In Search of One Bold Stroke to Save the Banks

[depakid]

One of the better pieces witten in lay language about the need for systemic solutions:

In the immortal words of Yogi Berra, it’s déjà vu all over again. Wasn’t it just four months ago that the government was racing to save the American International Group, forcing the sale of weak banks and writing huge checks to stabilize the teetering banking system? The worst was over — or so we were given to believe.

It sure hasn’t worked out that way. In November, not long after it was handed $25 billion in new capital, Citigroup was back for more — another $20 billion in bailout money and a government backstop of more than $300 billion in potential losses. This week, alas, it’s Bank of America’s turn. It came crawling back because of the huge write-down of its shiny new toy, Merrill Lynch. It got another $20 billion and a backstop against losses of $118 billion in troubled assets. There are rumors that Wells Fargo might also need more capital.

When is it going to end? Because of declining asset values, the original bailout money has largely disappeared. “It’s like putting money in a pothole that keeps getting bigger,” said Daniel Alpert, the managing partner at Westwood Capital....

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...That initial recapitalization was necessary. Without that government-financed capital, many more banks would have been insolvent, or would have been hoarding capital, fearing future asset write-downs. But the underlying problem has never gone away. The toxic assets are still on the books. Banks still don’t really know what they are worth, so they continue to be written down in piecemeal fashion....

(A quick reminder for readers who wonder why the banks shouldn’t be allowed to go bankrupt, like any other company that made the kinds of mistakes banks made. The answer is that the banking system is the engine of the economy; if banks stop functioning, economic activity will grind to a halt. Indeed, at least some of the pain we are going through now is the result of the banking system’s not functioning properly.)

The key point here is that any systemic solution has to deal with the bad assets, once and for all. They need to be properly valued and they need to be isolated. “How do you know how big the hole is on the balance sheet of Citi until you have a decent valuation?” asks the Princeton economist Alan Blinder. That is the primary reason the banking system can’t attract private capital and has to rely on the government — no prospective investor has any idea how deep the hole is. That will start to become clear only when these assets are either written down to zero (unlikely) or start trading again.

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Simon Johnson, a professor at the Sloan School of Management at M.I.T., and a well-known blogger on banking issues, says he believes that it will take $1 trillion to really do the trick — money, presumably, the government will get back once the banking system is healthy again, and private capital comes in to replace the government’s capital.

“It’s not rocket science,” Mr. Johnson said. “When you do a recap, you need overkill. But then, you also have to take the bad assets off the books.” In the recent deals it cut with Citi and Bank of America, the government tried to “ring-fence” bad assets — that’s its phrase, not mine — by agreeing to absorb losses on securities that have been identified as toxic. But that is still a piecemeal, one-bank-at-a-time approach.

Mr. Blinder, a former Fed governor, told me that he thought the government should be thinking about the entire problem differently: “It should go market to market instead of institution to institution.” He pointed to actions by the Federal Reserve as a possible model: it has revived the commercial paper market by creating a commercial paper funding facility — and has done the same with several other important debt markets. In effect, it is guaranteeing the smooth functioning of those markets. And that approach has worked.

More: http://www.nytimes.com/2009/01/17/business/17nocera.html?hp

The article ends with the sentiment: "Inauguration Day can’t come a moment too soon."