bad bank is not really a bank at all. It is a special purpose vehicle, similar to those off-balance sheet vehicles that triggered this crisis

TO BE NOTED: From the FT:

"Germany needs more than an accounting trick

By Wolfgang Münchau

Published: May 17 2009 19:31 | Last updated: May 17 2009 19:31

After the US, the country with the biggest banking problem is probably Germany. Last week the German cabinet adopted a bank rescue plan worth looking at in detail. If you want to know how long the European crisis will last, this might give you the answer.

The Geithner/Summers plan in the US has two fundamental planks – a strategy to ring-fence structured finance products for which there is no market, and a strategy to recapitalise the banking system. Both seem to be based on unrealistically optimistic assumptions about the economic recovery. And both have been criticised sharply, mainly for that reason.

The German scheme is constructed very differently. It is a ring-fencing plan only and it is voluntary. Under the draft legislation put forward by the German government last week, a bank can apply to set up its own bad bank. A bad bank is not really a bank at all. It is a special purpose vehicle, similar to those off-balance sheet vehicles that triggered this crisis in the first place. The proposed SPV will have a shelf life of up to 20 years. It buys the structured securities from the bank at 90 per cent of book value – the price at which the securities are currently valued on the balance sheet. In return, the SPV issues new debt securities to the bank, guaranteed by the government. So if a bank shifts structured securities with a notional value of €10bn ($13.5bn, £8.9bn) to the SPV, it gets €9bn in good securities back. The state is the guarantor. The idea is to give the banks an incentive to lend again.

Will it work?

The answer is: not in the way that has been proposed. First of all, the plan is a giant accounting trick. Under fair-value accounting, it could not possibly work because the bank would have to make a provision for future losses of the SPV. This would, of course, defeat the very purpose of the plan. It is constructed in the same spirit as some of the more eccentric debt securities.

The fundamental problem is that the strategy might actually deter recapitalisation, which surely should be a priority. Under the plan the bank, not the government, is fully responsible for the SPV’s losses. So if the SPV sells the securities at a loss, the bank will have to pay for the loss out of earnings. So the bank will have to divert an uncertain proportion of its future earnings to pay off the SPV’s losses, and all this for up to 20 years. Which private investor in their right mind would provide new equity capital to a bank under such conditions?

A spokesman for the federation of Germany’s private banks made a good analogy when he compared the scheme to a deep freezer. The banks are trying to buy time. When the crisis is over, they hope that the structured securities can be sold at reasonable prices. Until that happens nothing is resolved.

Why did the government opt for such an obviously daft plan? The answer is because it costs next to nothing. There is only a cost to the government if the SPV goes bankrupt, which is not going to happen soon, if at all. The SPV even pays a fee to the government to cover the expense of issuing the guarantee. So the scheme tries to be the equivalent of a free lunch.

But it is only cost-free in a narrow accounting sense. The economic costs are huge. Last week the German government was told that the tax shortfall would be €300bn over three years – two-thirds of that due to the crisis. If you split the loss evenly over the three years, the pure tax effect of the crisis makes up some 3 per cent of gross domestic product for three years running. Not bailing out the banks will almost certainly end up being more costly than bailing out the banks. But a bail-out would be unpopular, and the government does not want to touch this issue until the federal elections in September. Until then, we have an insufficient ring-fencing plan only.

What about after the elections? Will there be a better plan then?

I am not sure. Peer Steinbrück, Germany’s finance minister, last week gave a characteristically belligerent comment about the US stress tests – effectively accusing the US authorities of fixing the results. His position is that recapitalisation is primarily a problem for the banks, not the government. If the state were to recapitalise the banks, his scheme might just work, but without it, it cannot. No sane private investors are going to pour money into a structure whose obvious purpose is to deceive them.

The German political classes have yet to comprehend that recapitalisation is necessary, and that it will end up costing the taxpayer a lot of money. The plan as it stands now offers no resolution, only procrastination. While US banks have already written off a fair proportion of the bad debts, the Europeans are adopting schemes that allow the banks to postpone resolution.

The more I think about it, the more I am reminded of Japan. But this might be unfair to the Japanese. They solved the problem eventually. If we freeze our toxic securities for 20 years, a Japanese-style lost decade will soon come to be regarded as the optimistic scenario."

Rather than taking over and running banks, the FDIC should split each bank into two parts.

TO BE NOTED: From the WSJ:

"Banks Need Fewer Carrots and More Sticks

Insolvent institutions should be taken over by the FDIC.

By R. GLENN HUBBARD , HAL SCOTT and LUIGI ZINGALES

The results of bank stress tests -- expected tomorrow -- will no doubt prompt calls for further government guarantees and capital injections. But continuing to prop up the banks with government cash is a mistake. There is a better approach.

Getty Images

A well-capitalized banking sector is a necessary ingredient for effective intermediation and economic recovery. But today's system is not well-capitalized. How can we move in the right direction?

In a market economy, the government can create the right incentives by using a combination of carrots and sticks. Thus far, the government has only used carrots with the banks. One major carrot is the Troubled Asset Relief Program (TARP). The initial infusions were very generous -- the Treasury got back securities worth $78 billion less than the $254 billion it invested -- as the Congressional Oversight Panel pointed out recently. In addition, the FDIC's guarantee of short-term debt was worth $100 billion just for the original nine TARP-participating banks. And the mortgage-related asset guarantees offered to Citibank and Bank of America were worth tens of billions of dollars more.

A new round of expensive TARP injections -- by converting the government's preferred stock into equity -- may follow the release of the stress-test results. In addition, the Treasury's Public-Private Investment Program (PPIP) plans to subsidize the purchase of banks' "toxic assets" by hedge funds and other investors. We estimate that the government will spend $2 for every $1 the private sector will put in. Yet even with this large subsidy, PPIP's chance for success is low because of the substantial gulf between the bid and ask prices on the toxic assets, and the reluctance of investors to partner with the government.

Not only is the carrot approach not jump-starting lending, it is also angering the American people. It's hard to justify to taxpayers that we need to reward the same group of people who, rightly or wrongly, are perceived as responsible for the current situation.

It's time for government to use the stick, beginning with creditors. The first step should be an announcement that the FDIC guarantees of short-term debt, set to expire at the end of October, will not be renewed. Insolvent banks -- defined not by stress tests, but as those that cannot fund themselves in the private market -- will be taken over by the FDIC. Of course, this takeover plan must be clear and credible. Otherwise creditors will play "chicken" with the government, knowing that at the last minute the government will flinch and fail to remove the guarantees.

