Replacing Government Bank Liquidity Programs with Orderly Shutdown of Bankrupt Banks

The government is trying to stabilize banks through liquidity programs such as TARP, TALP and PPIP. These programs will fail for the reason provided below. These programs should be replaced with a program to shutdown failed financial institutions in an orderly and socially responsible way. This change will shorten the readjustment period of the recession/depression by years and will reduce the total cost of the government adjustment plan by trillions of dollars

This article is an extension of my earlier article “Obama Wants a 'Better Plan'? Here's One: Bite the Bullet”. Readers asked for more details on how we do this. This article provides some insights on implementing “Bite the Bullet”.

First, let’s look at why the current government programs to stabilize the banks through liquidity programs are condemned to failure. Trillions of dollars of financial instruments (bonds, CDOs, CDSs, etc.) are now worth 20% to 90% less than their original value. These programs rest on an erroneous assumption that government liquidity programs can return the value of these financial instruments fairly close to their original value, and certainly avoid 50% and even 90% write-downs which now appear likely. The following three explanations show why this is an impossible dream:

1. The financial instrument in question do not have a liquidity problem - they have a price problem. One of the great myths now being spread is that there is a liquidity problem for the assets often described as toxic. That simply is not true. The banks are not willing to sell them for “market value” in part because they would be bankrupt. Bonds of General Motors sell for less than 10 cents on the dollar and they are 100% current in payment of interest. General Motors bonds do not have a liquidity problem. Yet mortgage backed bonds owned by the banks, which may or may not be current on payment of interest, are offered by the banks for, say, 60% of the original value and they have no buyers. They do not sell for these prices not for lack of liquidity, but rather because buyers do not think they are worth 60 cents on the dollar. Assume all your neighbors have their house on your block up for sale for $500,000 and you are asking $1,000,000. The reason you cannot sell your house is not for lack of liquidity. The reason you cannot sell your house is because you have too high a price. In short, trillions of dollars are going to “provide liquidity” to the banks which is not the problem.
2. Prices must go to real value, not the erroneous initial value. Our current problem was created by massive monetary creations assisted by new financial instruments which made things look better than they were. Our financial institution leaders induced the bond rating agency to rate these bonds as triple A so that they could sell the bonds. Now we know that many of these bonds are really junk or near junk. It is not liquidity that is missing, but lack of good credit that has reduced the value of these bonds. All of these bonds were rated through a computer program which did not adequately rate the risk. These bonds are worth less today not because of liquidity, but because we now know the original credit assumptions were flawed. The original prices of the bubble high are not reflective of the real value of the instruments. While the government has said that time will fix the prices of many of these assets (and thus the totally illogical reversal on the use of mark to market accounting), the truth is likely to be that the assets will continue to decline in value over time as more bad news comes out about the underlying credit worthiness.
3. Printing money has a history of bad results. While it is true that less liquidity affects prices of the bonds, the above two explanations show why the bonds are worth less. But history is replete with governments trying to solve their problems by printing money. Germany in the 1920’s and the last two centuries of Brazil and Argentina show what happens. The lessened liquidity in the US economy is a necessary part of the adjustment process. There is growing consensus the Alan Greenspan’s attempt to fix the “dot.com” boom of 2000 through easy money was a direct cause of the problem we now have. Printing the money to increase the money supply to inflate the value of the bonds is a fatally flawed strategy which history shows clearly will have a bad outcome.

In summary, it's my belief that the government programs designed to solve the problem by pumping liquidity in the markets are condemned to failure. Not only will these policies greatly extend the time necessary to adjust the economy (read about Japan in the 80's and 90's), but they will create massive trillion dollars losses which in large part are neither necessary nor beneficial. What alternatives do we have?

Extending the currently authority the FDIC has to create an orderly and socially responsible shutdown of banks to other major financial institutions represents a viable way to deal with the problem of bankrupt institutions. Let’s look at how this works.

FDIC closures have been an outstanding success. One measure of this success is that no one talks about it. A bankrupt institution is taken over at night and opens the next day under new ownership. A decision is made as to what assets and liabilities are absorbed by the new buyer. The government ends up with losses, or at least assets with deferred collectability, but life is generally uninterrupted for the normal person using the bank.

These rules apply to commercial banks. They do not apply to insurance companies like AIG, nor do they apply to hedge funds, private equity, or merchant banks. Also they have not been applied in recent times to mega commercial banks, although the actions at WaMu and Wachovia are certainly relevant to this discussion.

Let’s first look at the benefits of FDIC-type rules for financial institution closure. First, there is the legal authority to abrogate contracts that really harm the interests of the bank creditors. There is the ability to remove the people who are more a part of the problem than the solution. If AIG were operating under these rules, the problems of the contractual bonuses are solved immediately and simply. Secondly, there are independent people who come in and make decisions. Things happen and happen quickly. The only difference between Citibank and the Bank of Podunk with $50 million in assets is 3 to 6 zeros more in the value of assets in Citibank, but the concept of what to do and how to do it is the same. (It should be pointed out there is more complexity, as 5 mega banks havve 96% of derivatives and other complex financial instruments which small local banks do not generally have.) I do not suppose that FDIC is perfect, but in a world where there are a lot of crazy, illogical things happening, they really seem to work pretty well. Since extending FDIC type control over pseudo banks requires new legislation, we might want to think of it as “emergency regulations” which have a specific life of 5 years, so that we have the chance to get out of our current problems and then reevaluate the need for continued use.

