Too Big to Bail Out? Ireland, GM and the Fate of America's Banks

What's Ireland got to do with GM's bankruptcy and America's banks? The two issues would seem impossibly remote. Except that both situations call for governments to make choices about how to assume and resolve private debts that have become too burdensome. As Ireland shows, in this age of financial leverage there may be entities that are too big to fail -- but we're also starting to see the failure of entities that are too big to bail out.

This morning's news of a bailout of the Irish government that would allow it to avoid having to raise money on the bond markets for three years provoked PIMCO luminary Mohamed El-Erian to caution that the path of least resistance for policy makers is, in short, the road to hell.

El-Erian says that bailing out Ireland instead of restructuring its debt is the most feasible solution for Europe politically. "But we should not confuse feasibility with desirability," he warned. That's because each small step toward averting a crisis takes a larger step toward creating an insurmountable crisis. El-Erian wants to see Europe confront the inevitable -- default and debt restructuring -- while there's still confidence in the union and Germany's economic strength can provide an anchor.

Here's how El-Erian put it on Reuters today:

In a wider policy debate, debt restructuring would be considered as a possible pre-emptive option rather than a disorderly inevitability. [...] At its roots, the approach addresses liquidity but not solvency. It adds to the debt overhang rather than reducing it.

You can try to ring fence Spain. You can provide financing to Ireland, Portugal and Greece for three years and try to leave them out of the market and maybe restructure their debt down the line. But if Spain falls off the cliff, there is not enough official money in this envelope of European resources to bail out Spain.

Spain is too big to fail, on one side, and too big to be bailed out. In Spain, there's a trillion Euro in public debt. On top of that public debt, you have almost a trillion of the foreign liabilities of the private sector -- houses, financial institutions, corporates -- Spain was running a current account deficit to finance the excessive spending of the private sector. So it's not just public debt but private debt that has to be rolled over.

The request for help was a humbling turnabout for Ireland, which just last week was insisting it could manage its own finances. It does not view itself as being as profligate or irresponsible as Greece was in running up deficits, and has been preparing a four-year budget plan filled with sharp cutbacks that is intended to reduce its deficit to 3 percent, from 32 percent, of gross domestic product.

But the Irish government has been sinking further and further into debt since its 2008 decision to protect its banks from all losses. The banking system had become so weakened that it could not afford to wait any longer for help.

This is exactly what the U.S. did so successfully with General Motors when it put the company through a pre-packaged bankruptcy. GM's successful launch on the IPO market last week showed how powerful a fresh start can be, especially when the burden of releasing the company from its debt can be shared by all the interested parties.

In essence, El-Erian wants Greece, Portugal and Ireland put into a pre-packaged bankruptcy -- something he sees as inevitable -- sooner rather than later. Such a move would set up a strong precedent for shared sacrifice rather than the the scramble that's currently taking place.

Restructuring Ireland's debt would set another important precedent about how to deal with reckless bank debt. The U.S. has chosen a difficult path for dealing with its still unresolved banking crisis. As Andy Kessler pointed on the Wall Street Journal's op-ed page, Fed Chairman Ben Bernanke's QE2 program is battling deflation and unemployment by trying to put a floor under housing prices.

If QE2 works, it will keep housing prices from falling further which would set off a chain-reaction within the banks' books where toxic assets built on housing values still lie. That chain reaction would bring the banks down again. If QE2 doesn't, we'll have deflation and more unemployment.

So far, it isn't working. Kessler suggests that the next step isn't another round of bailouts but to seize the banks directly:

This time, the Fed should do what it didn't do in 2008-09: detoxify and recapitalize the big banks. The Dodd-Frank banking reform provides the authority for the Fed and the Federal Deposit Insurance Corp. (FDIC) to do this.

So what is arguably the most successful bailout of the 2007-2010 era was in fact a non-bailout: It was a bankruptcy reorganization that eliminated the most toxic aspects of a century old rust bucket of a company. The new firm has clean books, is well capitalized, is without crushing debt, has a less onerous labor contract, pension and health care obligations. Its hard not to see how this was anything but a ginormous winner for all involved.

Which brings me to the Banks.

Currently, the United States has a weakened financial sector. Many of the largest Banks are technically insolvent, but thanks to an accounting rule change, are not required to admit this simple mathematical fact. They are carrying an enormous amount of bad loans on their books. They are sitting on several million REOs -- bank owned foreclosures for which there is essentially no market. This shadow inventory of houses amounts to years worth of sales, not mentioning the depressing effect the excess supply will have on prices.

But as with Ireland, those problems won't just go away. They're liable to get bigger and worse. There's only so long we can avoid the problems by hoping a larger entity like Europe or the IMF can bailout the situation. "There's not going to be someone coming from Mars or the moon to bail out the IMF or the Eurozone," Roubini said tartly on Squawk Box. He might have also said that there's not going to be someone coming from China to bailout the U.S. . . . forever.

Image of ECB building courtesy of UggBoy♥UggGirl [ PHOTO : WORLD : SENSE ] via Flickr