– John Kemp is a Reuters columnist. The views expressed are his own —

Both Goldman Sachs and Morgan Stanley reduced the size of their commodity trading books during the third quarter, according to their latest filings on Form Y-9C (”Consolidated Financial Statements for Bank Holding Companies“):
While the gross fair value of physical commodity inventories held on their balance sheets rose — sharply in Goldman’s case — the gross fair value of the commodity contracts was down.

Most of the shrinkage came from smaller positions in exchange-traded futures contracts, as well as a reduction in over-the-counter (OTC) options. OTC swap positions also fell.

But the gross notional value of forwards was little changed.

In the protracted Washington debate over the war in Afghanistan, the most concise analysis so far has come from America’s top soldier: “If we don’t get a level of legitimacy and governance (there), then all the troops in the world aren’t going to make any difference.”

Admiral Mike Mullen, the chairman of the Joint Chiefs of Staff, was speaking two days after Hamid Karzai was declared the winner, by default, in August elections so massively rigged that a U.N.-backed electoral complaints committee threw out about a million Karzai votes. That forced a run-off from which his challenger, former foreign minister Abdullah Abdullah withdrew, saying the second round would be just as fraudulent as the first.

So much for an exercise in democracy President Barack Obama had used as his rationale for escalating the war a few months after he took office. “I did order 21,000 additional troops there to make sure that we could secure the election, because I thought that was important.”

It was. It showed that the United States and its NATO allies are fighting on the side of a corrupt and discredited government in a war, now in its ninth year, for which, according to Defense Secretary Robert Gates, there can be no purely military solution.

An angry assessment of the Afghan leader last year by Thomas Schweich, a former top anti-narcotics official in Afghanistan, has proved prophetic. Karzai, he said, had been playing the Americans like a fiddle ever since he came to power. “The U.S. would spend billions of dollars on infrastructure improvement; the U.S. and its allies would fight the Taliban; Karzai’s friends would get rich off the drug trade; he could blame the West for his problems; and in 2009 he would be elected to a new term.”

U.S. officials, including Admiral Mullen, are now calling on Karzai to purge Afghanistan of corrupt officials by arresting and prosecuting them. This is an unlikely prospect. In his victory speech, Karzai said he would work to wipe off “the stain of corruption” but said that could not be done simply by removing corrupt officials.

The implicit notice that there would be no major house-cleaning followed a telephone call Obama made to Karzai to say it was time for “a new chapter based on improved governance (and) a much more serious effort to eradicate corruption…” If previous promises from Karzai are any guide, the new chapter will remain unwritten.

BOXED IN BY RHETORIC

Obama is close to making a decision on a request by General Stanley McChrystal, the U.S. commander in Afghanistan for as many as 40,000 additional troops. If the president followed the logic of Admiral Mullen’s analysis, he would send none. But he will, because he is boxed in by his own portrayal of Afghanistan as the “good war” (as opposed to the war in Iraq) and his definition of why the U.S. must be in Afghanistan.

“This is not a war of choice,” he said in a speech in August. “This is a war of necessity. Those who attacked America on 9/11 are plotting to do so again. If left unchecked, the Taliban insurgency will mean an even larger safe haven from which al-Qaeda would plot to kill more Americans. So this is not only a war worth fighting. This is fundamental to the defense of our people.”

One of the most passionate arguments against this reasoning has come from Matthew Hoh, the first State Department official to resign in protest over the war. Hoh, a former Marine Corps captain, said in his letter of resignation that if the U.S. strategy really was to prevent al-Qaeda from regrouping in Afghanistan, then America should also invade and occupy western Pakistan, Somalia, Sudan and Yemen - all countries with an al-Qaeda presence.

“Our presence in Afghanistan has only increased destabilization and insurgency in Pakistan where we rightly fear a toppled or weakened Pakistani government may lose control of its nuclear weapons. To…follow the logic of our stated goals we should garrison Pakistan, not Afghanistan.”

Instead, he wrote, the U.S. was following the example of the Soviet Union, a previous and unsuccessful occupier, by bolstering a failing state.

Would inflation be good for stocks?

With the monetary and fiscal spigots open wide, some investors say equities are a good place to be. But David Einhorn of Greenlight Capital has warned that inflation could compress price-to-earnings multiples. A look back to history suggests his fears are warranted.

