New York Times economic columnist Joe Nocera knows how to talk straight. Consider his recent comments about the current banking crisis:

As for taxpayers, the harsh truth is this: there are hundreds of billions of dollars of prospective losses still on the balance sheets of banks that will have to be written down. Everybody knows that. Someone has to eat those losses. Even wiping out shareholders will only get you so far. The rest is going to have to be absorbed by the government. There is no other option. This fact needs to be faced squarely. (1/23/09)

A quick reminder for readers who wonder why the banks shouldn't be allowed to go bankrupt, like any other company that made the kinds of mistakes banks made. The answer is that the banking system is the engine of the economy; if banks stop functioning, economic activity will grind to a halt. (1/17/09)

President Bush and Secretary Paulson failed to speak clearly and plainly about the realities summarized by Nocera. As for President Obama, the New York Times reported:

Privately, most members of the Obama economic team concede that the rapid deterioration of the country's biggest banks, notably Bank of America and Citicorp is bound to require far larger investments of taxpayer money, atop the more than $300 billion of taxpayer money already poured into those two financial institutions and hundreds of others.... Adam S. Posen, the deputy director of the Peterson Institute for International Economics [says]: "I would guess that sometime in the next few weeks, President Obama and Treasury Secretary Tim Geithner will have to come out and say, 'It's much worse than we thought, and just bite the bullet.' So far the Obama administration has signaled that it is trying to avoid that day."

Whether President Obama and his administration will take the brave step of biting the bullet and speaking clearly to the public about these realities is yet to be seen.

Will the "Bad Bank" Solution Work?

The consensus among economists is that in order to re-establish sustainable growth in our economy, the banking system must be restored to solvency. Given the intense public focus on the solvency and stability of the nation's banking system, if the Obama administration fails to take corrective action, and do so relatively soon, an adverse reaction in the equity markets is almost certain. Based on statements of Secretary Geithner, the markets expect that the administration is developing a plan to restore solvency to the banking system. In the short run, President Obama can divert attention to the needed fiscal stimulus, but that window of opportunity is limited.

There are key practical and political impediments to the "bad bank" solution currently bandied about in the news media and by public officials as the solution du jour. The proposal would reportedly buy "toxic assets" from banks and transfer them to a government run rescue entity similar to the Resolution Trust Company, which was used to liquidate saving and loans during the 1980's debacle.

The first problem is that there is no good way to value these toxic assets. This was the principal reason that the Bush administration abandoned the original TARP proposal to buy these assets. As Geroge Soros has stated, "Toxic assets are, by definition, hard to value. The introduction of a significant buyer will result not in price discovery, but in price distortion." Many of the instruments at issue are so arcane and complex that there is no adequate pricing mechanism.

Even if some pricing mechanism for the toxic assets could be formulated, the result would be two unattractive alternatives: (1) the government will pay market prices for the toxic assets. In that case, the banks would not sell them to the government or, if they did, the collapse of the banking system would be accelerated; (2) the government will pay substantially more than fair market value, in which case the banks will receive a huge gift and taxpayers will suffer a big loss.

Paul Krugman, this year's winner of the Nobel Prize in economics, believes that the Obama administration will make the huge gift to banks. In a recent New York Times column (1/19/2009) he stated:

Maybe private buyers aren't willing to pay what toxic waste is really worth... But should the government be in the business of declaring that it knows better than the market what assets are worth? What I suspect is that policy makers -- possibly without realizing it -- are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as a "fair value" purchases of toxic assets.

He says that if the Obama administration adopts such a course it would be engaged in a new form of "voodoo economics." In short - a smoke and mirrors approach that hides the underlying reality. Both liberal commentators such as Krugman and the Republican congressional leadership would be harshly critical of such an approach.

One thing is certain - President Obama does not want or intend to be seen as making a "huge gift" to bank shareholders. At the same time, the banking system needs a major capital infusion, which it seemingly has limited ability to pay back. This dilemma is a major challenge to the new administration.

Commentators disagree on the additional amount that the U.S. banks have yet to write down in order to achieve solvency and stability. Most analysts, including the International Monetary Fund, indicate that it will be well over a trillion dollars. Simon Johnson, the former chief economist at the IMF, estimates the additional cost to the government will be between $1 and $2 trillion. By contrast, President Obama's fiscal stimulus plan is estimated to cost $825 billion. A trillion dollars of additional cost would amount to almost 10% of the current federal debt. Obviously, any estimate of the total cost of a "bad bank" is better characterized as a guestimate. There are a host of hidden aspects and unknowns. Key variables such as when and how vigorously the economy will recover are highly speculative.

There are several other political challenges to the adoption of the bad bank plan: (1) The Obama administration will be extremely reluctant to fashion bank relief that on its face is more generous than the relief provided by the Bush administration; and (2) President Obama both politically and philosophically will want shareholders to pay for bank losses before taxpayers pay for them.

While many individuals have called the first expenditures of TARP funds for the banks a "gift," in fact, it was far from that. Rather than simply "giving" the banks money, the Treasury purchased preferred shares in the banks, which requires the banks to pay 5% annual interest for the first five years and 9% thereafter. Treasury also obtained an option to purchase common stock equal to 15% of its investment in preferred stock. The second stage of preferred stock investments of $25 billion each to Citicorp and the Bank of America required an interest payment of 8% and further required the two banks to reduce their common stock dividend to one cent for the next three years. Thus, while the common stock was not directly watered down, it was effectively so. After the agreement, the stocks of both banks dropped sharply.

If the Obama plan appears to give banks more than the fair market value of the purchased toxic assets without a substantial quid pro quo, it will suffer by comparison to the Bush plan. Following the example of Citicorp and the Bank of America, banks who sell their assets to the "bad bank" might be required to reduce their dividends to one cent for three years or more in order to rebuild capital. It is hard to imagine that the administration would not require such a concession from banks that benefit from the toxic asset buyout, given the BofA-Citi precedent. In the alternative or in addition, banks might be required to provide the government warrants on common stock to help pay for any shortfall that the "bad bank" suffers during its administration of the toxic assets or at their eventual resale to private investors. If either of these steps is required, it will significantly offset the boost to bank stocks that investors are hoping for from a toxic asset buyout. In any event, as Joe Nocera warned, taxpayers are likely to be stuck with a big bill for which there will be no compensation.

A further major obstacle for the bad bank is the up to $2 trillion cost to taxpayers when added to the $825 billion stimulus. News reports indicate that administration officials are concerned that borrowing that amount may drive up interest rates to a level which would impair the economic recovery or imperil the dollar.

Anyone who believes the "bad bank" is a sure thing needs to think again. There are a lot of hurdles to be cleared. The alternative of totally wiping out shareholders and effectively nationalizing the banks involves political risks that Obama is unlikely to take. As some commentators have indicated, such an option would be politically poisonous. Whatever the Obama administration does to rescue the banking system is almost certain to provoke a higher level of criticism than the fiscal stimulus package.

The bottom line is that the entire bank bailout problem is a huge quagmire. Working though that quagmire will be no easy task. The devil is in the details. While announcements that a "bad bank" relief plan is on the way may propel the markets upward in the short run, the problems of working out an acceptable political compromise and requiring concessions from financial institutions are likely to wipe away some, if not most, of those gains in the long run.