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I disagree with the Congressional Oversight Panel’s (COP) conclusions about the wisdom of using Geithner's toxic asset plan to help small undercapitalized banks outside of receivership. The Congressional Oversight Panel writes monthly reports about the Troubled Asset Relief Program (TARP) program also known as the $700 billion bailout.

The August 2009, COP report makes the false assumption that when a bank is insolvent that it ceases operations. This is not true. Receivership is the way that a bank’s liabilities are restructured when that institution is insolvent. A restructured bank's debts are reduced and depositors are always able to access 100 percent of their insured deposits right away.

In most cases, their management is changed, some liabilities to creditors are reduced, and one of their healthy competitors takes over the branches. Much of the time receivership means that a bank's shareholders are wiped out, but the branches are open for business and making loans the next Monday.

It is not clear that buying toxic assets from small banks would be a good idea. In banks that have not entered receivership, my papers “The Put Problem with Toxic Assets” and “A Binomial Model of Geithner’s Toxic Asset Plan” shows that the government must overpay for toxic assets to get banks to part these trash loans and securities. My research shows that troubled banks, which are not in receivership, will be the most reluctant to part with their toxic loans. That is because most of their stock price is derived from the volatility of the toxic assets. The Federal Deposit Insurance Corporation's (FDIC)'s receivership allows the FDIC to write down banks’ debt so these banks can emerge from restructuring healthier than they entered. My paper “Debt Overhang and Bank Bailouts” shows that toxic assets are the biggest problem when banks are poorly capitalized.

We have over 8000 FDIC insured institutions in the United States. Most of them pose no systematic risk. We can have many of these small banks merge without any of the merged banks coming close to posing any risks to the financial system if they fail. My research shows that Geithner's toxic asset plan called the Public Private Investment Partnership (PPIP) is most likely to be effective if it is used on banks that are in receivership. It would be a misguided subsidy, which would hurt the deposit insurance fund, if the Legacy Loans Program part of the PPIP is used on small banks which are undercapitalized, but not yet in receivership.

Using the PPIP to bailout every community bank’s shareholders and non-deposit creditors is a waste of taxpayer’s funds and will hurt healthy community banks because they have to compete with zombies. A much more efficient use of taxpayer funds would be to shore up the deposit insurance fund so the FDIC can afford to restructure banks before their losses mount.

The Congressional Oversight Panel’s August 2009 report seems to be advocating propping up zombie banks. That is very expensive, and does not help good borrowers get credit.

Disclosure: No positions.

Source: COP Report Advocates Propping Up Zombie Banks: Not Good