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The Federal Reserve has lowered rates to virtually zero and expanded its balance sheet significantly, stuffing banks with excess reserves that are available to lend. If the market picks up, banks will find themselves surrounded by creditworthy borrowers again and excess reserves could quickly flow into the real economy, increasing inflation.

In the meantime, many analysts argue that the government is likely to keep printing money to finance runaway fiscal deficits and large unfunded obligations for Medicare and Social Security, increasing inflation.

The Fed will tell you that deflation is the primary risk facing the economy as the private sector continues to de-lever. And inflation is hardly guaranteed. There's still time for the Obama administration to get America's fiscal house in order and the Fed can choose to tighten monetary policy. Highly unlikely both, but nevertheless possible.

If inflation is in the cards, why might that be bad for stocks? One reason is that investors will pay less for future earnings.

Historically, according to Howard Silverblatt of Standard & Poor's, investors have valued stocks of the S&P 500 at about 17 times earnings. If a company stands to earn a dollar per share in a given year then investors will tend to pay $17 for a share of its stock.

But if you add inflation to the mix, future earnings lose their purchasing power, which means investors won't pay as much for them.

Einhorn, at the Value Investing Congress on Monday, said that if we wind up with significant inflation, distant earnings will be discounted at higher rates, meaning "P/E ratios will collapse."

We see this relationship in action if we compare the average P/E multiple of the S&P 500 with inflation as measured by the Consumer Price Index. In the 1960s, when inflation was low, P/E multiples were high. In the 1970s, when inflation was high, P/E multiples were low. After Paul Volcker beat back inflation in the early 1980s, P/E multiples began a two-decade expansion.

To be sure, investors use expected inflation rates when discounting future earnings. That said, when building their models they tend to extrapolate the future based on the present.

Depending on its relative impact on revenues and costs, inflation may or may not be good for company earnings, but it will certainly shrink the multiple investors are willing to pay for them.

On this morning's conference call, David Viniar, Goldman Sachs' chief financial officer, emphasized the bank's valuable social role. His bank made markets and provided credit when other financial players were suffering.

But is Goldman really such an indispensible financial intermediary? One look at the firm's revenue breakdown shows that it's more casino than anything else, and some of the markets it makes still put the economy in danger.

With markets recovering and competitors falling away, Goldman's trading and principal investment revenue through the first nine months of the year was nearly $24 billion, on pace to break the $30 billion record set in 2007.

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Goldman, in other words, generates most of its revenue trading its own money and earning vigorish on customer transactions. It's a hybrid hedge fund and bookie, with an investment bank and asset management business thrown in for good measure.

With that in mind, one is left to wonder whether Goldman was really worth saving last year. What have taxpayers received for $50 billion worth of cash and guarantees, for giving Goldman access to the Federal Reserve as its lender of last resort?

Saving Goldman was largely about saving the derivatives market, which is so big and unstable that the death of one counterparty could mean the death of all. With big commercial banks like JPMorgan Chase in deep, saving the derivatives business was as much about protecting depositors and maintaining the integrity of the payment system as it was derivatives themselves.

Many of us didn't like it -- we thought banks like Goldman should have been recapitalized the right way, by wiping out shareholders and forcing subordinated creditors to eat their share of losses. But that ship has sailed. We socialized the risk while privatizing the profit because we were told we had no other choice: The government had to guarantee the biggest banks' liabilities because they were too unstable to survive bankruptcy or FDIC receivership.

If that's true, why haven't we seen any substantial reforms to reduce systemic risk? Congress is kicking around new resolution authority to help resolve failed systemically-important banks. But the goal should be reducing systemic risk to begin with. Yet serious reform of the derivatives market -- something that would reduce its size significantly -- is nowhere on the radar.

Indeed, Goldman's trading results suggest that market is coming back with a vengeance. It's playing in very risky markets with a capital structure that remains vulnerable yet is guaranteed by taxpayers.

To Goldman's credit, they've rebuilt their capital levels faster than anyone. Their leverage ratio has fallen from 35 to 16 in less than two years, despite pressure from equity analysts to juice returns by deploying "excess capital".

But at $50 billion, the bank's mark-to-myth, or level 3, assets remain as high as its tangible common equity, the cushion it has to absorb losses. And Lehman proved that conventional definitions of capital aren't worth much when push comes to shove. On Sept. 1, 2008 the bank was "well-capitalized" according to regulatory measures, two weeks later it declared bankruptcy and was showing negative net worth in the tens of billions.