Despite the clarity of such an approach, the market might be skeptical for several reasons. First of all, the FDIC lacks the staff to oversee, let alone run, several large and complex banks which may become insolvent. Second, the FDIC's main approach so far, as with Washington Mutual and IndyMac, has been to restructure the banks for acquisition. The trouble with this plan is that it is unclear who will buy the largest banks in the near future. Finally, it is politically unappealing to have a government institution run a significant fraction of our banking sector. Waiving the specter of nationalization, the creditors may try to force the government to bail them out.

We believe these problems can largely be avoided by adopting a simple approach. Rather than taking over and running banks, the FDIC should split each bank into two parts. One part ("the bad bank") will assume all the residential and commercial real-estate loans and securitized mortgages as assets, and all the long-term debt as liabilities. In addition, "the bad bank" will obtain a loan from the "good bank." This loan is necessary because the long-term debt of the old bank is not likely to be sufficient to fund the assets of the bad bank. The good bank will have all the remaining assets, including derivative contracts and its loan to the bad bank. It will have all the insured deposits and the FDIC-guaranteed short-term debt as liabilities. Once the split is accomplished, the good bank can be cut loose from FDIC receivership.

On the one hand, this split separates the toxic assets, whose value is very uncertain, in an institution that has no insured or guaranteed liabilities and poses no systemic risk. The bad bank will be like a closed-end mutual fund and can be run as such. The good bank will be well-capitalized, and the value of its assets will be clear.

The losers in this reshuffling are the long-term debtholders who get stuck in the bad bank. For this reason, we propose that they be compensated by receiving all the equity of the good bank. The old shareholders will get the equity in the bad bank. (In any restructuring, bondholders should do better than equity.) And the FDIC minimizes its risk because it guarantees the deposits in the good bank.

In fact, long-term debtholders who have debt claims against the bad bank and equity claims against the good bank will be better off under this plan than if the bank were liquidated or continued to operate as one bank. If the bank were liquidated, bondholders would stand to lose almost all their investment. If the bank continues to operate with government subsidies, the benefit of the subsidies are shared by both debt and equity. Under our plan, the debtholders will get all of the equity in the "good bank" and therefore all the upside of its future performance.

One of the major objections to letting banks fail is the argument that they are not really insolvent; they are just facing a temporary dislocation in the marketplace. But if this observation were true, the bad bank would surge in value, and the old shareholders of the banks, who received the shares in the bad bank, would gain. If it is false, the bad bank would default and the old shareholders would receive nothing (as they should).

In order for this plan to work, legislation would need to take effect before the withdrawal of the FDIC guarantee in October, so that FDIC procedures for handling failed banks can be applied to bank-holding companies. FDIC Chairman Sheila Bair has called for such legislation. Most importantly, this plan won't impose any new cost on the taxpayer.

Bold stress tests and government intervention reflect President Obama's use of Franklin Delano Roosevelt as a model in dealing with the current crisis. But he got the wrong Roosevelt. He should instead follow the motto of Theodore Roosevelt: Speak softly and carry a big stick.

Mr. Hubbard, dean and professor of finance and economics at Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Scott is a professor of international financial systems at Harvard Law School. Mr. Zingales is professor of entrepreneurship and finance at the Chicago Booth School of Business."

Whitney argues that the real problem is that banks are disinclined to lend

From the FT:

"Why Meredith Whitney thinks a “bad bank” is a bad idea Posted by Stacy-Marie Ishmael on Jan 29 16:10.

Meredith Whitney and her team at Oppenheimer remain steadfast in their opposition to the creation of a “bad bank” that would buy so-called “toxic assets” from Wall Street’s flailing institutions (and so, save the world).

Whitney argues that the real problem is that banks are disinclined to lend - and that simply removing these assets from their balance sheets will not change that fact:
Lending standards have tightened dramatically, and there is an unavoidable restructuring of risk taking place. Such causes money to come out of the system and lending to contract, with or without this “bad bank” structure. Lower asset bases, higher credit losses, and bloated expense structures will continue to pressure banks’ earnings power and capital creation. We remain cautious on the group.

Cautious, and consistently unimpressed.

Other highlights from the note, emphasis FT Alphaville’s:

We do not believe a “bad bank” structure addresses the root problem of contracting system capital.

Writedowns from structured securities and illiquid assets is only one challenge related to the commercial banks. A challenge of equal importance is rising defaults from on balance sheet loans. Due to the pro-cyclical nature of loss reserving, banks are required to build reserves when their earnings power is weakest.

If a bank were to sell its “bad” assets into a “bad bank,” it would still be left with lower earnings power from higher losses on “good loans” and the requirement to build reserves, lower earnings power from lower assets and a higher legacy expense structure, or both.

The greatest unknown regarding the “bad bank” is at what price the gov’t would pay for “toxic assets.” If the government elects to pay fair market value, the banks will likely not elect to participate as capital hits would be too dear; however, if the gov’t pays above market, the burden on an increasingly “taxed” taxpayer grows.

We would be most encouraged by banks selling “crown jewel” assets to cover their own losses. We believe private capital will readily invest in businesses that make money and grow. However, the banks do not fit this description. We remain cautious on the group.

Moreover, Whitney believes a handful of lenders would “dominate the lion’s share of the ‘bad bank’”. Those lenders, she argues, should monetize their “good” assets to cover their “bad” assets.”

And who might the lenders be? Well, by Whitney’s reckoning (and others), Merrill and Citi have the biggest exposure to residential mortgages, at $44.6bn and $26.7bn respectively. Citi also has a fairly significant exposure to US ABS CDOs, at $18.9bn gross and $6.9bn net. So does Bank of America, with $11.9bn gross and $5.3bn net. (Gross means after writedowns but before hedges, in Oppenheimer parlance).

Oppenheimer also points out that in addition to the question of how these assets will be priced, it is not clear what will be held to constitute a bad loan: “will it be by loan product, loan quality, or geography?”
This is an important consideration, not least because, as Oppenheimer notes,

A large percentage of banks’ exposures are to areas with the greatest home price declines and the most vulnerable negative equity positions. Will these too become “bad loans,” and if so, what will be left of banks’ “good loan” earnings bases?

Take Bank of America, which partly through its Countrywide acquisition has $94bn in exposure to Californian mortgages - or five per cent of the company’s total assets.

And as the table below makes clear, these kinds of exposures are no less significant for Citi, JP Morgan, Wells Fargo and Wachovia:

Whitney is right to contend that a bad bank would only treat some of the existing ills - and that is unlikely to be enough.

