The latest banking rescue has been widely panned by the punditry, with even Krugman voicing his dismay, yet was warmly received by the markets. The pundits are correct : this plan will not rescue the bad banks. Instead, the new plan will grease the flow of credit into the real economy, and lift all banks, both good and bad, along with the entire economy. In fact, I think that the new plan is a piece of genius. It finally rewards the good guys instead of the bad ones.
From the viewpoint of rescuing banks, the plan looks like a failure. It will accelerate price discovery of loans, which may cause the balance sheets of weak banks to actually deteriorate rather than improve. Banks will not tender their loans for sale if they know that the loans will fetch prices lower than their marked down value. The bad loans will stay on the books of the bad banks. What will come off the books of the banks are the good loans, those that are likely to perform well, but have been lumped together with the bad apples and now are stuck on the balance sheets of the good banks. By getting those loans off their balance sheets, the good banks will be able to do what they do well, assess credit risks and make more loans to good risks. The net effect will be an extension of credit to the economy, but in an intelligent manner, by making use of the expertise of the good bankers.
Under this plan, two groups will make out like bandits. The first group are the good banks which will be able to securitize and unload their good loans onto the markets, enabling them to make more loans. The second group are the investors in those securitized loans, who will be getting a huge government-sponsored loan on intrinsically profitable loans, leveraging their profit many times. To me, this is a refreshing change. Rather then rewarding the bad bankers who could not differentiate good credit risks from bad ones, and rewarding investors who relied on leverage to obtain eye-popping gains, the government is finally rewarding the good bankers who knew good from bad risks, and the conservative investors who did not rely on leverage and kept their powder dry.
Part of the reason why the plan has been so roundly criticized by bloggers is that the favored solution has been outright nationalization. The previous solution of extending government guarantees to loans on the books of the banks has a negative effect on the economy. It does not make the banks in question healthy enough to lend again. Instead, it is effectively a tax on the good banks to throw at the bad banks, since the bad banks are in business only because of the government guarantees. Nationalization is a possible way out of the impasse. Certainly, a nationalized bank can be made lend again, relying on the balance sheet of the government. However, this is also a tax on the good banks, because depositors and investors will prefer dealing with the government over private parties. The new Geithner plan suggests a third way out that avoids nationalization and is economically beneficial. Pump so much money into the good banks that they can now take over the bad banks. Although a bank such as Citigroup (and perhaps Bank of America) looks too large to be sold to any group, if the current plan manages to pump enough money into the good banks, there is hope that a conglomerate of the good banks can absorb a sufficient portion of Citigroup’s assets to finally solve the problem. It may seem unlikely now, but then again, mega-banks such as Wachovia, Merrill Lynch and Wachovia once looked too big to be taken over too.
The final criticism of the current Geithner plan is that it is too punitive on the taxpayer, who stand to lose too much. However, the bad loans have already been made and the losses have already been incurred. When the decision was made that bad banks cannot be allowed to collapse, it is just a matter of determining the combination of parties who should be made to shoulder the losses. Due to the magnitude of the losses, realistically speaking, the taxpayer has to shoulder the lion’s share. The only question is what mechanism to use to shift the losses onto the taxpayer. We can extend government guarantees to loans, nationalize banks, or pay private investors to absorb the losses. It seems to me that the last way is the only way which rewards the good guys, and are the least objectionable.
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