Derivatives have lead to systemic crises every 10 years or so -- portfolio insurance in 1987, Long-Term Capital Management in 1998, the global financial crisis a year ago -- yet cosmetic changes are all that is ever offered. The frequency and violence of such events prove that more is necessary to rein in these markets.

Wall Street and its protectors at the Fed and Treasury tell us the bailout was necessary to protect the financial system, to protect Main Street. That may be. But Main Street still owns much of the risk while Wall Street gets all of the profit.

Even as Goldman reported results that reflected in part the resurgence in derivatives, the House Financial Services Committee passed legislation that would increase derivatives regulation. But the bill is riddled with loopholes that Wall Street can easily exploit. A much tougher line is necessary.

Thirty-three TARP recipients missed a scheduled dividend payment to taxpayers last month, according to the Treasury Department, including 18 banks that missed a payment for the first time. It's a powerful indication that the U.S. banking system remains troubled. And it throws cold water on talk that taxpayers are "making money" on the bailout.

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"It's too early to tell if we're making money on TARP," according to Eric Fitzwater, an associate director at SNL Financial in Virginia. "Certainly the vast majority of the bailout money is still outstanding. While a lot of larger recipients say they plan to pay it back, we're still waiting."

The 33 banks that missed dividend payments in August have received $4.5 billion of TARP money. The biggest is CIT. Previously it paid $44 million of dividends, but with a bankruptcy filing looking likely, Treasury's $2.3 billion investment seems headed toward zero.

A few of the banks may ultimately be able to pay what they owe, according to Fitzwater. These newer banks -- "de novo" in regulator parlance -- actually are not allowed to pay dividends.

Still, the bigger issue is the ultimate cost of the bank bailout, which we may not know for years.

When stronger banks including Goldman Sachs, Morgan Stanley and American Express repurchased warrants at modest premiums after paying back TARP, most news reports suggested that taxpayers were profiting from the bailout. But those reports didn't tell the whole story.

For one, they ignored adverse selection, the propensity for the best borrowers to exit the program first, leaving Treasury holding the poorest performing investments. According to the latest data from Treasury, 42 banks have paid back some or all of the cash they got from TARP's Capital Purchase Program, $70.7 billion in total. But more than 600 banks remain in the CPP program. Together, they still owe $134 billion.

And this excludes other TARP bailout programs that are likely to cost billions. The automotive industry owes TARP $80 billion. And AIG owes TARP $69.8 billion. Much of that isn't coming back.

It's also myopic to view TARP in isolation. Take Citigroup. After converting its preferred equity investment to 7.7 billion common shares at $3.25, Treasury is showing a paper profit of $11 billion. Sounds great, right?

But Citigroup's common equity would long ago have fallen to zero if other bailouts, in particular FDIC's debt guarantee program, weren't insulating shareholders from losses.

Citigroup is the only large bank still using the FDIC's program. Two weeks ago, the bank sold another $5 billion worth of guaranteed debt, bringing its total issued under the program to $49.6 billion.

The bottom line is that the government still stands behind the banking sector. While the cost of this "no more Lehmans" policy may not be known for years, our experience with Fannie Mae and Freddie Mac tells us that such implicit guarantees ultimately prove very expensive. The fact that more banks are falling behind on dividend payments reminds us the tab is growing.

Deflation could be the biggest threat to the economy, but gold -- usually an inflation hedge -- is reaching new highs. That's because smart investors aren't playing the inflation trade, they're buying currency crisis insurance.

With the amount being spent by the public sector, with the huge amounts of leverage still in the system, there's a palpable fear that America won't be able to meet its obligations. Relative to GDP, the amount we're borrowing to finance deficits makes us look irresponsible.

When such economies hit a wall, investors make a run on the currency, typically moving their assets to a stronger currency, like the dollar.

But this time the problem is the dollar, along with other leading paper currencies, all of which are threatened by profligate fiscal and monetary policies. So some investors want out of the system entirely. Gold, as my colleague Neil Collins noted earlier, is a way to do that.

The gold market is small enough that a decision by a handful of money managers to increase their asset allocation from, say, zero to 5 percent can move the market. All the gold ever mined would fit aboard an oil tanker; its total weight of 125,000 tons amounts to a few hours' output for the U.S. steel industry.

But economists tell us that inflation isn't a risk now. Are they wrong? No and yes.

