Who's next?

Economics of Contempt has the rights of it:

Now we know why the Obama administration asked President Bush to go ahead and request the remaining $350 billion of TARP funds: Bank of America needs another bailout. No details are available yet, but everyone's assuming that the BofA deal will be roughly similar to the deal Treasury struck with Citi in November. The Treasury has already committed the first $350 billion of TARP funds, so it's essentially committing money that it doesn't have yet. They'll get the money eventually, of course, though with tighter restrictions on its use.

This episode just goes to show that Treasury and Fed officials have to be really careful about what they say and do in public. Ever since the Lehman/AIG failures, there have been Treasury and Fed officials at every major bank, constantly monitoring their books. Everyone in the market knows this. So when the Obama administration asked President Bush to go ahead and request the second half of the TARP funds, rather than waiting until Obama is sworn in on Jan. 20, the market was seriously spooked. Everyone interpreted the move to mean that one of the major banks was in trouble again, and will need another bailout to survive. Since everyone knows that Treasury and Fed officials are constantly monitoring the major banks' books, the move to request the second half of the TARP funds sent a signal to the market that something is wrong at one of the major banks, and the problem is urgent (otherwise why not wait until after the inauguration to request the funds?).

As soon as Obama had Bush request the funds, the race was on to figure out which bank was in trouble. At first everyone thought it was Citi, since it had just announced plans to raise capital by breaking itself up, including spinning off Smith Barney in exchange for $3bn from Morgan Stanley. To give you a sense of the fear that gripped the market after the Obama administration's ominous move, CDS spreads on Citi jumped an unheard of 100bps today (spreads don't usually move more than 5-10bps in a single day). Deutsche Bank's announcement this morning that it had lost $6.3 billion in Q4 just added fuel to the fire.

Now we know that the bank that's in trouble is BofA, not Citi. It's now clear that the BofA Bailout 2.0 is the reason Obama had Bush request the rest of the TARP funds, but that just confirms that the market was right to interpret Obama's move as a signal that one of the major banks was in trouble.

Felix Salmon is calling for nationalisation:

I can't see a solution to this problem short of nationalizing both Citi and BofA, and summarily firing the hapless Vikram Pandit along with the overambitious Ken Lewis. Lewis thought he could buy his way out of trouble, by acquiring Merrill Lynch; instead, he was simply tying his own already-troubled institution to an even more troubled institution. Pandit, it's worth noting, tried the same hail-Mary technique, when he put together a deal to buy Wachovia, but that didn't last long.

Citigroup, at $3.50 a share, simply doesn't have the time to implement its new plan to get smaller slowly. And Bank of America, at $7.75 a share, doesn't have the capital needed to absorb Merrill Lynch. Both are now trading at option value: on the hope, essentially, that somehow equity holders won't be wiped out entirely. But they should indeed be wiped out, as part of a nationalization, along with preferred shareholders, including the government. TARP will show an immediate loss on its investments, which will serve as a salutary reminder for whoever's in charge of disbursing the second tranche.

Nationalization is a messy solution, and one which will make no one happy. But it's better than desperately trying to kick the ball down the field until the banks come back in a few weeks for even more money.

I'm tempted to agree.  One of the most valuable institutions to come out of the Great Depression was the FDIC, which is possibly the best regulator in the world at orderly winding up failed banks. 

The problem is, the FDIC was born in an era when branch banking laws meant most banks were very small, and grew up in an environment of small banking, and mostly stable banking.  It's good at dealing with failures, even big failures, in an environment of overall stability.  But what to do with gigantic bank failures in the current situation?  The FDIC's standard actions--wrap up the worst operations, sell off the remaining pieces, pay off depositors out of government coffers--are hard to pull off here.  Who is there with the capital to absorb the struggling operations of BofA and Citigroup? 

That leaves nationalization, or liquidation.  And a fire sale of two of the country's biggest banks would be, she said with dramatic understatement, very bad for the health of the financial system.  It's simply not strong enough to absorb the losses.

In the past few days, I've spoken to a few economics people who are feeling a little perkier about the economy's prospects.  I tend to think we're in a lull before the storm gets a second wind.