Nationalization and "Bad Bank" Analysis

Dr.Paul Krugman “Wall Street Voodoo”

“recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.”

“What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value

80 thoughts on “Nationalization and "Bad Bank" Analysis

  1. I don’t see nationalization as being a good solution because government doesn’t do much well. Look how government screwed up the relatively simple idea of TARP to make it virtually completely non-functional.

    Also, what would that cost? If buying the toxic assets is too expensive, how could buying all the assets not be completely out of reach. The government can’t just steal assets. They have to pretend to pay FMV.

    Finally, the big problem with the banks was a lack of risk control. I don’t see government doing that better. About 6 years ago or so the State Attorney General’s office failed to file a notice of appeal on a multi-million dollar judgment against the state. That wouldn’t happen at a private law firm. Not only would there be better systems in place, but someone high up would actually take a personal interest in seeing that the thing was filed.

  2. Just let the dead banks die. Government can hire some of the competent people from dead banks, and direct funding towards well-managed middle-sized banks and credit unions who hasn’t made mistakes, and let them grow and hire more people and take over the businesses formerly served by giant now-dead banks. In future, more regulation to prevent the formation of giant risk-taking banks so that this won’t happen again.

    That’s how market should work. That’s how creative destruction works.
    That’s how regulation should work (to prevent massive anti-competitve and chaos-prone industrial-banking giants from forming in the first place)

    I voted for Obama, but now his “dramatic action” rhetoric and “I ran for all the children” bleeding-heart is already getting on my nerves. probably 4 more years of drama queen with half-baked ideas.

  3. If all the banks are left on their own, they and the economy collapse further. If the government buys their assets at a price high enough to keep them solvent, it just amounts to a wealth transfer from the taxpayers to the executives and stockholders. It would also encourage bad risk taking because you can rely on government subsidies if the worst happens.

    If the government nationalizes the banks and wipes out the shareholders,
    1) It ends up costing less than paying to make the banks solvent while paying stockholders and exorbitant executive salaries.
    2) It allows the proper outcome for the risks taken by the shareholders and executives.
    3) It is certainly not a slam dunk that the government would run the banks worse than the banks do now. Frankly I don’t know how they could do worse.
    4) It would not be a permanent nationalization, since the government would then sell the banks back to private industry. This is how the government gets most of the “investment” back. Look up the resolution trust corp in Wikipedia. This has been done before.

    Kary, the reason nationalization would cost less is because the government gets the bank’s assets. Also the bank could be broken up and sold rather than continue to be a black hole for cash.

  4. Banks need equity capital and ultimately the only capital that will make this work is private, not public. Government needs to allow private sources to come in, but they will not do so until it is explicitly stated that nationalization is not an option.

    Any nationalization that includes wiping out of common equity will trigger credit default event and subsequent CDS payments in hundreds of millions of dollars (ala Lehman) and many other entities will be wiped out – hedge funds and other banks that hold positions in such swaps insuring Citi and BAC debt. You will see then further forced liquidations of all sorts of assets, depressing already depressed prices.

    What is needed is elimination of market-to-market rule that forces banks to keep writing down value of performing securities to the value of the last distressed sale in absence of any market. Banks should be allowed mark-to-model for long-term assets, with regulatory disclosure of default rates and income performance of such securities.

    Further, banks should be encouraged/forced to downsize by selling assets, thus reducing systemic risk from mega-bank failures.

    In addition, credit default swap market should be regulated as insurance market it is, with limits of exposure, strict capital requirements to issuers and presence of insurable interest to buyers.

  5. “Kary, the reason nationalization would cost less is because the government gets the bank’s assets”

    Well if it doesn’t cost much, maybe I should buy all the banks then! 🙂

    During the energy crisis California was threatening to buy all the electrical production in the state. It was a silly thought because at the time they were making a lot of money producing electricity, so the state would have been buying at the top of the market (something they later did with long term contracts to buy electricity). It was an empty threat to buy the assets, because they couldn’t have afforded them. I’m not sure how the US Government could afford to nationalize the banks either. We’re not a middle east country where we just seize the assets. Would they borrow the money to pay all the shareholders, or would they print it? What would be the effect of either?