The conventional way economists view inflation is to look at things like "output gaps." When the economy falls below a level of output it previously achieved, it is said to have unemployed resources. If you think of inflation as workers demanding and getting higher wages, which leads to higher prices for the goods and services they produce, then inflation isn't a threat.

So economists tell us more borrowing and money printing won't be inflationary as long as people are unemployed.

One problem: Their models ignore the fact that peak output was artificially inflated by a credit binge. Borrowing more to sustain an unsustainable level of spending borders on insanity, yet that's precisely what such economic models tell us we need to do.

There's an extra variable these models don't account for -- the Chinese and all major lenders to the United States. They don't much care if our employment rate is below desirable levels. At a certain point, they may recognize that the United States is acting like a banana republic and choose to stop lending.

When that happens, we might see a "sudden stop" event: Capital inflows to the private and public sector cease as everyone races to get out of dollars.

Eric Sprott, CEO of Sprott Asset Management has $4.5 billion under management, $2 billion of which is invested in physical bullion -- silver and gold -- stored at banks in Canada. Another large chunk is invested in gold stocks.

He views gold as an insurance policy against both inflation and deflation. Central bank quantitative easing policies mean "we're printing paper currency like crazy," so he doubts the long-run value of fiat currencies.

On the flip side, if central banks pull back, you could enter a deflationary spiral, essentially a banking collapse, in which case "your deposits wouldn't be returned to you. Better to have physical gold in your control."

Most economists and investors still labor under the illusion that there's a way out of debt that doesn't involve a drastic reduction in the paper value of wealth. Smart investors aren't so sure and want at least a portion of their assets out of the financial system.

A dollar crisis isn't necessarily coming tomorrow, so there's no guarantee gold's price will keep going higher. Still, gold is a decent insurance policy against economic Armageddon.

By Peter Thal Larsen and Rolfe Winkler

LONDON/NEW YORK, Oct 5 (Reuters) - Of all the reforms proposed by global financial regulators over the past 12 months, none looks as appealingly straightforward as the leverage ratio. What could be simpler than linking the total amount of assets a bank can hold to the amount of capital it has to absorb losses it makes on them?

Alas, such a task is more difficult than it appears. There is little international agreement about how to calculate banks' assets or capital, let alone what the ratio between the two should be.

A few years ago, even the idea of such a simple measure seemed hopelessly out of date. Banks were busy building sophisticated computer models to measure the risks they faced. They were allowed to tweak the amount of capital they held against assets depending on how risky the computer thought those assets to be. Then those models failed.

Now bank regulators want a blunt measure that will cap banks' expansion, regardless of what their models say. Despite the complexities, they are right to try.

Still, finding a consistent way to measure banks' assets is a daunting challenge. For instance, U.S. accounting rules allow banks to report their net derivatives exposure. International Financial Reporting Standards used by most European banks don't. Take Deutsche Bank: At the end of 2008 its gross derivatives book accounted for nearly half its total assets of 2.2 trillion euros. Using IFRS, Deutsche's leverage ratio is 1.3 percent but under U.S. GAAP it's 4.2 percent.

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Regulators agree that any calculation of leverage should adjust for these differences to discourage regulatory arbitrage. But barring an unlikely shift to global accounting standards, this will undermine the leverage ratio's simplicity, which is central to its appeal.

Measuring capital is also a thorny issue. U.S. regulators believe that only tangible equity -- cash raised from shareholders or retained through earnings -- should count as capital. That is sensible: Only this capital occupies the true first loss position. Without it, investors higher up the capital structure tend to panic and run for the exits when losses mount.

But the emphasis on tangible equity has gone down badly with European banks, which have historically stuffed preferred shares and other forms of hybrid capital into their capital structures. If these are excluded from capital measures, European banks will have to find tens of billions of additional equity -- or shrink their balance sheets even further. Another objection is that U.S. banks are currently allowed to count deferred tax assets as capital, even though these are worthless if the institution cannot make a profit.

Even if these problems can be overcome, the leverage ratio is not foolproof. After all, U.S. regulators have long imposed a 4 percent leverage ratio on banks. But this did not include off-balance sheet assets. More recently, Swiss regulators introduced a leverage ratio for UBS and Credit Suisse that explicitly excludes the banks' Swiss loan books from their asset calculations. Some bankers argue that, because the ratio does not adjust for balance sheet risks, it may even encourage banks to load up on risky assets.

