The Two Sides of the Financial Rescue
I 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..
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