A very good comment by former Treasury Secretary James Baker in the Financial Times, “How Washington can prevent ‘zombie banks’,” warns that the US is on its way to repeating the Japanese error of propping up dud banks and creating a moribund economy as a result.
His program has the merit of being simple (at least in concept). Unfortunately, now that the banking mess has become highly (as opposed to somewhat) politicized, any new program has to fit within the confined of soundbite-constrained communications if it is to have a hope of being considered.
Many of its elements will be familiar to readers of this blog: doing triage on the banks, closing the hopeless ones, haircutting or wiping out bondholders. And it is noteworthy that Reagan Republicans see nationalization (or receivership, or pre-privatization, if more business friendly branding makes the medicine easier to swallow) as less bad than the alternatives.
In all of these proposals, the element that is generally ignored is what to do with the underlying borrowers. A similar triage need to be done there. This crisis will not be on the mend until we see large scale writeoffs and restructurings.
As readers may have inferred, I am distressed at the reluctance to tackle methods to restructure or unwind structured vehicles, which could require legislative fiat. Admittedly, the will to take radical action of any sort is notably absent in DC, along with the awareness that the provisions of most structured deals effectively prohibit debt restructuring/renegotiation, which is normal for traditional loans and bond deals. It is not much of an exaggeration to say that the economy is being held hostage by these vehicles, yet it is somehow unacceptable to even contemplate cutting this Gordian knot.
From the Financial Times:
We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios….
Yves here. That is Washington-speak for “the stress tests are inadequate.” Back to the article:
Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.
This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.
After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.
The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.
To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.
This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.
Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.
Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.
Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.
During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.
Anonymous 
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Yves,
I agree with you on moral grounds that it seems right to puts banks into receivership and give the bond holders a haircut. Believe me, no one would be happier than me than to see Bill Gross lose his shirt. But I wonder if this is really at all practical.
For example, by my last calculation, US commercial banks and finance companies have $2.74T in debts. Who do you think owns these? Obviously, most of it is owned by other commercial banks and financial institutions. So if you haircut the bond holders, you inflict another round of damage on the financial sector which may cause more failures and hence more bondholder haircuts. It is not clear to me where this stop or if it stops at all.
Some of the damage will got to highly leveraged European banks. So then it becomes a issue of international politics.
I am sure the Europeans and probably everyone else is telling Washington to clean up their F#?cking banking system in order to prevent more damage from being exported overseas. Giving them lectures on moral hazard is probably not the right tactic. The capitalistic system has been tested and it has failed. There is no need to test it again. It is time to contain the damage and move on.