Shock therapy for the banks?

Thomas Friedman has a thought-provoking column in Sunday’s New York Times, titled “Time for (Self) Shock Therapy.”  Unfortunately, one of the thoughts provoked is “A lot of this is oversimplified,” but there are still some good ideas and some good exposition in it.  On the eve of the inauguration, Friedman suggests that President Obama’s first White House meeting should be with the presidents of the 300 biggest banks, and he should tell them there’s a new sheriff in town.  The first paragraph of Obama’s imaginary indictment of the bankers is nicely put, especially the heart metaphor:

“Ladies and gentlemen, this crisis started with you, the bankers, engaging in reckless practices, and it will only end when we clean up your mess and start afresh. The banking system is the heart of our economy. It pumps blood to our industrial muscles, and right now it’s not pumping. We all know that in the past six months you’ve gone from one extreme to another. You’ve gone from lending money to anyone who could fog up a knife to now treating all potential borrowers, no matter how healthy, as bankrupt until proven innocent. And, therefore, you’re either not lending to them or lending under such onerous terms that the economy can’t get any liftoff. No amount of stimulus will work without a healthy banking system.”

Friedman then has Obama announcing a thinning of the herd, kind of like FDR’s bank holiday of 1933, whereby the healthy banks would be recapitalized and the sick banks liquidated:

“So here’s what we’re going to do: we’re going to unclog the arteries. My banking experts have analyzed each of your balance sheets. You will tell us if we’re right. Those of you who are insolvent, we will nationalize and shut down. We will auction off your viable assets and will hold the toxic ones in a government reconstruction fund and sell them later when the market rebounds. Those of you who are weak will be merged. And those of you who are strong will receive added capital for your balance sheets, after you write down all your remaining toxic waste. I am not going to continue rewarding the losers and dimwits amongst you with handouts.”

Aside from the Hollywood rhetoric, this sounds appealing (and makes me wonder if maybe Tim Geithner was chosen for Treasury precisely because as New York Fed president he probably knew the vital signs of the big banks better than any other non-insider).  But I doubt it could be done anywhere near that easily, or even as easily as in 1933.  “Insolvent” seems to be a slippery concept at today’s banks — many that are currently solvent still have all those toxic assets and could slip into insolvency as either the market or reality forces further write-downs of their values.  More to the point, balance sheets are increasingly irrelevant for the big banks.  Off-balance-sheet activity has exploded in the past couple decades, and since the repeal of Glass-Steagall in late 1990s many of these banks are not even banks anymore, at least not in the traditional sense.  Exhibit A: credit-default swaps that the “bank” has issued that expose it to billions or trillions of dollars in risky obligations don’t show up on the balance sheet.

I like the idea of some kind of Darwinist approach here, however.  My caveat is that it would be hard, especially without the full and candid cooperation of the banks.

The most valuable insights in Friedman’s article come from others, namely author David Smick and portfolio manager Steven Eisman:

“Right now,” said David Smick, author of “The World Is Curved,” “the bankers are sitting on mountains of cash, including our bailout money, because they know their true balance sheets are a disaster — far worse than publicly stated.” The situation will likely worsen as delinquent consumer and auto loans are piled atop bad mortgages. “Obama needs to inject some truth serum into the banking discussion. No one trusts the banks, and even the bankers don’t trust each other.” Bringing clarity to bank balance sheets, said Smick, “is the first step to fixing America’s bank lending problem.” …

“I wish people would stop saying that this is a crisis of confidence,” said Steven Eisman, a portfolio manager and banking expert at FrontPoint Partners. “The loss of confidence is just a symptom of bad credit and over-leverage. The banks are not lending because they know their balance sheets are loaded with future losses and they don’t have enough capital. The TARP gave them preferred equity, which is nothing more than a bridge loan. We need the government to force the banks to write down all their bad assets now and then recapitalize themselves, preferably with private capital. Those banks that cannot raise sufficient capital should be seized and their deposits sold off.”

Good stuff.  And good to see Friedman taking on a new topic and finding some good ideas on it.  The opening line of his conclusion is a keeper as well:

“A stimulus package that does not also unclog the arteries of our banking system will never stimulate sufficiently. “

There seems to be an important similarity in stimulus strategies and bank bailout strategies.  Households have a debt overhang, banks lack capital.  Throw some money (tax cuts or capital injections) to either one, and if they’re rational they’ll hold onto it, not spend or lend it.  Meanwhile, the recession keeps on deepening.  I’m just echoing scores of other economists when I say that getting out of both of these holes is likely to be a lot more expensive than politicians are willing to admit at this point.

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