Placing an appropriate cap on the expansion of banks' balance sheets is crucial to the future of banking regulation. If it's too loose, banks may rush into another crisis. If it's not applied consistently, banks will arbitrage differences between regimes. Some will argue that if it's too tight, banks will constrict lending or will dump safe assets in favour of risky ones.

But this misses the point. The leverage ratio is not designed to replace risk-based measures of capital: it is a safety net in case those measures fail. Despite the difficulties involved, regulators should not be deterred from introducing it.

(e-mail: peter.thal.larsen at thomsonreuters.com; rolfe.winkler at thomsonreuters.com)

Investors are celebrating an incipient "recovery," but the interventions responsible are sowing the seeds of a more violent contraction down the road. The problem, quite simply, is debt. We've accumulated record amounts, yet many economists tell us we need more.

Leading the charge is Paul Krugman. He exhorts us to borrow our way back to prosperity, but he doesn't acknowledge that his brand of Keynesian economics ignores debt's consequences. If you look at a chart of America's total debt burden, he's leading us over a cliff.

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The problem begins with the flawed way Krugman and other economists measure well-being. Primarily, they look at measures of activity, like GDP. These tell us how much people spend, but say nothing about where we get the money.

Every so often, we overextend ourselves, buying too much useless stuff with too much borrowed money. So we cut back, dumping the third family car and swapping the McMansion for a townhome.

But this is problematic for Krugman and other economists. Less spending means falling GDP. It means "recession."

They ride to the rescue with two blunt instruments -- monetary and fiscal policy -- that encourage more borrowing and thus more spending. More spending equals "growth" so economists congratulate themselves for engineering "recovery."

But if recessions never happen, bad businesses and unpayable debts are never washed away. They grow like cancer inside the system.

Since the mid-1980s, we've intervened whenever the economy hiccuped, so sectors that should have shrunk sharply -- like housing and finance -- never did. Feasting on easy credit, these sectors have exploded as a percentage of the economy.

Now, since individuals and corporations refuse to borrow more, the only way to grow spending is for the government to borrow.

According to George Cooper, author of The Origin of Financial Crises, "what is missing from today's debate is recognition that previous growth rates were artificially supported by an unsustainable credit binge, itself the result of the misapplication of Keynesian policy."

Cooper counts himself a Keynesian but says Keynesian policy has become "dangerously distorted."

"We should be using Keynesian stimulus only to arrest the rate of credit contraction not to reverse it. The harsh truth is that our economies desperately need a recession."

That's because they desperately need to de-lever. As you can see in the first chart, debt relative to GDP is at record highs.

If we want sustainable growth, spending that drives it must come from savings, not more borrowing. To get there, we must first pay old debts. And that means recession.

Krugman is clearly aware of the consequences of excessive borrowing.

"I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits," he wrote in 2003, citing a $1.8 trillion 10-year deficit projection from the Congressional Budget Office.

Fast forward six years, total debt has jumped 70 percent relative to GDP and optimistic projections put the 10-year deficit at $9 trillion.

This time, however, Krugman dismisses deficit "hysteria," arguing that we can grow our way out of debt. "We did it during the Clinton administration," he told me when he visited Reuters last week.

But we didn't. While Clinton balanced the federal budget, Americans plowed through their savings. We kept growing because, in the aggregate, we were still accumulating debt.

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Krugman has also argued that we can handle larger deficits because we have in the past. After all, public debt peaked at 118 percent in 1945 compared with 65 percent today.

Two problems. First, the argument ignores tens of trillions of unfunded obligations for Medicare and Social Security, debt Krugman loudly lamented in his 2003 column.

It also ignores the higher private debt burden facing us today. According to economist Steve Keen, "Private sector debt accumulated in the 1920s was wiped out by the Depression, so in 1945 the private sector's debt burden was only 45 percent of GDP. In that situation it was easy to wind down public debt from levels reached to finance WWII."

Today, private debt is a suffocating 300 percent of GDP, making more public debt that much harder to pay down.

We know how this movie ends. Look at California -- or Argentina.

We chortle from afar -- "how did their budget get so out of whack?" -- yet our own profligacy puts us squarely on that path. Like them, we've shown no political will to deal with debt. And so it will deal with us.

But we can print our own currency, you say. If all else fails, the United States can inflate its way out of debt.

Nonsense. If we try, our foreign lenders will cut us off.

