It is clear by now we have to address the problem of our banking system, which is at the heart of our predicament. Without sound banks, credit doesn't flow and the entire economy is at a standstill.
It is also clear we can't keep digging the hole we are in, throwing good money after bad by trying to bail out every insolvent bank and backstop every bad mortgage. Moreover, usurping private industry is an expensive proposition with dreadful unintended consequences. Once a few banks are nationalized, shareholders will ditch all others, fearing that their stock would soon be worthless as well. These banks would then also need government support.
The guarantees that the US government has already extended to the banks, and the large but in hindsight inadequate capital proffered them under the Troubled Assets Relief Program (TARP), is not dissimilar from those given by the Japanese government in the mid-1990's to resuscitate their major banks. The result there was that the Japanese banks used the cash to effectively transfer the losses to the taxpayers. Subsequently, they were still undercapitalized, and prolonged the credit crunch and the bubble's terrible consequences. Between 1992 and 1998 the cost to the Japanese economy from bad lending quadrupled from 5% of GDP to over 20% of GDP.
That is happening here now. We are keeping appearances, making believe that those toxic assets are worth more than they trade for today. This is not a strategy, but a desperate act to avoid short term pain. It will exacerbate our problems and create an unbearable financial burden that might crush us.
We have to face the banking crisis head on, and the sooner we do it the better. Banks need to be disciplined; those that can't survive must go. When that happens, the better managed, better capitalized banks can distinguish themselves. Otherwise we are wearing down the incentive of the more viable banks to engage in good lending as opposed to self-preservation and sucking up more of Washington's cash.
Instead of spending more money on the failed institutions, which is Sisyphean and wasteful, why not follow the suggestion of my friend Mike Meixler, an Arizona money manager, and dedicate $100 billion from the TARP budget to creating community banks? Take the money earmarked to large, corrupt and failing banks that wretchedly brought us to the precipice, and have the FDIC offer matching capital to anyone setting up a new community bank.
Say someone in Stockton, Calif. puts up $25mm to launch a community bank. Washington provides an additional $25mm, and asks for nothing in return except that the new bank will be supervised by the FDIC and comply with regulatory requirements. We limit the new community banks to no more than $100mm each and no more than two banks per population of 500,000, to make sure they are spread around.
This will attract many savvy business people because they can double their equity on day one. It will rejuvenate the banking industry because you will now have new community banks unsaddled by toxic assets, with pristine balance sheet and eager to lend; and magnified by the reserve ratio, it will create available credit at least 20 times the capital the government provides.
That is a much better solution to the banking industry than anything I have seen from Washington thus far. I am aware that the government will not get its money back, as this is not a loan. But I doubt we will see our money back from Citigroup or the other troubled banks, so we might as well spend it wisely on people that are deserving and can actually do some good with it.
The only argument against this proposal is that it will put the large banks out of business. But they are effectively insolvent anyhow, and are not lending the new money they got from the Treasury because they are afraid it will not be sufficient to support their huge liabilities from the glory days. So let those foolish banks go. The more we delay solving this crisis, the more damage to the system, the more pain for the stock market and the higher the ultimate price to fix the banking crisis.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.