Jonathan Alter: How to Save the Banking Crisis

As the old song goes, the thigh bone's connected to the knee bone, the knee bone's connected to the leg bone, the leg bone's connected to the … you get the idea. The entire economic crisis is connected to the woes of the banking industry. We loathe these institutions for good reason. But the brutal truth is that we need 'em. If we don't figure out how to get the hundreds of billions of dollars in toxic assets off the balance sheets of the megabanks, then credit will remain frozen and it's only a matter of time before we're all eating cat food.

This doesn't mean President Obama has to drop everything else and just focus on banking, which is the argument advanced by the same knuckleheads who didn't see the collapse coming. There are only so many hours in a day that any man should be made to discuss credit-default swaps. Good presidents multitask and strike quickly across a broad front early in their terms. But Warren Buffett is right when he says that the president needs to be clearer on the subject of the banks.

So let's take a little jaunt into that byzantine world. With some common sense, we should be able to puzzle through the various remedies. The alternative is to let the pinstriped insiders make all the big decisions. Obama told a group of CEOs last week that after stress-testing the banks (learning the extent of their insolvency), the government will "provide [banks] the support to clean up their balance sheets." That sounds good, and nearly everyone agrees that recovery depends on it. But what exactly does it mean?

We don't know yet. After proving too vague in a February rollout, Treasury Secretary Tim Geithner now says he will unveil the new plan soon. He and Larry Summers are dropping hints, but the specifics are still being worked out; we should dive into them now, before it's too late.

There are basically four options to address the banking crisis, two of which are nonstarters. The first is to celebrate the recent uptick in banks' stocks (Citigroup's share price now exceeds its ATM fee!) and do nothing—let the market exercise its healing powers. We tried that once before, under Herbert Hoover. Not smart.

The second option is to nationalize the banks. True nationalization means permanent government ownership, which is favored only by a few aging socialists. If things get bad enough, we could get a temporary takeover, but calling it nationalization just polarizes the debate. So please join me in banning the "N" word.

Option three, which has the momentum right now, goes by the name Public-Private Investment Funds (PPIFs). Sheila Bair, the chairman of the FDIC, calls this the "Aggregator Bank" plan, because the government would lend to these partnerships. Geithner let slip recently that the price tag for taxpayers is $1 trillion.

Option four is informally called the Good Banks–Bad Banks approach, and it was endorsed in broad outline early this year by Federal Reserve chairman Ben Bernanke. This won't do as a name—"bad banks" sounds evil. So let's call this the "transitional banks" plan, or the Holmes Solution, in honor of Max Holmes, an astute asset manager who first outlined the idea in the Feb. 1 New York Times. It was hot for a while, but faded. Now, in amended form, it needs a second look.

The PPIFs would involve the establishment of heavily leveraged investment partnerships that would compete with each other in buying toxic assets from the banks with the help of government loans and then reselling them. Let's say one of the partnership funds wanted to raise $1 billion. The government and the heavy-hitting private-equity firm (or hedge fund) would each contribute $100 million and the remaining $800 million would come from the Federal Reserve, which would essentially be guaranteeing the deal. After these funds stripped the banks of their worst assets at fire-sale prices, the banks would record heavy losses but then be able to grow and lend again.

PPIFs sound good but could bomb. Investors might not bite. In November the Fed launched the Term Asset-Backed Lending Facility that offers investors backing to buy securitized consumer debt (like car loans). So far, few takers.

The big problem with all the toxic assets is price. No one trusts anyone else's balance sheet. There's likely a massive gap between what the banks say these assets are worth and what private parties would pay for them. While it's the right approach to let the market set the price, the banks might not sell so cheap, which means the toxic assets would remain on their books and the arteries of credit would stay clogged.

Alternatively, the Fed's backing might lead to deals that are cut too quickly. In which case the whole thing could blow up, like a bigger version of what happened last year to Washington Mutual or Merrill Lynch. Even the proper homework ("due diligence") might take six to nine months and still not lead to agreement on the price. Then there's the problem of selling an idea that would let billionaires pile up huge new mountains of debt and get richer still, virtually risk-free. We've seen that movie before.

The Holmes Solution has many of the same elements as the PPIFs, but figures out a clever way around the problem of price. Holmes would create four new federal entities for the four megabanks. These new transitional banks would take possession of the toxic assets but not write a huge check for them from the taxpayers. This is key. The original "bad banks" idea of last fall foundered because it would have required large-scale purchases at distressed prices.

Under this plan, we'd speed up cleanup and delay taxpayer pain. Overnight, the balance sheets would be clean and the banks—returned to health—would attract investors and begin lending again. For accounting purposes, the assets would be priced at the audited book value at the end of 2008. But this would not be a meaningful number, because the transitional banks would be sitting on these toxic assets for months or even years until a proper market price is ascertained.

The government has the resources to be patient and wait for the asset values to rise. In exchange for the assets, the transitional banks would select and assume an equivalent amount of the banks' debt, then contract with private asset managers to negotiate with the banks' bondholders and other creditors. The government would have warrants in the banks, so the taxpayers could benefit when the stock prices of the banks recovered.

Remember, the tough part is placing a proper value on the assets. With transitional banks, there would be more time to do so. "If you try to determine today the correct valuation, it's a little like the SATs," says Holmes, who runs Plainfield Asset Management in Connecticut. "You can't complete it in the time allotted. No one will be able to come up with the right number, and in the meantime the banks will expire on the operating table." Edward Altman, a professor of finance at New York University, prefers the Holmes Solution to the PPIFs, even though the taxpayer exposure is also huge. "It's better to structure incentives for working out liabilities than selling into this market," he says.

The main objection to the Holmes Solution is that it's alchemy—that "you can't just transfer assets into the ether," as Bair says. But the idea is not nearly as fanciful as what conservatives—and several Democrats—advocate when they call for the end of "mark to market" regulations, which would let banks simply make up their asset valuations out of thin air (though the current market price under those regulations can also be misleading as to the assets' underlying worth).

Besides, every severe economic crisis demands a bit of alchemy. In 1933 Franklin Roosevelt's Treasury Department temporarily added the word "Bank" to the words "Federal Reserve Note" printed at the top of every dollar bill. It got around a gold problem and helped ease the crisis. Now, as then, the solution to these complex banking problems is deceptively simple: whatever gets you through the night.

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