Generally, I'd agree that entities that make bad choices should suffer the consequences. and that the government should never reward stupidity or avarice. A flawed institution should be culled from the economy as quickly and efficiently as possible. But how should that be implemented?
Clearly, all of the shareholders of a flawed bank should be wiped out and the workers and managers should be fired. But that leaves some unanswered questions:
1. What happens to the depositors, bondholders, and others that have long-term contracts with a flawed bank?
2. How many of them should get a haircut and what is the legal mechanism for doing that?
3. How do we handle the assets of a flawed bank?
4. Who steps in to provide the productive capacity (e.g., transaction-servicing, deposit-taking, loan-making, capital-structuring functions) provided by that flawed bank?
If only one bank in the system had over-leveraged (i.e., borrowed too much money) and then put that money in risky assets (i.e., mortgages, car loans, consumer debt, etc.), then we'd just let the FDIC or bankruptcy court handle it. With that mechanism for dealing with insolvent institutions, the depositors would be made mostly whole, bond holders might see a haircut, some assets might be auctioned off, and a competitor would gleefully take-over the business functions and nicer assets (e.g., branch network and performing loan portfolio) of the dead institution. If we have a single (or very small number) of flawed institutions, then the FDIC and bankruptcy courts can handle questions 1 through 4 quite easily.
But what do we do when:
1. What if almost all financial institutions are over-leveraged and invested in risky consumer debt?
2. What if the assets of these flawed institutions are illiquid or low-ball prices on these assets would drive other institutions into bankruptcy?
3. What if the institutions have heavy direct and indirect cross-holdings such that a haircut for the bond holders in one institution drives other institutions into bankruptcy?
This is a problem far beyond what the FDIC or bankruptcy courts can handle.
The deeper problem is that there is no way to pin the losses of the banks on the banks -- they don't have the money now and they actually never even had the money. In a very real sense, banks are only pass-through entities that connect creditors to debtors with a bit of a buffer defined by the reserve ratios. Yes, the banks (and their regulators) horribly botched both their reserve ratios and due diligence on lending, but that does not change the essential fact that the banks don't have money because it's all spoken for by the bank's creditors. To the extent that a bank's debtors default, the bank's creditors take a haircut. To the extent that one bank's creditors are another bank's debtors or other participants in the economy, the failures will propagate. And to the extent that most debtors (e.g. consumers) depend on a functioning economy and a functioning economy depends on a functioning banking system, then problems in the banking system all but guarantee defaults by the debtors.
This implies one of four options:
1. Allow the entire system, not just the flawed banks, to collapse
2. Buy the toxic assets (i.e., bad consumer debt) of the flawed banks for above market prices with taxpayer money (TARP as sold to Congress)
3. Inject taxpayer money directly into the flawed banks (TARP as implemented)
4. Nationalize the flawed banks and slowly unwind the asset and liabilities of the banks.
I hate these choices, but don't see an alternative because the money that the banks lent out is well and truly gone (unless home prices magically pop back to where they were a year ago).
