How Treasury's Bank Bailout Could Make Things Worse

An anonymous commenter makes an excellent point this morning about banks' willingness to participate in Treasury's bailout scheme:

Isn't the big hurdle getting the banks to offer up their assets to the auction process by FDIC? Once they do that, whether they accept the bid or not, it seems hard to imagine they would be able to value the assets very much above the highest bid offered. For example, if the assets are valued on their books at 50% of face value, they offer them in the auction process and the highest bid is 30%, I would think it would require a little chutzpah to decline the bid and go back to valuing these assets significantly above what has been shown as a market price.

To put it another way, far from making things better, the Geithner plan runs a serious risk of actually making them worse.

The status quo, absent any Treasury proposal, is basically the Hempton plan: let profitable-but-insolvent banks work their way slowly back to solvency by making large operating profits and not paying dividends. But the problem with the Hempton plan is that it only works on a kind of don't-ask-don't-tell basis: the banks can't be publicly insolvent, since then they need to be taken over by the government.

The minute the Treasury plan is put into action, we'll have a lot of public price discovery for the banks' bad assets. And if the prices don't clear -- if the minimum price the banks will accept is higher than the maximum price that the public-private partnerships are willing to pay -- then no one will any longer be able to perpetuate the fiction that America's banks are solvent. And without that fiction, the Hempton plan -- the muddle-through status quo -- is toast.

The big hope of the Treasury plan is that the private sector will be willing to pay a higher price for leveraged assets than it would for unleveraged assets. The returns on private capital are being leveraged by five or six to one in this scheme, if not more, which means a high chance of them making lots of money, and also a high chance of the capital being wiped out entirely. During boom years, that was a wager that many investors were willing to take. But now? I'm not sure. Chalk it up as yet another thing-which-has-to-go-right in order for this scheme to work. There are far too many of those for comfort.