Sunday, October 19, 2008

Paulson's bailout team should start culling insolvent banks

This is an interesting interview in the WSJ with a monetary expert who who is not only a scholar of the earlier big financial crash -- the Great Depression --but was around when it happened. She is Anna Schwartz, who co-authored, with Milton Friedman, "A Monetary History of the United States" in 1963. Since 1941, Ms. Schwartz has been on the staff of the National Bureau of Economic Research in New York City. At age 92, she was a teenager when Wall Street crashed in 1929.

Ms. Schwartz fears Treasury Secretary Paulson and his team will use federal bailout money to try to make weak banks solvent. I hope her fears are misplaced. As she emphasizes, the problem is not liquidity -- the Federal Reserve and Treasury have flooded the banking system with liquidity -- but solvency. Solvency is the ability of a financial institution to withstand a rush against its deposits and other funds. If an institution is leveraged, say, 40 to 1, it has little chance of surviving panic withdrawals, regardless of injections of bailout cash it may receive.

It shouldn't take Paulson and his team that much time to size up an institution's ability to stay solvent. Experts have pointed out that Fannie Mae has all the tools that are needed to calculate the value of so-called "toxic" securities and weigh them on balance sheets. Those institutions that are over-leveraged should not get any bailout money. There are 5,250 banks and saving banks insured by the FDIC, more than enough to survive a solvency evaluation and provide adequate credit for personal and business customers.

Let the culling begin.

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