Some readers may say “Is this really biting the bullet” if the government (and therefore the people) are going to end up with part of the bill? My answer is yes, this is biting the bullet. Here is why. First there is a consensus, I believe in the US, that smaller, less sophisticated depositors should in some degree be protected from a collapse of the financial system. In terms of dealing with the bad assets, they are known and quantifiable things. Maybe not quantifiable if we can sell a mortgage backed CDO for 100 cents on the dollar or 5 cents on the dollar, but at least we know a worst case number. Independent people can probably put a pretty reasonable number on the current value. In short, US government policy must be to close banks large and small which do not have the liquidity and capital to justify being open. This will involve a cost. So where is the benefit?

The benefit must come from shutting down the mega bailout liquidity programs of the government, wrongly presented as a solution to the bank problems. These trillion dollars programs must be stopped as a part of implanting this new legislation. The objective of the bailouts is to deal with the banking and subsequent credit problems for the nation. The proposal here is to junk the non effective bailouts based on massive liquidity injections and close down the banks where they really cannot survive. In summary, we should support Secretary Geithner’s idea to increase FDIC type coverage to other types of financial institutions with the proviso that this will be done only on the quid pro quo of eliminating or winding down the current bank liquidity type programs (TARP, FALP, PIP etc.) which this writer considers as damaging and costly. At a bare minimum, we stop PPIP and other new programs of this type.

There is another, hard to quantify benefit from this proposal. I believe the mangers of America’s business are for the most part competent people doing their best. However, the government bailout programs have given all the wrong incentives for these mangers to look for effective, independent solutions to their problems. When survival becomes largely dependent upon finding market place solutions instead of deals with the government, we are going to find a lot of creativity which is currently hidden by being forced to game the system with the government. PPIP is probably the most incredible new way to game the system to the detriment of the larger society.

Disclosure: No positions

Comments

[Fighting Yoda:]

Agree with the views of the author.

Here are some excerpts from the Congressional Oversight Panel led by Elizabeth Warren (to be published today):

Still, it said a bank liquidation would be “least likely to sap the patience of taxpayers” and “provides clarity relatively quickly” to the markets.

“Allowing institutions to fail in a structured manner supervised by appropriate regulators offers a clearer exit strategy than allowing those institutions to drift into government control piecemeal,” the report said.

The report also said that past successful financial rescues were accompanied by governments’ “willingness to hold management accountable by replacing -- and, in cases of criminal conduct, prosecuting -- failed managers.”
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Yes the Zombie banks and corrupt managements must go. PPIF is a complete scam, similar to the AIG bailout of Goldman. Moral hazard and accountability must be brought back - till then there will be no confidence in the system and the market will simply bobble around.

Apr 08 01:36 AM

[Hillsfar:]

James, it all sounds so logical and workable. But unfortunately, I think this is all wishful thinking. When has the Federal government demonstrated a willingness to force banks to take the drastic, prudent, but ultimately never-taken measures needed? A more powerful outside force has to exert itself - as the IMF and G7/8/20, etc. did with Asian countries in the 1990s. It hasn't happened with the U.S. and it very likely won't.

Apr 08 01:37 AM

[ArkansasAngie:]

A more powerful source?

How about the American people?

The longer it takes the more time there is to obfuscate.

Say Phil Gramm! Is this recession the result of a bunch of whining wimps or YOUR eviscerating laws for your buddies?

Too big to fail is too big.

Instead of spending time spending money, Congress should try figuring out how to keep this from happening again. These laws need to be on the books now and applied. Let's start breaking up these companies to a manageable size now.

Apr 08 06:05 AM

[PainfullyAware:]

The Patriot Act has undermined public dissent. You are labeled a "Domestic Terrorist" and stripped of your constitutional due process of law at whim of this legislature.

I fear that because of this fact that Americans will be pushed to desperate measures.

"Those that make peaceful revolution impossible, make violent revolution inevitable" John F. Kennedy

Peaceful Revolution may still be possible through Amendment 10 of The Constitution. It is too bad that not many understand the document that birthed this nation. We would not be where we are today if the majority did.

Money Is Power - Remove The Money - Remove The Power.

Apr 08 02:37 PM

[Teutonic Kn...:]

Mr. Wood,

I agree with you. At current price levels, American Real Estate is still looking to be unrealistically high.

It used to be the case, as was three decades ago, that the only way a young starting family could move up in the housing ladder is to "trade-up" on its way. This means that they would first start with a 3-bed townhouse, then a 3-bed bungalow, then a 3-bed single garage two-story, then onto something more luxurious.

The Housing Bubble changed the rules of the game too fast, with disastrous results.

Teutonic

Apr 08 11:17 PM