Bad Luck for Good Banks

Treasury Secretary Hank Paulson will probably never live down his statement to Congress that, "If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out."

Arnold Schwarzenegger tried this, too, when he said, "To those critics who are so pessimistic about our economy, I say: Don't be economic girlie-men."

Too bad neither of the comments seemed to work.

Let's focus on Paulson's bazooka: the mother of all bailout packages. Details are still absent, but that plan will likely purchase bad assets from banks, which should unclog the plug in the debt market and allow lending to resume, at least in theory.

There are all sorts of negative consequences to the proposed deal, including forcing taxpayers to hold the bag, sending inflation through the stratosphere, and running out of ink at the Treasury's printing presses. Those are problems that affect you, the taxpayer, but what about other innocent victims of this mess: the few banks that aren't in trouble?

Seriously, do those even exist?
Yes, believe it or not, there are a handful of banks that are actually doing just fine: Wells Fargo (NYSE: WFC  ) , BB&T (NYSE: BBT  ) , and US Bancorp (NYSE: USB  ) , just to name a few. BB&T -- wonder of all wonders -- approached a 52-week high last week.

What does the bailout mean for them? Nothing good, to be honest. Here are a handful of bazooka backfires the good banks will have to deal with:

  • Dwindling opportunities for distressed purchases. One good thing about a financial melee is the opportunity for healthy banks to swoop in on floundering banks at bargain prices. Remember JPMorgan Chase's (NYSE: JPM  ) original offer for Bear Stearns, which amounted to less than what the Yankees paid for Alex Rodriguez? Odds are, JPMorgan will make a fortune off of that deal. Once the government starts artificially propping up banks, the prospect of bargain purchases that'll pay off down the road goes down the tubes.
  • Competition won't diminish. Banks that were on the verge of going bust -- like Washington Mutual (NYSE: WM  ) -- will remain competition for healthy mortgage lenders, which would have had the market to themselves if the forces of a free market had been allowed to run free.
  • Increased regulation. I'm only guessing here, but the odds that bank regulation will be turned on its head in the coming years seem pretty good. Who knows what that could mean: increased capital requirements, a clamping down on certain types of lending products, and maybe even forced breakups. For banks that know and have known how to manage their risk appropriately, that's a terrible thought.
  • Increased interest rates. Again, I'm only guessing, but the odds that pumping $700 billion into the financial system won't cause a tsunami of inflation seem pretty slim. What happens when inflation goes up? Interest rates go up ... ergo, bank margins get pinched, home affordability goes down, and it becomes more difficult for homeowners to refinance.
  • People lose faith in the financial system. One of the most shocking developments of last week was that Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) -- banks that by most accounts sidestepped the financial crisis -- faced the possibility of collapse. Should it be any wonder that the last remaining independent Wall Street banks had to switch to bank holding companies over the weekend? The mother of all bailouts sent a false signal to the financial world: "We're all up to our necks in trouble. Every single one of us needs help. The entire system is ruined." Unfortunately, that isn't true, and now the banks that were smart enough not to leverage to the moon with subprime CDOs have to pay for it.

Yes, I happen to be one of the few who think the bailout will end up being a net positive. Regardless, what a shame that nearly every bank that kept its act together over the years has to pay the price of those that were overrun by greed and speculation.

Free markets? What a joke.

Related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase, BB&T, and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 23, 2008, at 6:31 PM, foolishkids wrote:

    I doubt the issue is limited to Subprime CDOs. It is much more widespread as it involves mortgage backed securities. Many banks (Good banks) own these. Several tens of billion dollars. They are normally regarded as current asset and liquid. However with the credit problems and home mortgage defaults, their value is un known if not at extreme discounts. Over night bank assets are vaporized. If this is not a financial meltdown then what is. I hope the law makers pass this bail out as it is good for America. Without quick action, not only banks (all of them) are going to fail in a domino but wall street and main street is going to burn down. When there is a fire, you fight it, you do not wait for fire to burn down everything. Surely there is future after a fire but who wants it?

  • Report this Comment On September 24, 2008, at 12:44 AM, crca99 wrote:

    Two years down the road I'm going to buy every historical book I can on the subject to see if I can understand then what's happening now before our eyes. Naively, it seems the idealized relationship between borrower and lender was eroded. Like espionage, the middle links multiplied and each knew only what the player before or after them dealth with leaving no one to identify the whole scheme. Tricky mortage options, inflated appraisals, uninformed ratings, fancy asset backed securities, tranches carved or hedges built or whatever we'll never know.

