Dear God, let’s just kiss the US economy goodbye. It may take a few years before the loyalists and permabulls throw in the towel, but the handwriting is on the wall.

The Obama Administration, if the Washington Post’s latest report is accurate, is about to embark on a hugely expensive “save the banking industry at all costs” experiment that:

1. Has nothing substantive in common with any of the “deemed as successful” financial crisis programs 2. Has key elements that studies of financial crises have recommended against 3. Consumes considerable resources, thus competing with other, in many cases better, uses of fiscal firepower.

The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).

Why is this a bad idea? Let’s turn to a study by the IMF of 124 banking crises. Their conclusion:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

In case you had any doubts, propping up dud asset values is a form of forbearance. Japan had a different way of going about it, but the philosophy was similar, and the last 15 year illustrates how well that worked.

What we have from Team Obama is a bigger abortion of a “throw money at bad bank assets” plan that I feared in my worst nightmare. And (when we get to the Post preview), they have the temerity to invoke triage to make what they are doing sound surgical and limited.

Those who remember the origin know that triage means focusing on the middle third of the wounded on the battlefield : abandoning the goners to die, leaving those wounded but stable to fend for themselves for the moment (they were in good enough shape to wait to be transported or hold on to be treated later). The middle third, those in immediate danger but who might nevertheless be salvaged, get top priority.

The concept of “triage” recognizes that resources are limited, tough decision need to be made, and some are beyond any hope. But in Team Obama Newspeak, triage means everyone can be saved because resources are presumed to be unlimited:

The basic problem confronting the government is that banks hold large quantities of assets that they value on their books for much more than investors are willing to pay…

Yves here. The spin is so thick I have to interject after one sentence. Note how the problem is that the investors don’t want to pay enough, not that the assets are in most cases fetid? Back to the article:

Since the early days of the financial crisis, officials have struggled to unwind that knot. If the government buys the assets at prices that banks consider fair, the Treasury would take a huge loss when it ultimately sells the assets for much less. If, instead, the government insists on paying market prices, the banks may not survive their losses.

Yves here. See how saving the banks in their current form is presumed to be necessary? This is the phony policy constraint that is leading to all the distortions. The savings and loan crisis’ Resolution Trust Corporation is touted as a good “bad bank” model (it’s far from the only one). But guess what? It got those bad assets from banks that died. That little detail seems to be neglected in modern accounts.

Back to the article:

Instead of taking a single approach, the Obama administration plans to divide assets and other loans into three categories, each with its own solution, according to sources familiar with the discussions, speaking on condition of anonymity because the details are not finalized. The government would buy and hold on to those assets whose falling prices are putting banks under the most pressure. Officials want to limit these purchases because of the vast expense. The centerpiece of the plan would be a guarantee to limit losses on a second group of troubled assets that can be kept by the banks because they have more stable prices. And it would allow banks to retain and profit from their healthiest assets. Beyond these initiatives, the government also is likely to inject more capital into troubled institutions.

Yves again. This sounds completely arbitrary, despite the pretense of faux science. Do they want to buy the assets most underwater? The assets most at risk of further price declines? The assets with that are the hardest to value (like lower rated CDO tranches?). It may simply be that the Post reporter doesn’t appreciate the issues at work, but I wonder if the extreme vagueness reflects instead failure to come to grips with the real objectives (which means Wall Street will be able to manipulate them) or that they don’t want the public to know what is going on (per the persistent stonewalling of efforts to find out what securities the Fed has bought and taken as collateral).

As John Paulson pointed out, a lot of poor quality paper is trading. The idea that it is illiquid is a myth.

The problem is not a lack of price discovery, as the discussion above pretends, it’s a lack of investor willingness or ability to take losses. And readers have said if a particular piece of paper doesn’t fetch a bid, that’s because its real value is not materially above zero. But per above, that’s the sort of dreck that Team Obama would buy.

And what, pray tell, is the point of the guarantee? The loss exposure on a guarantee (versus a purchase) at the same nominal price is the same, although the initial cash outlay is considerably different. Ah, but if the paper is guaranteed, then your friendly bank welfare recipient can bring the junk to the Fed and get nice cash back.

So we the taxpayers are going to eat a ton of bank losses that should instead be borne first by stockholders and bondholders This program should be labeled the Pimco bailout plan, since the giant bond fund holds a lot of bank debt. That shows what a fiction Obama’s populism is. It’s mere posturing and empty phrases. Look at where the dough goes, and it is going first and foremost to the big money end of town.

Now I do not labor under the delusion that there are cheap or easy ways out of our financial sinkhole. People are suffering, and we are only partway through the process of contraction and writeoffs. I heard of a suicide today, a jewelry dealer who was $400,000 in debt (also owed a lot of money but unable to collect) who threw himself off 10 West 47th Street (from someone else in the building, this is no urban legend). A tragedy, and a visible one, and there is plenty of less acute but no less real trauma afoot.

But Team Obama is taking the cowardly approach of distributing the costs among the most disenfranchised group in the process, namely the taxpayer, when there far more obvious and logical groups to take the hits. Shareholders and bondholders bought securities KNOWING there was the possibility of loss. A lot of big financial institutions have been on the ropes for over a year. A security holding is not a marriage. When conditions change, prudent investors reassess and adjust course accordingly. If anyone is long a lot of dodgy bank paper now, they have only themselves to blame. Any why are rank and file bankers still exempt from pay cuts when the workers in another failing US industry, autos, expected to take big hits?

This is the most roundabout and probably the most costly way to not solve this problem. Another warning from the IMF paper:

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

The most amazing bit is the government acts as if it has no leverage. Look how Paulson sent teams in to inspect the accounts of Fannie and Freddie and put them into conservatorship. The reason it is obvious that this program is a crock is that it has been cooked up in the complete and utter absence of any serious due diligence on the toxic holdings of the big banks.

As we discuss in a separate post, the one punitive element, executive comp restrictions, are mere window-dressing. Welcome to change you can believe in.