Another Colossal Mistake

Your government just blew it again. Big time.

How?

By allowing the biggest zombie banks, Bank of America and Citigroup, to pay back TARP before we dealt with the biggest problem plaguing our financial policy of the past few years: Too Big To Fail.

As long as the banks were on the hook for that TARP money, the government had some ability to dictate reform. Now it has none.

And in case you missed what is really going on here, the banks that repaid TARP are now getting all the benefits of government help with none of the drawbacks. They just ditched the bad stuff--namely, pay caps--and kept the good stuff (implicit bond guarantees, subsidized super-low interest rates, no obligation to do anything for anyone). Obama can jawbone all he wants about "fat cats," but that's all he can do. Wall Street has him and the rest of Washington right where they want him: By the balls.

Why does this matter? Because, as Alan Greenspan of all people just observed, taxpayers are still on the hook for everything, and the government now has no bullets left.

If all goes well over the next few years--if the economy continues to recover, if the Fed keeps interest rates low, and if the US continues to be able to borrow at reasonable long-term rates--none of this will matter. This latest gift to Wall Street will just become a bad memory like all the rest.

If all does not go well, however--if the economy relapses into a double-dip, if the Fed is forced to raise short-term rates to combat inflation, if loan losses exceed expectations--the government (and Wall Street) will have a big problem on its hands.

If the banks get in trouble again, or if it becomes plain as day that they're never going to start lending because their balance sheets are in rotten shape, the government won't be able to do anything. After watching the appalling bailouts and bonuses of the past year, taxpayers will start a revolution before they allow the government to put hundreds of billions of dollars directly into the pockets of Wall Street again. If we come to another crisis, therefore--or even if we simply crawl along sideways--this will put the government into a bind.

In a just world, the way out would be to finally make the bank bondholders pay for their stupidity, converting bank debt to equity and correcting the error made last time. In the heat of another crisis, however, the government will likely be terrified at the thought of rocking the boat and will fight tooth and nail to give bondholders another free pass. If this proves politically impossible, the government might actually have to let some firms fail, or risk being run out of town. And because we have yet to create a system in which banks CAN fail in an orderly manner without taking the whole economy down, this could put us on a path to Japan (zombie banks) or another Lehman-like disaster.

What should the government have done while it still had some leverage?

Raise capital requirements, forcing the banks to use their tremendous profits to build big cushions against future problems instead of paying huge bonuses. Given the forced bailouts of last year, why on earth should banks be allowed to pay out normal compensation ratios for the next few years? Why shouldn't they be forced to keep this money on hand for a rainy day?
Make every bank build "contingent convertible" bonds into their capital structures, thus creating an automatic bailout mechanism whose cost will be borne by the banks' capital providers instead of the taxpayer. These bonds, which automatically convert to equity if the banks' capital falls below a certain level, eliminate the need for government intervention. If the bank runs low on capital, the bond converts, and the bank is automatically recapitalized (and its ownership changes accordingly).
Instead of implementing these simple fixes, however, the government has given up its last bit of leverage. It continues to implicitly guarantee all the big banks under Too Big To Fail, but now all it can do to shape their behavior is make disapproving noises about "fat cats" (who, by the way, are doing exactly what any sentient being would do under the circumstances, which is take the free money and use it for the benefit of employees and shareholders).