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, Paulson made equity investments in the banks. This, however, didn't 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.
Here is a simple four step process:
(1) A troubled bank is given an opportunity to set up a wholly owned subsidiary. The subsidiary then buys from the parent company all the operating assets. From the name and logo, to the branches, accounts and employees, the profitable parts of the bank are sold at fair market value. Because banks, branches, and deposits are sold fairly frequently, there are metrics readily available to enable us to price these assets.
(2) The federal government funds the subsidiary with both enough money to buy the operating assets and sufficient capital to operate the bank and have it function as a lending institution. The funding would come in the form of a cumulative preferred stock. Cumulative means that the new bank need not pay dividends if it can't spare the cash, but those dividends will accrue. The rate can be discussed; in the federal bailout of Chrysler in 1979, Chrysler paid one percentage point over the government's cost of funds.
(3) The bank would spin off the newly capitalized subsidiary to its shareholders. The old banks that contained the toxic assets would be renamed and operate as closed-end mutual funds working to unwind all the financial positions. The cash from the sale of the operating assets would give these funds money to unwind positions in an orderly way.
(4) Though public shareholders would own both corporations, nothing could be taken out of the "old bank" until all positions are unwound and liabilities paid off. Nothing could be taken out of the new operating bank until the government's preferred stock was brought current and bought back from the government.
When the spin-off is completed we have a rock-solid bank, with no toxic assets, no liabilities, and total transparency ready to serve its role in commerce, and we have a closed-end mutual fund gradually unwinding its toxic positions.
Of course it is reasonable to ask why this hasn't been proposed already. If the solution is so simple, why haven't bright people like Larry Summers, the head of the White Houses National Economic Council, pushed the idea?
There seem to be three reasons: First, the banking crisis really is not getting the degree of attention it requires. Massive stimulus packages, omnibus reconciliations and a host of political priorities seem to have obscured the centrality of this issue and the necessity of fixing the banks. Second, the S & L crisis of the 1980s and early '90s, in which the Resolution Trust Corporation served as a "bad bank" seems to have conditioned everyone to think in the mode of the government taking over distressed securities. This proposal requires a paradigm shift to focus on buying the good assets. Third, and perhaps most important, Wall Street isn't pushing such a proposal on government officials because investors in the "old banks" could lose money.
Although the new banks will be perfectly sound--and those Citigroup signs around the world perfectly safe--there is no guarantee that the "old" corporation will have enough assets to pay all its liabilities.
This brings us to what the real purpose of the government's efforts in this area should be.
That the government needs to act to ensure adequate lending capacity, a normal flow of commerce and even to maintain the national prestige will win wide agreement--certainly during a crisis. But the administration's current efforts go far beyond this. By putting equity into the banks, the government is taking a junior position to every bondholder, in effect transforming bank bonds into Treasury bonds.
This is neither necessary nor desirable. Banks are not the government and their bonds are not Treasury bills. Lending to private banks entails all the risk of lending in the private sector.
Increasingly the question is whether the Obama administration is prepared to stand up to those who made imprudent investments so it can move to clean up the financial system or whether it will try to muddle through, constantly having one crisis after another, constantly infusing cash into the banks, all to make sure that no bondholder ever has to experience the consequences of his decisions.
Jim Prevor is the founder and CEO of Phoenix Media Network, Inc.