The Bailout Keeps Getting Bigger and Badder

According to the Wall Street Journal, our top economic officials are busy trying to come up with The Plan that will save our banks.  In order for The Plan to work it must be definitive.  It cannot be piecemeal, like a bailout here or there, followed by a guarantee or two.  In order for the financial system to be stabilized, markets must believe that The Plan will work, after many prior disappointments.  The best way to accomplish this feat of calming markets is to continually leak news to the press that includes larger and larger numbers every day.  If an $819 billion stimulus package won't do it, then we have to start talking about a $1 to $2 trillion "bad bank."  But wait, the markets only rallied 3% on that news.  Cue the leaks with a $4 trillion estimate.  The Plan du jour involves buying a portion of banks' bad assets and offering guarantees against future losses on some of the remainder.  By Monday, I'm certain that this two-part plan will have morphed into a three-headed monster, but I digress...  

The government "bad bank" would buy assets that have already been marked down heavily.  Although this implies that the assets will be taken off of the banks balance sheets at their current marks, we're still not really sure if those marks are anywhere near the ballpark.  Only time will tell how much this will ultimately cost taxpayers, or, as some incurable optimists have posited, how much money we'll make on trading the biggest hedge fund in the history of the world.  The remainder of the "toxic assets" would be covered by a type of insurance against future losses.  According to the article "banks have probably given these assets an overly optimistic value because they plan to hold them." The loss guarantees will be similar to those already granted to Bank of America and Citigroup, with the government and banks sharing the future losses.  Additionally, the Treasury is also likely to inject more capital into banks.  We are covering as many bases as we can.

Today's Heard of the Street Column asks "What if nearly half of US banking assets turn out to be bad?"  Goldman Sachs analysts are estimating that troubled assets could exceed $5 trillion, if defined as assets that could show a loss rate close to, or above 10%.  This number represents roughly 40% of the $12.3 trillion in total assets of US commercial banks.  The article includes a nifty, but alarming, chart from Goldman detailing holdings and losses on troubled US assets excluding securities/loans held by wholly government-owned entities (it is unclear to me if that includes Fannie or Freddie):

       

If there is a silver lining in any of this, it is that the rest of the world seems to be in the same pickle, except much worse off.  Governments around the world are busy crafting plans to save their own banking systems, offering guarantees and bailouts.  Ultimately, the question as to whether any of these plans will work boils down to whether the market believes that a country has the resources to cover the cost of a massive bank clean-up.  If markets lose faith, then you wind up with a situation like Iceland, with a crumbling currency that leads to a collapsing financial system followed by a failed government.  

In Alphaville today is an interesting chart assembled by Dresdner that depicts bank liabilities relative to GDP for the Eurozone/G10.  It should be somewhat reassuring to know that at least in terms of leverage, the US (a little over 100%) looks relatively sane compared to, say Ireland (over 400%.)  Those who worry about a currency crisis in the US (as I do at times) should be heartened by the information in Dresdner's analysis.