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RIP: Credit as Money

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Crucial change in "bad bank" concept never addressed.

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The drumbeat over the Obama administration's plans to fix the banking crisis has reached fever pitch. Over the past week, what appears to be a carefully choreographed series of leaks has raised expectations that the administration has something very big planned (my guess is that it would've been announced today, but for the delay in Timothy Geithner's confirmation as Treasury Secretary).

Various newspapers and blogs have speculated on the details, some of which would be truly dramatic. Examples include: An omnibus take-over of a raft of banks; a process that would include wiping out existing shareholders; converting debt to equity to avoid the new N-word (nationalization); the FDIC providing a backstop for deposits; and, to restore trust in bank balance sheets, the establishment of a new entity to buy, hold, and trade trillions of dollars in now-suspect bank assets.

Clearly something needs to be done, and just as clearly, the banks have gotten wind of the proposals and are trying to head off the scariest parts of the plan. (I interpret the trumpeted insider-share purchases by JPMorgan Chase's (JPM) Jamie Dimon and execs at Bank of America (BAC) to be a message: "Hey, no need to nationalize us, we believe in our equity value!")

Ignored by much of the commentary, however, has been a small but crucial change in the proposed composition of the much-discussed new entity to buy toxic bank assets. Moreover, if this entity comes to pass, it will serve as the grave for a widely shared -- but very dangerous -- artifact of the bubble years: the confusion of money as credit.

First, the new wrinkle in the "bad bank" concept.

Last week on CNBC, Sheila Bair, the outgoing and incoming head of the FDIC, remarked on the possibility of setting up an entity funded by both public and private money to buy toxic assets. The involvement of private money is new, and the timing of this announcement begs many questions. In the CNBC interview, Bair said, "One approach we think might have some merit is what we call an "aggregator bank" where you would set up a facility capitalized through some portion of the TARP fund to acquire troubled assets…"

So far so good. The basic idea has been floated many times over the past year. But then she remarked that the new structure would "also require those institutions selling assets into this facility to contribute some capital cushion themselves…"
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