Krugman on bailing out banks: It is a must read; after inauguration, this is mess to be dealt with

I don't agree with all of Nobel Prize-winning columnist Paul Krugman's political sentiments, particularly the barbs he sends out at Republicans.

But he is very smart. And reading his columns is like getting your degree in economics, which is what he won the Nobel Prize for. I was an economics reporter for 10 years early in my career, so I really appreciate his effort.

His latest lesson on how not to save this nation's banking system is a must tutorial. You may have to read it over several times, but it is worth the time for comprehension.

In the following excerpt, Krugman assembles a mythical bank called Gothan with $1.2 trillion in assets and $1 trillion in liabilities. It so happens that Gotham is also carrying $400 billion in bad mortgage securities that no one can yet put a certain value on. Perhaps they are still worth $200,000.

Yet technically, the bank is probably insolvent. And Krugman is distressed at what the Obama administration is proposing:

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

The current buzz suggests, however, that policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward a compromise approach: moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” that would resemble the Resolution Trust Corporation, but without seizing the banks first.

Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, recently tried to describe how this would work: “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?

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 “fair value” purchases of toxic assets