I think the reason that a lot of the leaders of finaincials didn’t react to the information about risk was standard psychology. When you are faced with taking a bad hit now or risk a very very bad hit later, it becomes easy to imagine that the things you hear are not true and that it will all be good. I mean that was pretty much the story since 2006 lots of people predicted the crisis, yet very few acted. I seriously doubt that the lack of action was because they were convinced that the government would soften the blow with a bailout package. Its not like the bailout was a sure thing sailing through congress, or that it took ALL the pain away and restored the world to the wonderful days of the past. If you were 100% sure that things would happen the way they did, you would have done much better by being on the other side, than by staying a getting bailed out.

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BR: Many people don’t know that the headline writer is usually a totally different person/editor than the author of the article!

No, I agree. We don’t disagree that much.

If Geithner, et al. are secretly planning on chopping up the zombies, I won’t believe it until I see it. To me, it looks as if they plan to “follow the Japanese model” — Geithner isn’t a great liar and he really seems to believe that “liquidity” rather than price is the problem with some of the “troubled assets.” Is he not up to the job — as Chris Whalen and others believe, or is he really a mastermind schemer who will try to save the world as he lies through his teeth? That’s the conundrum we have with all of our top finance officials — it’s almost impossible to know where they have been completely inept, and where they have just been lying, for whatever reason. But then, that’s one of the consequences of a bailout that was never explained truthfully or adequately, and the joke stress tests are a further consequence of that bailout. And again, were the stress tests inadequate by design, as a PR move, or are they really that clueless? The unemployment numbers were ridiculous (literally) and the delinquency rates on conforming mortgages that they estimated were actually lower than what was being reported at the time the tests were done.

One danger of trying to get taxpayer money paid back, no matter how long it takes, is that the temptation to throw good money after bad is just too strong. What politician is going to advocate letting Citi die, when they say all they need is just 20B more and then they’ll be fine, or something like that? Wait, I think Citi already did that, but you know what I mean.

You wrote: “However, the fact that you didn’t see the kind of collapse I described, is in my opinion because they intervened. I think they had to intervene[.]”

Peter Boettke of GMU has a post on the Austrian Economists blog from a couple days ago where he argues that the bailout itself helped to destabilize the markets because the expectation of the bailout, the uncertainty of who the firms would be, and uncertainty about what the terms would be exacerbated the situation by short-circuiting market forces and the adjustment process. I suggested he look even further back, because the banks and I-banks had some idea, or a good idea, of how bad some of the players were, and yet they didn’t reduce leverage enough and they didn’t wind down risky trades and they didn’t do anything, apparently, about short-term liquidity issues. Absent a subservient Fed and FRBNY, these institutions would have acted on information about others’ insolvency and their own risk and adjusted accordingly. They didn’t.

In a sense, the October bailout called itself into being. Had their been no expectation of a bailout, by the Fed at least, people like Dick Fuld would have behaved differently, and so the conditions which necessitated the bailout would not have arisen in the way that they did. The moral hazard argument has a long time horizon — something that BR writes about at length in Bailout Nation.

It is my hope that they do not follow the Japanese model and keep zombie banks alive for decades. They should eventually take the zombies out, but allow the system to digest each zombie one at a time until they are all gone – yet they cannot announce that even if it is their plan. Taxpayers have an investment in those banks and you don’t want to talk it down before you liquidate it. You also do not want to close a bank with a loss to taxpayers if it has a chance of surviving long enough to at least pay back all the money it got from government. My hope is that they will come up with new stress tests that use mark to market on assets and a more realistic level of stress. They have the info now so they could calibrate their tests to make sure it does not take out more than a few at a time.

On the CDS we agree. Way too much of that money ended up paying for what I consider illegal gambling. Only some of it payed for legitimate insurance needs.

What is this about “when all lending locks up”? You can see in data from the Minn. Fed from last year that “all lending” did not lock up. Yes, there were problems in commercial paper, but if you look closer, high quality, non-financial CP was just fine. Meanwhile, regular old commercial bank lending was up. The problems in CP were primarily with the financials and with the securitization market. Without a bailout, there would have been an adjustment period from “shadow” to “normal” banking, but the Minn Fed data suggests this was already taking place. I’ve still seen no data or evidence suggesting that Whirlpool or Cambells Soup couldn’t fund day-to-day operations. It didn’t happen, nor was the only alterrnative TARP.

Plus, TARP didn’t unfreeze (the not so frozen) credit markets. The Fed took care of that. Besides, LIBOR continued to climb, if I remember ccorrectly, even afterr the bailout — but even still, LIBOR wasn’t pricing in the imminent collapse of the entire banking system. The TARP was neither a panacea nor was it absolutely necessary — many of us said so at the time. Too bad my idiot congressman didn’t listen.

Finally, FDIC wouldn’t resolve the banks “in October” — clearly they couldn’t. It would take some time. But that is a far cry from saying bail them out or let them all fall at once. Banks can keep operating, even when they’re insolvent (clearly). This disaster scenario in which all banks liquidate their assets at once is just a scare tactic to cover for the bailouts. Chris Whalen has also explained how BHC’s like Citi could be restructured voluntarily, without formal bankruptcy, if FDIC receivership is deemed too expensive. But voluntary restructuring of the debt was never on the table. Why? Why isn’t it on the table, now? If the bondholders think they can hold the US govt hostage, then we need to replace some people at Treasury post haste. There is no reason under the sun that we are still protecting Citi’s bondholders at 100 cents on the dollar, just as there was no reason to pay out on AIG’s CDS at 100 cents on the dollar. (My idiot congressman only seemed to discover this sometime in March.)