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The Two Sides of the Financial Rescue

PH2009060901816.jpgI don't really know how to summarize a post that I'm linking to because it is, itself, uncommonly clear summary of the past year in Treasury thinking. But since I don't trust you all to simply read what I link to, let's give it a shot. James Kwak begins with a capsule explanation of a bank's balance sheet. "As anyone still reading about the financial crisis is probably aware," he writes, "a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities."

A strategy to save banks by using the right side of their balance sheet involves, essentially, pumping money into them, generally in return for equity. A strategy to save banks using the left side of their balance sheet involves helping banks rid themselves of the bad assets that are gumming up their business. Kwak tells the story of Treasury's efforts to save the banking system as a mad oscillation between the right and left sides of the balance sheet:

The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.

I'd amend Kwak's final line a bit: The argument is that as long as the economy keeps improving and the banks can continue raising capital, everything is fine, no matter how many toxic assets the banks hold. And that may be true! But it continues to be the case that the PPIP plan fell apart not because the Treasury Department decided it was unnecessary but because the banks, which were suddenly flush with fresh capital, refused to participate in it. And that was probably a smart bet from their perspective: The government has made clear that it will not allow them to fail. If the economy sags again, their capital dries up and they prove unable to hold the assets to maturity, the PPIP, or some other federal program, will always be available to help them out of their bind. But if that happens, the presence of those toxic assets on the left side of their balance sheet will make the downturn worse for the rest of us then it would otherwise have had to be.


Photo credit: AP Photo/Richard Drew..

By Ezra Klein  |  July 1, 2009; 10:41 AM ET
Categories:  Financial Crisis , Solutions  
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Comments

I think about this is an even simpler way. On the left side, banks have assets that were way way overvalued unless you think housing can't ever go down in price. The price has gone down, making part of that chunk vaporize - but they stubbornly refuse to to smell the burning trash in their vaults.

On the right side, they have way way overleveraged the depositors/investors (liabilities and equity, respectively) cash, because greed for profits and a belief that the house of cards couldn't fall (plus grossly inadequate regulation that allowed the kids to eat all the cookies in the jar that they wanted to).

On both sides, they have Daddy (the Fed and Treasury): helping to keep (or reflate to 'normal') the value of the real estate (and related bundled mortgage-backed securities and hedges) through various slight-of-hand tricks and essentially dishonest shilling, on the left side. On the right side, free money from Daddy! And mark-to-magic bookeeping too, authorized by the council of elders.

There is no longer any reality in realty or in banking. Totally manipulated, with hardly a pretense of 'free market'.

We need to reteach the meaning of "caveat emptor" to several generations that didn't learn Latin. Or, face reality, and let the institutions that were as irresponsible as kids at the cookie jar learn what "you are insolvent, therefore out of business" means.

Posted by: JimPortlandOR | July 1, 2009 12:28 PM | Report abuse

Re-instate the Glass-Steagall Act immediately. The change to mark to myth, or mark to market, allowed the banks to manipulate their books and raise chump change to make some repayments.

The buy back of toxic assets needs to stop. The banks have been busy separating out the toxic assets into several piles. One pile has class A paper, loans underwritten with PMI insurance or high standards, and on the other side those steaming heaping piles of no money down loans that are true tirds.

Guess which pile will be "offered" to the public. Guess who will end up getting this shoved up their colon. Go take a look in the mirror.

Support Ron Paul and demand an immediate audit of the Federal Reserve.

Posted by: Bubbette1 | July 1, 2009 3:22 PM | Report abuse

Sorry, call your Congressional representative and demand that they support HR 1207 to audit the Federal Reserve.

Posted by: Bubbette1 | July 1, 2009 3:24 PM | Report abuse

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