And Now You Find Yourself In '82?

As Simon Johnson notes, the administration seems to be following a different script for dealing with the banks from the liquidation/receivership/subsidization troika Elizabeth Warren outlined in her last TARP oversight report. This fourth option - what Simon Johnson calls "forebearance" - is essentially hoping banks can earn their way out of insolvency. By relaxing accounting rules on mark-to-market and providing just enough capital to keep banks operating, the administration hopes that a rebounding economy along with cheap money will provide enough earnings opportunities for banks to work their way back to health. Johnson points out that this is more or less the approach Volcker took with the banks after the 1982 Latin American debt crisis likely pushed many into de facto insolvency. But Johnson sees three factors that make such a policy succeeding today unlikely:

• this is a global slump
• the real economy will probably keep deteriorating, unlike the 1982 recession when there was a sharp turnaround after the Fed lowered rates
• there are more speculative attacks on banks today

Hedged Bet argued that forebearance was the real Geithner plan after Warren Buffet hinted as much on CNBC last month. It seemed like a plan to emulate Japan's zombie banks then, and it still does now. Let's hope this really isn't the plan.

Warren Drops A Bomb on Geithner

While she speaks in a mild-mannered tone, make no mistake: Elizabeth Warren TKOs Tim Geithner. In a measured tone, she lays out the three approaches to dealing with financial crises:

1. Liquidation, i.e. Chapter 11
2. Receivership. FDIC seizes the insolvent banks, separates the good and bad assets, recapitalizes the banks/gets bondholders to perform debt-for-equity swaps, and sell back the good bank to private investors
3. Subsidies. These can either be direct, in the form of capital infusions, or indirect, such as buying toxic assets at inflated prices.

Then Warren examines Treasury's policy of subsidization to date, before concluding

Treasury's overall approach seems based on the premise that the banking problem is temporary - and look, we all hope that's the case. If it is, more aggressive steps may never be needed. It is possible, however, that Treasury's approach fails to acknowledge the depth of the current crisis. The economy may not come roaring back. And the big profits that propped up the banks during the housing boom may not return. For some, that means it is necessary to consider alternate approaches.

Translation: this is not a liquidity crisis, and we're going to have to put insolvent banks into receivership. Hopefully Congress is paying attention.