The banking crisis is worsening as the economy continues to sink. It’s not just that bank balance sheets are still stuffed with “toxic” assets probably worth far less than what they’re listed for — subprime loans mixed up with all sorts of other things. It’s because more and more individuals and businesses that had been credit-worthy six months ago can’t make their payments. As a result, bank shares are plummeting. So what should the new administration do?
Set up an aggregator or “bad bank” to buy up assets the banks want to unload — along with the conditions I set out a few days ago designed to prevent remaining shareholders, creditors, executives, traders, and directors from profiting off taxpayers.
One way to determine how much the government should pay is through the mechanism Hank Paulson told Congress he’d use back in late September, which he never followed through on — a reverse auction. It might work like this: The Treasury offers $10 million to any bank that wants to offload. Banks will compete with eachother to get that $10 million by offering securities they consider to be worth at least that much if and when they could ever be sold on the open market. They also provide the “auctioner” with whatever information they have — both about why their bids are credible and why the auctioner should be skeptical about the valuations of other bidders. Once the auctioner accepts one of the bids for $10 million, the auctioner then increases the offer to $25 million, and takes in a new set of bids for securities that the banks think are worth that amount. Banks that lost the first bid would add a new bunch of securities to their first-round entrees, and try to make their case. And so on.
At the end, the government (you and I) own lots of securities at firesale prices that have been competed downward. They’re put into the Bad Bank for safe keeping until they’re eventually resold on the open market — hopefully at a price that’s at least as much as they cost. And the banks have cleared up their balance sheets, which enables them both to borrow and to make new loans.
Sounds simple, but it’s not. For one thing, the prices the banks get on the securities they unload might be so low relative to their face value that the banks are effectively insolvent (this may be why Paulson gave up on the idea). For another, it depends on sufficient competition among banks to get the prices down, and some big banks are big enough to stifle competition. For another, it requires a Treasury staff (auctioners) sufficiently smart and large to effectively evaluate the information they receive. For another, in order to really clear bank balance sheets of junk, it may require far more than the $350 billion left under TARP.
Still, it may be the only alternative — outside a large-scale reorganization under bankruptcy. (The problem with the current bankruptcy laws as applied to banks is that changes in the law that went into effect four years ago don’t give banks enough time and resources to reorganize. Under the former law, Lehman might have been saved.)