Opinion: Only A Federal Bank Can Save U.S.

This is the moment of truth. The U.S. banking system is grossly insolvent; only a federal bank can save the economy now.
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By Lynn Tilton, CEO of Patriarch Partners

It's time to face certain harsh facts. The first salvo of U.S. TARP failed to revive lending and its abuses have left the American public angry. While we have pumped billions of dollars into banks to sit idle, the dearth of credit is suffocating the American economy.

Now, America is waiting for TARP redux, Treasury's newly announced Financial Stability Plan, to offer the path to salvation and recovery. The truth is that even the multi-spoke plan presented by Treasury Secretary Timothy Geithner last week has little chance of plugging the vast and expanding cavity in the global economy burrowed by the evolving financial meltdown.

Although the plan, in its straw man structure, offers programs and spending that should have a long-term positive effect, nothing presented in Geithner's proposal will stem the daily hemorrhaging of jobs from credit-starved small- and middle-market companies struggling for survival. Until such time as we reverse the trend of job losses, we cannot begin to experience an economic recovery.

If we are to avoid a punishing depression and rebuild America's industrial base, the only solvent and enduring lender -- the U.S. Government -- must step up to lend directly to American companies through a provisional federal bank.

The truth is that the losses in our financial markets are too enormous to be healed simply by a bailout of the debts of our banking institutions. Nouriel Roubini, of New York University, estimates that U.S. loan and security losses will reach $3.6 trillion with banks suffering half, or $1.8 trillion, and the remainder to be absorbed by other players in our financial system.

In light of the immense disaster that lurks within the credit default swap (CDS) market, where approximately $30 trillion remains exposed to "settlement," that loss projection seems optimistic. If default rates in 2009 exceed 15% as predicted by both S&P and Moody's, losses in CDS securities alone could easily exceed $2.25 trillion.

In the third quarter of 2008, the capitalization of FDIC insured banks equaled $1.4 trillion. With at least $1.8 trillion in expected losses, and a very high probability of significant additional losses once CDS securities are added to the equation, the banking system is already mathematically insolvent. Like a dormant volcano, the CDS market lies in waiting and will cause massive deleveraging and cash settlement when defaults rise rapidly, as expected.

The $250 billion that Treasury has allocated to shore up bank balance sheets seems paltry when measured against the enormity of the problem. While the toxic asset repurchase program Treasury announced last week will provide liquidity in the long term, it will not stimulate bank lending with sufficient speed to stem the loss of jobs in the short term. Even if banks are able to lend after suffering such losses, most never intended to use the initial TARP money to do so.

Only one out of 100 banks surveyed by

UBS

(UBS) - Get Report

said it would increase lending as a result of TARP. Even if additional TARP money was mandated towards lending, banks would offer funds only to the very most creditworthy borrowers, neglecting the injured industrial base that must be saved before recovery can begin. It is time we accepted the reality that the banks cannot and will not lead us to economic resurgence.

To solve the problem, we must set aside the abstract theories that, in large part, fashioned this calamity and work from the desired outcome backward. To save the American economic system, we must provide credit to small- and medium-sized industrial companies that have been, and will long be, the backbone of our economy. We have to ask ourselves, for a family rendered starving by a gambling parent, should we repay the bookie or instead give food to the hungry children?

The only solution is to create a provisional federal bank that would lend directly to American industrial companies. Overseen by a private-sector investment board, the federal bank could temporarily fill the credit gap left by private-sector banks that are still reeling from the consequences of their mistakes. As private banks recover and gain strength, the federal bank would sell its loan portfolio to the private sector, winding down over a period of five to seven years.

An initial investment of $100 billion from the remaining TARP funds would provide a noble start, and a private-sector investment board comprised of experienced volunteers would ensure that the bank's capital is deployed in the most productive manner.

If administered correctly, the bank would ultimately provide a profit to taxpayers. Spending on economic recovery does not have to increase the deficit, but rather can be a profit center. In order to bridge the gap between the current losses in the financial system and a resurgent economy, each dollar of fiscal spend must be allocated with an eye towards building value -- the creation of long-term profits rather than a cost to the taxpayer.

In this time of desperation, we must move past our ideological preconceptions about the role of government in the economy. Once we decided to stoke our rapidly declining economy with taxpayer money, adding layers that separate American industry from the capital we mean to deploy makes little sense.

Although most of corporate America will be tested by the years ahead, companies like

Caterpillar

(CAT) - Get Report

and

General Electric

(GE) - Get Report

who have access to commercial paper will be best suited to survive the storm. However, many companies that do not have the luxury of funding could again be strong and profitable but need immediate capital and time to rebalance. Absent cash, the liquidation of American industry and the loss of American jobs will continue its march towards further defeat with each passing day.

In the words of Winston Churchill: "In war as in life, it is often necessary, when some cherished scheme has failed, to take up the best alternative open, and if so, it is folly not to work for it with all your might." Truth is the starting point on the path to recovery and renewal. Once losses are quantified, coordinated solutions can be identified and executed. With truth, the unknown vanishes, panic and fear subside and the long journey home can begin.

Lynn Tilton is CEO of Patriarch Partners, a $6 billion private equity fund that specializes in rebuilding American industrial companies and distressed bank debt.