Another modest proposal

This one is even more modest than the last.

Let’s say you have ten banks and two of them are insolvent.  But you don’t yet know which two.  So the credit market is messed up for all ten because at some sufficiently high level of risk credit just shuts down.  The goal then is to reveal which two of the ten banks are insolvent.

I’ve been thinking of all those old puzzles where a bunch of guys enter the room and only so many of them have smudges on their foreheads and you have to find the algorithm to reveal that information.

What can be done?  Temporarily allow insider trading, with short selling of course?  (Bryan Caplan’s idea)  Make executives either resign or post personal bonds, where default of the bond follows if the bank ends up insolvent?  Change laws and make banks exhibit their books to the public and let traders sort it out?

I don’t know.  But maybe sorting out the bad banks is one alternative to finding and isolating the toxic assets.  Because once all the remaining banks are good and known to be good, the problem of toxic assets no longer seems so paralyzing.

I’m still not sure that the Treasury buying bank assets is to best way to make this sorting, and that’s leaving aside the price tag.  In fact maybe Treasury buying postpones this revelation of information.

Of course if eight of the ten banks are bad, maybe we don’t even have the luxury of asking these questions.


I tend to share the fear echoed in that last sentiment. Why? Because as yet we have not seen a serious proposal for a bank holiday, where we close down these institutions for a short period of time and send in examiners ... when the holiday ends, only the solvent and better capitalized institutions emerge - and hopefully the paralysis will stop.

So what can possibly prevent this from being a decent idea? First is that the holiday would become a permanent vacation for most firms. Second, maybe the Wall St. firms simply won't allow it, despite their precarious situation. Who knows?

neither Bear, Lehman,Fannie, Freddie nor Wamu were given the time to find out if their assets were sound or their capital was adequate. If an enormous amount of support is not provided right now there will be a run on all 10 banks. We can then sort out the hypotheticals while we shiver around the fires at night.

There was a short story (I forget the name, anyone have a reference?) where the intrepid detective locks himself in a room with all the suspects, in classic fashion, and proceeds to use logic and cunning to question everyone to determine who is the murderer. Except, as it turns out, he deduces that all of the suspects took part in the murder. When he announces this, they murder him too. The end.

Maybe the real problem is that all ten banks are sort of both bad and good.

I like the idea of Quantum Banking Theory-- it explains observer effects (if you look inside the box, the bank fails), non-locality (everybody fails simultaneously, even though there's no interaction), the failure of expertise (if you think you understand it, you don't), and the Financial Quantum Bell Theorem (when the bell rings and the music stops, everybody who doesn't find a chair goes bankrupt).

This seems to be already happening with the short-selling exemptions. Some banks have asked to be removed
from the "no short selling list". If the SEC continues to allow banks to do this, then information will
emerge: if you don't ask to be removed from the list, that means your loans suck. Investors will figure it out.

Sorry... misposted this comment below...

If I read it right, the gov't *made* $1.9 bn on the WaMu sale. If in fact WaMu was solvent, if not on a current basis, and they were in the worst shape (ok, maybe Wachovia), why doesn't that answer the question of whether it more like 2 or 8?

This assumes some insiders know what's going on. In some cases, this might be an unsafe assumption.

I think one key result of this financial crisis is that much of the key leadership within many of these companies... they didn't really know what was going on.

Your solution becomes less tenable if 8 of the 10 banks have these assets on their books.

friends can help you at any time

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