New York, 28 Jan. US Economy: Zombie Banks and why the US Tolerates them

Zombie banks are financial institutions that have negative balance sheets yet are still alive and operating. Like zombies, they are functioning when they shouldn’t be.

George Romero’s Night of the Living Dead brought zombies into popular culture when the classic horror film was released in 1968. These slow, lumbering corpses, reanimated from the grave, are out to kill, travel in packs, and can endure tremendous amounts of damage.

Everybody hates them and is scared of them, because they will feed off you before they infect you and kill you, probably by eating you alive. And you can’t really stop these relentless half-dead things – they just keep coming at you, and when they get you, it’s over.

It is fitting that many banks that are dead and useless are now called zombie banks. They too belong in the grave, come in droves, and will bring you under if they get a hold of you.

Nobel Prize winner Paul Krugman says, “recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.”

So it is easy to see that with all the bailouts growing in size and scope, the value in the banking system is kept alive – let’s say reanimated, out of the grave, by those optimistic shareholders.

This is the 'moral hazard' in action. When a company is bailed out it thinks it’ll get saved again, so it continues to take risks that in normal times would lead to bankruptcy. Other similar firms see this and, expecting their own bailouts, act in a reckless fashion too.

However, Krugman goes on to say that the moral hazards created are not as bad as nationalization would be. “Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims that elaborate financial rituals can reanimate dead banks.”

So we would rather have these zombies wander along, with no equity or life in them, even as they stack up more and more losses on their FDIC insured holdings.

Ron Portobello, EconomyWatch.com