The Wachovia model

It appears that many Members of Congress who voted against the financial bill yesterday think they saved the taxpayers a lot of money. They need to think again. This is a case, to quote the old auto oil filter ad, of “pay me now or pay me later.” The cost to the American citizenry will be high — from direct costs of FDIC insurance payouts on failed banks and higher unemployment insurance to the indirect costs of what Steven Pearlstein warns may be “a decade of little or no economic growth.”
As Pearlstein notes, the action is already shifting from Treasury to the FDIC. The Wachovia deal is a case in point. The New York Times (“In the Wachovia Sale, the Banking Crisis Trickles Up”) describes the heart of the deal:

Citigroup will pay $1 a share, or about $2.2 billion, for Wachovia’s banking operations. Citigroup will assume the first $42 billion of losses from Wachovia’s riskiest mortgages and transfer to the Federal Insurance Deposit Corporation $12 billion in preferred stock and warrants. In exchange, the F.D.I.C. will absorb all losses above that level.

This action was precipitated by a different type of bank meltdown. As the Wall Street Journal (“Citi, U.S. Rescue Wachovia”) explains:

Wachovia’s motivating factor was not a run on the bank. While the bank and its regulators were nervous that depositors would start yanking their funds, it didn’t happen; the bank was fully liquid and hadn’t needed to borrow from the Fed.
The bigger problem was a prospective downgrade of Wachovia’s debt by Standard & Poor’s and Moody’s, which representatives of the two ratings agencies had informed Wachovia could occur by Monday. That had the potential to sow greater fear among Wachovia investors and customers, not to mention increasing the bank’s borrowing costs just as a batch of its debt was set to mature.

It was Wachovia’s portfolio of toxic assets that was the problem. Or should I say presumed portfolio, because without a market it is next to impossible to determine what these assets are really worth. Thus, it was not a liquidity problem, but a credibility problem.
That sets up a different type of rescue operation that the standard injection of liquidity everyone is talking about. As the Financial Times (“Citigroup avoids missteps of other bail-outs”) notes:

The Wachovia deal is notable because the government – in the form of the Federal Deposit Insurance Corporation – is taking much of the risk on Wachovia’s portfolio of toxic assets in return for a potential ownership stake in the combined bank.

In other words, the Citi-Wachovia deal accomplished the same end goal as the requested Troubled Asset Relief Program (TARP). Even the Wall Street Journal editorial board (“Pre-emptive Plumbing”) — a group I rarely agree with –liked the deal:

But the good news is that regulators are starting to take the initiative in forcing quick resolution at the most troubled banks, handing them off to stronger competitors and working creatively to contain the risk of contagion. It’s a far sight better than the political gamesmanship that still consumes the adolescents on Capitol Hill.

What worries me, however, is that this was a rescue in an ad-hoc rather than systematic manner. With the collapse of the Paulson plan, ad-hoc may be all we have. We are already well down that road, as the following graph from Wall Street Journal (“Bailout Plan Rejected, Forcing New Scramble to Solve Crisis”) illustrates:

So, pay now or pay later. And, as the auto mechanism in the ad implies, later is always more expensive.

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