The Case For and Against Bank Nationalization

The Case For and Against Bank Nationalization
http://www.rgemonitor.com/roubini-monitor/255740/the_case_for_and_against_bank_nationalization
Matthew Richardson | Feb 26, 2009

Secretary Geithner’s financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.

Economic analysts have already performed such a test at the aggregate level. It was not a pretty picture. For example, Goldman Sachs looked at the U.S. banking sector’s holdings of the current “toxic” pool of assets, such as option ARM residential mortgages, subprime residential mortgages, Alt-A residential mortgages, credit card debt, second liens/home equity loans, consumer auto loans, and commercial real estate. Expected losses come in at around $900 billion. These losses give the banking sector very little wiggle room. Therefore, there is the real possibility that some LCFIs are bankrupt - the face value of the liabilities exceed the current value of their assets.

I. Insolvent Financial Institutions

If a bank is insolvent, there are three general ways to attack the problem.

The first is unbridled free market capitalism. I am sympathetic to this view. I wish we somehow could figure out a way to let the market work and let these institutions fend for themselves. Shareholders, creditors and counterparties knew the risks they were getting into. After all, why is some debt secured, why do we have collateralized lending, why do riskier assets deserve larger haircuts, etc…? But when Lehman Brothers went down, we looked into the abyss. This would be the equivalent of nuclear armageddon for the financial system.

The second is to provide government aid to the insolvent bank, to in effect throw good money after bad. This is sanctioning private profit taking with socialized risk. Since October of this past year, the government has followed this strategy. Let the banks plod along, throwing money here and there to keep them afloat, at usually way below market prices at a high cost to taxpayers.

It is not a totally crazy solution. There may well be a positive externality to spending taxpayer money to save a few so we can save the entire system. For economists specializing in the field of banking, however, this approach has a familiar ring. In Japan’s lost decade of the 90’s, Japanese banks kept loaning funds to bankrupt firms so as not to writedown their own losses, which resulted in the government supporting zombie banks supporting zombie firms.

As an example, consider the poster child for the “freebie” programs, the Temporary Liquidity Guarantee Program, started in late November of 2008. For a cost of 0.75%, it allows banks to issue bonds backed by the government, i.e., essentially risk free. The banks have accessed this market 97 times for $190 billion!

The biggest pig at the trough - Bank of America 11 times for $35.5 billion. But close behind, JP Morgan at $30 billion, GE Capital $27 billion, Citigroup $24 billion, Morgan Stanley $19 billion, Goldman Sachs $19 billion and Wells Fargo $6 billion. A not so surprising correlation with their respective writedowns (including merged entities), Bank of America $96 billion, JP Morgan $75 billion, Citigroup $88 billion, Morgan Stanley $22 billion, Goldman Sachs $7 billion and Wells Fargo $115 billion.

In terms of helping us move forward out of the financial crisis, this program has many problems. It charges the same amount for each institution, so it hardly separates the solvent from the insolvent institutions. It charges a fee which is grossly below what these institutions could issue in the marketplace given their current balance sheets, distorting the system. Wasn’t this the Fannie Mae and Freddie Mac problem? And it makes it less likely to cleanse the system of the toxic assets because these institutions can continue their way out-of-the-money option and hope that the prices of the toxic assets increase. In effect, the access to this capital allows them to continue to make the original bet.

The final way of addressing insolvency is nationalization. Over the past week, there has been debate about whether nationalization is the right word. According to a standard dictionary definition, it is the act of transferring ownership from the private sector to the public sector. Although this is literally what we are talking about here with certain banks, almost everyone agrees that the type of nationalization that would take place would be a temporary one. Thus, if everything went as planned, a better analogy would be of the government acting as a trustee in a receivership of the bank.

That said, I do think a term like nationalization is the appropriate description. It is a misnomer to think, as a number of pundits have suggested, that we have experience at nationalizing banks through the FDIC. For example, the latest bank (and 39th of the current crisis) to be closed by regulators is the Silver Falls Bank of Silverton, Oregon. It has three branches and assets of approximately $131 million.

It goes without saying that Silver Falls Bank is no Citigroup, Bank of America, Wells Fargo, or JP Morgan, among others. The complexity, size and systemic nature of these institutions deserve deep analysis.

The basic argument for nationalization is that we need an organization to simultaneously facilitate the reorganization of the LCFI and be a trustworthy counterparty to all the current and ongoing transactions. The only one with the balance sheet right now is Uncle Sam. But make no mistake about it. With nationalization of a LCFI, the government is the owner and the ultimate residual claimant. Once we take down the LCFI, we have crossed the Rubicon. The die is cast and there is no turning back.

II. Pros and Cons of Nationalization

It is therefore important to do it right.

* The good bank, bad bank model. Nationalization one-nil.