Related links:
The 20 worst housing markets in the US - FT Alphaville
Citi’s Parsons calls for ‘bad bank’ - FT

This entry was posted by Stacy-Marie Ishmael on Thursday, January 29th, 2009 at 16:10 and is filed under Capital markets. Tagged with Bailout, bank of america, citi, countrywide, JP morgan, merrill lynch, wachovia, wells fargo."

I then add:

Don the Libertarian Democrat Jan 29 17:10

When the plan to buy Toxic Assets was shelved, the price of Toxic Assets dropped dramatically, and investors like John Paulson bought some of the better deals. If the government gets back in, the price will magically rise. The only way that the purchase can help the banks is for them to transfer some of their losses to us at a better price. Such losses will be real.

Does he really think that Dick Fuld has been "practically exonerated" by this one highly contentious document

Here's Salmon again:

"Sorkin Exonerates Fuld

Andrew Ross Sorkin today has the most astonishing parenthetical I've seen in a long while:

(By the way, doesn't it seem increasingly hard to vilify Richard S. Fuld Jr., the former chief executive of Lehman Brothers, given what's happened since that firm filed for bankruptcy? If you haven't read it yet, there's a remarkable court filing by Harvey R. Miller, the respected lawyer at Weil, Gotshal & Manges overseeing the bankruptcy, that practically exonerates Mr. Fuld. See nytimes.com/dealbook)

The blog entry is here, and the court filing therein is simply dispatched by Sam Jones:

It is disingenuity of the highest order to suggest that banks like Lehman were passive victims of a stormy market. Their actions created the stormy market in the first place. Dick Fuld's Lehman reaped what it sowed.

In fact, the filing actively celebrates all the risks that were taken by Fuld and Lehman in the years leading up to the collapse, talking about Lehman's "four consecutive years of record-breaking financial results" between 2004 and 2007, and citing with admiration Lehman's soaring share price.

What's more, Miller's filing spends much more time on ad hominem attacks on Fuld's accusers than it does on seriously trying to defend Fuld's disastrous decisions -- something which is always a sign of a very weak case.

So why does Sorkin seem so inclined to take the filing at face value? Does he really think that Dick Fuld has been "practically exonerated" by this one highly contentious document, in the face of overwhelming evidence that Fuld levered up Lehman irresponsibly, refused to sell out when he could, and generally did nothing to save his bank until it was far too late?

Could this just be part of a campaign by Sorkin to get Fuld to talk to him? Sorkin doesn't just have his newspaper column: he also has TV and book projects going, and access to Fuld would be very valuable in what has become an extremely crowded meltdown-media marketplace. Alternatively, of course, Sorkin genuinely wants us to think that one overheated court filing is really sufficient to make him change his mind on the question of Fuld's basic culpability. So which is it?"

My reply:

From Bloomberg:

http://www.bloomberg.com/apps/news?pid=20601109&sid=aMQJV3iJ5M8c&refer=home

"Meanwhile, worried that his lieutenants wouldn't be able to fetch a fair price from an investor, Fuld was pursuing another strategy. The plan his associates devised would offload Lehman's toxic commercial-mortgage portfolio to an independent company, codenamed Spinco. The new company's stock would be owned by Lehman shareholders, and its startup capital would be provided by the firm. While Lehman would have to raise fresh capital to replace what it transferred to Spinco, investors would be buying into an investment bank with a scrubbed balance sheet. "

Actually, he sounds prescient. Maybe we should call the Aggregator, Bad Bank "Spinco" in his honor. Why not let him run it?

And here I thought that Spinco was another one of the Marx brothers.

By DonthelibertarianDemocrat Posted: Jan 27 2009 4:57pm ET

"We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers."

From Interfluidity:

"Nationalize like real capitalists

It will come to no surprise of readers of this blog that I favor nationalization of failed, systemically important banks. But James Surowiecki and Floyd Norris have a point. We absolutely should not nationalize as a means of persuading banks to issue credit more freely. If the government (idiotically) wants looser lending than banks are willing to provide, it oughtn't take their money and lend it. The government can lend its own damned money (well, our own damned money) if it thinks that profitable loans are not being made, or that for the good of the economy unprofitable loans must be made.( A GOOD POINT )

The reason to nationalize a bank is because the bank has failed and its former owners have no legitimate claim to its assets. The government has been forced to offer support with public money, thereby purchasing the corpse fair and square. We take the bank into public ownership because taxpayers who have been conscripted to accept extraordinary losses are entitled to whatever gains follow the reorganization they finance.( I AGREE )

When a bank is nationalized, shareholder equity should be written to zero, and existing management should be handled as roughly as the law allows. If we have a bit of courage, we should impose haircuts or debt-to-equity conversions on unsecured creditors( I AGREE ), but I don't think we have that kind of courage. "Toxic" assets should be revalued at pennies-on-the-dollar market bids or else written to zero and hived into "bad banks"( I AGREE ). Once we have a conservative valuation of the assets and know exactly what is owed, we'll know how much public money would be required to cobble a robustly funded bank from the wreckage. However, if we recapitalize "too big to fail" banks without restructuring them, we will quite deserve our next mugging( TRUE ). We had better cut these monsters into little, itty, bitty pieces. We should embed strict size and leverage limits into their itty, bitty charters, restrict their ability to recombine, and then hire management to run the little things on strictly commercial terms. Hopefully we will change what it means for a bank to run on commercial terms — We should create a tax and regulatory structure that penalizes scale and leverage across the board. Better yet we should decouple the payment system from risk investment by reorganizing banking functions into "narrow banks" and credibly not-guaranteed investment vehicles. But whatever the banking industry comes to look like, nationalized banks should be recapitalized once, then managed to compete in it, and for no other purpose. Taxpayers should seek to extract maximum value from their eventual privatization. But should any of the reorganized banks seek a second helping of at the public trough, they should be ostentatiously permitted to fail. Rather than an implicit government guarantee, successors of nationalized banks should face a particularly itchy trigger finger( THIS IS ESSENTIAL ).

Having nationalized "banks" make loans that prudent managers of a well-capitalized bank would not make is just a way of obscuring a subsidy and ensuring permanent quasipublic status by requiring on-going guarantees, bail-outs, and capital injections. Further, putting easy-lending public banks in competition with ordinary thrifts would resuscitate the destructive dynamic we have just put behind us, wherein bank managers must match the idiocy of their most foolish counterparts or watch their businesses wither.

