Should We Save the Banks?

My response to the question: What are your thoughts on the government taking over failing banks?

Preserving the financial system is critical and as long as the US government can do this, they should. This certainly does not mean that every bank will or should survive but the system itself should be supported while the US government maintains its creditworthiness in the world. The reasoning behind taking over the failing banks is to preserve the system. We saw the effects of allowing Lehman to go bankrupt. The credit markets froze as credit default swap spreads hit extreme levels. The stock market plunged 3,000 points as fear and uncertainty took over. Orderly bankruptcies and the slow unwinding of bank positions is critical for the banking system to remain in tact.

Nationalization is a misused word in the context of what our government is doing. The idea is to inject enough capital to shore up tangible common equity thus diluting current common equity stockholders. Presumably, the government will effectively wipe out any common stock value but allow the preferred shares and debt to keep their value. In a true nationalization, the debt and preferred would be wiped out as well. So, in these takeovers those that took the greatest risk, the common stockholders, are taking the greatest hit whereas the preferred and debt holders will theoretically come out okay.

The initial intended use of the TARP money was to buy troubled assets off banks' balance sheets. When Paulson realized how difficult it would be to price these complex assets, he scraped the plan for simple capital injections. While urgency was necessary, this was seemingly the wrong plan. Now, Geithner is attempting to reinstate the original TARP plans but he is also realizing this is easier said than done. Accurate price discovery is near impossible. Yet, I believe the government needs to find some rough estimate of value of the assets and put a price floor in the market. To truly save the banks, they need to eliminate the massive holes in bank balance sheets. The government could possibly help the MBS market trade again by creating a floor against which banks can begin trading. Without a liquid market for MBS, they will remain at fire-sale prices. MBS desks are ghost towns and banks are stuck in a "bought and now hope" situation. The second half of TARP could work to create a market again. Also, I think a "good bank, bad bank" plan may also work well by dumping the bad assets into the worst bank, allowing it to fail in an orderly manner, and supporting the better banks.

The US government is leveraging its creditworthiness in the world in an attempt to bail out the financial system. The government was complicit in the risk-taking behavior and is as just as much to blame as the greedy CEOs of investment banks and wide-eyed homeowners buying houses they couldn't afford. We will feel the pain of deleveraging the system eventually but the hope is that we can, in the short run, keep the financial system alive and functioning so the pain is more easily absorbed when it comes down the road. I cannot see the logic in US government allowing the system to disintegrate when its creditworthiness in the world allows it to raise capital at levels equivalent to inflationary rates. Though, it is a very precarious situation and there is no guarantee it works.