  • Report this Comment On September 24, 2008, at 1:13 AM, foolishkids wrote:

    Here is what I think happened. As the root cause of this is mortages going bust. When Greenspan lowered the rate to levels not seen for years perhaps decades, it created the opportunity to offer mortgages at very low rates, inflating the housing market. The Bush administration loved this as it helped to jump start the economy after 911. It also helped Bush to win a second term as economy was going in the right direction. Many Americans who could not afford buying a house in early 1990 could buy their dream home and those who had homes used their new lines of credit to borrow more and spend it. Then we started to outsource jobs to India, China and other places and as the result jobs were lost in the US. Un employment caused the mortgage defaults and now we are in this mess. Having said that, I think the American Financial Systems are the blood line of America. You can compare them to a interlinked highways. If you get a traffic jam there it could suffocate the economy in no time and that is why we need government to jump in or the world as we know it would be very different in 3 months. Major crash in wall street, depression in main street. A complete malfunction of the system.

  • Report this Comment On September 24, 2008, at 10:09 AM, DeadmanLiving wrote:

    When are we as Americans going to wake up? We can not continue to spend more than what we make. We can not continue to be fiscally irresponsible. By bailing out the same intuitions that promoted the fiscal irresponsibility, without any repercussions then are we not just delaying the problem even more?

  • Report this Comment On September 26, 2008, at 9:01 PM, GoNuke wrote:

    My parents grew up during the depression and went on to fight in WWII. My mother is a Fool as am I. She grew up in poverty. It was the post war boom that made it possible for her to go to University and become a professional engineer. We are already in a war and it isn't helping. DoD's annual budget is about two thirds the size of the proposed rescue package.

    When assessing risk there are two factors to consider: how likely is something to happen AND how bad is that something if it happens.

    Depressions are VERY bad. Even the small likelihood of a depression multiplied by the ravages of depression make the risk great.

    When the reactor is overheating you don't gamble on it cooling down by itself, you shut it down. When credit markets dry up as a consequence of mass fear you do not gamble that a depression won't result, you restore confidence.

    $700 billion minus what the assets turn out to be worth after confidence is restored is a cheap alternative to a depression.

    I don't want my parents to die in poverty and I don't want to live in Hooverville.

    All you disciples of Herbert Hoover should be reminded that. His policy of non-intervention by government was proved wrong then and it is wrong now.

  • Report this Comment On September 27, 2008, at 4:25 PM, RandiW wrote:

    WAMU declared bankrupcy

    today.

    In a Reuter's article found on

    Yahoo Finance, it was stated

    that WAMU has assets of

    32.9 Billion and debt of 8.2

    Billion. That leaves assets

    in the amount of 24.7 Billion.

    Either all liabilites were not

    included in the debt figures,

    the information is wrong, or

    my math is off. Please

    respond.

  • Report this Comment On September 27, 2008, at 10:45 PM, RaulChapin wrote:

    Randi, you declare bankrupcy not when your liabilities are higher than your assets, but when you can no longer pay your bills.

    They are quite different and the main problem lies in the fact that not all assets are liquid. In the case of a bank most liabilities can become liquid very quickly, such as in the case of a deposits or investments run. Basically people are willing to forego their interest in exchange for getting the capital.

    So when you run out of cash and liquid assets, and no one wants to lend you money on your non liquid assets... you can offer chairs and windows to the people you owe money to (In the case of a bank those who have deposits in it) but they are likely to not accept and thus you go insolvent and bankrupt.

    If indeed the assets of WAMU after taking out liabilities are in excess of 24.7 billion, after every one is paid, those assets would be sold (of course for much cheaper than their actual value... as the voultures will want fat profits from buying them) and the proceeds would be given to the share holders.

  • Report this Comment On October 04, 2008, at 5:36 PM, bigbroslittlebro wrote:

    Reminds me of a play in jr high school.

    As the play got going there was a noticeable activity that someone was walking past the rear curtains from left to right.

    Then it more, and sometimes several at a time.

    One of them came across the stage, actually in front of the back-curtain absentmindedly hurrying along carrying a little cup like a cup of water.

    Some one in the audience(lets call him Jim) asked, "What is going on?" She said, "The school is on fire."

    Jim asked "Is that a cup of water, surely you will need buckets?"

    She said, "No. It is gasoline". Then hurried along.

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