If we want to stimulate the economy, put idle resources to work, stoke animal spirits, whatever, we should do that with some combination of transfers, investment subsidies, inflation, and public works( I AGREE ). But if we are dumb enough to force-feed credit into the economy, let's not hide that behind a bunch of puppet banks( I AGREE ). And let's keep it very clear that we are not confiscating private firms in order to make them tools of the state. We nationalize reluctantly, when we have had no choice but to inject public money (or guarantee assets, which amounts to the same thing( TRUE )) in banks that otherwise would have failed( THAT'S IT ). We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers.( A GOOD POINT )

---

Some nationalization links

• Buiter — Time to take the banks into full public ownership
• Clusterstock — More Cries For "The Swedish Model" To Fix Banks, Why Are We So Afraid To Fix Banks The Right Way?
• Cowen — Why bank nationalization is a last resort, Is the Sweden plan so much better?
• Dillow — Arguing about bank nationalization
• Drum — Kevin Drum Smackdown Watch, Nationalization Revisited, Nationalization
• Fama — Government Equity Capital for Financial Firms
• Fox — Why hasn't the government nationalized Citigroup? Hank Paulson's sort of answer, The case for nationalizing Citigroup and Bank of America, and getting Robert Reich a fact checker
• Free Exchange — Why not nationalise?
• Hempton — Nationalisation after due process
• Jones — Nationalisation linkfest
• Kedrosky — Bank nationalization: Why Are We Pretending?
• Krugman — Wall Street Voodoo
• Gaius Marius — nationalization now!
• McArdle — Why not nationalize, like Sweden?
• Quiggin — What to do with nationalised banks?
• Salmon — The Urgent Financial Crisis Facing Obama, Insolvent Banks: Why a Debt-for-Equity Swap Won't Work, Felix Salmon Smackdown Watch, More on Bank Nationalization, Why Nationalization is the Best Alternative, Why We Should Nationalize Now, Nationalize Citigroup and Bank of America
• Surowiecki — Nationalization will not be easy, Where would bank nationalization stop?
• Yglesias — The grain

Update History:

• 20-Jan-2009, 7:00 p.m. EST: Eliminated an artless overuse of "guaranteeing" by changing to "ensureing"."

Since I agree, there's not much point in commenting any further.

" The trio of Bernanke, Geithner and Summers are likely to produce a veritable moral hazard monsoon.'

Buiter in the FT:

"Can the UK government stop the UK banking system going down the snyrting without risking a sovereign debt crisis?

January 20, 2009

From Reykjavik

Late last night I returned from a four-day visit to Iceland with Professor Anne Sibert, co-author of a report anticipating the collapse of the Icelandic banking system and joint carer for our cats and children.

Iceland’s largest three banks with border-crossing activities collapsed last fall, as did its currency. The three banks are in administration and new state-owned banks with a purely domestic focus have been set up. Strict capital controls make external borrowing all but impossible and discourage foreign investment. The country now has an IMF program. Strangely enough, the program does not impose any fiscal pain until 2010. This year the fiscal automatic stabilisers are allowed to work freely, although no further discretionary expansionary fiscal measures are being proposed. Starting in 2010, under the program, discretionary fiscal tightening of more than eight percent of GDP is envisaged between now and 2013. That number could be higher if the external indebtedness of the state turns out to be higher than the 110 percent of annual GDP estimate of the IMF.

The true state of the gross and net external indebtedness, including contingent off-balance sheet exposure, of the Icelandic state is a mystery even now( HOW CAN THAT BE? ). In addition to sovereign debt and sovereign-guaranteed debt, there are credit lines and possibly other contingent external liabilities whose take-up has to be estimated/guessed to get an accurate view of the state’s external obligations. It is possible that the IMF figures include an offset against the sovereign’s external liabilities in the form of an estimate of the recovery value of some of the external assets of the sovereign (e.g. its share in the assets of the UK subsidiaries of Kaupthing and Landsbanki). Assigning any positive value to these assets is an act of faith( YIKES ). In any case, it would be helpful to have the hard external liabilities and the soft external assets reported separately.

Iceland’s government had to let the country’s three main banks go into administration because it did not have the fiscal capacity to bail out financial institutions with balance sheets amounting to six to seven hundred percent of annual GDP. Any attempt to commit further government resources to the rescue of the banking system would have precipitated a sovereign default.

With each day that passes, estimates of the recovery value of the assets of the three ‘bad banks’ melts away like snow in April. The decision not to guarantee the liabilities or the assets of the banks (other than retail deposits, including retail deposits with foreign branches for amounts up to €20,000) was the only wise thing the Icelandic authorities have done in this whole sorry mess. It isn’t even clear that the Icelandic authorities came up with this sensible idea themselves. More likely the IMF opened their eyes. The creditors of the banks, which include Commerzbank and Bayerische Landesbank will have to explain to their own shareholders and tax payers why they now effectively own large chunks of three defunct Icelandic banks.

…to London

Returning to London from Reykjavik last night was like coming home from home. Allowing for the differences in the scale of the Icelandic economy and the British economy (the UK population is more than 200 times larger than Iceland’s Coventry-sized population), there are disturbing economic parallels. The excesses in Iceland during the past decade were greater than in the UK, but not qualitatively different. In both countries, the regulation of banks was laughably lax( MORE LIKE COLLUSION ). The UK’s much-touted light-touch regulation turned out to be soft-touch regulation. Relaxation of regulatory norms was consciously used by the British government as an instrument for attracting financial business to London, mainly from New York City. Fiscal policy in both countries became strongly pro-cyclical during the boom years preceding the financial crisis. Households were permitted, indeed encouraged, to accumulate excessive debt - around 170 percent of household disposable income in the UK, over 210 percent in Iceland.

Both countries permitted the real exchange rate of their currencies to become materially over-valued, more so in Iceland than in the UK, but still to a worrying extent even in the UK. The same version of the ‘Dutch disease’ - the crowding out of the non-financial internationally exposed sectors (exporting and import-competing) by the excessive growth of the financial sector and the construction industry - occurred in both countries, again to a greater extent in Iceland than in the UK, but to an highly undesirable extent even in the UK. Iceland’s gross and net external indebtedness are much greater than that of the UK, and its current account deficits during the years just prior to the crisis were much larger than those of the UK. But the UK too built up very large stocks of gross foreign assets and liabilities and ran persistent current account deficits.

