One of the most critical problems facing the US economy is the “credit crunch,” which shows up as an extreme reluctance by banks and other financial intermediaries to lend money. Without a normal flow of credit, no sector of the economy can function up to its capacity, and that of course leads to lower output and higher unemployment.

You’ve read a lot about the TARP and a raft of other ad hoc Treasury and Fed programs to stabilize the financial system. In practice, the objective of these historic and unprecedented measures has been to prevent a “meltdown,” which can happen if the failure of a sick institution triggers a cascade of failures in healthier ones.

The way that banks, investment banks, and other institutions avoid a meltdown is to stop extending short term credit to each other. This is rational because in a time of extreme crisis like last March or last September, you literally can’t be sure that any institution won’t fail by morning. So you don’t want to have lent anyone half a billion dollars the night before.

The problem with that, to use Ben Bernanke’s stark phrase, is that it can cause the economy to come to an end. You saw the beginning of that process in late September as the commercial paper and institutional money markets nearly froze.

The TARP and similar bailouts have indeed met the objective of preventing a systemic collapse of the financial system. The many people who speak out against the program on free-market and other grounds are misinformed to that extent.

What’s undeniable, however, is that the system is not performing its normal function of creating credit. How do we fix that problem?

The Fed and the Treasury have made it abundantly clear by their actions that they don’t intend to allow any of the major banks to fail. One huge bailout after another has shown that enough public money will be made available to prevent any default that could endanger the system. But just knowing that their survival is assured isn’t enough to enable banks to start lending again.

Many of them still hold large asset portfolios, including mortgage-backed securities, that are worth less on a current-market basis than they’re being accounted for. So they can’t be clear about their true capital position, and therefore they can’t expand their asset portfolios. That’s not just a matter of prudent banking practice, it’s also a matter of regulatory compliance. For the time being, the banking system is frozen in amber.

The bottom line is that it will take a very great deal of new capital to get many of the largest banks back in business. Far more capital than has already been expended in the TARP program. (And one assumes that the recapitalization of banks via the TARP may be coming to an end, given that the Democrats in Congress and the Obama people have said they want to change how these funds are used.)

There’s been a fair amount of talk about forming an aggregator, or “bad bank.” Capitalized by the Treasury and the FDIC, this entity supposedly would be chartered to acquire impaired assets from banks, which would allow them to make room on their balance sheets and, in time, attract new capital and start lending again. That’s the theory, anyway. There are many similarities to the structure of the Resolution Trust Corporation that restructured the S&L industry nearly 20 years ago.

How might this work? Well, as I’ve said a thousand times since September, the question is the valuation of the assets. Buy them from banks at current market value, and you force the banks to recognize losses that will bankrupt them, and require more bailouts (since we’ve implicitly pledged to the markets that they will survive).
Buy them at an overvaluation, and you force the taxpayers into a position where they could take losses. In either case, you’ve transferred a tremendous amount of value to the stakeholders of the assisted banks. These stakeholders include people who own common stock and debt issued by those banks.

It would be far more rational not to protect the stakeholders of nationalized banks. It creates too much moral hazard to signal to equity holders that they will be protected. The pattern for this was set last March, when Hank Paulson insisted that Bear Stearns shareholders accept a price of $2 per common share, all but wiping them out. A few weeks later, in the face of a certain spate of shareholder lawsuits, JP Morgan Chase was forced to raise the buyout price to $10/share. That set the expectation that equity would not be forced to walk the plank, a pattern that has been carried through all the subsequent bailouts.

It turns out that many of the common and preferred equity holders of assisted US banks are very important people indeed. Some of them are Saudi princes. Some of them are official agencies of the Chinese government. It seems clear that our regulatory authorities are being very careful not to burn a lot of people that will be needed to fund our fiscal deficits as time goes by.

And that means that the nationalization of the banking system can’t be completed in a clean, transparent way, as the S&L resolution was. By rights, a lot of large banks should be allowed to close down or recapitalize in an orderly fashion. This would recognize the reality that these banks screwed up big time, while containing the systemic risk.

Instead, the banks are going to continue frozen in amber, not allowed to fail but not allowed to get back to normal capital levels either. They will continue to act as brokers for Fannie Mae and Freddie Mac-guaranteed home mortgages, and probably will continue in the federally-subsidized student loan business. And of course they’ll continue to take enormous fees for retail banking transactions. But not a whole lot more.

(When you add new equity to a distressed bank, the bonds that the bank issued will increase in value, because there’s a perception that the new capital will take any losses ahead of the debt. In essence, people who contribute new capital are paying the debtholders ahead of themselves, and that makes it difficult for any rational private investor to buy new bank stock. Of course, the government isn’t bound by such concerns, since everything they do transfers losses to the taxpayers, who have no choice in the matter and therefore always perform the role of the greater fool.)

What will eventually happen is that a completely new financial industry will arise to fill the gap left by today’s walking-dead banks. I expect many of these companies to be some combination of commercial bank and investment bank, possibly with participation from the private equity industry. I also expect the new banks to be small or medium organizations at first, and to be centered in cities other than New York.

But I don’t expect any of the large zombie banks to actually go out of business. They’ll just sit on the economy as permanent dead weight.