A how-to guide for fixing America’s banks

For anyone who thought the U.S. banking sector was healthy, Warren Buffett’s $5 billion investment in Bank of America should be a wake-up call.

Many investors assumed the Wall Street bailouts of Bank of America and the other big banks more or less healed the sector. All it took was few trillion dollars in liquidity and a few $100 billion in recapitalization. Voila!

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In fact, the banking system was not saved. The massive injections of liquidity temporarily salved the day-to-day operations of banks, but they did not repair the more profound troubles. Indeed, pouring billions into nearly identical management teams that mismanaged risk, overleveraged exposure and drove banks off the cliff in the first place was an invitation for another crisis.

In past weeks, Bank of America has been under increasing pressure from investors. Its already damaged stock was cut in half, and commentators including myself argued that the bank was headed back toward the rocky shoals of insolvency.

On Thursday, Buffett stepped in, at least temporarily, to save Bank of America’s bacon. He was inspired, Archimedes-like, in the bathtub — an image I will likely carry with me for the rest of my days.

Buffett has put together a deal on terms similar to those he offered Goldman Sachs and General Electric: A fat 6 percent yield on preferred (not common) stock, and warrants to buy 700 million Bank of America shares at $7.14 each, good for 10 years.

A few items leapt out:

●Despite its repeated claims to the contrary, Bank of America needed both capital and a reputation reboot. Buffett provided a little of both, though I’m not sure which they needed more.

●With the Fed offering banks capital at nearly zero percent interest rates, why would BofA take money at 6 percent? This gives lie to the claim that BofA did not need more capital. (The counterargument is this was about the stock slide, not the capital structure, which remains opaque.)

●Investors are cautioned that unless you are buying on the same terms as the billionaire, you are making a very different bet than he is.

But all of this goes back to the failures of the 2008-09 bailouts. Consider what was actually done then, and you will understand why none of the underlying problems have been fixed:

●Bank holdings: They remain stuffed with declining assets, primarily in housing and derivative holdings. Another leg down in housing could be nearly fatal.

●Transparency: Balance sheets are unnecessarily opaque. Eliminating fair-value accounting via FASB 157 did not fix balance-sheet problems, but instead allowed banks to hide them.

●Capitalization: This remains too thin. Leverage should be mandated back to the pre-2005 rule change of no more than 12 to 1. Management does not keep adequate capital unless forced to do so (“sufficient” capital reserves cuts into profits).

●Misaligned incentives: Compensation and bonus schemes were not significantly changed after the bailouts, except during loan repayments. Thus, management and traders still have the same upside to roll the dice, but they do not have the downside risks, which remains on shareholders and taxpayers.