NorCalSavant

source: www.cnbc.com/id/28935289

The economy is still floundering and there are no signs of it bottoming out even in the near future.  The economic engine continues to be sluggish for many reasons.   One reason has been the lack of easy credit, the grease that lets the moving parts move when stopped, and move better and faster when tripping.  The credit crisis is still continuing to strangle the economy.

If you wonder, wasn’t TARP which was a part of the concerted federal response last fall, supposed to have taken care of that – well you are not alone.  The short and unfortunate answer is that Hank Paulson and other Treasury officials of the Bush administration mismanaged the first half of the TARP program.  The best that can be said about their execution is that no more banks have disastrously failed, although things haven’t turned around for the better the way they were expected to.

It reminds me of the execution of war on terror by Bush and others in his administration.  The war on terror initiated in response to 9/11 hasn’t captured the mastermind behind it because of a dilution of the focus of its execution.  The best that can be said about it is that there were no more terrorist attacks on the US soil.  Maybe, I am too demanding.  I wanted and still want bin Laden captured in addition to absolutely no more terrorist attacks.  But, I digress…..

TARP and the Failed Toxic Assets Rescue

Treasury officials used the first half of TARP funds to pump money into banks rather than purchasing their toxic mortgage-backed assets as per the original plan.  So far, Treasury has pumped about 200 billion dollars into over 200 banks in the form of preferred stock.  These shares return a 5 percent annual dividend the first five years and 9 percent after that.  The banks have the option to buy back the shares from Treasury after three years.  Participating banks need Treasury’s approval before increasing their dividends and have to agree to certain limits on executive compensation.  There were few other requirements.

So, how did the banks see this manna from heaven (read Treasury)?  An overwhelming majority of banks considered TARP funds as a no-strings-attached windfall that could be used for anything they wanted – to pay down debt, acquire other businesses, or invest for the future.  The bailout money was used by many banks for improving capital ratios – the amount of money available to absorb losses – for banks that merge.  There was no significant increase in consumer lending.

So what if the Treasury did not require them to lend the money they received from the government?  Why wouldn’t the banks lend those funds out voluntarily and make a profit?  Many banks not holding toxic assets are reluctant to lend in this economic environment, worrying about new loans going bad if the economy deteriorates.  Those holding toxic assets are hoarding capital, fearing future assets write-down.

Banks are reluctant to write down bad assets till they can raise enough capital to stay solvent.  However, they cannot raise private capital unless their books are cleared of the toxic assets, a classic Catch-22 situation.

Banks can’t lend because of the bad assets on their books, letting the economy to continue to nosedive for lack of credit.  A deteriorating economy is not conducive to banks making money and recirculating the profits into fresh lending for economic growth, another Catch-22.

The economic mess can not be sorted unless banks begin lending to consumers again.  There is a renewed push to deal with the banks’ toxic assets à la TARP classic.  That is to say a systemic solution has to be found to deal with the toxic assets for once and for all.

Options to Deal with Banks’ Toxic Assets

Two major options have been advanced for it.  One option is the nationalization of large banks holding toxic assets teetering on the brink of failure.  The other option is creating a so-called bad bank.  Both options are associated with political, fiscal and other problems.

Nationalization would mean government owning at least a controlling majority of shares in the bank and in effect guaranteeing bank solvency.  As the nationalized banks rejoin commerce with other banks, institutions and consumers, and make money as a consequence, the toxic assets slowly get written off the books.  Eventually, the nationalized banks return to healthy balance sheets, at which point the government can sell its shares back in the market.  The government gets its money back, the banks are private again, and everybody can be happy and back to business as usual.

When we talk about bank nationalization, we instinctively wonder why can’t they find private money.  It is important to understand that these banks are simply too risky at this time with their undefined toxic asset valuations for any private money investment.  Government infusion of money is the only option to save these banks.  And not saving these banks is not an option because of the disastrous consequence of letting them fail on the economy.

However, nationalization in all its perceived connotations is politically a dirty word.  Government cannot run a business because it doesn’t know how.  Government run business could be unduly affected by political influence.  And the list goes on.  These are all legitimate concerns, but are easily manageable given the extraordinary circumstances.  Political will could be easily exercised to sell government owned equity as soon as appropriate, i.e. when in the black.  The business management could be easily quarantined from political influence.  However, political advantages can be and will be gained easily by wrongfully invoking slippery slope arguments to the rightfully dreaded philosophies of communism and socialism.

Another option is for the government to set up a fund or a bad bank to buy the banks’ most toxic assets.  However, then the taxpayers will be stuck with the banks’ worst assets and none of their performing loans.  Resolution Trust Corporation set up in 1989 after the savings and loans fiasco to solve a similar problem ultimately cost the taxpayers about 124 billion dollars.  And that was a much smaller financial crisis than this one.

Given the political heebie-jeebies associated with nationalization, it is more likely that the government action to deal with the banks’ toxic assets will leave the taxpayers with a bill much bigger than 124 billion dollars.  There is little likelihood for the government action to be a pragmatic solution which doesn’t waste taxpayers’ money.

What do you think?

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