In order to have a healthy economy, we need a healthy financial system, and for a healthy financial system we need to cleanse the system of the bad assets. Otherwise, creditworthy firms and institutions will not have access to the needed capital, and will prolong the economic downturn.

This is the primary benefit of nationalization of some of the LCFIs. In receivership, it is much easier to separate the bank’s good assets and bad assets – to divest the firm from its toxic assets and troubled loans. This is because insolvent institutions will never take this action. If they did, it would by construction force them under.

The way it would work is that the healthy assets and most of the bank’s operations would go to the good bank as would the deposits. Some of these deposits are insured, others (e.g., businesses and foreign holdings) are not. But the likelihood is that the good bank is now so well capitalized that there would be no threat of a bank run. The net equity, i.e., assets minus deposits, would be a claim held by the other existing creditors of the bank, namely shareholders, preferred shareholders, short-term debtholders and long-term debtholders.

The goal would be to reprivatize the good bank as soon as possible. After all, the point of the exercise is to create health financial institutions which can start lending again to creditworthy institutions. In almost every successful resolution of financial crises in other countries, this was the path.

Of course, the tricky part of nationalization is the handling of the bad assets. The bad assets would be broken into two types – those that need to be managed such as defaulted loans in which the bank would own the underlying asset, and those that could be held such as securities like the AAA- and subordinated tranches of asset-backed securities. With respect to the former, the government could hire outside distressed investors or create partnerships with outside investors as was done with the Resolution Trust Corporation in the S&L crisis.

Along with the equity of the good bank, these assets would be owned by the existing creditors. The proceeds over time would accrue to the various creditors according to the priority of the claims. Most likely, the existing equity and preferred shares would be wiped out in such an arrangement and the debt would effectively have been swapped into equity in the new structure. Under this scenario, it is quite possible, even likely, that taxpayers would end up paying nothing. This is because, for the LCFIs, these creditors cover well over half the liabilities.

* Systemic Risk. Nationalization one-one.

The problem with the above solution is that it shifts all the risk of the insolvent institution onto the creditors of the LCFI. While this is fair to the extent the creditors were accruing the profits in normal times, it may lead to the “Lehman Brothers problem”, that is, this could create runs throughout the system.

Why did Lehman Brothers cause systemic risk?

Was it the counterparty risk, e.g., fear of being on the other side of interest rate swap, credit default swap, or repo transactions? This fear was well founded. Ask any hedge fund whose hypothecated securities disappeared in Lehman’s U.K. prime brokerage operations. It is pretty clear that the government would have to stand behind any counterparty transaction and publicly commit to this rule. Since most of these are margined and collateralized, however, many of the assets would show up in the good bank.

Or was it the short-term debt? The run on money market funds was directly attributable to the Reserve Primary fund’s holdings of a large amount of short-term Lehman commercial paper. One would presume the same thing would happen here as the short-term debt of all questionable LCFIs would come under pressure. It is highly likely that the government might have to step in.

As compared to the standard LCFI, Lehman had very little long-term debt. To understand whether a collapse in the LCFI’s long-term debt value is systemic, one would have to analyze the concentration of this debt throughout the system. If it is widely held, it is unlikely to have systemic consequences. Of course, it would have profound effects on future financing of these firms.

If the government has to cover the creditors, or at least some of them, what has been gained?

On the positive side, the system will have cleansed itself of the assets.

Moreover, to minimize the cost to taxpayers, it is not clear that the government will have to step in. If the government is completely transparent to the market who is solvent and who isn’t, and the reasons why this is, then the type of uncertainty that surrounded Lehman’s failure may be mitigated. Perhaps, the runs on the equity and debt of banks in September and October 2008 occurred because there was no clear message from the regulator.

That said, actions speak louder than words, and, in a dynamic setting where conditions change rapidly, solvent firms can become insolvent very quickly. While the government needs to do a thorough stress analysis, consistent across all the major banks, to find out the trouble spots, the only definitive way they can prevent a bank run on solvent institutions is to backstop all the creditors of these institutions. Maybe the government can provide a haircut, guaranteeing X% of the debt. In any event, in this case, the creditors of the insolvent institutions would not have to be protected.

* The toxic asset problem. Nationalization two-one.

It has been argued that trying to implement nationalization will be near impossible because we won’t be able to price the hard-to-value, socalled toxic assets. It is actually the opposite. The current problem is that banks don‘t want to sell the assets at the price the market is willing to pay for them. If we were banks, we wouldn’t want to sell them either. As long as the government is providing us free money to continue, why not continue the option? Hope is eternal.

