Tim Geitner's Secret Plan

Treasury Secretary Geitner did an interivew on the Planet Money podcast.  My first reaction was "man, that's the dumbest thing I've ever heard, this guy must be a complete idiot."  Fortunately for the markets, before I posted any of that, I did some thinking on the subject, and I think I have discovered Mr. Geitner's secret plan.

Liquidity vs. Solvency

At the heart of the debate over banking, the housing market, and the economy is the question of whether the problem is liquidity or solvency.

• The problem might just be that there isn't enough money, credit, and confidence to go around.  When everything settles down and the credit crisis is over, our house prices will recover, the mortgages on them will be backed by real collateral, and therefore the banks' balance sheets won't be swiss cheese.  The only problem is that right now, temporarily, there isn't enough money.  In other words, we have a problem of liquidity.
• On the other hand, house prices from 3 years ago might have been a delusional speculative bubble.  Houses are not going back up to that price because they were never worth that much, and only reached that value due to tons of easy credit.  Houses aren't coming back, the mortgages aren't coming back, ergo the banks aren't coming back.  The banks just owe more than they have, because their mortgages aren't worth squat.  In other words, we have a problem of solvency.

While I don't think that the real answer is 100% clean cut, I do believe that solvency is the major issue here.  I don't think housing prices are coming back any time soon.  To reach the housing prices we reached, we had to have a speculative mentality among buyers (e.g. "I'll buy the biggest house I can, because houses always go up") and easy money from banks (NINJA loans and all the rest).  The crisis has burned people bad enough that we're not going back there.

So when Geitner basically said "this is a liquidity" crisis during the interview, I raised my fist at the computer and did my usual ranting and cursing.  In particular, the treatments for solvency and liquidity are very different.  If the problem is liquidity, loaning money to the banks is just what we need; cure the symptoms and cure the disease.  But if the problem is solvency, every dollar we loan is a dollar flushed down the toilet, and one that just delays the day when the system is solid and functional again.

The Secret Plan

It was then that I realized that while my personal view of the crisis is the complete opposite of Geitner's stated public position, the current plan of action is exactly what I would do.

Treasury is working on a "stress test" - basically they're going to look at the banks books in detail and find out how screwed up they are.  Supposedly they will then think deeply about how the bank would do in a crisis, and offer them "credit support" (read: loans) if they need it.

Here's what I would do, e.g. "the secret plan".

1. Conduct stress tests, learning lots of interesting things about how sick the banks are.
2. In secret, prepare a nationalization plan/task force for all the banks that will need it.
3. Nationalize them all at once, suddenly, and without warning.  Surprise!
4. Immediately cut out and sell off the functioning parts.
5. Dump the rest of the toxic crap into something like a resolution trust corp to get unwound later at a loss that's hopefully not too ridiculously huge.

One of the problems with nationalization (or any market assistance plan) is that people will try to "front-run" it, or guess what is going to happen and try to make money speculating on that event.  So if you nationalize only the sickest bank, there will be a run on the second sickest bank.

Perhaps the current "stress test" provides the cover needed to really explore who is alive and who is already dead, and to prepare to take over and unwind any banks that really aren't solvent.