"Saving Capitalist Banking from Itself"

In addition to his weekly newsletter, John Mauldin¹ occasionally e-mails articles written by others as part of his "Outside the Box" series. Today's "Outside the Box" e-mail included a couple of good ones (both of which can be read in full here). To keep this post from getting too long, I'll post an excerpt from the second one in a separate post. The graphic above comes from the first, "Saving Capitalist Banking from Itself", by PIMCO Managing Director Paul McCulley². McCulley starts with a recap of the basics of fractional reserve banking and continues with a description of the shadow banking system. The excerpt below is from the "bottom line" part of his essay:

The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week.

And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF).

The formula? Take a small dollop of the Treasury's free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press. That's the formula for the TALF, to provide leverage, with no recourse after a haircut, to restart the securitization markets.

The same formula applies for the P-PIF, with the addition of FDIC stop out loss protection for dodgy bank assets that private sector players might buy. With such goodies, such players, it is hoped, will be able to pay a sufficiently high price for those assets to avoid bankrupting the seller bank.

Unfortunately, Secretary Geithner hasn't laid out the precise parameters of how to mix these three ingredients, which is driving the markets up the wall. But make no mistake, these are the ingredients, along with continued direct capital infusions into banks where necessary.

¹JohnMauldin@InvestorsInsight.com

²You may recall McCulley's name from a previous post where we excerpted one of his essays, "Breaking the Paradox of Deleveraging".