The "Bad Bank" of the United States: Will Obama Give Away $$ to Banks or Re-structure the Financial Industry?

I wrote yesterday about the progressive case for bank bailouts.

I should clarify that such a case can only be made if one is looking forward from the quagmire we are in now. Given the hemorrhaging of billions at the largest financial institutions, Obama has virtually no choice but to plan a rescue as the banks have become "to big to fail."

Simply put, that means that they are so large that their failure would effectively cause a landslide that would bury economic system. For example, their investments are spread so wide that liquidating them would kill markets, i.e. if they sold all of their mortgage-backed assets at fire sale prices, all the other banks would have to value their assets at those same prices. This is due to the establishment of "mark-to-market" accounting practices, which were designed to bring more transparency and accuracy to financial accounting. (Watch for this rule to be abandoned, which would be a travesty, as many in the industry have been crying that it is the accounting rule, not the specious value of the "troubled assets," that is the "real" problem with the banks).

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And that is only one of a myriad to ways that the collapse of a Citi would impact the financial system. Indeed, many economists and Wall-Streeters believe that the Federal Reserve's decision to allow Lehman Brothers, which was much much smaller than a Citi, to fail is the direct root cause of the escalation of the economic collapse in the last four months. If Lehman caused a heart attack, the thinking goes, what would happen if Citi, Bank of America, and others failed too?

Obama is not going to let that happen. So bailouts have to happen now. But what form each bailout takes is crucial to determining whether the taxpayer is getting a raw deal, which, it is obvious now, already happened with much of the spending of TARP 1.


Potential Problems with "Bad Banks"

Paul Krugman, my source for all things related to fiscal policy, recently wrote that he is concerned about the ideas circulating about establishing a federal "bad bank" that would purchase distressed assets like mortgage-back securities from the large financial institutions, but that there aren't enough details available yet to determine if such proposals could work.

The same problems that arose with TARP 1, he argues, could emerge with the "bad bank" scenario.

The big question is: would the government be buying the troubled assets at artificially high prices (in other words, paying to much and giving money away to the banks) or at a discount (which could then possibly be profitable)?


And What about Progressive Economic Policy for the Future?

Obama's team needs to already be thinking beyond this crisis to a restructuring of the financial industry. What kind of progressive economic (and maybe anti-trust?) plan could be enacted to make sure that such bailouts are never needed again?

The government could establish regulation and oversight that doesn't allow for institutions, not just banks but also hedge funds and savings and loans etc., to get so large as to be "too big to fail" in the first place. If this were the case, the FDIC would protect depositor accounts as the bank simply failed due to mismanagement and, for the most part, lays the losses squarely on the shoulders of owners and investors, not on the government.

The fact that the large majority of regional banks are in far superior shape right now when compared to the massive Citis and Bank of Americas (because the regional banks had better general risk management and hadn't merged with "investment banks" that caused massive internal trading losses, to give only two examples) is just a small piece of the evidence that lends support to the idea that smaller, local/regional banks are much healthier for the economy.