Strange Days Indeed

Practical obstacles to the bankruptcy option.

"No more bailout in lieu of bankruptcy."

Reasons why bankruptcy's not happening, IMHO...

[] First and foremost, the Barney Frank political problem, probably enough to stop the bankruptcy option all by itself.

Not to pick on Barney personally (well, maybe a little) but a couple weeks ago in the Financial Times he made it very clear that from here on in he does not want to see any big loss get dropped on (1) "The good people" who are creditors of the banks -- virtuous university endowments, pension funds, and other beneficial souls, who do not deserve to be damaged by others' wrongdoing and who should be protected; nor on ...(2) The equity owners. They've been pretty much wiped out already, and to totally wipe them out would send a message deterring anyone from ever investing in banks again; nor on ... (3) Taxpayers -- absolutely no more cash from taxpayers, he says!

But in bankruptcy somebody has to take a visible loss. The only possibilites are creditors, equity owners and taxpayers, and Barney ruled them all out. As long as this reflects what our ruling politicians think, bankrutpcy seems not an option.

Of course the result is taxpayers will take the hit when the govt has to throw $X00 million at whomever looks like being the next Lehman -- but as long as that's in an emergency, Barney & Co. have their political deniability. "We never planned to have taxpayers pay for this bailout, it was not our policy, but when emergencies like this happen we have to show leadership and rise to the occassion!"

The result looks like "Japan light". Like in Japan, the old banks carry forward with their managements and owners intact, with the govt funding emergency bailouts as needed. Unlike Japan, the banks aren't tied to zombie non-bank operating businesses, and there's an effort via the Geithner plan to get their bad assets out of them or at least priced at market value, so maybe they won't become zombies themselves.

More issues, generally ascending in merit...

[] Some people say that the banks' creditors (Barney's "good people") taking a trillion dollar hit would set off a devastating round of consequences, another Lehman and more. Others say nothing of the kind would result. That's empirical, I don't know. The Fed should have figured that out by now.

[] Realistically, it's not so easy to determine if a bank is bankrupt. John Hempton points out there are at least five different measures of solvency that can give very different readings for different purposes. And mistakes happen, in Sweden some banks deemed insolvent proved solvent enough to produce 20-fold returns. And Sweden's banks were much smaller, simpler and easier to value than US banks. Hempton thinks that forcing a big bank into bankruptcy or nationalization too soon would clobber the whole bank capital market (and that the WaMu takeover did just that.)

[] Speaking of Sweden, as everybody is, as a successful model of "nationalization", as Krugman is pushing, there are Swedes saying they didn't nationalize their banks, Norway did. Of 114 Swedish banks only one major one was nationalized. Their model,as per Anders Aslund, was good bank-bad bank with every bank's bad assets segregated in its own bad bank. There was no trading of bad assets as per the Geithner plan. The bad banks became investment trusts, were wound down slowly, most eventually turned a small profit, as did the govt in the end.

The key step in Sweden was the govt guaranteeing all bank debt so the banks retained inexpensive sources of funds, and big profitable spreads on lending, and so earned their way back to health.

[] Warren Buffett, Hempton and others have noted that US bank spreads similarly are historically high today, very profitable. So banks that aren't really bust by the five measures may not be nearly as bust as they may seem, and be able to earn their way back if their sources of funds are guaranteed by the govt. There may not be the need for more than a few bankruptcies/nationalizations. If that works, it could be the least costly option for all.

It looks to me like the real choice is between (1) bankruptcy, let the banks' creditors take their losses, which is how capitalism should work, and (2) the pragmatic govt guarantee of all the banks' debt to let 'em earn their way back. It's a risky choice, discussed here, trying to determine beforehand which would cost less.

In practice politics is driving us to #2, but in only an ad hoc manner, with only an "implicit" guarantee ("no more Lehmans!") which incurs all the cost of an explict one but without all the benefits, and without the transparency, asset-segregation and coordination of the Swedish idea that it sorta kinda follows. How the Geithner plan fits in it is problematic. And you're right, the govt isn't explaining how what it is doing is better than any other idea anyone else has.

One person's over-wordy opinion, FWIW.