A lot of knowledgeable people point to the bankruptcy of Lehman as the moment when the financial crisis turned into a near-panic. The reason is not that Lehman had a particularly large market cap, but that it controlled over $600 billion in assets and had a similar amount of debt. That meant a fire sale for certain types of assets and a lot of jilted creditors.

The upshot of the jilted creditors was that banks became afraid to loan money to each other because they weren’t sure they could get it back (Lehman’s liquidation was extremely disorganized, as one might expect from a $600 billion fire sale). That’s what freezes credit markets and that’s what makes the government so afraid of other bank failures. As Josh Marshall points out, what “nationalization” might really be about is organized liquidations:

The idea has never been to nationalize the banking sector as a matter of on-going national policy. It’s more like a highly structured and customized form of moving these institutions through Chapter 11 bankruptcy. In fact, we have a whole system in place for how this is done by the FDIC.

A friend of mine who’s a senior manager at a hedge fund wrote to me about this a few weeks ago (this is long, but I found it worth reading):

Imagine the panic among regular consumers if this FDIC insurance did not exist! Bank runs would most likely be weekly in the current environment. The government thought up a solution, and it is working great right now.

The government fixed the bank to consumer confidence issue, now it needs to fix the bank to bank confidence issue. What is effectively happening right now is that the way we are “fixing” the bank to bank confidence issue is we are just giving banks money. It’s moronic and stone-age in its methodology compared to the relative cheapness of the FDIC insurance scheme. We need a way to ensure that if a bank has a dealing with another bank, that a bank CAN go bankrupt and the other banks or hedge funds can quickly regain any assets they had stored with that bank.

The CEOs of a lot of banks oppose this. Why? Well, if your parents decided that your out-of-control spending and poor investment choices were likely to bankrupt you as a person but decided that they should just give you money, would you argue? Would you turn to your parents and say, “look, I don’t think you should give me money, just create an easy way for me to go bankrupt and I’ll be fine.” Of course not. The CEO’s of major banks WANT to be too big to fail, they want the government’s money. They don’t want a way that they can easily go bankrupt, lose their jobs and their pensions and their stocks, and slide into irrelevancy. Yet, this is exactly what taxpayers need. A way that a bank can go bankrupt seamlessly and the financial system stays afloat.

So, how do we ensure that a bank can go under seamlessly? Simple, just look at what happens when a bank goes under. When Lehman went under, every bank or hedge funds suddenly had any asset they had with Lehman effectively seized by an army of PriceWaterhouseCoopers administrators. Would you want your money in their hands? Of course, they immediately took the option that would keep themselves employed and money pouring into the hands of PWC for as long as possible – they tied up all assets and told all hedge funds and banks that they would have to make a legal claim to regain their assets and which assets were returned would be handled in court. Imagine the effects if you banked at Citibank, and if Citibank went under the policy was “you can’t get your money back, and if you want any of it you have to file a court claim.” Well, you can imagine the response, which was that every bank stopped having any difficult transactional dealing with any other bank, and fear gripped the market. Most figure they’ll get 15% of their assets back, and maybe not for years. Hence your current credit crisis.

As soon as a bank goes under, the federal government needs to step in and tell PWC or other consulting firms to go away and try to bill someone else a few million dollars a day. Over the next three weeks, while the federal government is in charge, employees may not leave, they must show to their job, and they must unwind every trade, and that is their only function. Valuations of these trades will be established by a third-party governmental group, which will effectively ask banks to value each other’s positions (without telling each bank which counterparty they are valuing and which way, buy or sell, they are valuing). All unwind transactions will be reported and recorded, collateral will be settled and returned where appropriate, the federal government will daily fund the unwinds and be first in line at the end of the three weeks to get assets.

Is it perfect? No. Is it far better than now? Absolutely. You currently have financial amateurs (PWC) who are also legal experts running a bankruptcy of Lehman. They are concerned with being perfectly fair, all the while they are running up a bill that will be in the hundreds of millions of dollars. Other banks and hedge funds don’t want fair, they want 95% accurate and right now. Which would you rather have if you had $10,000 at Citibank and they went under? Would you rather have a two year legal process that promised that all investors would be treated roughly the same way with whatever was left over while a big consulting firm soaked up millions in fees or would you rather get $9,200 right now and be done with it?

The only way to solve this bank to bank and bank to fund credit crisis is to do what we did many years ago with the bank to consumer crisis – minimize the impact of bankruptcy on the customer. Who cares about the equity or bondholders of the company, they come second. Confidence will return only when the effects of bankruptcy are minimized. Printing money and giving it to banks only means the banks will keep the money for themselves because the core fear – bankruptcy of a counterparty – is still there and hence will only marginally ease the credit crisis.