Monday, January 19, 2009

OMG! Zombie banks!

You're just trying to scare us, Spot!

Yes, grasshopper; it's true, but there is reason to be scared.

Come on Spotty! Who's afraid of a bank?

Apparently you've never had an installment loan, grasshopper.


But zombie banks are even scarier than regular ones. Paul Krugman, make that Nobel Laureate Paul Krugman, was talking about them just today:

Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans. [oh, and Governor Pawlenty, too]

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

The original TARP plan was to take the sludge off the banks' hands to make them solvent again. In other words, buy these assets from the banks. You'd have to pay more than market value, or it wouldn't do the banks' equity position any good. This is what Hank Paulson originally proposed. Again, here's Krugman on his blog:

It looks as if we're back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it — and that if only we get the price "right", the banks will turn out to be solvent after all. In other words, we're still in Super-SIV territory, the belief that fancy financial engineering can create value out of nothing.

Color me skeptical. I hope the buzz is wrong, and that something more substantive is being planned. Otherwise, we're looking at Hankie Pankie II: Paulson may be gone, but officials are still determined to believe in financial magic.

But Spot, why is this worse that buying preferred shares in a bank or, shudder, if the bank is under water, seizing its assets?

As Krugman explains, again in today's column, it makes a huge difference to the common stock holders of the banks:

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. [by overpaying for toxic assets] But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

This is the "moral hazard" that conservatives talk about, but it is still not as bad as what Krugman calls the N-word: nationalization:

Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks.

A zombie bank is one that really has no equity in it, but it stumbles along undead, racking up more losses against its FDIC insured deposits.

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