Why the Bank Bailouts are Not Working

By: MoneyWeek

800bn, 1trn, 2trn – just think of a number. Then double it. That seems to be the approach behind the latest batch of bail-outs.

To 'save' their economy, America 's politicians are churning out even more 'rescue' packages. All with more noughts attached. Now they've just "placed an eye-watering $2.3trn price tag on bailing out the US banking system", says The Independent's Stephen Foley , opening up "a second front in the battle to pull the country out of recession".

Hmm. History's taught us what happens when you open up a second front in a battle before you've won the first – you tend to lose the war.

There is a better way to fix the banking system – the 'free market' may yet have the answer, and without taxpayers having to pick up the bill. We'll get to that in a moment – but first, what's this latest bail-out package all about?

The problems with America 's latest bail-out plans

For the politicians, bashing bankers' big bonuses is the easy bit. But the sums involved are absolute peanuts compared with those needed to sort out the whole banking mess. And headline-grabbing sound bites don't keep financial markets happy for long.

So the acid test had to follow. America 's lawmakers really did have to sound as if they knew how they were going to get us out of this mess.

And on Wednesday, US Treasury Secretary Tim Geithner gave it his best shot: "The battle for recovery must be fought on two fronts: jump-starting job creation and private investment, and getting credit flowing again to businesses and families". He wants to inject more government money into some of America's biggest financial firms, set up a public-private partnership to buy up to $1trn of banks' bad assets - loans where lenders won't get much of their money back – and start a $1trn credit facility to push lending to consumers and businesses.

But then he made his first big mistake. He said he needed more time to work out the full details "so we don't put ourselves in the position again" of "quick departures and changes in strategy". Then he "ducked the tough questions investors want answered" about the latest shore-up scheme, says Bloomberg's Rich Miller .

In other words, trotting out his plans with a $2.3trn price tag – money that the US government doesn't have, so would have to get from taxes, borrowing or printing - just didn't cut the mustard. "He should have waited until he had his ducks in order", said Stone & McCarthy's Ward McCarthy. "The lack of detail leaves too much confusion, misinterpretation and speculation."

So the Dow dropped 4.6%, with bank shares hit by double-digit plunges. And although US shares nudged up a little yesterday as the previous 'stimulus package' passed muster with Congress, the big questions remain.

Can banks saddled with oodles of toxic assets really be saved?

If not, will they be nationalised?

And how big a bill will taxpayers have to pick up?

Because if all the dodgy loans on bank balance sheets are priced at what they're really worth, those banks will go bust. But if the banks get paid more for this rubbish than its 'true' value, taxpayers take a bath.

Why tax payers are right to be sceptical

And taxpayers are right to be sceptical. After all, if you set politicians loose with unlimited sums of money, you're just asking for trouble. The US Treasury has just admitted to "overpaying" $78bn for stakes in troubled banks as part of the $700bn TARP – Trouble Asset Relief Programme – bailout set up by Hank Paulson.

In short, vast chunks of taxpayers' dollars have just been wasted. Yet despite lawsuits from news services Bloomberg and Fox, there's been continued stonewalling on where the stuff actually went – the government clearly feels that in an "emergency" situation it doesn't need to be accountable for its actions. And all the while, US government borrowing is soaring.

Will we do a better job in Britain ? Given that we're following roughly the same path as the Americans, almost certainly not.

How to save the markets without costing the taxpayer

So is there another solution, that doesn't involve state guarantees, bad banks or nationalisation?

University of California Professor Roger Farmer reckons so. "We just need faith in free markets and a little creative intervention", he tells FT Alphaville.

You can read the whole piece here: How to fix the banks , but here's a rough summary of how his idea works. You create a fund of bank shares which investors can buy and sell. And the key is that the fund is backed, and the fund's price regularly guaranteed, by a country's central bank – like the Fed or the Bank of England.

Investors would be encouraged to buy the individual bank shares in the index to cash in on the central bank's backing. As bank shares are bought, prices rise until their collective worth equals the underwritten fund value.

What does all this mean in English? Well, in a nut shell, the central bank stands behind the banking sector as a whole with a chunk of money, but it's then left up to private investors to decide how this cash is split between the banks.

So the market sorts the wheat from the chaff. Any bank with a high proportion of toxic assets will lose capital to better-run lenders. And so new, well managed banks would attract capital, while old ones would fall in value, or fail.

Would it work? It would need some 'out of the box' thinking. Further, it certainly wouldn't be without pain, because some banks would inevitably go bust. But it takes the politicians out of the game. And here's the bit I really like. "This scheme could recapitalise the banking system at little or no cost to the taxpayer", says Professor Farmer.

That's the best notion I've heard in a very long time.

By David Stevenson for Money Morning , the free daily investment email from MoneyWeek magazine .

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