Time to End the Bailouts

Treasury Secretary Timothy Geithner told us last week that the country’s 19 largest banks had passed the stress tests. There are good reasons for questioning the results of these tests.

For example, the bad scenario used in the tests assumed that unemployment would average just 8.9 percent for all of 2009. The unemployment rate hit 8.9 percent last week and it is undoubtedly going higher, so clearly the economy will be worse than what was assumed in the tests.

But, we can skip the details and take the Treasury secretary at his word. If the banks are strong enough to get through the downturn, then can we end the taxpayer bailouts that were supposedly necessary to keep them afloat?

Should We Bail Out This Bailout?

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At the top of the list, the positive stress tests should mean the end of the Public-Private Investment Partnership (PPIP) program. PPIP was designed to clear the toxic assets from the banks’ books. PPIP involved a massive subsidy to the banks since it provided enormous leverage to buyers of toxic assets, while assigning them very little risk.

Even assuming no gaming (banks could pay third parties to bid up the price of their assets), the incentive structure of the PPIP would lead investors to bid far more for toxic assets than they would in a free market. The result would likely be that many investors would incur large losses with the taxpayers’ dollars. But if the banks are okay, why not just let the banks dump their bad assets in the market?

The banks also enjoy a variety of other subsidies. They can currently issue hundreds of billions of dollars of bonds with a guarantee from the Federal Deposit Insurance Corporation (FDIC). This implies a substantial interest rate subsidy. The savings from a government guarantee can easily be four percentage points of interest. If a bank has borrowed $30 billion under this program (which is the case with the largest banks), the subsidy amounts to a taxpayer gift of $1.2 billion a year.

The Federal Reserve Board has also created a variety of special lending facilities that allow the banks to borrow money at below-market rates. The Fed has close to $2 trillion in outstanding loans (a large portion of these loans are to non-financial companies) that were issued through these special facilities. If the banks are okay, we can shut these special facilities and to allow the banks to again rely on market financing.

Finally, it should be time to shut the AIG window. Many of the largest banks, including Goldman Sachs and J.P. Morgan, had bought derivatives from AIG’s financial products’ division. If AIG had been allowed to collapse last fall, then most of these derivatives would be essentially worthless. However, the government stepped in and decided to honor in full AIG’s obligations.

This commitment from the government was very helpful to the banks. Goldman Sachs in particular did very well, pocketing $12.9 billion (at 4.3 million SCHIP-kid years) on derivatives that might have been worthless without the government’s helping hand. If the banks are really okay, then we can let them bear the consequences of their bad investment decisions rather than foisting the cost of their mistakes on the rest of us.

In short, there is no reason to argue with Mr. Geithner and his assessment of the banks’ health. Let’s take him at his word and end the bailout.