Fallout: The Financial Crisis

Let some big banks fail!

Marketplace Staff May 7, 2009
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Fallout: The Financial Crisis

Let some big banks fail!

Marketplace Staff May 7, 2009
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TEXT OF COMMENTARY

Tess Vigeland: Wells Fargo was one of the banks that reportedly did not ace the stress test. And this afternoon it announced a $6 billion public stock offering to raise some cash.

There’s been plenty of debate over whether these stress tests were stressful enough. Did they go with a true doomsday scenario? But for now, the idea is that all this transparency should give investors a little more faith in the banking system. They know who’s in real trouble, and who’s not. But nowhere in all of this is there talk that well, now that we know all we need to know, maybe it’s time to let some of them fail. And that’s why commentator Dean Baker thinks we’re going with the wrong conclusions from the stress tests.


DEAN BAKER: The results of the stress tests are in, and many commentators are now declaring the banking crisis over. But this story doesn’t make any sense.

Citigroup and Bank of America are projected to need more than $80 billion in new capital between them to stay afloat. They plan to cover most of this need by converting the preferred stock that the government holds into common stock, the government stands to take a large loss on the deal.

For example, the government lent Citigroup $45 billion. The total current value of Citigroup’s common stock is just $20 billion. And, even this $20 billion market value figure is inflated because the government has guaranteed $300 billion of its troubled assets, which it is propping up its stock price.

Furthermore, there are reasons for questioning whether the parameters of the stress tests accurately reflected the grim state of the current economy. The “bad” scenario assumed that the unemployment rate would peak at 10.3 percent next year. With unemployment likely to hit 9 percent in April, a peak of 10 percent now seems like wishful thinking.

In the case of house prices, the bad scenario assumed a 20 percent price decline for 2009. However, house prices have been dropping at the rate of 2 percent monthly for the last several months. If even the bad scenario prove to be too optimistic then the stress tests were not a good measure of the banks’ health, so passing these tests is meaningless.

At some point we have to be prepared to come to grips with the fact that some of the country’s biggest banks are insolvent, that is, bankrupt. Rather than covering up their problems and throwing good money after bad, we should look to do with Citigroup what we have done with IndyMac and dozens of smaller banks.

We should have the FDIC take them over and restructure them. In this story, the shareholders would get wiped out, which is what happens when a company goes bankrupt, and the bondholders may be forced to take hits on some or all of their holdings. But, this is likely to be the least costly route for taxpayers and the quickest way to get the financial system back on a sound footing.

VIGELAND: Dean Baker is co-director of the Center for Economic and Policy Research.

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