad bank approach: How to value the assets, what other controls to place on the financial sector, and what to do with the executives that caused the problems, the so-called moral hazard. As Neil Grossman at Huffington Post says:
If the government has to bail out these institutions, make sure the taxpayer is really protected. Leave future asset appreciation in our hands and make sure management does not reap windfalls.
The issue is succinctly summed-up by Nobel laureate Joseph Stiglitz as swapping taxpayer’s "cash for trash". Nobel Prize winner Paul Krugman is jaded by Paulson’s give away of the first $350 Billion:
It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it — and that if only we get the price "right", the banks will turn out to be solvent after all. . . Color me skeptical. I hope the buzz is wrong, and that something more substantive is being planned. Otherwise, were looking at Hankie Pankie II: Paulson may be gone, but officials are still determined to believe in financial magic.
The valuation problem is developed in the following hypothetical:
The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors. . . "To date, the banks have stuck their heads in the sand," said Lynn E. Turner, a former chief accountant for the Securities and Exchange Commission, "and demanded that they be paid the price of good apples for bad apples."
Gerald Epstein at U of Mass sees the false paradigm of the bad bank as an extension of the trickle down theory ripe with moral hazard:
But, in fact, the "bad bank" approach IS a type of nationalization: it's just that we nationalize the bad stuff and virtually give away the good stuff. And we leave the bankers who caused this mess right there in the economy's driver's seat, just as before. Obama's economic team hopes the "bad bank" policy will allow the banks to raise private capital from the market, and to start lending again with the idea that this will contribute to an economic revival. But, more likely, it will prove to be a failed attempt to hit the financial "restart" button, to try to fix the banks up as they were before and hope their prosperity will "trickle down" to the rest.
The proto-typical example of nationalization is Sweden in the 1990's that had a similar housing bubble burst. That country's successful program is summarized:
Sweden . . . managed to survive their housing crisis. However, it took bold and dramatic action to solve the problem. They nationalized the banks -- cleaned them up. And then resold them after a few years. Eventually the US may have to go down that road, rather than trying to pussyfoot around with partial solutions like "bad banks" and "public-private partnerships." It is a much cleaner solution, and one that has been shown to work in the past, albeit on a much smaller scale.
Greg Mankiw, Econ Prof at Harvard breaks through the definitional clutter to focus on results when he
says:
If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure. . . Bankruptcy could become, in effect, a massive bank recapitalization. Essentially, the equity holders are told, "Go away, you have been zeroed out." The debt holders are told, "Congratulations, you are the new equity holders." Suddenly, these financial organizations have a lot more equity capital and not a shred of debt! And all done without a penny of taxpayer money! . . . But there is one thing I am sure of: If this is the route we go down, the government had better get in and out as quickly as possible. If it is done right, nationalization will be the wrong word to describe the process.
IMHO, more billions thrown at the existing structure will just be burned up in a giant bonfire of corporate diversion and waste by the present management class. I would also reject calls to supposedly restore confidence in banks by letting them lie on their balance sheets about how toxic their assets really are, by suspending the mark to market rule. Geithner says that we have more banks than Sweden. But, isn't he getting paid more than the Swedish Treasury guy that cleaned up their mess? We just need to get going pronto, or we can join Japan in losing a decade. Whenever you hear the pundits talking up the "Bad Bank" concept, listen carefully to see how they are going to value the assets the banks are going to sell us. Are the private "Vulture" partners going to get to rip us off? Without taxpayer control, what limits are going to be put on banks with our "free" money? It took MONTHS to get some real limits to executive compensation; what about planes, lobbying, acquisitions, mergers, resorts, dividends, prostitutes, and all the other things that inventive "Wall Street Talent" can imagine? (It’s not a prohibited bonus but a "retention payment") Author and market observer Martin Mayer warned:
A lot of what is called innovative is simply a way to find new technology to do that which was forbidden with the old technology.
With FDIC/bankruptcy receivers running the show, we don’t have to worry about valuation, diversion or rewarding the bad actors for their mess. We WOULD have to worry about the Saudi family members who are substantial shareholders in Citi and would get wiped out in a FDIC takeover/bankruptcy. Saudi Prince Alwaleed bin Talal is the largest individual stockholder in Citi.