Both countries pay the price for the hubris of policy makers who believed that they had engineered the end of boom and bust and replaced it with perpetual boom. The risks associated with asset market and credit booms and bubbles were dismissed (”how can you be sure it is a bubble? Do you know better than the market etc.”). In neither country have the responsible parties (the prime minister, the minister of finance, the governor of the central bank and the head of banking regulation and supervision) admitted any personal responsibility for the disaster. Instead we are told tales of a once-in-a-lifetime calamity, coming at us from abroad, that ruined a perfectly sensible and sustainable set of domestic policies, regulations, rules and arrangements. As if!

Both countries allowed the unbridled growth of banks that became too large to fail( THE REAL PROBLEM ). In the case of Iceland, the banks also became too large to rescue. In the UK, the jury is still out on the ‘too large to rescue’ issue, but I have serious and growing concerns. Incrementally, the British authorities have guaranteed or insured ever-growing shares of the balance sheets of the UK banks. And these balance sheets are massive. RBS, at the end of June 2008 had a balance sheet of just under two trillion pounds. The pro forma figure ws £1,730 bn, the statutory figure £1,948 (don’t ask). For reference, UK GDP is around £1,500 bn. Equity was £67 bn pro forma and £ 104bn statutory, respectively, giving leverage ratios of 25.8 (pro forma) and 18.7 (statutory), respectively.

With a 25 percent leverage ratio, a four percent decline in the value of your assets wipes out your equity. What were they thinking? The fact that Deutsche Bank used to have a leverage ratio of 40 and is now proud to have brought it down to just below 34 is really not a good excuse.

Lloyds-TSB Group (now part of the Lloyds Banking Group) reported a balance sheet as of June 30, 2008 of £ 368 bn and shareholders equity of £11 bn, giving a leverage ratio of just over 33. Of course, for all these banks, the risk-adjusted assets to capital ratios are much lower, but because the risk-weightings depend both on private information of the banks (including internal models) and on the rating agencies, they are, in my view, worth nothing - they are the answer from the banks to the question “how much capital do you want to hold?”. That the answer is “not very much, really”, should not come as a surprise. For the same date, HBOS, the other half of the new Lloyds Banking Group, reported assets of £681 bn and equity of £21 bn, giving a leverage ratio of just over 32; Barclays reported total assets of £1,366 bn and shareholders equity of £33bn giving a leverage ratio of 41, and HSBC (including subsidiaries) reported assets of £2,547 bn and equity of £134 bn for a leverage ratio of 19.

The total balance sheets of these banks about to around 440% of annual UK GDP. The government seems to be well on its way towards guaranteeing most if not all of it( THEY WILL HAVE TO ). No one outside the banks (and perhaps even no-one inside them) has a good sense of the true value of what they hold on and off their books.

There is a strong possibility that the UK banks are still hiding( FRAUD ) toxic or dodgy assets on and off their balance sheets, or are still valuing them at substantially more than their fair value. They are aided and abetted in this by the relaxation of fair value (mark-to-market) principles condoned by the International Accounting Standards Boards, when it permitted the reclassification of certain investments between the three categories of (1) ‘assets held for trading’ (which are valued at market prices and have these valuations reflected through the profit and loss account), (2) assets ‘available for sale’ (which are valued at market prices have these valuations reflected only in the balance sheet, not through the profit and loss account) and (3) ‘assets held for investment’ (which need not be valued at market prices). The new IASB rules are an invitation to management to hide capital losses or to delay their translation into the profit and loss account by strategic reclassification of the assets in question. It is truly scandalous that the IASB approved this ex-post reclassification of investments.( SO MUCH FOR MARK-TO-MARKET )

In the name of preventing a collapse of the UK banking system, we are witnessing the socialisation - at first gradual, but now quite rapid - of all balance sheet risk of the UK banks by the UK government. This is risky and, in my view, unwise( TRY NECESSARY ). The manner in which it is done also seems designed to maximise moral hazard( TRUE ). The good news is that it is unnecessary for restoring and maintaining the flow of new credit in the the British economy.

The state is stretching and testing its current and future fiscal resources both by guaranteeing or insuring ever-growing amounts of new and existing bank funding and bank assets, and through its assumption of private credit risk through such facilities as the £200 bn Special Liquidity Scheme (SLS), which swaps Treasury bills against securities backed by mortgages and other loans originated before 2008. The new £50 bn Asset Purchase Facility, through which the Bank of England will engage in qualitative easing (increasing the proportion of private and possibly illiquid securities in its portfolio) through outright purchases of private securities rather than by accepting them as collateral in repos and at the discount window, also raises sovereign credit risk, even though the Bank of England is required to purchase only “high-quality” assets. ABS backed by US subprime mortgages were considered high quality once.

In view of this progressive socialisation of the balance sheet risk of the UK banks, it is not surprising that there has been some convergence between the CDS rates of the UK sovereign and of the UK banks whose balance sheets are guaranteed or insured to an ever-growing extent by the UK sovereign. I expect this convergence to continue, with the CDS rates of the banks falling and that of the UK sovereign rising. A similar pattern of converging sovereign and banking sector credit risk premia can be observed in other countries. As the banks become more secure, the government becomes less secure( THAT'S THE TRADE OFF ).

The UK may not be the first EU member state to face a sovereign debt crisis. According to the rating agencies, the CDS rates and the 10-year sovereign spread over Bunds, the leading candidates for a sovereign solvency crisis are Greece, Spain, Portugal, Italy and Ireland. Some of these countries are in fiscal trouble not because of their sovereign’s exposure to the banking sector but for other reasons, such as a long-standing inability to reduce a very high public debt to GDP ratio, coupled with the prospect of large cyclical deficits as the economy goes into a deep recession. Greece and Italy fall into that category.

Among the countries where the sovereign is highly exposed to the banking sector, Ireland may well be the next country where the ‘too large to rescue’ theory may be tested, although countries like the Netherlands, Belgium, Luxembourg, the UK and, outside the EU, Switzerland, are also potential candidates for the ‘too big to rescue’ (without external support) club. Ireland’s outstanding sovereign debt is low as a share of GDP (around 25 percent) , but the exposure of the sovereign to its overgrown banking system is massive: the Irish state guaranteed the entire liability side of the banks’ balance sheets, except for the equity.

Irish 10-year sovereign debt spreads over Bunds stood at 198 basis points on January 16. We may get a test of Eurozone or even of EU fiscal solidarity before this crisis is over, as argued by Walter Munchau. I believe that this crisis will certainly deepen EU-wide fiscal cooperation between national governments. It may even provide the spur for the creation of an embryonic proper supranational EU fiscal authority with independent revenue raising and borrowing powers.

