A Bank Bailout That Works (Page 3)

Editor's Note: An earlier version of this essay erroneously stated that Sen. Christopher Dodd supports bank nationalization. In fact, Dodd has said he does not welcome nationalization, but "we may end up having to do that."

Is There an Alternative?

Firms often get into trouble--accumulating more debt than they can repay. There is a time-honored way of resolving the problem, called "financial reorganization," or bankruptcy. Bankruptcy scares many people, but it shouldn't. All that happens is that the financial claims on the firm get restructured. When the firm is in very bad trouble, the shareholders get wiped out, and the bondholders become the new shareholders. When things are less serious, some of the debt is converted into equity. In any case, without the burden of monthly debt payments, the firm can return to profitability. America is lucky in having a particularly effective way of giving firms a fresh start--Chapter 11 of our bankruptcy code, which has been used repeatedly, for example, by the airlines. Airplanes keep flying; jobs and assets are preserved. Under new management, and without the burden of debt, the airline can go on making a contribution to our society.

Banks differ in only one respect. The failure of a bank results in particular hardship to depositors and can lead to broader problems in the economy. These are among the reasons that the government has provided deposit insurance. But this means that when banks fail, the government comes in to pick up the pieces--and this is different from when the local pizza parlor fails. Worse still, long experience has taught us that when banks are at risk of failure, their managers engage in behaviors that risk losing even more taxpayer money. They may, for instance, undertake big bets: if they win, they keep the proceeds; if they lose, so what?--they would have died anyway. That's why we have laws that say when a bank's capital is low, it should be shut down. We don't wait for the till to be empty. Because the government is on the hook for so much money, it has to take an active role in managing the restructuring; even in the case of airline bankruptcy, courts typically appoint someone to oversee the restructuring to make sure that the claimants' interests are served.

Usually, the process is done smoothly. The government finds a healthy bank to take over the failed bank. To get the healthy bank to do this, it often has to "fill in the hole," making up for the difference between the value of what the bank owes depositors and the value of the bank's assets. It's no different from an ordinary takeover or merger, except the government facilitates the process. Typically, in the process, shareholders get wiped out, and often the government and/or private investors may put in additional money.

Occasionally, the government can't find a healthy bank to take over the failed bank. Then it has to take over the failed bank itself. Usually, it restructures the bank, shutting down many of the branches and lending departments with particularly bad track records. Then it sells the bank. We can call this "temporary nationalization" if we want. But whatever we call it, it's no big deal. Not surprisingly, the banks are trying to scare us into believing that it would be the end of the world as we know it. Of course, it can be done badly (Lehman Brothers, for example). But there are far more examples of it being done well.

The current situation is only slightly different. There are few healthy banks to take over the very many unhealthy banks, and the banks are in such a mess--and the economy is in such a downturn--that we don't really know how much money would be needed. We don't know if claims by depositors are greater than the value of assets, and if so, by how much. The banks may claim, If we hold the assets long enough, and if the real estate market recovers, and if our recession isn't too deep or long, then we can meet all our obligations. We are "solvent." We just can't get the cash we need.

Those are big ifs. That's why governments typically make judgments based on market values. Right now, the suspicion is that the banks don't meet their capital requirements with current market values, let alone the market values in the future, as real estate prices continue to fall and the downturn gets worse. (If banks don't have enough capital, we would give them short notice: either come up with additional capital, or you can't continue to operate as you are. We either find someone to take you over, or we run you, restructure and sell.)

The banks obviously don't want the government to play by the rules. They want to delay the day of reckoning. They want what is called forbearance. They say, Allow us a little slack now, because we are fundamentally sound. Of course they would say that. Of course banks claim that market prices underestimate true values. We learned the hard way in the S&L crisis, however, that delay is very costly. We are on track to learn that lesson again.

The Obama administration seems to be proposing a way out of this muddle: we will "stress test." We will see how well you fare. If you pass the test, we will help you get out of your temporary difficulties. Stress testing involves using mathematical models to see what happens under various scenarios. The banks were supposed to have been stress testing themselves on an on-going basis. Their models said everything was fine and dandy.

We know those models failed. What we don't know is whether the models the administration will use will be any better. Will they use the old, failed models? We have been told that it will take time to do the stress test, and while we wait, will we pour more money into failing institutions, with good money chasing bad, ever widening our national debt. We know, too, that the worst-case scenarios that will be used in the stress test are nowhere near the worst-case scenarios that some economists are depicting--implying that even banks that pass the stress test may need more funding down the line.

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