The Kroog Versus The Zombie Banks

Zombie banks are out there, Paul Krugman explains. There's tons of banks that are only solvent right now because of the future promise of bailout billions. What's the anatomy of the undead?

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price.

And the reality is much worse. "Gothamgroup Bank" up there is in terrible shape. Part of the assets it's claiming are debt owed to it by other banks facing the same zombie bank situation, so the assets it really has are far less, meaning the bank is even more insolvent than Krugman alludes to.

This in turn makes stockholders all the more confident Obama will have no choice but to to throw trillions more at the banks to keep them afloat. He has no choice. If he doesn't, the results will be more Lehman Bros.-style collapses that will threaten to become a cascade of multiple bank failures that will bring down the entire system.

That's the issue facing Citigroup and Bank of America right now. It's also the issue facing virtually every other large financial institution across the country, and a host of smaller ones. Japan went through the same problem two decades ago and for most of the 90's they were cleaning up zombie banks.

The ones in America are much, much larger. $350 billion might not be enough to clean up even a few of these banks, much less the system. But that's what Obama apparently wants to do, form a huge megabank to buy this toxic waste debt and then put the taxpayer on the hook for it, rather than bank shareholders. And it will take far more than the second half of TARP to fix this problem.

Once again, the banks are getting the best deal possible, while taxpayers are getting the worst. On the other hand, the alternative is complete financial collapse of the US economy. And frankly...the collapse may STILL happen even if Obama spends trillions to bail out the banks.

Talk about worst-case scenario.