"What is the least bad option?": Unfortunately, It's Not What They Recommend

From the WSJ, the following post:

"Following the fresh declines in markets, Peter Boone and Simon Johnson argue that the TARP is no longer succeeding in stabilizing markets. Below they lay out the government’s options. Boone is chairman of Effective Intervention, a U.K.-based charity, and a research associate at the Centre for Economic Performance, London School of Economics, and Johnson is a former IMF chief economist, and is currently a professor at MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. They run the economic crisis Web site http://BaselineScenario.com.

Treasury Secretary Henry Paulson announced earlier this week that the Troubled Asset Relief Program (TARP) has succeeded in stabilizing the U.S. banking system. This unfortunately no longer appears to be the case.

It is true that immediate financial meltdown was averted in mid-October through a dramatic bank recapitalization program. This convinced the market that leading banks were less likely to default and turned around debt prices.

But the share prices of major banks have declined steadily since that intervention and fell again sharply yesterday. The numbers now are remarkable. The market capitalization for Citigroup is below $40 billion. This is a bank with a $2.05trillion balance sheet, plus substantial off-balance-sheet liabilities that yet may come back on balance sheet. And it is not alone. For example, the market capitalization yesterday for Bank of America was under $70 billion, while its balance sheet is around $1.7 trillion. Some top banks are now worth less than their Tier 1 capital, which means that investors expect large or at least uncertain future losses.

The market view is clear: a severe recession is coming and big banks need a lot more capital. The private sector won’t provide enough. Despite the G-7 statement in October that systemic banks will no longer fail and despite the promises implicit in the TARP, no one knows what will happen as the economic outlook worsens. The particularly worrying development on Wednesday was that credit default swap spreads jumped (again) for some major banks — in at least one case, rising to over 350 basis points for the first time since the bank recapitalization program took effect. There is a real danger that access to private finance for major banks will dry up completely."

This is completely correct. The markets are completely focused on the government. There is no Plan B. At this point, non-intervention would result in an even worse eruption of fear and avoidance of risk, which I see to be the main problem now.

"In effect, the market is testing the government, pushing to find out how far it will let market conditions for banks deteriorate. The situation is analogous to that of a fixed exchange-rate regime, in which investors test how long a government is willing to hold a particular exchange rate. Eventually, the costs of holding the exchange rate may be too high and there will be devaluation, so why not get out now? Selling the currency, in that situation, is a one way bet. U.S. bank stocks and debt currently feel like the same sort of one-way bet to many. The solution to such crises requires two key ingredients: a credible plan, and actions to ensure that investors betting against the plan lose money. What is the right plan?

Doing nothing is not really an option. There is a risk that corporations, hedge funds and others will reduce their exposure to the most problematic banks, and this would effectively be a run. You can forestall collapse with massive quiet Fed support, but this is not even a band-aid. Problems easily spread to other banks and exacerbate problems on Main Street, as banks scramble to raise capital and liquidity by contracting credit, selling assets and competing with high deposit rates to find funds."

This is also correct, and explains, for example, why the servicers and managers and owners of bundled assets are unwilling to negotiate more settlements. The alternative will be awful, and they'd just as soon wait for a possible government plan. In essence, there is a Flight From Risk that only the government can combat .

"There are no good options, but three of the less bad choices are:

1. Repeat a TARP-type injection of capital, on similar financial terms, to all systemically important institutions. This will achieve a great deal: investors betting against the major banks in credit markets lose money, and — since the TARP terms are generous to current owners — some bank equity prices likely rally. Next time everyone will be more reluctant to bet against the banks. This plan is expensive — the entire remaining $410 billion in TARP may need to be deployed in this fashion. But the real problem is that, because the TARP terms were so favorable and the debate over auto makers has exacerbated bailout fatigue, there is dangerously little political will to support such actions.

2. Recapitalize the most troubled banks, but make the financial terms tougher. Banks cannot afford to pay much higher interest rates, but the government could take more warrants (i.e., options to buy common stock). This heads towards nationalization — if the government invests $50 billion in Citigroup on the same terms that Warren Buffett invested in Goldman Sachs, the tax payer will effectively get control. The message to markets will be: sell equities now because the government is set to effectively nationalize, but at least creditors would feel safe.

3. Some banks go into conservatorship, while all other banks get large new injections on original TARP terms. This would prevent contagion from failed banks to others, and it would penalize equity investors betting against “good” banks. However, some massive banks would probably see their business go under and this would prove highly costly for the government.

I'm for 2, although in an even stronger and clearer form.

"What is the least bad option? You need to keep the major banks private and able to raise capital again when the economy recovers, so option 3 is not appealing and this also puts a cap on the warrants in option 2. You can only keep the purely private route open with terms similar to what TARP offered, which is option 1. This will be unpopular. The only way to make this intervention at all palatable is by capping executive pay and benefits (perhaps they should sell their private jets and fly commercial?), and encouraging departures (without parachutes) at banks where confidence in management has been lost.

The message from a new TARP capital injection will be that America stands behind its commitment to systemically important financial institutions. But there is a good chance these commitments will need to be reinforced with still further TARP-type capital rounds in the future. This is the cost of the administration’s growing lack of market credibility, helped by the numerous abrupt (often warranted, but poorly explained) policy changes emanating from the Treasury, and the prospect of a very severe recession.

One longer term approach may now appeal to the Federal Reserve, i.e., a more expansionary monetary policy steepens the yield curve, raising profitability for banks and generating sufficient inflation. This is not without substantial risks, but house prices recover. Most large banks can and should survive in that scenario."

They make quite a bit of sense, given the current situation, but I still don't agree. This hybrid approach is a big reason that this government intervention is working so poorly, and the abrupt policy changes are built into a hybrid plan. Having said that, I doubt that 2 or something like it will happen.