A Truth, What We Should Do, and What We Will Do

I haven't ranted much lately about the government's plans to work out the problem the TARP was supposed to resolve: that banks still hold crappy assets which is resulting in them lending less than people would like. We've now come almost full cycle back to the original TARP plan, which was, to buy Troubled Assets (remember, TARP stands for Troubled Asset Relief Program). Of course, the problem is that if/when the government buys these troubled assets, they will, by definition, be overpaying for them.

John Carney over at Clusterstock had a good piece today, attacking the fallacy that many congressmen and senators have been spouting because they don't know better: that "We need to get bad assets off the books of the banks."

The problem is not that balance sheets are somehow "clogged" with bad assets. If that were really the problem, everyone would immediately agree to this deal: Clusterstock will take all the bad assets. Every single one. Give us your subprime mortgages, your second liens, your bundles of autoloans and student loans and credit card debt. If the problem is that you need these off your balance sheets, we're here to help.

We'll even sweeten the deal by offering to pay you one penny for the assets. Not a "penny on the dollar." We're bidding one penny in total for every asset at the market prices below the value you are carrying them on your books.

Any takers?

We didn't think so.

As our little offer shows, the problem is not that there are no buyers for these assets or that the assets are clogging balance sheets. The banks don't just want to get rid of the bad assets--they want to get rid of them by exchanging them for far more money than anyone is willing to pay. And there's only one entity around that can force people to pay more than they are willing for something--that's the government.

We've made this point before but it bears repeating. Any proposal to buy bad assets from banks means that the government will give the banks cash for trash. The "bad bank" will have to overpay otherwise the banks won't take the deal.

Part of the solution that's been discussed is the good bank/bad bank plan, which basically results in the government buying up all the crappy assets. The problem with this is that, as Carney alluded to, the government will be overpaying for the assets, because the banks don't want to sell them at the true market value (and don't be deceived - the true market value is low for a reason - not because they are "fire sale prices" as a result of frozen credit markets, which was the party line spewed back in October and November. For one example, see Carney's own comment under his post.)

The Kid Dynamite solution is simpler: take the money we'd use to purchase the bad assets, and instead fund a new bank - or several new banks that can resume normal, unfettered lending. This would have multiple effects: primarily that the velocity of money would be higher - these new, pristine banks would be able to lend more to qualified borrowers, because they wouldn't have any questionable assets to hinder them - and we wouldn't have to overpay for crappy assets to get into this situation. Also, the government could directly set mortgage rates and other consumer loan rates at whatever level they wanted through these new, government sponsored banks. The Fed wouldn't need to continue to try to bluff the market that it's going to buy treasury bonds to keep rates low - they could set the rates directly - almost like a new, clean, Fannie and Freddie. All deposits with the current "bad banks" should be guaranteed - and they should then be allowed to fail and unwound in a controlled manner. Maybe this is more difficult than it sounds, but I am convinced that as long as we protect depositors money (instead of SHAREHOLDER money), the bad banks can be allowed to fail and we can re-develop a healthy, unfettered banking system.

This idea is not groundbreaking - tons of other people suggested it back when the original TARP plan was announced. It should now be clear that we can't keep dumping money into insolvent banks and yelling at them "LEND DAMNIT!! WHY WON'T YOU LEND!" If you want to know why they can't lend, read Mish's piece on how fucked Wells Fargo is...

Now, this won't happen. What will likely happen is that the government will announce some sort of massive guarantee program, like what they've already done with Citi, AIG, and BAC. They will tell us that these guarantees will only apply if the crappy assets default, and that the crappy assets will be fine with time. The truth is that this will simply delay our day of reckoning for a little while - because the crappy assets will NOT be fine. As I've said before, you can't grow or wait your wait out of a leverage bubble. It's a matter of time.

-KD