Floyd Norris

High & Low Finance
Plan B: Flood Banks With Cash
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new_york_times:http://www.nytimes.com/2008/10/10/business/10norris.html

By FLOYD NORRIS
Published: October 9, 2008
Banks are supposed to lend money, but they aren’t doing very much of it these days. That is not the only cause of the global recession that is unfolding, but it is hard to see how economies can begin to recover without functioning financial systems.

The American government has responded by taking over more and more of the lending itself, while using indirect means to shore up the banking system. It has not worked.
Never in history have the Federal Reserve and the Treasury announced more plans to try to fix the financial system within a span of a few months — and rarely have investors been less impressed.
The Standard & Poor’s index of 500 stocks is down 22 percent since the end of September, and 42 percent since it peaked a year ago.
It may be time to try a new approach, and perhaps to abandon the announced details of the bailout plan passed by Congress with such difficulty only a week ago. The government needs to decide which banks it is sure are worth saving, and pump capital into them directly.
Treasury Secretary Henry M. Paulson Jr. indicated this week that he was considering such an approach, which would be much simpler and could be much more effective.
The announced plan for the bailout package was for the government to buy up dubious assets from banks, paying more than they are worth now but less than they are expected to be worth later.
If that is completed, banks will get cash — $700 billion or more. But their net worth will rise only to the extent the government overpays for the assets. Pricing those assets will be anything but easy, and the expectation of the government program has further frozen those markets. No one wants to sell until they can find out what the government will offer.
The alternative is to go in the direction Britain went this week. The government could use the $700 billion, or at least a large part of it, to buy preferred stock in banks.
The government could be selective in deciding which banks get the cash, and it could impose conditions on those that seek the money. Those banks could be required to come clean about the risks that they have taken in dubious assets, and to write those assets down to what a willing buyer would pay now.
With that information, the government may decide to let some banks fail. But the others, in which the government does invest, would have a government seal of approval that was backed up by cash.
And a lot of cash. A rule of thumb might be that if the government thinks a bank needs $4 billion in additional capital, it gets $8 billion.
The terms could be arranged so that the government gets a reasonable profit if the bank can pay the money back within five years, and can convert its stake into common stock only if that deadline is not met. That would give the current shareholders hope that their stock will be worth something someday, and perhaps avoid the further sell-offs that could otherwise arrive with the plan.
For much of the 14 months this crisis has been growing, the government has believed it was one of illiquidity — a temporary inability to raise cash — rather than insolvency — the issue when a financial institution is broke. The assumption was that the banks really would be fine when worries went away, and they had to be helped over that temporary hump. The Federal Reserve expanded both the amount it was willing to lend and the collateral it would take to back up loans.
The crisis, it turns out, is one of a lack of solvency, not just liquidity, and that is why banks fear to lend to one another. Each bank knows the games it has played in valuing assets — or at least could have played — and is loath to believe the balance sheets of other banks. That suspicion has chilled the interbank lending market.
The sad saga of the American International Group is one reason for that chill. When A.I.G. first said it needed help, $40 billion was said to be all it needed. Now the total is over $120 billion, as more problems are found.
One European precedent that the Treasury could study was used this week when the government of Denmark guaranteed both deposits in Danish banks and all interbank loans. The banks were ordered to halt dividend payments and share buybacks.
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Floyd Norris’s blog on finance and economics is at nytimes.com/norris.