The news for the last month has been the anticipated stimulus package which is supposed to "jolt" the economy back into growth. Ignoring whether or not that's a good idea, what's been largely forgotten--at least by the media--is the need to have a functioning banking system. Without banks operating smoothly, nothing else matters.

The problem originally identified during the September push for Congress to pass the Trouble Asset Relief Fund was that banks have too many "toxic" assets on their books that they can't properly value because they've been packaged and repackaged into numerous financial instruments whose value depends on the underlying mortgages being paid. So the idea behind the $700 billion TARP bailout was that the government would buy those assets to get them off the banks' books so the banks could then, presumably, resume operating normally.

Most of the "toxic assets" aren't loans that are actually in default--they are loans that are at higher risk of going into default. The assets are "toxic" because no-one really knows how to value an asset with such an unknown risk of going bad.

Back in September Republicans in the House offered an alternative approach that received very little attention: Instead of the government spending hundreds of billions of dollars to buy "toxic" assets that might not actually even "go bad," why not set up an FDIC-like system that would essentially be a government-sponsored insurance program for those assets. Banks with these questionable assets could pay premiums to the government to cover the risk involved in the underlying assets. If those government-insured instruments actually entered into default, the government would pay the difference to the bank out of the premiums that were being collected. As a result, the assets could be properly valued--or sold to other parties who would know the assets are insured by the government. Government would only have to spend taxpayer money if the payouts exceeded the insurance premiums paid by banks; which certainly could happen, but it would almost certainly be less than the hundreds of billions (and, ultimately possibly trillions) of dollars being spent by the government under the current approach.

This plan would have accomplished what TARP was supposed to accomplish, but which has completely failed. TARP funds have, instead, been used to purchase shares in banks with the intent of "recapitalizing" them. However, this doesn't address the problem that banks still have these toxic assets on their books. In its plan for the remaining $350 billion of TARP funds, it seems the Obama administration has gone back to the original idea of purchasing these assets from the banks. This could feasibly work if the banks have less than $350 billion of these toxic assets on their books; but it will not work if they have more than $350 billion of the assets on their books. I'd be willing to bet that the banking industry does have more than $350 billion of toxic assets which means the toxic-asset-purchase plan will not ultimately work... or will require far more government money to accomplish.

The "insurance" plan, however, would generate immediate revenue to the government from banks and would immediately turn the "toxic" assets into normal, non-toxic assets because their values would be insured by the government in return for the premiums paid by the banks. That government insurance would provide stability and certainty regarding the value of the assets, the banks and investors would be able to determine the value of those assets, and the banking industry could return to normal.

This is a very straight-forward plan that would cost far less than the hundreds of billions (and ultimately trillions) that the government has and will spend on the problem. The idea was inserted into the original TARP legislation as an "option" to placate Republicans, but it hasn't been exercised. It should be.

Regardless of the ultimate solution, however, it is pointless for the government to spend hundreds of billions of dollars on stimulus packages in the hope of triggering a recovery while the banks aren't functioning normally. Any recovery will require a functioning banking system. That's what has to be solved first.

Even if we assume that a stimulus package can jolt the economy into recovery (which isn't necessarily a premise I accept), spending stimulus funds without a functioning banking system is akin to trying to fill up the gas tank of a car that doesn't have an engine. Before anything else, we need to get the engine working.

UPDATE 1/31/2009: The day after I originally wrote the above analysis, Senator Shelby basically confirmed what I said about having to fix the financial sector first:

http://www.cbsnews.com/blogs/2009/01/30/politics/politicalhotsheet/entry4764929.shtml

Asked what changes Democrats and the White House must make to the bill passed Wednesday by the House, will no Republican support, Shelby was explicit: "we would have to basically scuttle it. Do a one hundred and eighty degree turn."

"We ought to attack the banking crisis first," Senator Shelby explained and he admitted that he told President Obama "you have your priorities wrong."

"Until we get rid of the cancer in the banking system, nothing is really going to turn around in this country because banks are not lending and if they are not lending they are not going to gain jobs you are going to continue to lose jobs."

"We've got to attack the portfolios of these banking institutions," he said. "Our banks are loaded with toxic assets." "They don't know what is in their portfolios."

Exactly. I'm glad someone in Washington understands the problem. I just wish it were the party in power.

UPDATE #2 1/31/2009: Again, the day after I wrote the above analysis I stumbled upon another article--this one indicating confirmation of my belief that the money available is no longer sufficient to buy up all the toxic assets.

http://www.foxnews.com/politics/2009/01/31/obama-single-action-cure-economy

Geithner previously said the administration is weighing the possibility of using a government-run "bad bank" to buy up toxic assets that are weighing on the books of financial institutions, but some officials now say that option is gone because of potential costs.