Does Rick Newman Understand Either Moral Hazard or Option Valuation?

Rick Newman calls the possibility of temporarily nationalizing troubled banks “scary” for reasons that are being properly ridiculed – a topic we’ll come to in a moment. But let’s start with this claim:

It wouldn’t solve the underlying problem. The main problem at struggling banks like Citigroup is a mountain of losses – which the banks may not have enough cash to cover … The government can pump taxpayer dollars into banks to help cover losses, which it’s already doing. But even if it owns the banks, “the government can’t make embedded losses go away,” says economist James Barth of the nonprofit Milken Institute. “The question is how to prevent additional losses.” If troubled banks were making wild decisions that were exacerbating their problems, then a government takeover might be one way to install more prudent management. But by most accounts, government regulators are now watching troubled banks so carefully that they’re effectively clamping down on any risky moves anyway.

The problem is not past decisions but the possible future decisions of zombie banks, that is, banks with liabilities exceeding the value of their assets. The fact that the government can observe a troubled bank does not erase the moral hazard dilemma inherent in letting the owners of these zombies continue to make management decisions. But the claim that is getting the most ridicule is as follows:

A government takeover would vaporize a lot of wealth. This is why the markets freak out every time there’s a rumor, or a rumor of a rumor, about nationalization. If the government took over a bank, public shares would suddenly be worthless and shareholders would lose everything. With Citi and Bank of America shares down more than 90 percent over the last 12 months, many shareholders have already lost a fortune. But there’s still a chance they’ll get some of it back if the bank recovers. That potential upside would disappear if the feds stepped in.

TPM reader AC nails this:

the only reason that the 90% to 95% losses that many have taken is not 100% is because of the chance that the feds bail out the banks but leave some equity outstanding (e.g., the 40% Citi solution). This, of course, is just a transfer of wealth from taxpayers to bank shareholders--like Paulson's funding of Citi greater than their market cap, to take meaningfully less than a 100% stake.

Paul Krugman recently made the same point:

And the market caps of these banks did not reflect investors’ assessment of the difference in value between their assets and their liabilities. Instead, it largely — and probably totally — reflected the “Geithner put”, the hope that the feds would bail them out in a way that handed a significant windfall gain to stockholders. What’s happening now is a growing sense that the federal government, in return for rescuing these institutions, will demand the same thing a private-sector white knight would have demanded — namely, ownership.

While Newman is correct in the claim that there is some remote possibility that the future cash flows of these banks will turn positive, there is also the strong possibility that the future cash flows will turn even more negative. The difference between the current market price of these bank shares and this Geithner put option is the current expected present value of cash flows – with each element of the probability matrix accounted for. Dr. Krugman et al. argues that the present value is negative. What I guess scares Mr. Newman is that the bank shareholders might lose the value of this Geithner put option, which of course is what we taxpayers would be giving away for free if we do not nationalize these troubled banks.