The government has finally come to its senses and will be injecting equity capital into banks instead of buying their trash assets. (It will still be buying the trash assets, too: It will just be doing it in secret, through Fannie and Freddie). This is good news: historically, equity injections have made for more successful bailouts than crap-asset removal, and they address the real problem–insufficient capital at the banks (which reduces the amount banks can lend).
However, there is still one important element of a smart bailout that is missing: forced asset writedowns. Before they get new equity, banks must be forced to write down the value of their assets to nuclear-winter levels. And they must disclose, in detail, the carrying value of their assets so the market can make sure they have done this.
Because the goal of investing taxpayer equity in banks is threefold:
- Improve the banks’ capital ratios, so they can start lending again
- Persuade private investors to invest in banks again
- Flush all the crap so we can start fresh…unlike Japan.
If the government does not force banks to write down their assets before injecting new equity, we won’t have fixed the problem. Instead, the US taxpayer will just be the lastest sucker to fall for the banks’ assertions that all the bad news is out of the way. Private investors, meanwhile, will stay on the sidelines and watch the taxpayer get sandbagged. Lastly, and most importantly (for the economy), banks won’t start lending again. Why not? Because they’ll want to keep all that new capital as a cushion for the next wave of writedowns.
Japanese banks played this game for a decade…and we know where it got them (NIKKEI Index is currently one-fifth of the peak value 18 years ago.) In Sweden, meanwhile, the government insisted on writedowns, and the economy recovered almost immediately.
(Sure, bank shareholders will get hammered with new writedowns, but the hell with them. They are not the taxpayers’ concern, and their additional losses won’t affect the economy or bank lending.)
So will Hank Paulson insist on massive writedowns before he spends hundreds of billions of taxpayer money? Doesn’t seem likely. In fact, right now, we seem to be headed exactly the opposite way. The banking lobby appears to have persuaded the SEC that the whole cause of the market meltdown is that banks have had to tell the truth about what their assets are worth, and the SEC appears to be poised to suspend mark-to-market accounting.