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So, the time has come for the banks to spill their beans.  By the end of the day tomorrow, our country’s leading financial institutions will have their fates discovered.  Is this really, though, a discovery?  Since the virtual stakeholder ownership of these institutions by our taxpayers occurred last fall, the element of discovery through price mechanisms is long gone.  Replacing market principles, arbitrariness now leads the day.  Washington ultimately decides the fate of these institutions.  They must, therefore, make one of two decisions.  One, the Fed could declare a blanket green light for these institutions by stating that their financial health is both current and sustainable.  This, however, would largely de-legitimize the bank stress test concept.  The primary reason for the test was the need for toxic assets to be revealed on bank’s balance sheets.  Even after the Fed’s massive purchases of mortgage debt and the TALF, which almost guarantees bad assets, there is still no wide agreement on what remains and how to price the remaining assets held on the books of these institutions.  Could several banks suddenly, over the previous few months, really have re-structured their activities as to remain profitable?  They could bring about a second scenario:  Allow a major bank to fail.  Without naming names, one could envision a major entity not having the wherewithal to continue with their previous business model, which could mean certain formal re-structuring and an utter disaster for common shareholders.  This second scenario is much scarier.  First, such a failure would be a likely catalyst for an extreme market reversal, especially in the financial sector.  Just as confidence has started to rebuild (S&P Financials are up almost 20% in three months) and investors are chattering about taking gradual steps into more risk, a scenario such as the one described would almost assuredly take the heat out of the recent rally.  Volatility, which has been on the decline this year in both equity and foreign exchange markets, will take hold once again.  This scenario, I would argue is quite possible.  Would the administration, taking fire from taxpayers over the recent bailouts, want to risk once again being seen giving a lifeline to this industry?  Letting one institution fail would be just enough to appear as if they are not handing out to the oh-so-derided bankers.  Letting more than one too-big-to-fail bank to fall would mean almost certain systemic risk elements to once again enter into play, which has been delightfully absent in the past few months.  Cynicism aside, the Obama administration, rightly so, will not want to risk damaging an economy trying to get its footing. 

So, what is the right decision from an overall moral hazard standpoint?  Should we guarantee the soundness of bank’s books even though, deep inside, we know that this is impossible?  Or should we let a bank fail and try to let whatever residues are left of a rational market to determine the outcome?  I would argue, although I am eating my words, that they (the administration) should decide on the first scenario.  Really, its a modest proposal.  We have, up to this point, bailed out entire industries on the verge of the collapse, in order to ensure that the entire world does not collapse before us, and the Greatest Depression to begin.  We have added, quite speedily, a monstrous increase in the overall debt that this country owes with the recent budget and stimilus packages.  Why, then, deviate?  At least, with the recent rally, we have seen markets better understand the relationship unfolding between the private and public sector, with former lines of demarcation suddenly blurred.  Perhaps, it is that we could excuse a little intervention now and then if that means more stability.  Allowing a too-big-to- fail bank to go under, would erase any future success in initiating clarity and calm to the world economy.  Maybe it would be a bit more freakishly Orwellian.  This is the moment the administration must truly use a little of bit of creativity and boldness.  The expedient route would be to allow a single failure.  The irresponsible route would be one that would allow several failures.  The wisest route would be to signal the “Loud and Clear!”

Please post what route you think is the best one for our future.  Lets watch this most interesting next week.  And hold onto our hats!

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