Bad Bank, Bad!

Unwilling to take the plain fact that most banks are insolvent to its logical conclusion, it looks like the latest idea from the Obama Administration is to create a "bad bank" to warehouse all the toxic assets mucking up the balance sheets of the financial titans, until the economy recovers and they can be sold, possibly at a profit. This only way this works for the banks is if the government essentially buys the assets well above current value. If they buy them at face value to store in the "bad bank," the so-called "good banks" couldn't survive because they would all be insolvent. In other words, this is the same idea that was the initial impetus of the TARP program, where the government would buy up all these troubled assets. Paul Krugman put it in joke form:

As the Obama administration apparently prepares to launch Hankie Pankie II — buying troubled assets from banks at prices higher than they will fetch on the open market — it occurred to me that an updated version of an old Communist-era joke may be appropriate: under Bush, financial policy consisted of Wall Street types cutting sweet deals, at taxpayer expense, for Wall Street types. Under Obama, it’s precisely the reverse.

It seems that the Administration and its Treasury Secretary are misunderstanding who they serve - or perhaps understanding too much. As Barry Ritholtz explains, the emphasis is being put on saving the current private banking system. Geithner has said “We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system.”

No! Defending these idiots was your old gig. In the new job, you no longer work for the cretins responsible for bringing down the global economy. Please stop rationalizing their behavior, and preserving the status quo!

Yesterday’s 13% surge in bank stocks is a clue as to what an obscene taxpayer giveaway this “bad bank” plan is — its free money for the firms that caused the problems, many of whom still have the same incompetent management in place that caused the problem. Purging toxic assets from bank balance sheets, without punishing the management, shareholders and creditors of these institutions for their horrific judgment will only encourage more of the same in the future. Its moral hazard writ large.

Dean Baker also spells this out. We're trying to resuscitate a patient who has flatlined. The banks are insolvent; they have more liabilities than assets. And nothing is going to change that. Keeping them in business will mean another in a series of taxpayer giveaways where the public pays for the fiction that the banks can be saved. But, if nationalization remains such a dirty word, Baker has an idea.

While the more obvious way to deal with the problem is to simply take over the bankrupt banks, and then put their junk in a bad bank, like with we did with the bankrupt thrifts in the 80s, there is a relatively easy way to limit the extent to which the bad bank is simply bank welfare.

We can just attach a clawback provision, under which the bank will be forced to make up any money that the bad bank loses on their junk, plus a penalty. For example, if Citibank sells $100 billion in junk, and the bad bank ends up selling it for $70 billion, then Citibank has to cover this $30 billion loss, plus a 20 percent penalty ($6 billion). This structure will both ensure that Citibank doesn't run off with our money and also discourage banks from trying to mislead the bad bank about the true value of their junk. (Senator Dodd proposed a similar measure in the debate over the TARP.)

If investors like sovereign wealth funds, who hold lots of our debt, are angered by any threat to their assets and won't stand for it without causing major shocks to the financial system, that's one other element to consider. However, policymakers increasingly will not stand for privatizing profits and socializing risk. Republicans will knee-jerk oppose it because Democrats brought it up, and there's enough of a coalition on the left for that to fail. There had better be meaningful provisions in here that protects taxpayers instead of just savin the bacon of executives.