How Geithner's Break from Reality Is Screwing Up TARP

Yves Smith lays out just how stupid Treasury Secretary Geithner's proposal is. I think these are the key points (italics mine):

Let's start with the basics. The US banking system is insolvent. Got that? Insolvent. That does not mean every bank in the US is toast, in fact quite a few are probably just fine, and another large group is no doubt hurting and undercapitalized, but a couple of years of not shooting themselves in the foot again would enable therm (via earnings) to rebuild their equity bases sufficiently to proceed more or less as normal.

The problem is that a significant portion of the very biggest banks are insolvent....

There are variations on the theme: the government can take them over and recapitalize them, clean them up and re-sell them, a la Sweden; you can wipe out equity investors and bondholders; you can try new twists, like various good bank proposals that have surfaced lately (making new entities out of the deposits and good assets and leaving the dreck with the existing bond and shareholders). While there would be many important details to be sorted out, this is not path breaking, except in the scale at which it needs to occur. And now, having had four [acute] phases of a credit crunch, the Fed and other central banks have plenty of liquidity [facilities] ready to deal with any initial overreaction. Rest assured, although radical measures would not be pleasant or easy, there are plenty of models and precedents.

But...here we have another scowling Treasury secretary, with a bit more hair than his predecessor, serving up the same fatally flawed approach as before: let's just throw money at the banks and hope they get better. This is tantamount to using antibiotics to treat gangrene. You waste good medicine and the progression of the rot threatens to kill the patient...

The elephant in the room is how do we solve the heretofore insurmountable problem that the market price of the bad assets is well below what the banks are willing to sell them for?

...There is no evidence in the various elements leaked that this impediment has been overcome, which raises the real possibility of a Paulson-like seemingly bold advance followed by an equally hasty retreat. Inviting investors in with you on the buy side does not address the issue of the pricing gap, unless the deal with the investors is intended to help obfuscate the overpayment to the banks.

Like I've said before, when trillions of dollars go poof because assets were overpriced (and then loans were made to purchase those assets, and then those overpriced loans were bundled.....), it's going to hurt. Which brings me to Financial Times analyst Martin Wolf:

Arguing today's toxic assets are "fundamentally worthless" - and there's lots more losses coming - Wolf says the lack of political will (or outright cowardice) to admit to reality means "we're really in trouble." Why? Because confidence in policymakers will continue to deteriorate as their ill-conceived solutions continue to fail.

Once policymakers (ultimately) agree insolvency is really the underlying problem, there are two options for dealing with the banks:

• Nationalize them, and then inject government capital as the U.K. government has started to do with RBS and Lloyds. (a.k.a. The Swedish Solution)
• Put them into FDIC receivership or force them into bankruptcy, whereby common stock and preferred debt shareholders get wiped out and "senior" debt holders end up owning the banks.

I think Geithner is terrified that they'll have to admit that large portions of the banking sector have gone bust because he does not want to nationalize or bankrupt the banks. Part of this is that he'll have to admit that he fucked up while at the NY Fed, but I think he's also terrified to admit that things won't be the way they used to be.

This is where some presidential leadership--forcing Geithner to accept reality--would come in handy. Just sayin'.

Related post: Drinking Liberally in New Milford has some additional thoughts about all of this.