The titans of Wall Street may not have done a bang-up job of running the American financial sector over the past few years, but would a bunch of politicians in Washington, DC, do any better? We're probably about to find out—and to understand how we got here, and why it suddenly doesn't seem like such a bad idea, you've got to start at the beginning. The very beginning.
In America, it's the stock market that gets all the headlines. If you're sentient enough to fog a mirror, you know that stocks have dropped by half in the past 18 months. It's been a disaster for 401(k)s and pension funds across the country.
But the fact is that this is a sideshow.
The total size of the US equities market—the value of every single share of stock traded on US exchanges—is about $10 trillion. The size of the US credit market is more than $30 trillion. What's more, credit is more important than equities. As the saying goes, credit is like oxygen: You don't realize how much you need it until it's gone. When credit dries up—as it has recently—the economy grinds to a halt.
But why has credit dried up? Let's back up again. The main providers of credit are banks, and the amount of money they can lend depends on two things: their capital stock and their capital ratios. Say that you and some friends decide to start a bank and you pitch in $1 billion to get things rolling. That's your capital. And say that your bank makes a profit of $1 billion for nine years in a row. Your capital is now $10 billion.
The amount you can loan out depends on your capital ratio, a number that's set in the US by the Securities and Exchange Commission. If you're required to have, say, a 5 percent capital reserve, that means your loan portfolio can be as high as 20 times your capital. That's $200 billion—and if you fudge things a bit, say through the creative use of off-balance-sheet vehicles, maybe you can loan out as much as $300 billion. If the average return on your loan portfolio is 5 percent, that means you're making about $15 billion per year with only $10 billion of your own money at stake. Not bad.
But then a crash comes. Homeowners start defaulting on their loans, and you have to write off the losses. That cuts into your capital; plus, with the economy falling, it's prudent to reduce your leverage. Instead of 30-to-1, maybe you'll cut back to 20-to-1. The end result is that you're lending way less money than you used to.
This is, roughly, what's been happening to the global financial system. Loan losses have reduced capital. Everyone is hoarding money. It's called deleveraging, and in plain English it means that credit markets are broken.
But things can still get worse. What happens if your capital is wiped out completely by loan losses? Then your bank is insolvent. The lights are still on, people still come to work, and bills still get paid, but there's no lending at all. And without lending, you aren't really a bank. You're a zombie.
So is the American banking system insolvent? It's probably pretty close. But this doesn't mean that every bank is insolvent. It just means that the overall average is neutral: Some banks are doing fine, while others are deeply in the hole. And the ones who are in the hole, which include some of the country's biggest, need to be dealt with. But how?
We could, of course, simply let the bad banks fail. But that's what the government allowed to happen to Lehman Brothers last September, and the results were catastrophic. Markets went wild, credit froze, and there was a run on money market funds that stopped only when the Fed stepped in to guarantee them. When a really big bank fails—and some of the banks currently in trouble are a lot bigger than Lehman—it can cause a cascade of defaults that ignites a global firestorm and destroys entire economies. So no matter how appealing it sounds on poetic-justice grounds to let the banks that got us into this mess simply go under, the infuriating fact is that we simply can't afford to let that happen.
Aside from allowing banks to fail, then, there are four main options. The first is to muddle through. The US banking system is still profitable, after all, and this means that over time insolvent banks will build their capital base back up and start lending again. Unfortunately, "over time" could mean years, and nobody wants a broken banking system for that long. (Japan tried this after its banking crisis of the early '90s, and the result is popularly known as the "Lost Decade.")
Option No. 2 is for the government to set up what's called a "bad bank" that buys up the banking system's "toxic waste," loans that have gone bad and are likely to get even worse, eating up bank capital along the way. Unfortunately, the reason this stuff is called "toxic" is because the eventual losses from these loans are impossible to forecast. Are they worth 70 cents on the dollar? Fifty cents? Twenty cents? Nobody knows, and without knowing that, it's impossible to buy them up. There's still a plan on the books to attempt the purchase of toxic assets, but most observers give it little chance of success unless it's so heavily subsidized by the government that it amounts to little more than a massive giveaway.
That leads us to option No. 3: recapitalization. Last year, after former Treasury Secretary Henry Paulson realized that buying up toxic waste wouldn't work, he decided to provide direct capital infusions to banks. The idea here is simple: If the banks don't have enough capital, then give them some more. Even with big losses, if you give them enough, then they'll be able to lend money once again.
One problem, though: There's no reason for taxpayers to simply give money to banks. We need to get something in return. But what?