Thursday, March 5, 2009

Who Needs Stress Tests?

Can we just put our major banks into receivership and be done with it? According to banks' own estimates of the fair market value of their financial instruments, Bank of America and Wells Fargo are insolvent. Citi is clearly there too (no wonder they never sleep). And it's hard to imagine JPMorgan won't join them, as more commercial real estate, auto loans, and credit card debt go bust as the real economy deteriorates over the coming months.

Yes, a temporary nationalization will be ugly. Wiping out management and shareholders is easy. But dealing with bondholders will be harder. Some will have their holdings converted to equity; others will have to take significant haircuts. Furthermore, to prevent a run on unsecured debt at other banks, all nationalizations should take place at the same time so that there is no uncertainty about whether a bank might be taken over. Simultaneity and transparency should prevent panic from engulfing the markets. Again, this is not a free lunch. In most cases, the bondholders who will take a hit are pension funds, money market accounts, and insurance companies. This will be painful for ordinary people. But the alternative - pouring potentially trillions of dollars into zombie banks - is far, far worse. If the IndyMac experience is any guide, where a group including John Paulson and George Soros bought the troubled lender six months after the government seized it, the four major banks could be back in private hands within a year. That's about the best we can hope for at this point.

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