"Bad Bank?" Bad Idea.

SCENARIO 1: I tell my son that if he washes the car, he can use it on the weekend. Will he be more or less likely to wash the car?

SCENARIO 2: I tell my son that he can NOT use the car unless he washes it first. He never washes it because he gets wrapped up in video games. So, I wash it for him, and then hand him the keys and tell him he can use it since it's clean. What lesson is learned there?

People respond to incentives, and people generally prefer to pass burdens on to others if they can get away with it. Why are these simple economic lessons so difficult for our thick-skulled politicians to understand?

On Wednesday, U.S. Treasury Secretary-designate Timothy Geithner suggested creating a so-called "bad bank" which would buy nonperforming loans. This bank would buy the worst loans that banks made, infusing cash into those banks (thus rewarding the financially wicked) and taking ownership of non- and under-performing real estate loans. Most estimates are certain that this will be a net cost to the taxpayers, with some estimates to the tune of $3 trillion to $4 trillion.

So, if I get this right, Banks made insane loans to non-credit-worthy people, lied about asssessed valuations, and engaged infraud; and then, sold them to other reckless banks in a grand game of hot potato. Speculators in the financial industry played the game, and many got caught with an awful lot of bad loans.

Geithner's proposed response? Let taxpayers absorb that loss, and give the banks a 'free ride.'

How is this different than Scenario 2 above?

This proposal permits banks and financial institutions to walk away from their own misdeeds, and pass the full burden on to innocent taxpayers. Instead, we should consider the OPPOSITE approach: Require banks to hold the loans that they make.

Suddenly, it will become very apparent who the prudent investors and lenders are, and who is out to play Roulette with taxpayer money. If Banks are forced to bear the burden - and enjoy the success - of their own practices, it will be a long time before we see a repeat of the current debacle.

Why the Bailout is wrong.

Listening to some of our nations top political leaders, one gets an uneasy feeling that The Great Depression II is right around the corner, unless we entrust the federal government to engage in a massive 700 billion bailout plan that will ultimately save ‘main street’ from Wall Street’s mess. But if that’s the case, why have over 200 leading economists from Harvard, MIT, Northwestern, the University of Chicago, and other respected institutions signed a petition opposing rapid passage of this bailout?

In basic English, the argument in favor of the bailout goes something like this: banks and other financial institutions have purchased mortgages which, for many different reasons, are now worth far less than their purchase price. As a result, banks have lost money buy purchasing them, and they can’t convince anyone else to buy them. If they can’t sell their ‘paper securities,’ they can’t raise cash. This, in turn, means they have no money to lend, and credit markets will be so tight that ‘Main Street’ will grind to a halt: businesses will not be able to borrow funds to meet payroll or expand their enterprises, and consumers will be unable to purchase homes and cars or pay their college tuition bills.

This line of reasoning scares many Americans (as its meant to), but is faulty for several reasons.

First of all is the cost. What is not being revealed to the American public is that over the last 5 months, the Federal Reserve Bank has already provided over 1.1 trillion dollars to financial institutions, in exchange for paper securities, in order to inject cash into the banking system. The 700 billion bailout is in addition to that which has already been injected – with an accompanying bill of over $17,000 per American household before this is over.

Second is the risk. I asked a spokesperson for the Federal Reserve Bank of Boston why Washington Mutual didn’t take advantage of the Federal Reserve’s Bank’s cash offer over the last few months. I was told that there were financial criteria that needed to be met in order to obtain that funding: in other words, the less credit-worthy, the less stable institutions were unable to partake. That means that the 700 billion Congress is about to authorize will be used specifically for those institutions whose paper is the most worthless, leaving the US Taxpayer with nothing in return for its “loan’ to these inept banks. Some commentators suggest that in reality, the taxpayer will make a profit on this paper, but if that was a realistic possibility, there wouldn’t need to be a government bailout: some enterprising institution would have purchased that paper already.

Third is the Moral Hazard created by helping the inept. No one is guaranteed success in a market economy. In the rough and tumble of competition, some win and some lose. If the most ineffective, negligent, inattentive and even fraudulent activities are rewarded by a bailout, what message does this send to the banks who were prudent in their decision–making over these years? The well-run banks ought to profit, and ought to be stronger and inept banks close; instead, we, the taxpayer will be helping the most irresponsible institutions stay afloat, and will pay interest for the ‘honor’ of so doing.

Fourth is the unfounded fear that credit will completely dry up. The fact is, banks do not lend their own money; they lend their depositors funds. Institutions may crash and burn, but their depositors funds are insured by the FDIC, and those depositors will simply place their funds elsewhere. Keep in mind that when Merrill Lynch was subsumed by Bank of America, there was no catastrophe: there was simply an efficient movement of resources. The Market worked without a taxpayer bailout. Similarly, when Washington Mutual ‘collapsed,” they opened the next day as part of JP Morgan. Not one depositor lost money, not one customer lost their line of credit – and not one dollar of taxpayer was required.

The Bailout is an unnecessary, expensive return to Feudal Britain, where the “Crown” owned title to all the land and used tax money to keep its favorite business partners afloat. This is precisely the time to allow the Marketplace to weed out poor investment firms and negligent banking facilities – and allow the rest of us to enjoy the prosperity that can be gained by resting secure in the knowledge that the best and brightest firms have been allowed to carry on financing activities