By William Isaac, Published by Investment Dealer’s Digest Magazine

Congress was badly divided last September on the Treasury bailout plan to purchase $700 billion in troubled assets from banks, and rightly so. Some six months and trillions of dollars later, our attempts to stabilize the financial system and stimulate the economy have borne little fruit. It’s time to consider alternatives to spending more trillions we don’t have.

I wrote a piece in the Washington Post, “A Better Way to Aid Banks” (September 27, 2008), expressing reservations about the Treasury’s Troubled Asset Relief Plan (TARP), which gave voice to the concerns of those who were squeamish about the bailout bill. Although a majority of House members – Republicans and Democrats, conservatives and liberals – voted against the bill on the first go round, the leadership of both parties was able to cram the bill through a few days later and TARP was born.

After noting that we successfully resolved a far more severe banking and economic crisis in the 1980s (21 ½ % prime rate, deep recession, and nearly 3,000 bank and thrift failures including many large regional banks) without creating massive turmoil in the financial markets or further depressing the economy, the Post article continued: “One justification . . . I have
heard for acting immediately on the $700 billion bailout is that bank depositors are getting panicky. . . . If the problem is depositor confidence . . . the FDIC could announce that it will handle all bank failures . . . as assisted mergers that will protect all depositors and other general creditors. . . .”

The FDIC took action not long after the bailout bill passed to reassure depositors and other creditors of banks, but its guarantee plan was limited and difficult to understand. Moreover, the FDIC charged fees for the guarantees, draining capital from the banks when it was most needed.

The Post article went on: “If we enact the $700 billion bailout will banks be willing to part with the loans and will the government be able to sell them . . . on terms the taxpayers would find acceptable? I have my doubts. . . . Having financial institutions sell the loans to the government at inflated prices so the government can turn around and sell the loans to . . . investors at lower prices strikes me as a very good deal for everyone but U.S. taxpayers. . . .” Before the Treasury could implement the TARP, it decided the plan was neither practical nor the best approach. It decided instead to invest capital in banks – a good move, in my judgment.

The Post article had suggested a program to shore up the capital of our banks that would have involved no use of taxpayer funds: “One alternative is a ‘net worth certificate’ program . . . Congress enacted in the 1980s for the . . . savings bank industry. . . . The FDIC resolved a $100
billion insolvency in the savings banks . . . for a total cost of less than $2 billion. . . . The FDIC purchased net worth certificates (i.e., subordinated debentures, a commonly used form of capital in banks) from troubled savings banks that the FDIC determined could be viable, given time. . . . The FDIC paid for the . . . certificates by issuing FDIC senior notes to the banks so there was no cash outlay. The interest rate on the net worth certificates and the FDIC notes was identical so there was no subsidy. If we were to enact this program today, [bank] capital . . . would be bolstered, [allowing] banks . . . to sell and restructure assets and get on with their rehabilitation. No taxpayer money would be spent. . . .”

The capital infusion plan implemented by Treasury created a political firestorm. The expenditure of taxpayer funds, coupled with administration of the program by the Treasury instead of the independent banking agencies, politicized the program and made it very high profile. While it will be difficult to unwind what we have already done, I hope we will consider
a different approach going forward.

The Post article offered a four-point alternative to the bailout bill: “If we were to i) implement a program to ease the fears of depositors and other general creditors of banks, ii) [reinstitute] restrictions on short sellers . . ., iii) [suspend or alter substantially mark-to-market
accounting] which has contributed mightily to our current problems by marking assets to unrealistic fire-sale prices, and iv) authorize a net worth certificate program, I believe we would settle the financial markets without significant expense to taxpayers. . . [This would leave] . . . $700 billion of dry powder we can put to work in targeted tax incentives if needed to get the economy moving again.”

While we have endeavored to address the depositor confidence and bank capital issues, there has been no action on two critical elements of the suggested plan. The Securities and Exchange Commission has done nothing to rein in short sellers, nor has it suspended mark-tomarket accounting. This leaves us in the untenable position of investing hundreds of billions of dollars of taxpayer funds in financial institutions while the SEC continues to destroy the capital as fast as we shovel it in.

We have misdiagnosed the disease and are therefore administering the wrong medicine. The major losses in the financial system are not cash flow losses but paper losses created by very bad accounting. Instead of throwing trillions of hard dollars at the problems, we need to fix the system that is turning cash profits into paper loses.

Banks do not need taxpayers to carry their loans, they need proper accounting and regulatory policies that will allow them time to work through their problems. Maybe, just maybe, we can find our way to stop burdening future generations with trillions of dollars of debt and try approaches that have helped us get through past crises without breaking the banking system or the Treasury.