Bailout 2.0

Bailout 2.0

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From the WSJ:

“The U.S. government is expected to take stakes in nine of the nation’s top financial institutions as part of a new plan to restore confidence to the battered U.S. banking system, a far-reaching effort that puts the government’s guarantee behind the basic plumbing of financial markets.

To kick off Tuesday’s expected announcement, the government is set to buy preferred equity stakes in Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. — including the soon-to-be acquired Merrill Lynch — Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp., according to people familiar with the matter. (…)

Other elements of the plan, which will be announced Tuesday morning, include: equity investments in possibly thousands of other banks; lifting the cap on deposit insurance for certain bank accounts, such as those used by small businesses; and guaranteeing certain types of bank lending. It builds on an earlier plan to buy up rotten assets dragging down banks, which failed to calm investor fears, and follows similar moves by major European countries.

Formulated jointly by the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corp., these moves are designed to keep money flowing through the financial system, ensuring that banks continue lending to companies, consumers and each other. A freeze in these markets rippled through the economy and helped cause stocks to crater last week.

Along with the government’s involvement come certain restrictions, such as caps on executive pay. For example, firms can’t write new employment contracts containing golden parachutes and their ability to use certain executive salaries as a tax deduction is capped. These restrictions are relatively weak compared with what congressional Democrats had wanted when they approved this spending, a potential flash point.”

Two big caveats before I go on. First, this reporting is preliminary; the report tomorrow should have more details. Second, I am not an economist, so take my opinion for what little it’s worth. That said:

This sounds a lot better than the original plan to buy up troubled assets. In fact, it sounds so good to Brad DeLong that he wants to start singing hymns of praise in Latin. And that’s a wonderful thing. So this post is not meant to detract from the fact that as best I can tell, this is a very, very good thing.

However, I note a couple of things that have generally been part of discussions of this kind of plan. First, there is no triage: no attempt to separate banks that are basically solvent from banks that are not. Second, there are no forced writedowns. I would have thought that either would be a very good idea, under the circumstances.

One of the things you really, really want, under the circumstances, is for everyone to know that the banks are now trustworthy: that no more big unpleasant surprises lurk in their balance sheets. One of the things that I gather you do not want is for banks to put off unpleasant revelations as long as possible. To do this, people seem to think that one should figure out which banks are insolvent, “and like Old Yeller, “gently” put them down.” Then:

“Before they get new equity, banks must be forced to write down the value of their assets to nuclear-winter levels. And they must disclose, in detail, the carrying value of their assets so the market can make sure they have done this.

Why?

Because the goal of investing taxpayer equity in banks is threefold:

*Improve the banks’ capital ratios, so they can start lending again

*Persuade private investors to invest in banks again

*Flush all the crap so we can start fresh…unlike Japan.

If the government does not force banks to write down their assets before injecting new equity, we won’t have fixed the problem. Instead, the US taxpayer will just be the lastest sucker to fall for the banks’ assertions that all the bad news is out of the way. Private investors, meanwhile, will stay on the sidelines and watch the taxpayer get sandbagged. Lastly, and most importantly (for the economy), banks won’t start lending again. Why not? Because they’ll want to keep all that new capital as a cushion for the next wave of writedowns.

Japanese banks played this game for a decade…and we know where it got them (NIKKEI Index is currently one-fifth of the peak value 18 years ago.) In Sweden, meanwhile, the government insisted on writedowns, and the economy recovered almost immediately.”

I suspect that Paulson and others in the administration have a hard time accepting the need for this sort of policy. They are, after all, conservatives, and this is, after all, partial nationalization of banks. But if my reading is correct, hanging back is a bad idea. If you’re going to do this sort of thing, you should be quick and aggressive about it. As I understand it, that’s the best way both the get the economy back on its feet and to get the government out of the banking business as quickly as possible.

But for all that, the plan sounds like a big step in the right direction.

PS: Image from here.