The government is expected to announce today a plan to save banks that are on the brink of failure.
Getting it wrong could trigger a replay of what happened after Lehman Brothers collapsed last fall the stock market in free fall, seizure of the credit markets, ripples of layoffs. Perhaps even a run on other banks so many customers rushing to pull out their cash that it would make the bank run in It's a Wonderful Life look like a feel-good holiday movie.
"The banks are at a terrible junction," says Robert Reich, a labor secretary under President Bill Clinton. "The bottom is falling out. Almost every area of the credit markets, we're finding people unable to repay their loans. That means many banks are basically insolvent."
"If one big bank implodes," he says, "the reverberations could be endless."
This January, the government took over six failed banks, including three on a single day. Last year, it took over a total of 25.
When it happens, the government swoops in and tries to minimize disruption. Recently, it has tended to close banks on a Friday and achieve something close to business as usual by Monday morning, arranging for other banks to take on the assets. ATMs have kept working, and people have had access to their cash.
So far, most of the failed banks have been relatively small, many with assets only in the hundreds of millions of dollars. But what would happen if one of the big banks, the kind that manage hundreds of billions in assets, went down?
"That would probably cause a complete meltdown of the American financial system," says Andreas Hauskrecht, an associate professor of money, banking and finance at Indiana University.
After the financial crisis accelerated last fall, the government increased the limit for the amount of bank deposits it will insure for individual depositors, from $100,000 to $250,000, effective through the end of this year.
And while few Americans have to worry about keeping anything bigger than that in the bank, the government could eliminate the limit altogether and insure all deposits regardless of size if a huge bank, such as Citigroup or Bank of America, were to fail, says Jim Wilcox, a professor of financial institutions at the University of California at Berkeley.
No one has ever lost money in an account insured by the Federal Deposit Insurance Corp. But no one has ever seen a bank that size go under, and news of a giant bank's downfall would probably touch off a panic in which even depositors with money in safe banks rush to get it out.
But there's a bigger economic problem: Other lenders, which hardly trust everybody these days anyway, would stop trusting anybody. Businesses, unable to borrow money day to day, would fail, with worldwide consequences.
It doesn't take an economics degree to realize that would be nothing short of catastrophic for the economy.'Bad bank' is complex
The Barack Obama administration must choose the best of several difficult options, or a combination. The emergency medicine prescribed by the last administration flooding the financial system with billions of federal bailout dollars hasn't worked. If anything, banks are sicker.
One idea under consideration is the creation of a government-run aggregator bank, or a "bad bank," that would buy up hundreds of billions of dollars in banks' toxic assets. The government also may decide to pump more money into banks and offer billions in dollars in guarantees against future losses.
But no single fix is seen as a magic bullet, and financial experts say the government is quickly running out of lifelines.
"The longer they wait, the more damage there is to the economy and the more it will cost taxpayers," says Frederic Mishkin, an economics professor at Columbia Business School and a former member of the Federal Reserve Board.
In theory, the government-run bad bank would buy soured debt that's gumming up the banks' books and clogging the flow of credit. That could shore up banks' base of capital, soothe investors and get banks lending again.
But in practice, it's far from simple.
For starters, no one including the banks themselves knows how much these assets are worth. The complex nature of mortgage-backed securities, credit default swaps and other contaminated products has made investors too afraid to touch them.
Goldman Sachs estimates the government would need to shell out $4 trillion or more to absorb all the banks' troubled mortgage and consumer debt.
How big is $4 trillion? It's more than one-third of the economic output of the United States in a year. It's more than twice as big as the first federal bailout and the coming economic stimulus combined. Just look
at all those zeroes: $4,000,000,000,000.
That prospect makes some financial observers queasy.
"We're asking the same people who got us into this mess to get us out. These are the guys who buy airplanes and decorate their offices for a million bucks," says Bill Seidman, a former chairman of the FDIC who ran the government bailout during the savings and loan crisis.
Seidman and others are calling for an alternative rescue plan that they say would avoid the pitfalls of past efforts: a short-term nationalization of the banks.
To many people, that very thought is an affront to the free-market system, more Argentina than America. But that's exactly what the U.S. government did in the S&L debacle of the 1980s.
With Seidman at the helm, the government-run Resolution Trust Corp. took over failed S&Ls and sold off their depressed assets repossessed homes, offices, cars, planes and even artwork. Any institution needing help had its management fired and its shareholders wiped out.
During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700 failed thrifts. Then it sold the cleaned-up S&Ls back into the private sector.
But Nationalization isn't a sure thing either.
In the S&L days, the government recouped some taxpayer money by selling the physical assets of the banks, things like real estate and cars not the hard-to-value paper assets held by banks today.
That wrinkle makes it much harder for the government to follow the RTC strategy, says Jonathan Macey, deputy dean at Yale Law School and the author of a book about a government bailout of Sweden in the 1990s.
"We're not talking about valuing buildings and dirt," Macey says. "This is quite a bit different."
In other words, it's uncharted territory once again.
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