Posted by: Nicholas Davis | March 16, 2009

Some clarity on the nationalization debate

James Kwaak from The Baseline Scenario nicely draws the boundaries of the bank nationalization argument:

“I think there are three main positions in this debate:

  • A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
  • A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
  • B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

The big divide is not between A1 (Rajan) and A2 (Simon and me). In both cases, you end up with a healthy banking system, at significant taxpayer expense. (A2 should be somewhat cheaper because it wipes out the shareholders, but I agree with Rajan that it is dramatically cheaper only  if the government is willing to restructure some of the liabilities.)

The big divide is between both of these and B, the position of the Bush and Obama administrations – both of which rejected aggressive measures in favor of just-in-time, just-big-enough bailouts. Now the government is conducting stress tests on an industry it has already said is adequately capitalized, and will follow that with a public-private asset-buying program that tries to split the difference between paying real market value and paying enough to keep the banks happy. I’ve quoted these exact words before, but here’s Krugman again: “The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up.”

Now, let’s say you agree that something more needs to be done. Then you have to choose between A1 and A2. A2 is the one people typically call “nationalization.” But which is more consistent with a capitalist system: protecting the creditors who lent money to a failed bank, the shareholders who invested in a failed bank, and the managers who failed . . . or firing the managers, wiping out the shareholders, and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses? Which one better approximates the incentives you want in a free market?”

Very good points. And since I hold no bank shares, I’m very happy to wipe out shareholders, fire some managers and return some proper downside to decision-making processes in the banking industry!

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Responses

  1. I’d like to go one further and say that I haven’t heard a single good argument against temporary nationalization. I have heard only two sets, in fact, though I admit I don’t read as widely as you cats:

    1. A generic, substance-free ‘we don’t want the federal government making our lending decisions.’ This is just silly dogma. It is not as if management would be cleaned out entirely and replaced by politicized bureaucrats; the only people wiped out would be shareholders, and their managerial influence over the banks has clearly been neglible at best and wealth-destroying at worst. So let’s not pretend that temporary nationalization turns Citi into the State Bank of Czechoslovakia circa 1966.

    2. That in the midst of the recession the government would be tempted to use the banks as a way to prop up other politically important parts of the economy, thus saddling them with uncommercial assets. It is hard to say how likely this one is, but surely this could be handled in the articles of nationalization? The risk of abuse at least seems manageable.

    Behind all the fancy talk I think lies a simple truth — most of what is going wrong now, even the ‘real’ i.e. non-financial losses, is being driven by fear. The only way to stop the fear is to put a floor under the possible losses. I guess A1 and A2 both do that, and frankly I don’t care how its done — my gut feeling is that neither option is nearly expensive as continued dithering. But I also expect there would be positive signalling effects from A2, because of its broader scope and greater finality. The floor is firmer — it eliminates the risk of a new class of assets suddenly becoming ‘toxic’, of the various purchase prices and capital injections being judged insufficient, etc. Yes it surely has its own set of downsides, but I have not hear them well articulated yet.

  2. Jesse, good points, but I think there are a couple of practical reasons why the US government isn’t taking option A2 (and hence why everyone, the G20 included, is talking A1 (expensive and hopefully effective) while doing B (cheap and ineffectual):

    1. Contagion – once you nationalize one, two or five banks, the stocks of other banks in line will fall as people worry about where it will all stop. This will in turn induce nationalization. Hence my argument that you have an FDR-like bank holiday, preferably global, and sort all-banks out at the same time. Perhaps the stress-testing that is currently going on at the 20 biggest banks is a way of ascertaining where the line will be drawn if it comes to that!

    2. Congress and cash – When taking over a bank, the government needs to pay out the banks creditors (its bondholders at least – deposits are already mostly guaranteed), which will require further reserves of taxpayer money and hence a trip to congress for Tim Geithner to explain why the money to do A2 at a small scale wasn’t enough. Which is a trip that Tim probably doesn’t want to make right now. Note that the government wouldn’t want to just let the creditors go down altogether, as the ripple effects could be huge – à la Lehman – and even a haircut to bondholders could cause spreads to balloon and other things to start stuffing up again. Good discussion of this here http://baselinescenario.com/2009/03/06/bank-liability-guarantees/.

    So, when the govt is caught between a rock and a hard place, and neither the rock nor the hard place are providing much cash, the answer seems to be “B” combined with a lot of prayer.