But even if the UK is not the next European country to face a sovereign debt challenge, there is a non-negligible risk that before too long, the growing exposure of the British sovereign to the banking system (and especially to the foreign currency funding risk faced by the UK banking system), together with the 9 and 10 percent of GDP general government fiscal deficits expected for the next couple of years, may prompt a loss of confidence by the global financial community in the British banks, currency and sovereign.

We may well witness the UK authorities going cap-in-hand to the IMF, the EU, the ECB and the fiscally super-solvent EU member states (if there are any left), prompted by a triple crisis (banking, sterling and sovereign debt), to request a bail out( ROUND AND ROUND IT GOES ). I hope and trust that the UK authorities are in regular contact with the IMF, the US administration, Brussels, Frankfurt and the leading EU member countries to prepare for a possible internationally coordinated bail-out operation for the British banking system and sovereign.

My belief that the UK government should take over all UK high street banks (on a temporary basis) is based on the simplification this would provide as regards the governance of these institutions under extreme circumstances, when private ownership and governance have clearly failed( TRUE ), and on its positive effect on incentives for future bank behaviour (’moral hazard( I AGREE )). When the public interest and the interests of the existing private shareholders and the incumbent managers and boards of directors diverge( THIS IS WHY A HYBRID WON'T WORK ) as manifestly as they do in this crisis, the sensible thing to do is to buy out the existing shareholders (as cheaply as possible). That way the failed and failing management and boards can be restructured (fired without golden parachutes) and the new owner can insist on and enforce an open, verifiable valuation of toxic and dodgy assets, on and off the balance sheet of the bank.( YES )

The non-state shareholders of the UK high street banks ought no longer to be a factor in the discussion of what to do. As of yesterday, their market capitalisations were (according to today’s Financial Times) as follows: Lloyds Banking Group £10.6 bn, Barclays £7.4 bn, RBS £4.6 bn and HSBC £60.8 bn. And these valuations reflect the implicit subsidies( YES ) granted the banks through their access to such state-owned and state-run facilities as the Special Liquidity Scheme, the government’s guarantee of new bank borrowing, deposit guarantees, and the mitfull of new insurance/guarantee schemes announced yesterday( YES. NOT ENOUGH. ).

The second major rescue package for UK banks in three months includes very large (and in at least one case potentially uncapped) packages of guarantees and insurance offered to the banks by the state on terms that are not clear. This is very much in the US tradition, promoted by the US Treasury, the Fed and the FDIC, of maximising moral hazard for a given amount of immediate crisis fire-fighting. In the incoming Obama administration, both Treasury Secretary Geithner and NEC Chair Summers have had many years of experience, in the US and all over the globe, throwing good money after bad in pointless bail-out packages( YES ). The trio of Bernanke, Geithner and Summers are likely to produce a veritable moral hazard monsoon( WELL PLAYED ).

The second installment of the UK bank rescue package provides unnecessary, undesirable and costly comfort for existing management and boards, for existing private shareholders and for existing creditors and bond holders of the banks. It is unnecessary because the same quantum of crisis-fighting solace can be provided with much smaller effects on the banks’ future incentives for excessive risk taking, by taking the banks into full public ownership and restricting government guarantees to new credit flows( YES ).

A modest proposal

So here is my proposal:

(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.( YES )

(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.( YES )

(3) Don’t issue any more guarantees( HERE I DISAGREE ) on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.

(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing( GOOD ) for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.( OK )

Capitalize the bad bank with the minimum amount of capital required to meet regulatory norms. Fund the rest of the assets through a loan from the state to the bad bank or through a bond issued by the bad bank and bought by the state.

As regards the bad bank, that’s effectively it. With toxic and dodgy securities on the asset side of its balance sheet and with the state owning all the equity and as the only creditor, the assets can either be sold off, if a market develops again, or held to maturity, earning whatever cash flows they may yield.

(5) As a special case of (4), take the high street banks into full public ownership and treat these existing banks in their entirety as bad banks. Close the existing banks for all new business. Transfer the deposits of the high street banks (now the bad banks) to new (state-owned) ‘good’ banks (or perhaps rather, not yet bad banks). Replace the deposits on the books of the bad banks with loans from the state to the bad banks or with bond issues by the bad banks purchased by the state. Let the new banks (New Lloyds, New RBS, New Barclays and New HSBC) acquire, in a competitive bidding process also open to other market participants, any of the assets of the old banks. Run the new banks as competing publicly owned, profit maximising banks until they can be privatised again, when a sensible regulatory regime for banks is in place and the market for bank shares recovers. Don’t guarantee or insure any items on the balance sheet of the old banks. Use guarantees/insurance exclusively for new lending and new investments by the new banks. Gradually run down the old banks as their assets mature, as under (4).( A GOOD PLAN )

The miracle of limited liability applies also when the state is the owner. As long as the state-owned bad banks (which could be merged into a single super bad bank) don’t obtain sovereign guarantees for their obligations( I SEE THIS AS KEEPING THE CALLING RUN GOING ), the financial exposure of the sovereign is limited to its equity stake and the existing guarantees and insurance it has provided in the past.

It is key that there be no further injections of funds by the state into the bad banks until there are no longer any private creditors. If a bad bank becomes balance-sheet insolvent or liquidity insolvent and it still has private creditors (as it would, in general, under the model of item (5)), the bad bank should be put into administration and its debt to parties other than the British state should be converted into equity. That equity would be then be purchased by the UK state. With the bad bank now not just 100 percent state-owned but also without private creditors of any kind, the assets can be managed as the state sees fit - one hopes in such as way as to maximise the present discounted value of their held-to-maturity cash flows.( OK )

The balance sheets of the British banks are too large and the quality of the assets they hold too uncertain/dodgy, for the British government to be able to continue its current policy of extending its guarantees to ever-growing shares of the banks’ liabilities and assets, without this impairing the solvency of the sovereign. Britain risks becoming a victim of the new inconsistent quartet: (1) a small open economy with (2) a large internationally exposed banking sector, (3) a currency that is not a serious global reserve currency and (4) limited fiscal capacity. It risks a triple crisis and a threefold run: on its banks, on its currency and on its sovereign debt.( BUT ISN'T IT IN A CALLING AND PROACTIVITY RUN ALREADY? )

Limiting the exposure of the sovereign to what is fiscally sustainable may imply giving up on saving (all of) the banks. If my proposal for institutionally and legally separating existing stocks of assets and liabilities from new flows of credit and lending is acted upon, the flow of new lending and the supply of new credit need not require the survival of all (or indeed any) banks hitherto deemed systemically important.

