You can't get there from here, part two

As I write this the U.S auto makers are asking for a piece of the bailout pie, so I have to type fast to catchup. I'm behind in my blogging. But, I'm only one person. I can only handle one bailout at a time. So, let's pick up where we left off. The $700 billion bailout has been passed. It's stated goal was to inject fresh capital into banks struggling because of bad mortgages on their books. It's been too early to determine whether the program has been a success, so it would not be fair to judge it. However, we can take a look at the underlying issues and see if it has a chance to work. History can tell us if we are right, later.

Anyone who has spent any significant time with me since the Bear Sterns bailout knows that I have disagreed with almost everything that has been done, thus far. I am not one to disagree and then not offer a solution, however. Essentially, I believe that the free market can and will take care of the financial crisis, in its own time. It's a lot like having the flu. You cannot do anything about it, you just have to ride it out. Like the flu, though, we can do some common sense things to make the recovery easier.

The problem with the government bailing out Bear Sterns, AIG, Fannie Mae, and Freddie Mac, as well as propping up failing banks with fresh funds is that the markets cannot tell what investments are worth. By markets, I do not just mean the stock market. I mean all types of financial markets including real estate, investments, banks, etc. The problem is not a lack of money for banks to lend each other, it is that the banks do not know which banks are healthy and which ones are not. No one is going to lend if they are not assured of getting their money back, with interest. Recently the government has expressed disdain for the banks for not lending, claiming it is there job to lend. That is only partially correct. A bank's job is to lend to an acceptable risk, and pricing for whatever the risk is. If the risk is higher than normal, the loan must be structures accordingly, i.e. higher interest rate, more stringent collateral requirements, personal sureties. Lending otherwise, is what got us here in the first place. The banks are lending. Most are also going back to the basics, rather than taking on unacceptable risks.

Most economists agree that home values have to find a floor before we can even think about a recovery. That will be difficult with this bailout. Not allowing problem banks to fail or homes to be foreclosed artificially inflates home values. Keep in mind that 98 percent of banks are properly capitalized, and it is estimated that only 117 of the over 8500 banks are actually in danger of failing. If banks are forced to deal with their bad home loans one of two things will happen. First, the bank could try to renegotiate the loan with the borrower. Banks do not want to foreclose. They want their loans paid back, with interest. If this could not be accomplished, the loan would be written off, and then the home would be foreclosed upon, and sold on the open market. Granted, the home would be sold for less than the bank would like, but it would be sold and a value (albeit a low value) would be established. This is the beginning of the process of reestablishing home values. I did not say it wold be easy, and you certainly cannot put a time limit on it, but it is the only way to truely establish a value. The markets must be allowed to function properly.

This idea is not mine. The government proved this would work when it established the Resolution Trust Corp to handle the orderly dismantling of the Savings and Loan industry in the early to mid 1990s. Not only did the RTC do it's job, the taxpayers did not lose a dime.

Another idea that is being tried is to increase FDIC coverage for deposits at all banks, healthy or otherwise. The FDIC has temporarily increased coverage from $100,000 to $250,000 until Dec. 31, 2009. In addition, non-interest bearing transaction accounts (i.e. a checking account) are insured for any amount. The idea was a noble one: help the depositors feel good about their deposits. But, like the help with the bad loans, this distorts the market. Keep in mind that 98 percent of the banks are just fine. (that number has not change since the last paragraph) Depositors were certainly upset, and many of them panicky, but reports show that, during the third quarter of the year, before the increase in FDIC limits, money was not withdrawn and shoved in mattresses, rather it flowed from unhealthy banks to healthy banks. Consumers made rational choices. Rather than follow the high rates, they went for safer options. They trusted the banking system, in spite of their worries. They just did not want to go through the worry of an FDIC takeover of their bank. In addition, ther are so may ways to structure an account that it is easy to increase a person's FDIC coverage, without leaving a bank. Corporations do not have as many options, but they can get coverage in non-interst bearing transaction accounts.

The point is that the market, i.e. consumers will make the choices for the government. When the dust settles, the government can buy the assets of the failed banks, like the RTC did, package them, and sell them. There is always a buyer if the price is right.

Don't get me wrong. Markets can never be completely free. This crisis proved that. Where money is involved, greed generally rears its ugly head. As we have seen in the last year, it does not take many to bring down everyone. This can be remidied through proper regulatroy legislation, including criminal penalties for those responsible for fraud and other acts against the interests of investors. Investors can and will lose money, but perpetuating the frauds that went on in the investment banking and mortgage industries must be punished, and punished severely.

Thanks for taking the time to read this. I'll talk to you soon.