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Pundit’s Plan For Solving
The Banking Crisis

Jim Prevor’s Perishable Pundit, March 27, 2009

You may have caught on TV or on the Internet a spoof that ran on Saturday Night Live making fun of the government’s flailing around in an attempt to find an approach that would solve the banking crisis.

The comedic clip portrays Secretary of the Treasury Timothy Geithner unveiling a new plan to set aside $420 Billion. This time the money won’t go for more bailouts… no, instead, the $420 billion will “go to the first individual who comes up with a workable plan to solve the banking crisis.”

You can watch the clip here:

Well, we couldn’t let a challenge like that go to waste, so we wrote up the solution. The Weekly Standard, a high-powered political magazine based in DC, picked up our bait:

How to Detoxify the Banks
The Bush and Obama administrations have shared an unwillingness to see any of the major banks go under, hence the problem we have in solving the current banking and financial crisis. Though both presidents pointed to an alleged systemic risk to the economy owing to the size of the big banks, it is probably also true that any administration would be sensitive to the enormous weight these institutions carry as symbols of American prosperity, influence, and power. A collapse of Citigroup, for example, would be seen by many as an economic equivalent to the collapse of the World Trade Center.

At the same time, there is no great constituency in America for nationalizing banks in America, and there is obvious risk that, if nationalized, such banks would be run for political purposes. Other proposals — to launch new banks, for example — are not serious responses to the scale of the problem.

Happily, there is actually wide consensus on what needs to happen, and the solution is simple. In fact, Hank Paulson almost had it right. Since there is no stomach for seeing giant banks fail, the need is to separate the toxic waste, or the damaged assets these banks carry on their books, from the good assets. This was the idea behind the original Paulson plan, the Troubled Asset Relief Program or TARP.

The Paulson plan foundered on this unavoidable fact: If the Treasury bought damaged assets from the banks at fair market value, the banks would be revealed as insolvent; if the Treasury overpaid for the assets, so as to make the banks solvent, the shareholders would unfairly benefit.

To avoid this Gordian Knot solve the problem because nobody could be certain that the amount invested was sufficient. It also was a solution that had its limits. As bank stock prices swooned, the Treasury would acquire a majority stake becoming the owner of the banks, if it put in enough cash to make the institution solvent.

Indeed, in the latest bailout for Citigroup, Treasury Secretary Tim Geithner overpaid for common stock. The main reason he did so? To keep the U.S. Treasury from becoming the majority owner.

The stock market tumbled when Geithner unveiled the Obama bank bailout, to no small extent because the plan was exceedingly vague. Undoubtedly this is because it has come up against the same problem as the Paulson Plan there is no way to price the toxic assets in a way that saves the banks and avoids bailouts for their shareholders.

The way to cut the Gordian Knot is to leave the toxic assets where they are and focus instead on setting up a mechanism to purchase the good assets. To be more precise, leave the financial assets where they are and buy the operating assets.

You can read the rest here.

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