  3. OK, well, I am not so well versed in this question. I had assumed all liabilities would be guaranteed, though maybe with some sort of rescheduling of payments to allow the receiver to manage things in practice. I thought the whole point of saving the big banks would be to guarantee their liabilities. I am not nearly familiar enough with their balance sheets to know whether some of them are not appropriate to save for some reason. And I guess I see now that this would mean that clients of some (saved) banks would be spared while clients of other (not important enough) banks would be wiped out. But I guess I think fairness is really a second order issue here. The ‘too big to fail’ principle is already out there. What that means is that they are too big to be allowed to default. Which means life ain’t fair for the clients of the small banks.

    As far as the ripple effects of nationalization, I am not sure I see that as being more dangerous than continued uncertainty. And unless you actually buy the B1 idea that ‘the banking system is essentially sound’ then the uncertainty has no foreseeable end and will destroy more of the economy than a run on the grey-zone banks.

    As far as that B1 theorem goes, I am really concerned that certain people, Geithner among them, really is acting on this idea that the ‘fundamental value’ of the assets has to be given a chance to emerge. In my opinion this was probably true at some point early last year, and will probably be true again sometime at the end of this year. At both of those moments, securitized debt was/will be undervalued. At the former moment, the government probably had a chance to prop up the ‘true’ value. At the latter point, distressed debt investors will be looking at a lot of upside. But at the moment, with the effects that have been sown in the real economy, the fear about these assets is looking to become a self-fulfilling prophecy, no? They are not going to recover on their own, not until rock bottom. That seems to be where its headed anyway.

    • Good points Jesse – we’re now seeing how this PPP plan of Geitheners might address the issue of fundamental value – on one side, the government’s commitment to set a price for the assets will mean they are worth something (and bias that price to be higher than “true” value), and the private sector involvment will assist in price-setting (and bias them down to the extent that private investors want to buy low and sell high). I really hope it works!

  4. The trouble with guaranteeing all liabilities explicitly (across all banks, or even just the 10 biggest) is that that means that US taxpayers take on the cost of all the bonds of those financial institutions, which would mean trillions of taxpayer dollars at stake in instruments of dubious quality – not to mention the fact that anything debts that bondholders can call-in will be directly drawn from the treasury. Which is why the government hasn’t just said “no worries, we’ll under-write you no matter what” to the banks. But, equally, balance sheets show that many of the banks are under-water yet stocks are still positive, so equities above zero must be trading on both an implicit guarantee by the government (as everyone recognises that to let citi simply die would be to destroy most other banks, all of whom are invested some way in citi) and the hope that asset values are worth something in the future. We live in a strange time.

    As you say, the only banks not worth saving are the small ones, and 16 have already gone under (been nationalized, effectively) this year alone. All of them were small banks (like the Security Savings Bank in Nevada), taken under the wing of the FDIC with assets acquired by other banks. Like you, I’m still not sure what happens to bondholders though – in this case, the FDIC stated they had to cough up $59.1 million, so I suspect the bondholders got nothing, since the depositors must be the most senior debt.

    I agree with you that the big problem is the uncertainty, which is why Tim et al are doing their best to dispel it with confidence that “things will turn out right”. While this may well be wishful thinking, it is a lot cheaper than the alternative, since everyone thinks that allowing the really “too big to fail” institutions go down will invoke a concertina of failures, with further disruption to lending and transactions etc that everyone is trying to avoid. But the problem with “saving” a set number of banks through nationalizations is that equity-holders will flee any and all banks that might be next to go, hence driving down capital ratios and inducing a self-fulfilling prophecy of failure (in parallel with asset values). We need the uncertainty to go away to know exactly who is OK and who needs saving – it’s not enough that talking heads reassure us of this while balance sheets are in the red, the market either needs a proper restructuring plan or a set of guarantees, and at the moment we have neither so the fun continues.

    I figure that, in the end, the government will (with a complicit congress) buy the toxic assets of the major institutions at huge cost to the taxpayer, justifying the expense in the name of saving the financial system and thus bailing out most shareholders and all bondholders while massively levering up national debt.

    Regardless of how it goes on, we need a few more rules to ensure that systemic risk is dealt with – none of these guys should get too big to fail, no more OTC trading that is too complex to dissasemble when things go wrong, clear statements of positions held to the market and regulator etc etc. We also need a few more rules to ensure that there is no upside without a downside. Bring back the partnership model, 5 year delayed bonuses contingent on continued performance etc etc.

  5. […] debate over? It seems that the Obama administration is definitely going with plan A1. From Yves Smith at Naked […]


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