Immediately after Treasury Secretary Geithner announced the framework of the new bank bailout program the stock market sank hundreds of points, as I hope he expected it would do. The plan fails to address the real banking problem and fails to fully acknowledge the real housing problem.
The real banking problem is that the asset bases of hundreds of banks including the very largest among them have collapsed in value. Banks typically lend about $12 for every $1 in assets they have. Because the value of their assets have crashed, without moving a muscle many of them have become devastatingly over-leveraged with loan to asset ratios of 30 to 1. We have known since time immemorial, although we willfully ignore it every time we think we have found free money, that bank leverage ratios at this level lead only to one place… dead banks.
This is why when the first $350 billion of the TARP funds were distributed to the banks they didn’t suddenly start lending. Those funds rescued them from the brink of collapse but did not reduce their loan to asset ratios to any sort of level that would have made it responsible for them to lend more money out. If prudent ratios are 12:1, the banks ended up at 30:1, we rescued them by bringing them back to, say, 20:1… they still are going to need a lot more money before they can start resp0nsibly lending again.
To make matters worse, the banks are not teetering on the edge of insolvency. According to a number of prominant economists including Nobel Laureate Paul Krugman, the big banks are already insolvent and have been for many months now. The only way these banks have been able to continue functioning in remotely bank-like ways is by everyone agreeing not to realistically value their mortgage backed assets. By looking the other way and pretending that they are worth more than they are, the banks have continued to borrow money from the Federal Reserve to pay off their own lenders but, in reality, the gig is up. The banks have collapsed, even if they haven’t fallen down yet.
When banks collapse three groups of people get hurt.
- Bank investors lose their investment in the bank. The value of their stock goes to $0. This is bad for them, but no worse than when any of their other investments go bankrupt, and they get compensated for this risk through the return they demand on their investment.
- Bank bond holders lose their investment in the bank. The value of their bonds goes to $0. This is bad for them too but, again, no worse than when any of their other investments go bankrupt and, like stockholders, they get compensated for this risk through the interest they demand on their loans.
- Bank customers are the big losers. There are no mechanisms like interest or dividends that compensate them for the risk that their uninsured deposits and day-to-day operating funds will vanish overnight in a puff of Wall Street smoke. They lose everything, and the economic ripples start here as businesses, suppliers, employees, and customers all end up eating a share of a loss for which they never received compensation.
The fact that bank customers lose without compensation is the one and only factor that differentiates an insolvent bank from any other insolvent business. FDIC insurance, to the extent that it covers deposits, was created to ensure that bank collapses would not leave savers penniless. It does not, however, provide for continued short term operating loans. So it helps, but it doesn’t help enough to avoid economic shock waves, closures, Main Street bankruptcies, and unemployment.
Protecting these vulnerable, uncompensated bank customers from the effects of bank collapses should be the government’s one and only banking related concern right now. But that is not what we are seeing in any of the bailout proposals that have come along so far. All of the bailout proposals and actions have maintained at least some mechanism that maintains at least some value for bank stockholders and bondholders. That is reason number one why Wall Street crashed dove today. Making people whole for losses they have already been made whole for does nothing at all to solve the problem and is just patently, blatently, disastrously, unfair.
The second reason Wall Street doesn’t like the new bailout proposal is that it insists that banks lend out the money the government gives them! This seems logical on the surface, but remember the problem in the first place is that the banks are insolvent! They already have loan to asset ratios of 30:1. If we add to their assets and then insist that they lend those assets out, it does very, very little to reduce the lending to asset ratio to a responsible, sustainable level. We may be able to defer some problems this way, and we may be able to soften the economic blow to the customers this way, but it is massively inefficient and doesn’t ultimately solve the problem. The banks are insolvent and the only real solutions are going to have to have that as their starting point.
What this means is that the stockholders and bondholders have to be wiped out. In order to keep the banks functioning without impact to their customers, the government will have to assume their operations and provide them with new assets at a sufficient level so that their loan to asset ratios are sustainable. Once the government does this, it can go about selling them back to a public that will be as eager to invest in clean, healthy financial institution as they were before this mess. It is a trade. The government puts in the money that the old investors lost, and then new investors put their money in so the government can get its money back out. Bank customers, in the meantime, experience a seamless transition as if nothing had happened.