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By James Kwak

I don’t envy President Obama’s economic team. When it comes to fixing our banking system, there is no easy solution.

I’ve been sick the past few days, but someone pointed out this article in The New York Times a few days ago that has a concrete illustration of the problem: a bond that an unnamed bank is holding on its books at 97 cents, but that S&P thinks is worth 87 cents (based on current loan-default assumptions), and could fall to 53 cents under a more negative scenario . . . and that is currently trading at 38 cents. Assume for the sake of argument that all of our major banks are insolvent if they have to mark these assets down to market value. The crux of the issue is that any scheme in which the banks receive more than market value is a gift from taxpayers to bank shareholders, and any scheme in which they are forced to take market value is one that the banks will not participate in. Let’s look at a few possibilities:

  1. The government forces banks to write down their assets to reflect worst-case scenarios (unless they do this, no one will have confidence that the asset values won’t fall further), and then recapitalizes them to make them solvent. This is a desirable outcome, but bank shareholders won’t go for it because they will be mostly wiped out. This is roughly what Sweden did with two banks, but Sweden nationalized them first, so the shareholders didn’t matter.
  2. The government creates an aggregator bank to buy up toxic assets. If the aggregator pays market value, no bank will sell; if it pays above market value, it’s a gift. The current idea I’ve heard is that the aggregator will only buy assets that have already been significantly marked down, but that doesn’t really help the banks any.
  3. Another idea is having the government guarantee toxic assets, as it did for Citigroup (NYSE:C) and Bank of America (NYSE:BAC) so far. But this doesn’t solve the problem. There is already a market to insure toxic assets - it’s called the credit default swap market. If the government provides insurance at existing market prices, no bank will buy it, because the cost of the insurance would make it insolvent. If the government provides cut-rate insurance, as it almost certainly did for Citi and B of A, then it is a gift. The only “benefits” of an insurance arrangement are: (a) it’s much less obvious that the government is giving bank shareholders a gift; and (b) the way Citi and B of A were structured, it wouldn’t require a lot of cash from Treasury (and hence from Congress), because most of the guarantee was provided by the Fed.
  4. Meredith Whitney thinks that the banks should sell their “crown jewel” assets - presumably, businesses they have that are still in good shape - to private equity firms, and use the cash to repair their balance sheets. This would be a nice solution, but I don’t foresee it happening. Given the choice between selling the good operations and being left with barely-solvent portfolios of runoff businesses, or holding onto the good operations and hoping for a government bailout, I think all the Wall Street CEOs are betting on the latter.

I think there are two possible outcomes to all of this: (1) the government makes a gift to bank shareholders and justifies it on the grounds that there was no other choice; or (2) the government forces the banks to sell assets at market value and accept a government recapitalization program - either by exercising its regulatory authority (similar to an FDIC takeover) or by just buying out all the common shareholders at their current low prices. In option (2), the government would then re-privatize the banks at some point. But there’s no easy solution.

Source: Searching for a Free Lunch, Banking Edition