Whenever there is a systemic banking crisis there is a need to recapitalise the banking/financial system to avoid a destructive credit contraction. But purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to do this.

Such government-led recapitalisation – via the use of public resources – can occur in a number of ways: by purchasing bad assets or loans; an injection of preferred shares; an injection of common shares; a purchase of subordinated debt; an issuance of bonds to be placed on the banks' balance sheet; an injection of cash; credit lines extended to the banks and government assumption of government liabilities.

A recent IMF study (pdf) of 42 systemic banking crises across the world shows how different crises were resolved.

In only 32 of the 42 cases was there any government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any such action. Of the 32 cases where the government did recapitalise the banking system, only seven included a programme of purchase of bad assets/loans (like the one proposed by the US Treasury).

In 25 other cases there was no state purchase of such toxic assets. Even in cases where bad assets were purchased – as in Chile – dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets. Of course, in most cases multiple forms of government recapitalisation of banks were used.

But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay. Even in six of these seven cases, purchase of bad assets such recapitalisation was combined with such moves as government purchase of preferred shares or subordinated debt.

In the Scandinavian banking crises (Sweden, Norway, Finland) which are a model of how a banking crisis should be resolved, most of the recapitalisation occurred through various injections of public capital rather than a government purchase of bad assets.

Purchase of toxic assets – in most cases in which it was used – made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).

Thus the claim by the Fed and Treasury that spending $700bn of public money is the best way to recapitalise banks has absolutely no factual basis or justification. It is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer – the common and preferred shareholders and even the unsecured creditors of the banks.

Even the late addition of some conditions is a fig leaf of dubious value, as they are totally vague and fuzzy.

With $700bn of public cash the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. The rescue could have been achieved with a cheaper and better use of public money.

Indeed, neither does the plan address the need to recapitalise those financial institutions. This could have been done via public injections of preferred shares into these firms; via required matching injections of tier one capital by current shareholders to make sure that such shareholders take first-tier loss; via suspension of dividends payments or via a an unsecured debt-for-equity swap.

All these actions would have implied much lower fiscal costs, and they would have been cheaper and shared the burden of responsibility more equitably.

For example if the private sector had done its fair share, only $350bn of public money would have been required; and of this $350bn, half could have taken the form of purchase of bad assets and the other half should have taken the form of injection of public capital in these financial institutions.

So instead of purchasing (most likely at an excessive price) $700bn of toxic assets, the government could have achieved the same result, or better, by spending only $175bn in the direct purchase of toxic assets.

And even after the government bail-out, banks that have not yet provisioned for such losses and writedowns will be even more undercapitalised than before. So this plan does not even achieve its basic objective.

The treasury plan also does not explicitly include an HOLC-style programme to reduce the debt burden of the distressed household sector. Without such a component, the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.

Thus, the treasury plan is a disgrace: a bail-out of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown.

It is pathetic that Congress did not consult any of the many professional economists that have presented – many on the RGE Monitor Finance blog forum – alternative plans that were more fair and efficient.

This is again a case of privatising the gains and socialising the losses; a bail-out and socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this treasury scam that does little to help millions of distressed, debt-saddled home-owners.

This article is cross-posted and re-edited for style and length by permission of the author. The original blog can be viewed here.