There was no other choice.                                                            Photographer: Andrew Harrer/Bloomberg Photographer: Andrew Harrer/Bloomberg
There was no other choice.                                                            Photographer: Andrew Harrer/Bloomberg Photographer: Andrew Harrer/Bloomberg

"To avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at 'high rates.' " -Walter Bagehot, Lombard Street

Former U.S. Treasury Secretary Timothy Geithner has been promoting his new book, ``Stress Test: Reflections on Financial Crises.'' I haven't read it, and based on what I have heard him say, I won't. Geithner doesn't seem to understand how the crisis came about, what alternatives existed to the bank bailouts, or the impact they had. Indeed, Geithner makes multiple claims about the bailouts, none of which survive scrutiny.

Geithner argues that the bailouts were the best response to the financial panic. The financial system needed to be protected from collapse, he says, and there were no true alternatives. If part of the rescue worked to the benefits of the “arsonists who set the original fire,” that was merely an unfortunate side effect.

Those arguments stand in stark contrast to what many critics, me included, have written about the crisis. Rather than talk my own book, ``Bailout Nation,'' I want to respond directly to the Geithner claims.

No alternatives to bailouts: This is a popular talking point from the Bush and Obama administrations. It is belied by subsequent events. There were many alternatives, not the least of which was bankruptcy reorganization.

What would this have involved? Insolvent banks would do what all insolvent companies are supposed to do: go to that nice federal building with the columns out front called the U.S. District Bankruptcy Court. The government steps in as lead creditor. (The Federal Deposit Insurance Corp. continues to guarantee all bank deposits). Uncle Sam provides so-called debtor-in-possession financing during the bankruptcy proceedings so the company can keep the doors open and the lights on.

Let’s use Bank of America as an example: In reorganization, each division would be spun out as a separate company via an initial public offering. All of these are clean and well-capitalized, without toxic debts on their balance sheet. Bad loans and investments get sold for 20 cents or so on the dollar. We are the left with a Merrill Lynch, a Countrywide and a Bank of America, each sold to investors as freestanding, low-debt entities. Original Bank of America shareholders would have been wiped out and bondholders would have endured a major haircut. This would have been much more painful short term, but in the long run it would have been healthier for the economy.

Getting paid for risk: If you lack the courage to follow the actual bankruptcy laws, than at least follow Bagehot’s admonition to lend freely to solvent companies at high rates. Instead, at a time when capital was impossible to come by, the government offered almost-free money.

A lifesaving investment, when no other creditors were available, should have netted the investor an enormous return. This compensates the taxpayer for the inordinate risks they were forced to take, and avoids a moral-hazard problem in the future. Instead, we are about breakeven on all of the investment.

De-financialization of the economy: In the half-century before the credit crisis, the financial-services industry grew rapidly. As a share of gross domestic product, financial services tripled in size, rising from 2.8 percent in 1950 to 8.3 percent in 2006. The industry also was the largest money maker in the Standard & Poor's 500 Index, accounting for almost half of the index's per-share profits in the middle of the last decade.

This was a result of a number of factors, including an excessively accommodative Federal Reserve. The financial crisis began the process of de-financializing the US. economy. It was a market solution to government intervention. The bailouts halted that process in its tracks. The financial industry is recovering some of the decline in its share of GDP and S&P 500 profits.

Lobbying: One of the smartest acts of Congress was mandating that as a condition of their bailouts, the government-sponsored entities (GSEs), such as Fannie Mae and Freddie Mac, could no longer lobby Congress.

One of the dumbest acts of Congress was not mandating that major financial firms be barred from lobbying Congress as a condition of their bailouts.

This would have been a game changer.

Bondholders made whole: Many critics are seemingly unaware of who were the biggest winners were in the bailouts. It wasn't necessarily senior management, or even the banks themselves. Rather, it was the bondholders. They received 100 cents on the dollar for making irresponsible and imprudent loans to insolvent financial institutions.

This was an unnecessary giveaway, contrary to what Geithner has claimed. Mandating a haircut for bondholders who wanted to be repaid could have easily been arranged. Or they could have taken their chances in bankruptcy court. Past experience suggests they might have received 25 cents on the dollar. Holders of GSE paper would have screamed bloody murder upon realizing that owning a risk instrument means you might lose money. Instead, they were paid in full. That never should have happened.

Throwing trillions of dollars at the banks was the cowardly choice. It was the comforting course for the people in power. After all, it wasn’t their money.

The harder, braver thing to do was to allow insolvent banks to go through the legal process of reorganization. That would have been painful, scary and much harder to do, yet ultimately much better.

Geithner & Co. took the easy way out. It's no wonder we still suffer from the hangover of those decisions.


To contact the author of this article: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.