Those last lines of the excerpt from the classic song "Chicago" by Graham Nash, performed almost 40 years ago by CSNY, described a period of militancy and optimism in America, a perspective that seems the polar opposite from the gloom and resignation we see today. Revolutions come when expectations are rising, not falling.

But as we said during our comments at the latest AEI/PRMIA event in Washington last week, "Bust Bankruptcy and Bailouts,"  the US economy and banking system are in far better shape than those in Europe and Asia. We can fix this mess if we have the courage to act - really act.  But don't mistake the talk of "decisive action" coming from Washington as anything of the kind. A desperate rear-guard action is being fought by the Fed and OCC, an effort to defend what remains of the large money center banks and domestically-owned primary dealers. Call this the Geithner Plan, which we described last week:  ("The Big Banks vs. America: A Roundtable with David Kotok and Josh Rosner.")

As with the muddled thinking on asset valuations we heard last year from Fed Chairman Ben Bernanke, this new plan supposes that there is a "happy medium," some compromise that awaits taxpayers in the US (and the UK too) in terms of buying bad assets from already insolvent banks without requiring the purifying step of insolvency and restructuring.

Indeed everyone from our usually sagacious friends at BreakingViews to the Financial Times to US Economic lider maximo, Larry Summers, seem to be coming under the nonsensical notion that there is some alternative to restructuring for the large money center banks in the US and Europe. The editors of the FT in particular seem to forget that their continued existence as a business comes from a healthy, private financial market, not the politically-conflicted statist paradise envisioned by Geithner, Bernanke and their masters at Goldman Sachs (NYSE:GS).

We are encouraged that a growing number of Republicans in the Senate seem to have figured out that the only way to protect the US taxpayer from further rape at the hands of the profligate souls who inhabit the senior appointed posts at the Fed and Treasury is to first mark the assets of the largest banks to market, a process that must necessarily wipe out the equity of these institutions. Like we said last week, the bondholders are the true owners of Citigroup (NYSE:C), Bank of America (NYSE:BAC), et al.

One key indicator that the children's hour continues at the Treasury and Fed is the talk of issuing more equity warrants to "protect the taxpayer" as part of a bold plan being considered by the Obama Administration. Geithner is said to be the chief proponent of this idiocy, but we have heard even good friends in the analyst and Buy Side worlds prattle on about how we can draw the line at the equity of the parent companies of the money centers and then commence a credible recap.

In that regard, we hear that Geithner met with C Chairman Dick Parsons on Friday to discuss the Geithner Plan, continuing the conflicted flow of communication between Treasury and C that was legacy of Secretary Hank Paulson.  When is the Congress going to remind Geithner et al that political appointees are not supposed to be communicating directly with the regulated banks?  This is a task which, by law and practice, is assigned to the professional, civil service staff officers at the OCC and Fed. Just what are Geithner and Parsons talking about, we wonder?

Further to our interview last week, Josh Rosner of Graham Fisher & Co. tells The IRA that Geithner is trying to sell the Obama Administration on the idea of a "bad bank" for only trading, "available for sale" assets, while yet another pointless insurance "wrap" would be proposed for "held-to-maturity" assets. Unfortunately, much of the toxic waste currently burdening US bank balance sheets is now hidden in the banking book, having migrated from the trading book over the past few months. Seen in this light, the Geithner plan represents merely another delaying tactic that will increase the cost of the C resolution to the taxpayer, which incidentally is a violation of federal law.

No, just as we believe that the losses at Fannie/Freddie must eventually involve a haircut for non-collateralized debt holders, the situation at the larger money centers such as C and BAC demands the treatment described by Eugene Fama at University of Chicago (See, "Citigroup: Too Big To Sell -- At Least All at Once").   While the customers and counterparties of the subsidiary banks of these groups will not be affected, we cannot see how the creditors of the parent holding companies will avoid a haircut - at least so long as Fair-Value Accounting is the law of the land.  Just remember Washington Mutual.

Let's look at C through fair-value eyes using the year-end 2008 data released last month. If you look at the average earning assets of $1.635 trillion, only $650 billion are bank deposits, with the remaining liabilities needed to support these assets funded from market sources.  If you take a relatively conservative loss rate assumption of 30% of assets, including charge-offs and additional M2M losses, we possibly are talking about total losses at C in excess of $500 billion or a multiple of tangible equity capital, meaning that the only way to mark-to-market C's assets is to accept that the equity is gone and begin by imposing a haircut on C's creditors.

Thus when you hear people in Washington talk about buying bad assets from already insolvent banks, the illogic of their position should be apparent to all. Let's walk through the two basic alternatives under a "bad bank" approach.

Scenario A:   The Treasury buys the "bad" assets at inflated prices, say par value, taking the assets from the bank without incurring a loss. The unrealized loss is passed to the taxpayer, who now owns this asset at well-above market value. Unless you believe that the market value of these assets will recover at some time in the future, the prospect is for a subsidy by taxpayers to the bond holders of the large bank. The solvency issues of the large bank may or may not be resolved, but in consideration for taking the bad assets, the taxpayer is clearly now the owner.

Scenario B:   The Treasury first forces the banks to write down the value of their assets in a one-time "Come to Jesus" M2M exercise, a global celebration of Fair-Value Accounting, if you will. The equity and the junior sub debt of C would be completely wiped out, with senior bondholders and new investors comprising the new owners. The large bank will then be solvent and could continue to sell assets and restructure its business to repay the taxpayer for previous support and meet a new business model.

The "Bad Bank" approach in Scenario A represents further delay and temporizing, a strategy that ensures that the US economy remains mired in crisis and recession for years to come. Scenario B represents a painful but ultimately quick remedy, the path whereby we can jump start the US private sector and get on with the process of rebuilding the global financial system. All that is required is courage and leadership, two qualities that still seem to be lacking in Washington.  

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