  6. Kary, any banks nationalized would already be insolvent and the shares worthless. The office of thrift supervision could declare them insolvent based on the fact that their liabilities are worth more than their assets. Follow the link below to see when we did it before. It was costly, because the government took over the bank liabilities, but less costly than giving them enough money to keep floundering, like we have been doing. The shareholders would get the same treatment as WAMU’s and every other failed bank’s.
    Also read the Krugman article.

    2Kt, if there are private sources lining up to buy into these banks they have nothing to worry about from nationalization, because they actually aren’t insolvent. They also don’t need any of the bailout money.

  7. This is a little tangential, but I have put together a podcast, and slide deck, outlining the case for deflation. If this theory holds (i.e. that we are in for a lengthy period of deflation, and there is nothing governments can do to prevent it), then additional bail-outs and stimulus (such as the bad banks) won’t do anything to help, and will only put the nation in a more dire financial situation.

    Here is the link to the slide deck. You will see that the deck itself has links to download the audio podcast.

  8. Cautious,

    Sources are not lining up because the policy applied so far is incoherent and lacks clarity.

    If feds do large nationalization, you can kiss stock market good-bye. Look at UK bank shares- it’s self-reinforcing slide. Threat of nationalization kills the stocks, which in turn kills credit rating, which in turn kills ability to raise any capital.

    Incentives should be provided for private capital to invest in banks. Whether it is tax credits or favorable credit terms, it’s the only way to have the crisis solved.

  9. CB, I don’t see the discussion being so limited. In fact the second quoted material above expressly mentions nationalizing all the banks.

    BTW, the link from the Financial Times seems pointless if not worthless. Losses since a certain date balanced against capital raised since a certain date. That might be relevant if the banks were on the edge as of the start date, but otherwise I don’t see the relevance.

  10. 2kt,
    I believe that the only thing holding the stock price above zero is the hope of government intervention. I believe the reason they can’t raise capital, except through government handouts, is because they are actually insolvent. However, if you are correct and the incoherent policy is the problem, we should be able to solve it just by promising not to intervene further. No government incentives for private investment should be needed. Most experts don’t seem to think they would last long without the “incoherent policy” of government handouts though.

    I’m sure the discussion is wide open at this point. After all there are millions of people with millions of viewpoints. Fortunately, I have a feeling it won’t be long before we know exactly what the new administration wants to do.

  11. The reason they can’t raise capital, and the stock price is so low, is because of the meddling by Congress in the original TARP plan. Announce a large investment by government (or any other large entity) in any industry and the stock price will suffer, because of the potential dilution.

    As to their already being insolvent, doubtful, but that would depend a great deal on future real estate prices. The current balance sheets could just as well understate the solvency as be hiding insolvency. The bigger risk to banks is more likely bank runs. I hope we’re past that sort of thing, but you never know.

  12. Kary wrote: “The reason they can’t raise capital, and the stock price is so low, is because of the meddling by Congress in the original TARP plan.”

    Actually, I think that the reason they can’t raise money is because they have extremely poor balance sheets, unquantifiable potential losses that aren’t accounted for, and an increasing number of non-performing loans.

    I suppose one could argue that this mess is largely the responsibility of policy makers who have kept interest rates so low for so long (goosing the credit bubble), but mis-management of TARP has very little to do with it.

  13. Well obviously the banks were having issues with stock prices prior to TARP. But TARP was the nail in the coffin for bank stock prices. I wasn’t a big fan of TARP when Paulson first suggested it (I was on the fence), but Congress totally screwed it up by allowing it to become an investment vehicle, and now members of Congress are complaining about how screwed up it is.

    I think it was Mack who said something to the effect that you don’t get to be a Senator by being good at anything, other than being popular.

  14. The big banks are all kaputt, bankcrupt except for possibly Morgan. It’s time to buy up all the bad debt, nationalize them, fire all executives, clean up and expose the books and then sell them back to investors. This should coincide with stopping all housing relief programs and articifically low interest rates so home prices can quickly reach bottom. The sooner this is done the sooner we will be able to get the economy back on solid footing. Yes, it will hurt and it will be costly but it’s the quickest way to recover and rebuild.

  15. “you don’t get to be a Senator by being good at anything, other than being popular.”

    Well, I believe our new President who was a Senator is good at more than a few things beyond being popular. Mack was probably just being sarcastic.

    I agree with sniglet here:

    “Actually, I think that the reason they can’t raise money is because they have extremely poor balance sheets, unquantifiable potential losses that aren’t accounted for, and an increasing number of non-performing loans.”

