Finally Prepared to Kill Zombies?

Earlier this year, Nobel Prize-winning economist Paul Krugman took the position - as did former Chairman of the Federal Reserve Alan Greenspan - that large American banks, the ones to which the term "too big to fail" has been applied, ought to, in fact, be temporarily nationalized through receivership by the Federal Deposit Insurance Corporation (FDIC):

Lately the Federal Deposit Insurance Corporation has been seizing banks it deems insolvent at the rate of about two a week. When the FDIC seizes a bank, it takes over the bank's bad assets, pays off some of its debt, and resells the cleaned-up institution to private investors. And that's exactly what advocates of temporary nationalization want to see happen, not just to the small banks the FDIC has been seizing, but to major banks that are similarly insolvent.

The real question is why the Obama administration keeps coming up with proposals that sound like possible alternatives to nationalization, but turn out to involve huge handouts to bank stockholders.

What we got, of course, was exactly what Dr. Krugman warned us about: the Troubled Assets Relief Plan (TARP), a $700 billion plan that uses public money to purchase unmarketable assets from struggling financial institutions in the hope of strengthening their balance sheets. In other words, an attempt to treat symptoms instead of addressing the underlying illness:

... it’s basically saying that, you know, there’s nothing really fundamentally wrong with our banking system; there’s just this crisis of confidence, and so nobody wants to buy, you know, asset-backed securities, nobody wants to buy stuff that’s ultimately backed by home mortgages, and if only we could get people to see that these things are really pretty decent assets, then the banks will be in fine shape. And that’s the trouble. You know, there’s an argument that says maybe they were somewhat underpriced, but to make this the centerpiece of your financial rescue plan is just—well, as I wrote in the column, it leaves me with a feeling of despair.

TARP has allowed banks to essentially operate as if their financial underpinnings are actually healthy and to pay out enormous bonuses to their employees. While this has generated plenty of popular outrage that taxpayer dollars are effectively flowing straight into the wallets of the already-wealthy, such bonuses have continued unabated and without apparent shame. As Daniel Alpert, managing director of New York-based investment bank Westwood Capital LLC noted - without any evidence of irony - “The large banks are knocking the cover off the ball. [The industry is] making money, though with government help.”

The argument against FDIC receivership has always been a bit hard to see, although backers of government handouts to the financial sector have pointed to the facts that the agency has both plenty on its plate with the number of banks it has seized, and that it is running out of money. Of course, the simple solution to that would be to use the money allocated for TARP to fund the FDIC. The bill to taxpayers would almost certainly be smaller and management of the funds more transparent, but for some reason, this is rarely discussed as an option.

On Thursday however, Treasury Secretary Timothy Geithner stated that, not only should the Federal Reserve lose its ability to bail out firms in the manner in which it propped up insurance giant AIG, but that the FDIC is the proper mechanism for enforcing the notion that no financial institution should ever be considered too big to fail:

Any firm that puts itself in a position where it cannot survive without special assistance from the government must face the consequences of failure... We cannot put taxpayers in the position of paying for the losses of large private financial institutions... We must build a system in which individual firms, no matter how large or important, can fail without risking catastrophic damage to the economy.

Mr. Geithner's statement came in support of H.R. 384, legislation designed to bring increased accountability to TARP now and to any similar situations that may arise in the future. More accountability is always a good thing, especially in the realm of public funds, and TARP is unquestionably a reality that needs to be addressed. The Treasury Secretary's new-found appreciation for the function of the FDIC might turn out to be a case of closing the barn door after the horse has already bolted, but a drive to ensure that zombie banks are not allowed to live on remains the right course of action.