The banks are on their own

We have reached the moment of truth.

The US House of Representatives have just voted down the revised Paulson bail out bill. This means only one thing; the banks are left holding their toxic debt. The US government isn't going to take anything off their hands, at least not this week.

So what happens next? There are two extreme scenarios and any combination in between.

Either a 1930s style bank run......

The bail out was based on a single assumption; the level of toxic debt was so large that much of the US banking system could no longer function. Stripped to its core, this amounts to saying that many banks were effectively insolvent.

It then follows that if anyone has any uninsured deposits in a US bank, then it would be prudent to take them out. This simple logic means a widespread run on banks, a collapse of the financial system, which in turn will be followed by a huge contraction of economic activity.

However, there is an ironic twist to this scenario. As banks go bust, the Federal Deposit Insurance Corporation comes in and takes on the assets of failed banks. The government may end up with much of this toxic debt anyway.

...Banks write off the debt and move on....

Perhaps, Wall Street was exaggerating about toxic debt. It really was an attempt by banks to push their losses onto the public sector. In reality, banks could have absorbed these losses all along.

The Republicans saw through this scam and voted it down. With today's vote, banks will now get serious about writing off toxic debt and within a few weeks, the worst will be over.

...and anywhere in between

Those are the two end points of the spectrum of possible outcomes. My feeling is that we are closer to the first point.