A conversation came up about banks during Super Bowl Sunday. The question was asked: where did the money go? Where did the money that the Treasury gave the banks go? A large fuss was also made about the current bonus payment headline and the Citi plane headline.

The central point raised was about what good has all that money done? What do we have to show for it? It was sold as a $700bn package that would be catastrophic to decline, yet we didn’t appear to need it because nothing had been done with it that had improved the nation’s economic performance or its outlook. There were senior marketing, law and business operations professionals in the conversation.

US banking is insolvent. It’s been insolvent since September. This point is not widely understood but needs to be. It’s how $700bn can be appropriated and half spent but have no apparent or obvious lasting cure administered.

The US Treasury played the 911 wagon the week of September 15th, 2008. They poured the promise of funding onto the insolvent banking sector before it could be run on by depositors and investors. That act was performed as a legacy lesson from 1929 to stem the failure of the US financial system. It props it up to this date. JPM, WFC and many regional banks will tell you they are fine. This ignores that a long line of their counterparties aren’t. When a “fine” bank’s debtors cannot pay, it becomes like all the banks that aren’t “fine”.

What does insolvent mean when it relates to the banking system? Everyone’s financial assets denominated in dollars that are not in gold, a mattress and maybe treasuries (i.e. bank deposits, stocks, bonds etc.) go into freefall. Where they settle is directly related to the suddenly shifting probability you have of collecting on them, as everyone demands their money from financial institutions at the same time. 40 cents to the dollar…20 cents….there would be a chaotic settlement process that washes out what a financial asset is worth. This leads to outright collapse in hard asset prices, like houses.

Nobody would have been able to pay anybody on a broad basis because every financial asset they held would devalue to reflect its collection risk. During this process assets are frozen by institutions. You cannot access your money because the institution can’t access it either. Refer to the footprint of the Reserve money market fund that fell only 4% to 96 cents on the dollar in September. Shareholders could not access their funds for months and the Treasury had to step-in for liquidation support. This was just one fund ($62bn) with a small paper discount to par of $1.

And what of FDIC insurance on deposits? FDIC insurance is a promise to pay. Its micro value is in securing institutions that fail here and there, one at a time. Its macro value is in preventing panic that leads to widespread bank runs. In a system collapse, FDIC insurance has no sway. The US Treasury could print money 24/7 and distribute it, eventually. But the paper dollars you’d receive would also be revalued by the nuclear dilution of printing money, while adding no underlying value. It would say “1 dollar” on the paper but the value it could be exchanged for would be the same 20 cents that everyone else’s fell too.

This is where the money went. It’s what we are getting for our $700bn appropriation. Underestimating its impact ignores that the asteroid missed the Earth…for now…because a promise of $700bn swung it out of harms way.

The new administration enters the fray at this point, with their compass.

Ed Note: This blog endorsed the original TARP approach. It was designed to imitate the historic RTC method and/or the asset exchange method (currently circulating under the name “bad bank”). This blog did not endorse the alternative recapitalization method subsequently undertaken by DC and highlighted here for its holes and troublesome risks.