by Calculated Risk on 2/11/2009 03:55:00 PM

Excerpts from Martin Wolf: Why Obama’s new Tarp will fail to rescue the banks

All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.

Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value ... The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. ...

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities.
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Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. ...

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing.
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The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. ...

By asking the wrong question, Mr Obama is taking a huge gamble. ... He needs to rethink, if it is not already too late.

It is very important that the bank stress tests be completed quickly (within 30 days), and the results made public. This will help remove some of the uncertainty, and might make it clear whether or not the U.S. needs to preprivatize (a kinder term for nationalize) the banks.