A how-to guide for fixing America’s banks

Imagine: What if we’d gone Swedish on banks like Citi and BofA — nationalize ’em, clean ’em up, spin them back out to the markets by placing them into a prepackaged reorganization (a polite phrase for bankruptcy). Here’s how that might have played out:

First, the easy stuff: Fire senior management. Not just the chief executive. Nearly the entire top floor at the bank, including the board of directors, is canned. Equity shareholders are wiped out. Whatever is left after all is said and done goes to the bondholders, typically, at 25 to 50 cents on the dollar. (In Sweden, bondholders got 100 cents on the krona, but that currency was significantly devalued. So the bondholders were not made whole; they lost 50 to 75 percent in real value.)

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Temporary nationalization is the play: Uncle Sam provides debtor-in-possession financing to keep operating. All of the bad holdings, mortgages, derivatives and other liabilities are pulled out and auctioned off. This includes the bad real estate (REOs), the CDS/CDO book, defaulted mortgage obligations. Remember, there are no such thing as toxic assets, only toxic prices. At some valuation, these are worthwhile investments — just not 100 cents on the dollar. Let healthy buyers pay 15 to 30 cents. And anything that is worthless gets written down to zero.

Recapitalize the parent bank, and spin off each division: IPO Merrill Lynch for $20 billion. Spin out a clean Countrywide for maybe $8 billion. Sell off all the non-depository bank pieces.

What you have left is a well-capitalized bank, owned by taxpayers, with well-capitalized divisions as stand-alone companies. All of the above have transparent balance sheets. Eventually, everything gets IPO’d back to the public markets. Uncle Sam gets repaid, and whatever is left (if anything) goes to the bondholders.

You would have also created a transparent, unleveraged, adequately capitalized banking system that would be a contributing member of the U.S. economy, rather than zombie banks that don’t realize they are already dead.

But all that was a missed opportunity — for W and O alike. What we have instead is banking behemoths that apparently still require extraordinary intervention (a.k.a. life support). Many of these remain mortally wounded by holdings that would have been shed in any type of reorganization.

I suspect that the downturn in the sector is a credible bet that these banks are not in any condition to withstand a recession. If the banks come crawling back to Uncle Sam for another bailout, it will be proof that “rescuing” financial institutions that blow themselves up is the wrong strategy.

Real capitalists know failure is part of the process. We may well have another chance to fix the banking system. Let’s hope we do it right this time.

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.