With options, we often talk about them being in, out or at the money. When options are in the money, there is a high probability of receiving a payoff.? When options are out of the money, there is a low probability of receiving a payoff.? When options are at the money, it could go either way.

The same is true of banks.? There are some banks that were cautious during the boom era, and their underwriting stayed conservative.? There are others that were so aggressive that once the results of their sloppy underwriting/investing begin to be realized, it will be obvious that they are deeply insolvent.? Then there are those banks that hang in the balance.? Which way will they fall?? Will they survive or not?

I’m not in favor of blanket nationalization of banks.? My best example is the stupid move by Hank Paulson where he forced bailout money on a bunch of big banks, with no attention to whether they needed the money or not.

Who could use the capital?? The banks that have big holes in their balance sheets can’t use the capital, because it will just plug holes, and maybe it will not be enough.? Those that are healthy don’t need the money, and there is a public policy reason why the government should not forcibly buy stakes in solvent companies.? But those that are on the brink could really benefit from a capital injection.? Anything to remove the uncertainty, and the high cost of incremental capital due to uncertainty over survival.

My point is that our dear Government, should it decide to intervene in the banks at all, should aim its capital injections toward banks that are on the cusp of creditworthiness.? (On the cusp assuming that assets and liabilities are fairly valued).? Those that will likely eventually be dead should be declared dead, the assets absorbed by RTC 2 (in concert with the FDIC), and the liabilities absorbed by other local banks.? Those banks that are healthy should continue on.? Giving them more capital in order to lend more is a cute idea, but really, why should the government get involved if there is no crisis?? Many solvent banks are looking for quality borrowers now, and finding few of them.

An aside: Why are we giving money to bank holding companies? If there is trouble in the regulated subsidiaries there might be a reason to help there directly, after cutting off the subsidiaries’ ability to dividend back to the holding company (and watching transfer payments — a good transfer pricing accountant is worth his weight in gold.)? Let the unregulated subsidiaries die, and the holding companies too.? If there are excess assets of these entities let them be distributed through chapters 11 or 7 of the bankruptcy code.? I understand exceptions for systemic risk reasons, but if the operating regulated banks are firewalled, that shouldn’t be as big of a problem.

I’ve been a critic of the industry that I grew up in for a long time, but the state insurance regulators have a better handle on their companies than the banking regulators do from a solvency standpoint.? The insurance risk models work better, even though the companies are more complex.? Imperfect as the insurance risk-based capital models are, they captured much of the action.? The banking regulators did not get as much data, and did not see the damages that could occur in a real credit bust, because many were obscured by securitization and derivatives.

There is no need to nationalize the banking system.? Set up RTC 2.? Let the regulators look at the banks on an asset-by-asset basis, and analyze what the hard-to-value assets are worth.? Compare values across companies to make fair comparisons.? Do triage then.? Send the insolvent to RTC 2.? Pump some money into the operating banks that are marginal, after cutting off dividends to the holding companies.? Let the healthy banks look for opportunities on their own.

Our existing legal framework can deal with operating bank solvency problems.? We did not need something as big as TARP 1 to solve issues at the operating banks… but if we are profligate in handing out money to bank holding companies, then even TARP 2 might not be enough to deal with all of the mess.

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One more note: there have been times in insurance regulation where the regulators looked the other way and said to themselves, “Meh, the company is insolvent if we marked it to market today, but if I just give them a few years, operating profits will bail them out.? We didn’t pay close enough attention to the issues involved in the new assets they bought or new liabilities they issued, so I will be embarrassed in front of the Governor, legislators and media if this company goes down.? I will forbear for now.”

And, about half of the time, that strategy worked.? Half of the time it didn’t, leading to a deeper hole and deeper embarrassment.? In more than a few cases where it worked in the short run, in the long run, the management culture of a firm that survived did not learn the lessons of undue risk taking, and blew it up again.? Part of fixing the system is weeding out bad management teams.

So, when I see arguments that say, “Let the banks in trouble borrow at low rates.? The positive carry will bail out their balance sheets over a period of years,” I say, “Been there.? Done that.? Got the T-shirt, and a Polaroid of them drinking the Kool-aid.”

Why provide a subsidy in such a haphazard way?? Manay banks have spent a great deal of time and effort developing low-cost deposit bases, and rotten managements should now receive a low funding cost?? If banks know that the regulators will forbear, and even subsidize their incompetence, why shouldn’t they take the free option, and continue to speculate?? Let the RTC 2 deal with the problem, and let them borrow at Treasury rates.

Part of the need to collapse bad banks is a need to eliminate bad management teams.? Without that, the system will not reset properly as bad debts get cleared.? They will get cleared eventually, but what will the nation look like when it is done?? Will we still have the same level of property rights and the rule of law?? Will we have a currency that is worth anything?? If the last century changed the value of a dollar from a dollar to a few cents, what will happen with this century?