As Krugman warned in 2003: "My prediction is that politicians will eventually be tempted to resolve the (fiscal) crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar."

Yet today Krugman is leading the march, arguing that we can borrow indefinitely as long as deflation remains a threat.

Tell that to the Chinese.

What happens when they stop buying our bonds? To Cooper's point, we'll need government intervention to cushion the blow of de-leveraging. But there's a difference between cushioning the blow and reinflating the bubble, which is what we're doing, wasting trillions propping up housing and banking.

The risk is that we'll have nothing left when we really need it, when the Great Leveraging becomes the Great De-Leveraging.

Former Federal Reserve Chairman William McChesney Martin joked that it was his job to "take away the punch bowl just as the party gets going." But Alan Greenspan never did, choosing instead to spike it every time the party slowed down. The results were more than a little unfortunate.

Now, faced with years of economic stagnation, most economists conclude interest rates will stay low indefinitely. The Fed is doing little to disabuse them, though an opinion article from Fed Governor Kevin Warsh in today's Wall Street Journal tries to warn us not to get complacent.

Warsh says, a bit technically: "'Whatever it takes'... cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns." In other words, if the Fed only intervenes during downturns, it risks its credibility as protector of the dollar.

But talk is cheap. Not since Paul Volcker raised rates significantly in the early 1980s has the Fed done anything substantial to fight the forces of irrational exuberance. The Fed won't reestablish its bona fides until it puts the economy through pain.

With a "recovery" under way, the printing press running on high to support the housing market and $850 billion of excess reserves just waiting to spark inflation, the Fed's credibility is, well, strained to say the least.

So Warsh goes a bit further: "Policy likely will need to begin normalization before it is obvious that is necessary, possibly with greater force than is customary ..."

Dollar bears like me like the sound of "greater force than is customary," but we don't believe the Fed would actually use it.

Why should we? Earlier this week, the central bank put out another wishy-washy policy statement that says it will hold interest rates low "for an extended period," while gradually weaning the economy from the support of the printing press.

That will only encourage investors to take on risks that will tie the Fed's hands later on.

To avoid a return to that status quo, we need more than tough talk. We need a fire drill -- a quick, small rate increase that no one is expecting.

Always telegraphing your moves months in advance is what breeds complacency. Investors make stupid mistakes and the Fed is left to pick up the pieces, putting the dollar at risk.

So, Kevin, if you're worried about investor complacency, give us a rate increase when we least expect it. Perhaps next week?

Remember PPIP? The Public-Private Investment Program was to provide cheap government financing to encourage investors to overbid for banks' toxic assets.

Investors would overbid, it was thought, because they were being offered a free put option. If the toxic assets they bought fell further in value, taxpayers would be left holding the bag.

The program has been largely left for dead, but the FDIC still sees some life in its part of the plan. Last week, the agency had a pilot sale, offering loans out of the estate of failed Franklin Bank, whose assets are in FDIC receivership.

Sure enough, the winning bidder elected nearly the maximum available amount of non-recourse leverage, resulting in a 22 percent premium for the assets over bids that didn't take advantage of leverage.

On the surface, this seems like a good thing for taxpayers, since the higher purchase price accrues to the FDIC's Deposit Insurance Fund.

But in a new paper, Linus Wilson of the University of Louisiana at Lafayette argues that while the auction prices are increased by leverage, the increase is offset by the loan guarantee the FDIC makes as part of the deal.

So at best it's a wash and at worst the "subsidized leverage discourages the winning bidder from maximizing the value of loan portfolios."

If true, this last part is problematic. The point of getting assets back into private hands is that private investors are supposed to be better than the FDIC at managing them. But if the structure of the sale discourages investors from maximizing value, then FDIC may be short-changing itself in the long run.

At least in this case, the 22 percent purchase premium was captured by the Deposit Insurance Fund, since the pilot sale was for assets already in FDIC receivership.

But FDIC conducted the test with an eye toward using it on living banks. If it does so, shareholders and creditors of those banks will capture any increased value that results from government leverage, while taxpayers will be left holding most of the risk.

Another potential problem according to Wilson: Inflated prices from PPIP auctions may give other banks an excuse to mark up their own assets, reducing their incentive to raise necessary capital.

A better idea is to let asset prices fall to levels that don't require government support. Shareholders and bank creditors should eat those losses. Such a recapitalization will put the financial system on firm footing again, providing a strong foundation for sustainable growth.