I look forward to the time when I will be blogging on the best way of privatising the banks again, under new regulatory and governance regimes."( ME TOO )

I still believe that gurantees are needed to end the Calling Run, and the Bad Bank idea is a little iffy to me. But this plan is worth a try.

"I don't see how this verbal nonsense is any more than a way to keep the shareholders of the banks whole. "

Via Free Exchange, on TPM:

"The Idea That Won't Die

01.19.09 -- 1:05AM

By Josh Marshall

We seem to be sweeping back around to the original TARP idea -- buying up the banks' 'toxic assets' to allow them to clear the decks and start lending again. It's not completely clear to me whether this is being pushed mainly by the carryover regulators like Sheila Bair who are trying to sell the idea to the Obama team or whether it's actually the Obama team that's now carrying this ball. But just as it was when this was Paulson's and Bernanke's idea back in the Fall, the whole premise is based on the idea that the US taxpayer buys these securities for far more than they're worth( I AGREE ) -- which we could do more honestly, if no more wisely, by just giving the banks a bunch of money to help them get back on their feet after losing so much money( TRUE ).

The tell is in the article that got this ball rolling in the Journal on Saturday (emphasis added): "Ms. Bair said the assets could be purchased at fair value, the figure banks use to value their own assets. Such a move would remove the challenge of placing a price on assets that rarely trade." In other words, buy these things at what the banks insist they're worth( YEP ), even though everyone seems to recognize that the essence of the problem is that the banks are still sitting on massive losses they're still unwilling to account for. (The same article in the Journal notes a study which holds that the banks have so far accounted for only about half their losses.)

The lesson here is the one Orwell was teaching in his famous essay on language. Garbled language leads to garbled thinking and is an invitation to lying. "Toxic assets" is simply the buzz word for stuff banks bought for far more than it was worth. Period. All these buy-back schemes involve buying them for the price the banks want them to be worth.( YEP )

It's like a scene out of some bizarro, Wall Streetified Antique Road Show. The bankers come in with their old china and cabinets from the attic that they're sure are worth $20,000. Sadly, the appraiser informs them they're only worth about $850. Only of course they're not from the attic. They bought them only last year convinced $20,000 was a steal back at the height of the antique crap craze. And now they're condemned to roam the byways of America looking for an appraiser or antique buyer who will finally recognize the true value of their crap and pay them $20,000 to help them get their money back. Unless of course we agree to pay them $20,000 for it now and let them get back to their lives and stop all the craziness.

I think we'll probably need to spend a lot more money unwinding the mess the banks got us into. But I don't see how this verbal nonsense is any more than a way to keep the shareholders of the banks whole."( THAT'S MY VIEW )

“In the end, either banks will have to be nationalized or have their bad loans split off into another institution."

From the NY Times:

"In Europe, New Efforts to Bolster Lending

By DAVID JOLLY

PARIS — After a first round of costly bank bailouts and stimulus programs came up short, governments in Europe and the United States are moving more forcefully to assure that bailed-out banks lend more money( MORE LIKE DON'T NEED TO HOARD MONEY ) to offset the recession that has engulfed both continents.

On Monday, a day after officials of the incoming Obama administration promised to take steps to force banks to lend, Britain outlined details of a new £100 billion, or $147.5 billion, plan to limit banks’ losses from troubled assets in exchange for their pledge to increase the flow of credit.

“In return for access to any government support, there will have to be an increase in lending, and that will be legally binding,” Gordon Brown, the British prime minister, said.

As if to illustrate the depths of the problem, the Royal Bank of Scotland warned on Monday that it faced losses of up to £28 billion or $41 billion for 2008, a record for any British company. The bank’s already depressed shares fell nearly 67 percent, touching off a rout in European financial stocks that could extend to United States markets when they reopen on Tuesday.

The second round of efforts in Britain and Europe to jump-start lending comes as the region girds for a more painful recession than expected. The European Commission warned on Monday that the 27-nation European Union faced a “deep and protracted recession” that would shrink the economy by 1.8 percent in 2009 and cut 3.5 million jobs across the bloc.

Adding to the sense of urgency, Standard and Poor’s ratings agency downgraded Spain’s sovereign debt from its AAA rating. Greece’s sovereign debt was cut on Wednesday, rekindling worries about what might happen to the euro zone as a whole if a member were to default on its public debt.

The bleak prospects have prompted leaders to try other ways of urging banks to lend as it becomes more clear that the bailout measures pledged by governments at the height of the financial crisis in autumn have not flushed away the bad loans that still clog the system( THEY ARE STILL BEING CALLED ). If anything, the problems are set to worsen as the downturn accelerates( YES ).

President Nicolas Sarkozy of France is to meet on Tuesday evening with French bankers to press them to lend more money to French businesses. “The banks must understand that the times have changed,” Christine Lagarde, the finance minister, told a business daily, Les Échos, on Monday. The French plan would require banks receiving new capital injections to make “precise commitments,” including giving up bonuses this year, she said.

Late Sunday, Denmark announced an $18 billion aid plan for its banks, saying it would inject the funds on the condition that the recipients increase lending.

In Germany, Deutsche Bank’s chief executive, Josef Ackermann, who is also chairman of the Institute of International Finance, an organization of the world’s largest financial institutions, suggested last week that the creation of so-called bad banks might be the way forward( A POOR WAY, BUT IT IS A WAY. ).

In a bad-bank arrangement, governments would buy up scorched( ANOTHER NEW TERM? ) assets, said George Magnus, senior economic adviser at UBS Investment Bank in London. That contrasts with the method now being used in the United States and Britain, where troubled assets remain on the balance sheet, but losses beyond some limit are insured by the government.( COULD ALSO WORK. THE GUARANTEE IS THE IMPORTANT THING TO ENDING THE CALLING RUN. )

“There is no ‘right’ way and both schemes have their merits and drawbacks( A FAIR POINT ) under given and local circumstances,” Mr. Magnus wrote in a research note. He said the bad-bank plan might be more suited to the United States, while Britain might be able to manage with its plan for an insurance program because it has far fewer banks.

Members of the incoming Obama administration are considering proposals that include buying up bad assets, a return to the original vision of the $700 billion Troubled Asset Relief Program.

“The focus isn’t going to be on the needs of banks,” Mr. Obama’s chief economic adviser, Lawrence H. Summers, said on the CBS program “Face the Nation.” “It’s going to be on the needs of the economy for credit.”

