The Obama administration’s plan for bailing out the banking system is morphing into a hybrid plan:

The nation’s top economic officials are discussing a new way to stabilize the financial system by buying a portion of banks’ bad assets and offering guarantees against future losses on some of the remainder, in an effort to help banks while trying to mitigate the cost to taxpayers.

This approach, which merges two competing ideas, was discussed this week at a meeting that included Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair, according to people briefed on the meeting. The emerging plan comes as the administration seeks to jolt the economy with an $819 billion stimulus plan and a series of additional moves designed to stem foreclosures, overhaul financial regulation and get credit flowing again.

Geez, can anybody in Washington DC make a decision and stick to it? The uncertainty of the bank bailout plan has been hanging over the market for almost 5 months now. Until the administration comes up with a plan for the financial sector – and sticks to it for more than a week – the market and the economy will not recover.

One of the problems with government intervention is that there are too many constituencies that must be satisfied. There are too many cooks in the kitchen. As Bill Seidman, who led the FDIC and RTC during the S&L crisis put it:

“This is a horse designed by a committee and it looks like a camel.”

The best solution would be the one that we’ve used for most bank failures over the last 30 years. Let them fail and then have the FDIC sell off the assets. The idea that letting one of these big banks fail would be fatal to the system just seems a red herring to me. The big banks have a vested interest in pushing that idea and have lobbied heavily to be bailed out, but they are looking out for their own interests, not taxpayers. There are plenty of well-run banks in this country that would be glad to take over the good parts of the banks that have failed. And there are plenty of private equity and hedge funds that would be happy to bid for the bad assets in a competitive auction.

The problem with the bad bank model is that it is hard to determine a price to pay for the bad loans that is fair to taxpayers and doesn’t bankrupt the banks. Commentators and politicians who characterize the bad bank model as being like the RTC are leaving out a crucial part of the RTC model. The RTC didn’t buy assets from existing banks. RTC took over the bad assets of S&Ls that had already failed. There was no argument over the price to be paid because they didn’t buy the assets. They accumulated them and conducted a series of auctions to get them back into private hands. That is a model that worked and worked fairly rapidly.

Whatever plan the administration comes up with will just prolong the agony. The Japanese did this in the 90s when they propped up the bad banks and the result was 20 years of stagnation. We face a choice. We either let the bad banks fail and conduct an RTC like auction and the pain will be intense but relatively short. Or we can we can do what the Japanese did in the 90s and get the same results they did. Personally, I say rip off the bandage and get it over with.