But let’s be real. The banks bought illiquid assets with credit risk using short-term liquid funds to borrow against. For taking these types of risk, the banks got paid a hefty spread. And, in normal times, they raked it in. But there is no free lunch in capital markets. In rare bad times, illiquid, defaultable, assets are going to get greatly impaired. There is no mulligan here. It will be easier to resolve this within a receivership.

To make the point using a real economy analogy, this past Christmas, Saks Fifth Avenue sold their designer lines at a 70% discount. Designer labels and boutique shops on Madison Avenue were up in arms. How could they sell $500 Manolo Blahnik shoes for $150? In this economy, they are $150 shoes.

Moreover, receivership allows one to separate out the assets without having to price them.

* Managing a LCFI. Nationalization two-two.

Does the government have the ability to run a LCFI? In a recent conversation, Myron Scholes told me he was also in favor of nationalization, but as long as it lasts just 10 minutes.

With literally tens of thousands of transactions on their books, who is going to manage a LCFI while it is a government institution, good bank or bad bank? Certainly, no one envisions Barney Frank or Christopher Dodd as the Chief Investment Officers of these firms, but there are many concerns. The government can go and hire professionals as they have done with Fannie Mae, Freddie Mac and A.I.G. But much of the value of a Wall Street firm is in its vast array of intangible, human capital. This labor is incentive driven. How much franchise value will be lost during the nationalization process?

Let’s assume this gets sorted out and the government mirrors employment practices elsewhere at other firms. But then with the government’s protection in receivership, who is to prevent the LCFI from making too many, risky loans. They will have a competitive advantage over solvent, albeit less supported banks. This issue has recently come up with other government supported institutions. Indeed, the argument has been made that A.I.G. and Northern Rock to name just two have undercut their competition by respectively offering overly cheap insurance and mortgages.

* Moral hazard. Nationalization three-two.

There is something unseemly about managed funds buying up the debt of financial institutions under the assumption that these firms are too-big-to-fail. In theory, these funds should be the ones imposing market discipline on the behavior of financial firms, not pushing them to becoming bigger and more unwieldly.

It has been said by many that this is not the time for thinking about moral hazard. I disagree. If we bailout the creditors, then effectively we have guaranteed all debt of future financial institutions. We have implicitly socialized our private financial system.

It is certainly true that we can institute future regulatory reform which tries to quell the behavior of LCFIs. But this will be complex and difficult to implement against the implicit guarantee of too-big-to-fail.

Thus, nationalization resolves the biggest regulatory issue down the road, namely the too-big-too-fail problem of banks that are systemically important. In one fell swoop, because the senior unsecured debtholders of the bank lose when it is nationalized, market discipline comes back to the whole financial sector.

So the large solvent banks will have to change their behavior as well, leading most likely to their own privately and more efficiently run spinoffs and deconsolidation. The reform of systemic risk in the financial system may be easier than we think.

III. Concluding Remark

We are definitely caught between a rock and a hard place. But the question is what can we do if a major bank is insolvent? Sometimes the best way to repair a severely dilapidated house is to knock it down and rebuild it. Ironically, the best hope of maintaining a private banking system may be to nationalize some of its banks. Yes, it is risky. It could go wrong. But it is the surest path to avoid a “lost decade” like Japan.

IV. Case Study: Sweden[1]

Sweden has been cited frequently as a model of “nationalization”. While this is probably an exaggeration, the Swedish model is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden’s economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and U.S. banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the U.S., while there are over 7,500 institutions, the majority of assets are concentrated in the top 15 or so.

Sweden’s credit and real estate boom in the late 1980’s closely mirror the U.S.’s similar boom prior to the current crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies that financed their operations via commercial paper whereas in the U.S., unregulated special purpose vehicles (SPVs) via asset-backed commercial paper (ABCP). When the bubble began to burst, there was also sudden collapses in these markets as a few of these companies and SPVs began to fail.[2] Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital, otherwise to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank - failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalized.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden are relevant, however, for the current crisis:

1. Decisive action in terms of evaluating the solvency of the financial institutions.
2. Some form of “nationalization” of the insolvent firms.
3. Separation of these insolvent firms into good and bad ones with the idea of reprivatizing them.
4. The management of the process was delegated to professionals, as opposed to government regulators.

The issue of course is whether the complexity of the institutions affect how these principles should be applied in the current crisis. Complexity alone does not nullify these principles.

Professor Richardson is a contributor to the NYU Stern School of Business project, “Restoring Financial Stability: How to Repair a Failed System”, John Wiley & Sons, March, 2009.
[1] Many of the facts here are taken from Tanju Yoralmuzer’s piece, “Lessons from the Resolution of the Swedish Financial Crisis.”
[2] In Sweden, in September 1990, a finance company called Nyckeln went bankrupt, while in the current crisis, in early August 2007, three ABCP funds run by BNP Paribas halted redemptions, leading to a run on the system.