Simon Adamson, a banking analyst at CreditSights, an independent research firm in London, said he thought that Europe was also “edging toward the creation of bad banks.”

Under Britain’s latest bank bailout, its Treasury will “protect financial institutions against exposure to exceptional future credit losses on certain portfolios of assets” in return for a fee. Participating institutions will take the initial losses, with the Treasury bearing about 90 percent of the rest( YIKES ).

Britain’s central bank could buy up to £50 billion worth of “high-quality assets” from banks, giving it more monetary policy tools after it cut its benchmark interest rate to a record of 1.5 percent this month. The government is also extending measures to increase liquidity, including a £250 billion program to let banks to issue government-backed( THE GUARANTEE IS THE IMPORTANT THING ) bonds. The latest steps would cost taxpayers an additional £100 billion on top of the £37 billion plan announced in October and a £20 billion stimulus plan announced in November.

Mr. Brown said he was angry at Royal Bank, whose losses include as much as £20 billion of good-will write-downs from the acquisition of a portion of another bank. “Almost all their losses are in the subprime markets in America and related to the acquisition of the bank ABN Amro,” he said. “And these are irresponsible( NEGLIGENT ) risks, which were taken by a bank with people’s money in the United Kingdom.”

European bank stocks fell sharply on Monday on fears that more pain, including the wiping out of some shareholders, might lie ahead( TRUE ). Last week, the Irish government nationalized the Anglo Irish Bank, rendering equity stakes worthless.

Peter Dixon, a global equities economist in London for Commerzbank, said the latest British rescue plans were “a step in the right direction.” But, he added, “In the end, either banks will have to be nationalized or have their bad loans split off into another institution. That’s the only way they will be clear( GUARANTEED. ONLY THE GOVERNMENT CAN DO THIS. ) about their capital positions( YEP ).”

Carter Dougherty contributed reporting from Frankfurt."

should the government be in the business of declaring that it knows better than the market what assets are worth?

Paul Krugman with a post saying what I've been saying:

"Wall Street Voodoo

By PAUL KRUGMAN

Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans.

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.( YES )

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout( YES ).

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse( YEP ). Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future( WE NEED ONEROUS CONDITIONS ). Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.( THAT'S MY PLAN )

The current buzz suggests, however, that policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward a compromise( HYBRID ) approach: moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” that would resemble the Resolution Trust Corporation, but without seizing the banks first.( A BANK OF CRAP )

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, recently tried to describe how this would work: “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?( IT'S A NON-ANSWER )

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.( I AGREE )

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth( THAT'S MY POINT )? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again( THAT'S IT )?

What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value” purchases of toxic assets.( YES. AND IT WILL BE A DISASTER WHEN DISCOVERED. )

Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover( THE ANSWER ). Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks.

Unfortunately, the price of this retreat into superstition may be high. I hope I’m wrong, but I suspect that taxpayers are about to get another raw deal — and that we’re about to get another financial rescue plan that fails to do the job. "

This has been my position since October.

"it’s mainly based on a false analogy."

Paul Krugman on the Bank Of Crap ( Aggregator, Bad, Toxic, Bank):

"More on the bad bank

OK, I’ve been doing more homework on the “bad” or “aggregator” bank idea that seems to be gaining ground. And here’s what I think: it’s mainly based on a false analogy.( TRUE. I HAVE A BAD FEELING IT'S ALL THOSE RTC ALUMNI HORNING IN ON THE ACTION. )

What people are thinking about, it’s pretty clear, is the Resolution Trust Corporation, which cleaned up the savings and loan mess. That’s a good role model, as far as it goes. But the creation of the RTC did not rescue the S&Ls. The S&Ls were rescued by (1) having FSLIC seize them, cleaning out the stockholders (2) having FSLIC pay down enough debt to make them viable (3) reselling them to new investors. The RTC’s takeover of the bad assets was just a way for taxpayers to reclaim some of the cost of recapitalizing the banks.( TRUE )

What’s being contemplated now, if Sheila Bair’s interview is any indication, is the creation of an RTC-like entity without the rest of the process. The “bad bank” will pay “fair value”, whatever that is( THAT'S THE PROBLEM ), for the assets. But how does that help the situation?

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. In other words, we’re still in Super-SIV territory, the belief that fancy financial engineering can create value out of nothing.

Color me skeptical. I hope the buzz is wrong, and that something more substantive is being planned. Otherwise, we’re looking at Hankie Pankie II: Paulson may be gone, but officials are still determined to believe in financial magic."

I believe that we can't do anything but overpay for these assets. Someday, when that is discovered, a lot of people are going to discover that our system is not being run in their interest. I hope that I'm dead by then.

So I wonder do why the nationalization option never made it into the WSJ story. If it's been rejected as an option, I'd love to know why.

Felix Salmon is like me, only I feel this evasion of responsibility is more tragic than he does:

"Bailout Incrementalism Continues

According to the WSJ, Treasury and the Fed are considering two big ideas. The first is to create a new state-owned "bad bank" to buy up toxic assets -- TARP I, essentially, rebranded. The second is to institutionalize the deals given Citi and BofA, so that anybody can get them.

But where is nationalization? It's a better idea than either of these, because it gives the government more upside and also more control -- both over management decisions and over the degree to which the banks are actually lending.( THE GOSPEL TRUTH )

Anecdotally, even anti-big-government Republicans are coming around to this way of thinking: more half-measures simply aren't going to work( HYBRID ), and if we are going to end up nationalizing, better we do it sooner than later( TRUE ). So I wonder do why the nationalization option never made it into the WSJ story. If it's been rejected as an option, I'd love to know why."

Ideology. I base my positions on the following people:
Bagehot,Graham,Fisher,Keynes,Hayek( Of The Road To Serfdom ), Austin, Wittgenstein, Merleau-Ponty, Charles Taylor, Anthony Giddens, Nozick, Rawls, Gewirth, and mostly Edmund Burke. A Whig. Have the people who claim to be Burkeans ever really read him?

The inability to understand Political Economy and Politics is our main problem. In this crisis, the following people have been invaluable:
Buiter,Wilmott,Salmon, Justin Fox, Kedrosky, DeLong,Free Exchange, Nick Rowe,Davi,Setser,Peston, Dean Baker,Mankiw, and a few others. A lot of these experts remind me of a comment made about a famous philosopher by my famous philosophy teacher:" Polymath you say? Why he doesn't even qualify as a monomath".

The investors I like:
W.Gross,J.Grant,W.Buffet, Jim Rogers, John Paulson, Hugh Hendry, are all over the place. But they have been helpful as well.