    TJ, Do you think the new administration has the guts to do as you proposed?

  16. 2kt:

    “Incentives should be provided for private capital to invest in banks. Whether it is tax credits or favorable credit terms, it’s the only way to have the crisis solved.”

    Do you know if this is being proposed as part of the stimulous package or as part of handing out the remaining TARP funds?

  17. Hi Cautious Buyer. I like your ideas. One of the problems I keep coming back to is the size problem. What to do first? Would we nationalize the banks one at a time, as each one steps up to confess their sins, or would we be better off doing all of the big banks at the same time?

  18. I think Obama got the guts to do it as such but probably not to go against Barney Franks and Chris Dodd and co. who will fight to the end to burn all available funds on foreclosure relief etc.

  19. Nationalizing the insolvent banks is not needed and only prolongues the current crisis.

    There are banks out there today that aren’t in these dire straights and will only be punished if there competitors are bailed out.

    Instead of throwing billions of dollars at bad banks, here is a better solution:

    The US government will create 10 new banks
    and distribute $35B to each of them,
    using the remaining $350B of TARP money.

    These new banks will immediately IPO
    on the NYSE to become public entities.

    The US government will request and receive preferred shares
    from each of these banks with a dividend of 9%.

    The Federal government requires these new banks
    to pay back the $35B loans at some
    determined point in the future.

    These new banks, with clean balance sheets,
    will be capable of lending approximately $3.5T.

    -Karl Denninger-
    The Market Ticker


    Rescuing “bad banks” is insanity talk…

  20. TARP has been badly mishandled.

    The problem with TARP is that its original plan was abandoned is favor or recapitalization through preferreds. It sounded good on paper, but it does not relieve banks of “toxic” assets. The way most CDOs are structured, it takes 10% default rates with 50% severity for senior paper to lose any principal, but banks already written that paper down to $.70 or less. TARP, as originally proposed, would have removed those assets from banks and provided them fresh capital to lend. The Feds could hold the paper to maturity and (if bought at level paper is written down to) realize a decent return.

    As it is done now, preferreds saddled banks with additional expense costs and MBS/CDOs continue to be illiquid, so the problem remains at hand, except now stocks are killed into oblivion and now banks face credit downgrades and further declines. Banks now must hold cash to protect capital ratios (instead of lending it), so the problem remains, except it is much worse due to awful market conditions.

    Nationalization is a default event for credit purposes and banks have hundreds of billions of debt. The payouts on bank debt covered by CDS may wipe out significant number of hedge funds, whatever remains at AIG, etc. and by domino effect a number of foreign banks, etc., etc.

  21. I think the US and world economy needs the big banks as in infrastrucutre and employees and can’t afford to have a full out bankcrupcy chaos. Banks are also inherently profitable if they stick to proper risk management. To accept deposits for 4% and lend that money at 6% is the type of fundamentals that is always profitable with strict risk management. The problem is the crushing liability from bad debt, what you need to do is remove the bad debt and the management that allowed it to happen but keep the infrastructure, good debt and deposits, this is of course simplified but you get the idea. Bankrupt bank stocks should be worth close to zero. Nationalize them, fire the executives, change the names if that makes people feel better, but keep the infrastructure and deposits. The gov. can hold the bad debt and payout losses as it matures and hopefully all will not turn to losses.

  22. And as soon as the bad debt it gone from the balance sheets the “new” banks will immediately be profitable and ivestment worthy, attract new capital and start lending with sound risk management and strict gov. oversight and regulation. The new banks should be sold to the private market as soon as regulation is put in place/law.

  23. Where will the government get the money to buy the trillions of dollars of bad debt?

    China and japan will only say “no mas” to buying our debt at some point.

    Is Obama going to cut government spending?

  24. If you nationalize the banks you own the debt. Then you hold it separately from the banks and sell back the banks. You don;t need to buy the debt but you need to hold it and pay losses as they mature.

  25. It’s not much different use of money from what the bailouts are intended to today, the big difference is that with nationalization the banks are not going limp around on the verge of bankrupcy for years dragging every other part of the economy into the gutter with them until the debt is cleared. It will be immediately cleared and lending and profits can resume. And with nationalization the management who caused the crisis will be removed and it can be made sure that the bailout money is used solely for it’s purpose.

