Saving the Banks
AS LAST week's dreadful new unemployment report showed, the U.S. economy is still in free fall. But, important as it is, the fiscal stimulus plan upon which President Obama and Congress have spent most of their efforts so far is at most only part of the solution. The economy can't recover as long as the nation's financial system remains in suspended animation. Through episodic bailouts, the Bush administration prevented a total meltdown -- which was necessary, but far from sufficient. As it prepares to unveil its plans for the second half of the $700 billion Troubled Assets Relief Program (TARP), the Obama administration has a chance to dispel the confusion and uncertainty that still cripple the banks and, by extension, the entire economy.
The basic problem is this: America's financial institutions remain burdened with "toxic" assets, i.e., instruments (often of mind-blowing complexity) for which the market has collapsed. Goldman Sachs says that about $1 trillion in illiquid securities still haunts the banks' balance sheets. The resulting paper losses are eating away at the banks' capital, and without a stable capital cushion, banks do not dare lend money, even to quite creditworthy customers. As long as the toxic assets remain, private capital will shun the banks -- and government capital will get eaten up by more and more losses. One way or another, this corrosive uncertainty must end.
Broadly speaking, the Obama administration has three options, each of which has been tried in similar crises in other countries.
First, it can nationalize insolvent banks, take their bad assets directly onto the government's balance sheet and try to manage them at a minimum cost to the taxpayer. This has the advantage of decisiveness -- but the huge disadvantage of involving political authorities in the banking business indefinitely.
A second approach would be for the government to use TARP money to capitalize one or more "bad banks," which would buy and -- with the help of experts recruited from the private sector -- manage toxic assets, thus freeing the remaining "good banks" to resume normal operations. This is more promising, since it includes an exit strategy for the government and might jump-start a private market for the assets. But there is a huge risk that the government would badly overpay in the first place.
Finally, the government could agree to pick up the tab for any losses above a certain level, in return for a fee from the banks. It has already done this with Citigroup and Bank of America. With this guarantee, the banks could more safely hold the securities to maturity or sell them to private investors, who would be secure in the knowledge that Uncle Sam's got their back. This proposal probably has a much lower upfront cost than either nationalization or a "bad bank." The downside is that it perpetuates ambiguity about the ultimate valuation of the assets.
Whatever approach, or combination of approaches, he chooses, Mr. Obama must level with the public about the costs and benefits. One misconception he should dispel is the expectation -- unfortunately being encouraged by some members of Congress -- that the banks must immediately use whatever aid they get to restore lending to pre-crisis levels. Easy credit is part of what got us into this mess, and, even without the toxic assets problem, there would be less lending in a recession. No, it's not fair that banks that helped create the crisis might get a fresh start subsidized by taxpayers. But, unless we want a Japan-like "lost decade," there is no alternative. What's crucial is to set a strategy that is coherent, decisive and transparent -- and then stick to it.