Two naive questions from someone with no economic training:

1) What's the evidence that the "toxic assets" are undervalued? How do we know they're not overvalued?

2) What would be so bad about letting banks deal with their balance sheet woes through the bankruptcy courts?

These are not naive questions. They are in fact absolutely fundamental questions that no one has answered properly.

The argument is that on a cash flow basis the "toxic" assets should be worth more than anyone is willing to pay for them. However as nobody knows the future rate of default nobody actually knows what they are worth.

The reason that many people dislike the bankruptcy solution is that they fear that everything involved in a bankruptcy will be time consuming and complicated. The argument is that the time and uncertainty involved in a bankruptcy proceeding will only fule further paralysis. I think that bankruptcy would probably be a better option because it would force everything to unwind.

Good answer to the first question---exactly right.

But I would add to your second answer: the other and perhaps more potent fear regarding bankruptcy is the prospect of contagion in the banking industry. Allow one very large bank to go bankrupt, such as Citigroup or Bank of America, and suddenly a very large number of other banks may find themselves in trouble. It is an old, old problem in the banking industry: a run on one bank can easily turn into a generalized banking panic, followed by the failure of hundreds of banks, with the ensuing economic catastrophe. Counter-party risk is the phrase du jour to describe all these fears. And it happens because of all the complex inter-linkages in our financial system, with banks having many loans to other banks...

It is an old, old problem in the banking industry: a run on one bank can easily turn into a generalized banking panic, followed by the failure of hundreds of banks, with the ensuing economic catastrophe.

leroy is worried that there may not be enough money to fund his precious welfare state. obama is too. maybe then the whining complainers will finally get off of their lazy asses.

Obviously, based on the record that one bank failure often leads to a cascade of bank failures, it seems that we have sufficient evidence that the structure of the banking system is incorrect. Since this is one of the more highly regulated industries, we correspondingly have evidence that the regulation is faulty. Thus, it is time to redefine the structure of the regulation. What would you suggest?

Thus, it is time to redefine the structure of the regulation. What would you suggest?

i damn sure don't suggest letting bawney fwank and chris dodd have anything to do with restructuring and regulating.

i suggest stocking up on guns and ammo.

The definition of insanity is to do the same thing and expect different results.

leroy - what do you mean by "bank run" regarding Citibank? Obviously, their deposits are well covered by FDIC. As far as their investment banking department is concerned- I don't see how the term applies.

Are you forgetting that there was a bank run on IndyMac bank, which was also 'protected' by the FDIC?

Evidently, FDIC protection no longer is an adequate insurance against the risk of a bank run. One reason may be that the FDIC itself is in danger of running out of money. Which is why they are raising the fees on all banks for deposit insurance, a move that has angered many small and medium-sized banks that had nothing to do with this financial catastrophe. [Higher FDIC insurance fees will naturally cut into their profits, perhaps by a very considerable margin.]

Besides, bank runs are not the only risk subsumed within the phrase 'counter-party risks'. Has not the justification for the bailouts of Bear Stearns and AIG (and etc.) all along been that if these firms were allowed to fail, that the consequence would be severe knock-on effects throughout the entire financial system? [Of course it has.] And that fear would seem to be justified to some extent by the extreme credit crunch and financial panic which followed the bankruptcy of Lehman Brothers, which WAS allowed to fail.

This is what happens when you get financial firms that are 'too big to fail'. They are too big to fail because they are too inter-connected with all the other gigantic financial firms.

Think of it as a house of cards, for that is what it is.

LeRoy_Was_Here:

Are you forgetting that there was a bank run on IndyMac bank, which was also 'protected' by the FDIC?

Evidently, FDIC protection no longer is an adequate insurance against the risk of a bank run. One reason may be that the FDIC itself is in danger of running out of money. Which is why they are raising the fees on all banks for deposit insurance, a move that has angered many small and medium-sized banks that had nothing to do with this financial catastrophe. [Higher FDIC insurance fees will naturally cut into their profits, perhaps by a very considerable margin.]

Besides, bank runs are not the only risk subsumed within the phrase 'counter-party risks'. Has not the justification for the bailouts of Bear Stearns and AIG (and etc.) all along been that if these firms were allowed to fail, that the consequence would be severe knock-on effects throughout the entire financial system? [Of course it has.] And that fear would seem to be justified to some extent by the extreme credit crunch and financial panic which followed the bankruptcy of Lehman Brothers, which WAS allowed to fail.

This is what happens when you get financial firms that are 'too big to fail'. They are too big to fail because they are too inter-connected with all the other gigantic financial firms.

Think of it as a house of cards, for that is what it is.

Your point about FDIC is well-reasoned, though hardly a proof. No depositor in the USA has been screwed since the Great Depression.

Your other stuff about "too big to fail" is mere speculation and rather vague. I grant you that similar language is issuing daily from the likes of Geithner and Bernanke ( and perviously Paulson), but I and many other Slate posters simply do not trust the motives of these guys.

MisterPerson: Your point about FDIC is well-reasoned, though hardly a proof. No depositor in the USA has been screwed since the Great Depression.

LeRoy: True. So far. But those sound like 'famous last words', to some extent. And many people are getting screwed in other ways, such as losing their pensions. One of the lesser understood 'functions' of AIG is that it insures the pensions of many, many Americans. If AIG were to actually 'go under', look out!

MisterPerson: Your other stuff about "too big to fail" is mere speculation and rather vague. I grant you that similar language is issuing daily from the likes of Geithner and Bernanke ( and perviously Paulson), but I and many other Slate posters simply do not trust the motives of these guys.

LeRoy: I don't trust their motives, either. But I do not doubt what they have been saying about systemic risk, and the inter-linkages in our financial system. And what happened in the weeks and months after the collapse of Lehman Brothers strongly supports those views. We had such a severe credit freeze that many were saying the economy was close to cardiac arrest. There were warnings that farmers might not be able to get the loans to buy the seeds for next year's crops....which would have catastrophic consequences. For what it is worth, I have a slightly greater degree of trust in Bernanke than I do in either Geithner or Paulson. Bernanke really does come from a small-town America background. Geithner and Paulson have been Wall Street denizens for almost their entire adult lives. Bernanke was genuinely outraged by the AIG fiasco. One does not sense that from Geithner.

It seems to me that a far simpler solution to a credit freeze would have been for the Fed to simply start making loans to business and private firms while forcing the so-called "banks" into single function components, including commercial banks, brokerages, insurers, and then the great mass of high risk functions. Assets could have been dispersed among the various components so that the first three named here met regulator requirements and the remaining assets, even if they had a negative value, allocated to the high risk functions. The latter components would have been allowed to fail. The only sort-of-public funds at risk would have been those conventionally loaned to the businesses and private firms, and these would have been lent with conventional terms and requirements.