  26. I don’t think he can cut spending at the moment, he will probably have to increase it. The whole issue is money in circulation. It does now good sitting in a bank, it has to be spent or lent.

  27. Just following up on my comment 22, and that maybe if Obama had followed McCain’s lead and suspended the campaign . . . . A large part of the blame for that should be put on McCain. Rather than unilaterally announcing his move, he should have consulted with Obama so that they could have jointly worked out an arrangement for a temporary delay in the campaign. As it was done, it made it difficult for Obama to follow suit.

  28. tj wrote: “If you nationalize the banks you own the debt. Then you hold it separately from the banks and sell back the banks. You don;t need to buy the debt but you need to hold it and pay losses as they mature.”

    Who’s going to buy back the banks after you’ve nationalized them?

    Also, you don’t pay anything as losses occur. They would just represent loans that don’t get repaid. No money is exchanged. I don’t get that statement.

  29. “Who’s going to buy back the banks after you’ve nationalized them?”

    I would. If you take the bad debt out of the banks and offer them to the stock market the interrest will be huge. We did this for many companies in Sweden when we prepared for EU. Former government owned companies that was offered to the market as the PTT was hugely popular to the market. Big banks without bad debt will be no different, they will be popular.

    Let me rephrase that. The gov holds the debt and as losses materializes you absorb them. Currently the banks absorb the losses with help of government bailout money. No big difference on where the money goes or are supposed to go but it’s huge to the bank if they can operate without the crushing liabilities.

  30. The worst is the uncertainty of the size of future losses which makes the banks hunker down and the investors to flee. Without that undertainty things will get a millions times better for the lending industry.

  31. TJ wrote: “I would. If you take the bad debt out of the banks and offer them to the stock market the interrest will be huge. ”

    I’d agree with your comment 32, but as to this, I don’t understand how the process of nationalizing the banks helps anything, as opposed to just buying their bad assets. Buying their bad assets would get investors interested in them again. I just don’t see investors being interested in anything that has been previously nationalized, because what’s been nationalized once could be nationalized again–or at least that would be the perception.

  32. Buying the bad assets will force a price on them which is extremely difficult. Noone really knows it and you risk over paying. It also creates huge moral hazard and a huge give-away to current stock holders when the stock sky rockets. It doesn’t remove the executives that has shown utter incomptence and greed. The risk to be nationalized again is not a bad thing since it will only happen if the bank is bankrupt, in both scenarios you are screwed as a share holder. I heard Morgan’s and Boas CEOs bought stocks for millions of dollars in their companies so unfortunately your scenario is the more likely one. They will make out as bandits when our taxes will pay off the result of their mistakes.

  33. Kary,
    The investors who currently own the banks are the types who would and have made decisions and hired executives that ran the banks into the ground. If you bail them out by buying the toxic assets, there is no reason not to do the same in the future. What has been bailed out can be bailed out again later.

    If you nationalize and wipe out the shareholders, the new buyers will know they have to make the bank stand on it’s own, which is the only long term sustainable way to run any business. If the executives and the board make decisions that screw the banks long term, the shareholders will bail, the board will see their net worth decline, and they will fire the executives. If the board and executives make good decisions, more people invest in the stock, all is good. That is what should happen to a business in a free market economy.

    Who will buy? The same investors who buy into every other business knowing that it has a chance to fail but believing it has a good long term strategy. The reason they buy isn’t always because the company can’t fail due to the government bailing them out, nor should it be.

    Remember, nationalization is an option for failed companies as an alternative continued bailouts or letting them collapse and cause the credit default event 2kt is worried about.

  34. On top of the economic benefits of the nationalization it is clearly a huge opportunity for the new adminstration to immediately show the country and the world that “Change has arrived”.

  35. Good article Nolaguy. It sounds to me like a version of tempory nationalization though. The one difference from what I was imagining is that it would resolve the debt by giving pieces of the banks to the debtholders instead of the government keeping it. I’m not sure that this wouldn’t trigger all the CDS contracts and wreak havoc in the market. Obama should have people who know that answer.

  36. most of these banks with the loads of bad debt are already insolvent. those debt holders will walk with nothing if the bank goes under.

    Orderly cramdowns will give the debt holders equity for future gains, and get the balance sheets back to where they can loan money again – all without a taxpayer bailout.

    Yes, the stockholders get punished – but that’s a risk of investing.

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