Can Obama Save U.S. Banks?

Following the September 2008 bankruptcy of Lehman Brothers and the subsequent market turmoil, the Bush Administration used fear one last time. In this instance, it got Congress to approve a $700 billion bailout package for the financial sector.

This bailout package was the financial sector equivalent of the Iraq War Authorization of 2002. It was thin on substance and designed to make Hank Paulson the imperial Secretary of the Treasury, acting with immunity, impunity, unlimited discretion and without accountability.

Just as during the buildup to the Iraq war, an intimidated Congress acted in haste. While they rejected the original, measly three-page proposal offered by the Administration, Congress asked far too few questions and finally surrendered in early October when it approved the Financial Stabilization Act.

Maybe the acronym of the Troubled Assets Relief Program, TARP, at the core of this Act, could have been a red flag. Tarp is most commonly used to cover up things that are unseemly, sitting around in our backyards (without actually removing those things).

Also, members of the U.S. Congress might have wished to question then-Secretary Paulson's judgment to delegate running TARP to a 35-year old with no meaningful money management experience. Lastly, word associations with the 35-year old Treasury official's last name, Neel Kashkari, might have been a sign of things to come, because cash and carry is indeed what the banks did. They took the U.S. taxpayers' money without delivering on the promise to start lending again.

By the end of 2008, $350 billion, half of the authorized program, had disappeared. As so often, it was difficult to determine whether this disappearance had been carefully orchestrated by the Bush Administration in a Madoff-kind-of-way or whether the $350 billion Houdini act was simply the result of sheer incompetence. One thing is for sure, the condition of the nation's banking system has dramatically deteriorated over the last three months in spite of this giveaway.

At this juncture, even a tightly structured, well-intentioned release of the second half of TARP would do little to mend the system. More drastic action is required. President Obama has wisely drawn on the experiences of his predecessors in outlining his own approach to the presidency.

He may wish to recall that, on the day after his inauguration in March 1933, President Franklin D. Roosevelt shut down the nation's banks and sent in government auditors to assess as accurately as possible the state of the financial sector. He did so in the midst of the Great Depression — and against the backdrop of deeply eroded confidence in the solvency of the nation's banks.

As we attempt to fend off a looming depression today, and as we try grappling with the collapse of the economy's central nervous system, its banks — it is timely to take bold steps in this new Era of Responsibility. President Obama should propose, and Congress should approve, an Emergency Regulation Act or ERA I. This Act should be accompanied by an Economic Reconstruction Act or ERA II, which I will describe in a subsequent feature.

ERA I would be designed to do the following: For the period of one year, all banking oversight in the United States would be coordinated by one agency. This would combine the efforts of regulators and supervisors currently operating on behalf of the Federal Reserve, the FDIC, the OCC, the SEC and a slew of other federal and state agencies. All other overseers would — on a temporary basis — report to the designated coordinating agency.

The chief overseer and the supporting agencies would prepare a schedule of audits for the next 30 days. Such schedule should cover as many banks as possible and focus on a realistic assessment of the balance sheets of these banks. In order to meet this very challenging schedule, the chief overseer would also hire major accounting firms to assist in this exercise.

At the end of the 30-day period, the chief overseer would make a determination of the degree of solvency of each institution. Those institutions deemed insolvent would be declared bankrupt and their assets and liabilities would be transferred into a special purpose vehicle, established by the federal government — and dubbed EraBank.

Those institutions identified as having solvency problems (probably the majority of institutions that will be reviewed) will be taken over by the government. This will squeeze out all private equity. While this sounds painful to investors, in reality investors' incremental losses will be minimal as many of these banks are already trading near penny-stock levels.

Lastly, those banks considered sound will be allowed to operate as privately-owned institutions. However, the overseers will closely monitor these banks in order to avoid any surprises under these very fluid conditions.

The rationale for ERA I is that the U.S. government simply is not in a position, at this point, to reasonably assess the real damage to the financial system. This is largely due to the fact that the banks themselves have demonstrated an inability or unwillingness to define the magnitude of challenges to their balance sheets.

Therefore, the government is also currently unable to propose and implement viable solutions or even estimate the costs of rescuing the system. Under such circumstances, any public sector injection of capital is just as effective as administering a blood transfusion to a badly injured patient without any effort to assess his condition — or to take first steps to stop the bleeding.

The real work starts after overseers have identified those banks with meaningful solvency problems and have taken them over. Depending on each case, the new owners of these institutions may choose from a host of remedies.

In some cases, more capital may indeed suffice. In other cases, it may be necessary to transfer impaired assets to EraBank at fair market value. There are banks that will need to be disassembled into independently operating entities to make them manageable as well as to foster competition.

Conversely, some of the then state-owned banks may need to be merged to create synergies and economies-of-scale. In all, this process of reconsolidation may take at least two years.

In cleaning up the balance sheets of the state-owned banks and by restructuring the financial system, the U.S. government sets the stage for a recovery of lending. However, such new lending will be governed by a new regulatory framework that should be multilaterally designed and ratified.

It should be the endgame for the U.S. government to return the revitalized banks to the private sector through massive initial public offerings (IPOs), maybe as early as 2011. EraBank's horizon should be to hold the underlying assets to maturity, to restructure them where necessary (especially in an effort to reduce the number of foreclosures), and to sell them to the market where profitable.

The word nationalization leaves a bitter aftertaste, especially in free-market America. Yet, far-reaching nationalization of banks has become an indispensable interim step.

The ultimate goal is to repair the U.S. banking system, to rebuild its role as financial intermediary, to restore market confidence — and to create the basis for sustainable and equitable economic growth in the United States.

Americans must overcome their intuitive aversion to this drastic, but necessary step. As President Obama said so eloquently in his inaugural address: "The time has come to set aside childish things."