Another Perspective

Kill the Big, Bad Banks

Providing welfare for credit-crack dealers is hardly the way to rehab a credit-addicted economy.

By 2.4.09

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Why is the federal government preparing to spend good money on bad goods -- namely the banks' toxic assets -- and then planning to store them in a so-called "aggregator bank," hoping they will improve with age? It's like politicians buying bags of rotting garbage and dumpster debris from their bankrupt cronies as a pretext to kick back public tax dollars to them. It's not right, and it won't work to revive the financial system and rejuvenate the economy.

Every day we read that one primary reason the financial system is on the brink of collapse is that the banking industry extended too many loans to consumers and businesses that weren't creditworthy. We also read the reason the economy is in a nose dive is businesses and consumers have stopped borrowing because they no longer have access to credit.

Taken together, these two premises imply the following conclusion: One key to reviving the economy and putting the financial system back on a sound footing is to provide creditworthy customers sufficient loans at reasonable interest rates. We are being told the only way to do that is to "save" big, bad banks.

Just the opposite is true: The only economically sound and morally just course of action is to close existing insolvent banks and replace them with new, sound banks.

The argument for saving the big, bad banks is suspect on its face because it is both so counterintuitive and so self-serving of the banking establishment. The argument also is profoundly weak because critical convincing evidence has not been provided to support the thesis that saving big, bad banks is required to prevent an economic meltdown. In fact, most of the data suggest just the opposite. Moreover, if we think about the situation for a few minutes, it stretches credulity to believe that persuasive supporting evidence for saving the big, bad banks will ever be produced.

It is easy to detect the fallacy of maintaining insolvent banks on life support by keeping them hooked up intravenously to the federal teat. A couple of "thought experiments" suffice.

How many creditworthy borrowers who want to borrow can't find loans right now at reasonable interest rates? How much total credit does that entail, i.e., how big is the current "credit gap"? Conversely, how many potential borrowers currently in search of credit are not creditworthy and hence should not be receiving new loans? How much credit does that involve?

Even without hard data, a moment's reflection suggests there is unlikely to be a positive credit gap. Given we are in a major recession, the number of creditworthy borrowers (and the aggregate amount of credit they would receive) is certainly less than it was before the recession hit, which means the total number of potential borrowers who should be receiving credit has shrunk.

Moreover, according to the latest data from the Fed, the total amount of commercial and industrial loans made at all commercial banks rose by almost 14 ½ percent during 2008, and consumer loans rose slightly more than nine percent. How on earth could there be a credit gap among creditworthy borrowers when their number has shrunk while the aggregate amount of loans has increased so substantially during a recession year when the economy was supposedly in the throes of a "credit crunch"?

If the credit gap is zero or close to it, then all of this talk about needing to juice up credit markets to save the economy implies that what we really are being urged to do is generate a lot of new loans to people who should not be borrowing money. That is to say, the nostrums being foisted on us are probably just more hair of the dog repackaged in fancy containers and sold as a potent economic elixir. This toxic potion is being hawked by big, bad banks, who themselves are in constant need of a federal "fix" to keep them out of the gutter so they can continue dealing the federal money through as loans to credit addicts on Main Street. Providing welfare for credit-crack dealers is hardly the way to rehab a credit-addicted economy.


TAKING THIS LINE of reasoning a bit farther, let's examine another widely accepted assumption: If all of the insolvent banks were shuttered, there wouldn't be enough lenders left standing to make all the justifiable loans to creditworthy borrowers at reasonable interest rates. In other words, regardless of how big the credit gap might or might not be right now, it would balloon to unacceptable proportions if we didn't prop up the big, bad banks to keep them lending.

Again, it is very difficult, if not virtually impossible for anyone to estimate the magnitude of credit shrinkage that would occur if all insolvent banks stopped lending tomorrow. However, a little thought experiment can help us get a handle on this issue too.

Rather than keeping zombie banks upright and mobile by constantly bailing them out and purchasing their toxic assets, what if the government were to shut down all insolvent banks, put them into receivership, and seize their assets? What if the government then placed each bank's deposits and all of its performing assets into a newly chartered bank and offered the shares of that bank for sale in a public stock offering, perhaps underwritten by the federal government. The proceeds of the stock issue would be used to capitalize each new bank, calibrating the amount of capital that needs to be raised by the amount of deposits and performing assets placed in them. At the end of this process, one (or several) new, good bank(s) would replace each old, bad bank that was closed.

This solution should provide an adequate flow of credit from the newly created good banks to satisfy the demand for credit at reasonable interest rates from creditworthy borrowers. Where is the evidence to the contrary?

Then, under its bankruptcy authority, the government could vitiate all legal encumbrances on the remaining distressed assets, which heretofore have prevented disassembling them and cleaning them up. Place the distressed assets into a clean-up/work-out facility similar to the Resolution Trust Corporation that cleaned up the S&L mess. Open up the distressed assets. Discard the bad apples. Clean up and repackage what's left by reworking them into new assets. Bring them to market through auctions and negotiated sales where they will sell readily at market-clearing prices. (The key to this clean-up/work-out effort is recognizing that the whole toxic asset is worth far less than the sum of its parts, so each component or valuable combination of the component parts must be extracted from the rotting asset bushel and brought to market separately rather than trying to bring the entire much lower-valued or worthless asset to market whole.) The proceeds of these sales could then be used as far as they would go to pay off the old bad bank's creditors. Let Uncle Sam take a fee for his workout and re-chartering services.

Who's afraid of killing the big, bad banks?

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About the Author
Lawrence A. Hunter is president of the Alliance for Retirement Prosperity.