Turning Japanese, I really think so…

Okay, it’s not for every taste, but Elizabeth Warren’s August report to Congress on the TARP and bank bailouts makes for interesting reading — as well as a clear reminder that we’re not yet out of the financial woods, despite recent leaps in the stock market.

Warren’s Congressional Oversight Panel helps explain why, like a faulty plug in your sink, the fact that the Treasury and the Fed have poured billions into the banking system doesn’t necessarily mean that any more than a wee dribble makes it out into the “real economy,” where real businesspeople and home owners need credit in order to start companies, hire folks and get the economic wheels turning. That’s because there’s a plug in the sink — a big mess of bad loans.

As with Japan two decades ago, the COP points out, there is a serious question as to how much big banks really want to admit their loans have gone south, take the losses, and try to move on. This is the approach the Treasury has tried to encourage with its Public Private Investment Program or PPIP, designed to give the banks enough cushion to declare and right off their losses.

But banks seems to be bulking up on loan loss reserves without really writing off their bad loans. The trouble is — what is the right value to put on a loan that is defaulting. Do you say there is really no value at all to the asset? Do you say that the parcel in question or the office building is really worth what you thought when you made the original loan –and time will prove you right? Or is it somewhere in between?

As the COP group notes:

To the extent banks have not written-down troubled assets, they are in effect continuing to invest in those assets by holding them for a future return. That is not an unreasonable strategy in itself. But it only postpones the day of reckoning if it turns out that, rather than appreciating, the assets depreciate.

This is the same problem the Japanese faced: Why declare a loss now, if you can hold on long enough and perhaps find that you get yourself bailed out by an economic “rising tide.” The problem is…how long can you wait? And how long do you stop making attractive new loans while you wait for your older loans to recover any value? How many of you have tried to get a bank loan lately??

Warren’s panel points out that the banks that are “too big to fail” — think Citicorp and J.P. Morgan will probably be okay — because the Federal Reserve will ride to the rescue once again if they become imperiled. But the smaller neighborhood banks could be in trouble if unemployment continues to rise and retail and commercial real estate falls apart, since they are less geographically diversified and could be “taken out” by just a few major hits from failed loans.

Many suspect this could be the shoe that drops next.