Seven Suggestions for Dealing with the Banking Crisis--Page 2

1. First, the Fed should stop with the reckless magnitude of recent money printing (in particular, to fund massive purchases of agency-backed mortgage securities) and scale back its role to the lender of last resort and keeper of short-term interest rates. The risk of a broken currency and asset flight out of our country is too great and the goal of reflating a tainted asset class (housing) to previous highs will never work when consumer confidence is so badly broken. If anything, my bet is that these freshly printed funds will once again inflate things that people need (commodities) rather than things that people merely want, such as the levered purchase of homes and cars without pausing to save a down payment.

2. Next, let's drive a stake through the zombie banks. We need to do this before they infect the rest of the economy and financial market through a combination of aggressive deposit competition, politically directed lending to the connected club, and scaredy-cat underwriting of loans to small and midsize entrepreneurs. To accomplish this, the government should demand that auditors and regulators enforce realistic accounting standards each quarter to best reflect the underlying values. This is clearly no easy task with illiquid assets and I'd emphasize that balance sheets need to reflect properly conservative credit loss assumptions, but not oversized illiquidity discounts on reasonably underwritten whole loans. More accurate financial statements would help eliminate the ethereal counterparty fear that is born from delayed surprises like Merrill Lynch's last reported quarter as a stand-alone entity.

3. If best-effort--rather than the papered-over--accounting leads to capital shortfalls, government regulators should then make a decision about whether the bank is a good bank or a bad bank. At its core, a good bank has sound assets and ongoing earnings power from its existing business model. Bad banks are those that have lost their earnings power due to the faded debt bubble or made so many mistakes with their loan book that there's too much rot to salvage the whole. The Treasury should inject common equity into good banks (to be sold off when the market returns) to bring them up to snuff. Bad banks should be taken over by the FDIC while ensuring that depositors, lenders, and trading counterparties are made whole, but common and preferred equityholders are wiped out. The bank should then be auctioned off to the highest bidder with its branches, deposits, and cleanest assets in tow. The toxic stuff should stay at the FDIC to be auctioned off when the market returns. If one of the largest U.S. banks were to fail, it would admittedly leave a large pile of assets at the FDIC to wait for better times, but that is better than having a fire sale in a market suffering from lack of bids. We regard the quick sale of the healthy portion of the failed bank as critical. Banks fully owned by the government would likely steal market share from private banks, even if they're healthy, destabilizing them in the process. While this good/bad bank triage is likely to send the equities of marginal banks crashing even further, a wholly transparent process that ends with capital injection into good banks would likely shore up confidence after the fact, unlike the current charade of pretending all large or politically connected banks are "healthy."

4. Throughout this process of weeding out the zombie banks, we view the protection of creditors as critical to preventing a backslide. If lenders face substantial losses during workouts at the FDIC, wholesale lending will once again evaporate from the entire system, and dominoes would begin falling regardless of the health of the institution. Why lend to a bank at 5% when the maximum loss can approach 100%? FDIC guarantees of newly issued debt and liquidity support from the Fed have been employed to address the drying up of wholesale funding and this rebuilding of confidence shouldn't be derailed.

5. With banks sitting in government hands even temporarily, politically directed lending is within easy reach. The government should avoid as much as possible telling banks, public or private, how to lend. Capital has been wildly misallocated, and the last thing we need is more misallocation of resources. If the government decides it is compelled to make a particular loan or set of loans, it should go around the banks to accomplish these goals via direct lending, so as to avoid polluting the competitive landscape any more than is absolutely necessary. We suspect many of these government-directed loans will end badly and we think Uncle Sam should be held fully accountable rather than forcing banks to do his dirty work only to provide a convenient scapegoat after the deed is done.

6. Transparency about the sorting process of undercapitalized banks between good and bad banks is also critical. The entire decision tree needs to be spelled out publicly and in detail. At what capital level or under what kind of liquidity conditions are banks forced into the triage process? For example, the rule could be that banks with less than a 7% Tier 1 ratio that also produce a quarterly loss enter the triage process. Similarly, any bank that loses more than 10% of its deposit base in less than a year's time enters triage. In triage, a bank must prove to regulators that its earnings power is intact and that rotting assets on its balance sheet are conservatively marked. Third-party assessments and valuations should be relied upon as a key input. Backroom deals that lead to arbitrary decisions foster a lack of confidence, which leads to a higher cost of capital at the least or, at the worst, outright fire sales of bank equity and counterparty fears.

7. Turning to the addled housing market, with existing home inventories of nearly 4 million (close to double normal frictional inventory levels) and a massive pipeline of foreclosures forthcoming as indicated by mortgage loss curves, the government also must intervene more aggressively in this key market--the most widely held and typically the most levered asset on household balance sheets. Bankruptcy cram-downs of mortgage debt--where bankruptcy judges could alter the terms of mortgage loans--seem appealing and do provide a stick to encourage private workouts. We fear they could lead to a massive wave of filings, however, which would cause a spike in homes for sale and pull forward losses across a wide variety of consumer loan categories, stressing an already fragile banking system. Instead, we think the Treasury should use government capital to buy down principal balances for stressed homeowners that currently live in their home, demonstrate the willingness to stay, and prove that they have enough earnings power to have a legitimate shot at remaining a homeowner with some timely help. Speculators and recently unemployed people with few assets will inevitably face foreclosure and these homes must clear the market. The latter could be addressed via social programs, either private- or government-funded. On the demand side, subsidized rates and tax breaks should be directed only at first-time homebuyers who actually take inventory out of the system.

Together, I think this package of ideas--combined with an effective fiscal stimulus package--should facilitate an orderly clearing of the housing and financial markets sooner than might otherwise occur. Most importantly, I think the aim should be to encourage the most orderly transition possible toward increased savings, thrift, and responsibility.

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