Monday, April 20, 2009

Another Step Toward Bank Nationalization (Without the “N” Word)

There are two theories about this latest announcement from the Obama administration about bank capitalization, in which unnamed officials tell a New York Times reporter that converting government-owned shares from preferred to common will stretch public resources at no cost to taxpayers. You could take it at face value, as Paul Krugman does. In this case, the government officials (described as “top economic advisors”—is that Larry on the other end?) are amateurs, unaware that both types of share ownership constitute a capital cushion, for the reasons Krugman lays out. I have questioned team Obama’s judgment in the past, but I don’t think this is likely.

The other explanation is that this is a misdirection play, not-so-secretly concealing a significant step toward nationalization. Real nationalization means control, not just ownership, so the switch to common stock is potentially very consequential. Of course, much of the political and financial establishment is terrified at this prospect, so some other explanation was needed. Hence the (absurd) claim that this conversion is simply a technical move that economizes on scarce federal dollars. Of course, you need a compliant press to pick up the decoy and run with it, and the Times is doing its part. Since no reputable economist would make such a goofy alibi publicly, the article has to be anonymously sourced. Check, check and check.

Should proponents of nationalization be dancing in the aisles, or in the lobbies of their favorite financial institutions? While the political deftness of the latest move can be praised, from a policy point of view it continues the flawed process of piecemeal response. Real nationalization has profound impacts on existing private shareholders and creditors. If it is introduced slowly or one bank at a time, it can set off a panic throughout the system, causing financial chaos and severe political blowback. This is why the stress tests are so problematic: there is no immediate action implied if a bank fails—on the contrary, it has half a year to raise more capital after being branded a proto-zombie. No wonder the banks have been waging a preemptive battle to convince us that they shouldn’t be given a failing grade. A real stress test as part of a coherent, comprehensive policy would result immediately in seizure for those who come up short. The same can be said about the scheme to tiptoe gingerly into nationalization via step-by-step share acquisition: there is too long a gap between the banks’ awareness they being eaten and their actual ingestion. During this pause of several months many nasty things may happen.

For what it’s worth, I repeat here my criticism of nationalization as a strategy for rebooting finance. By acquiring the banks, the government acquires their liabilities. The evidence (amplified by rumored forthcoming revisions in IMF estimates of financial losses) is that the public cannot afford to make these claimants whole. This means in turn a complex round of negotiations over how much of a writedown should be imposed on which classes of claims, a politically messy business with system-level consequences. Until these questions are resolved, the banks and other institutions cannot function in a remotely normal fashion. In other words, nationalization isn’t a solution, only another framework in which to grope for one. Granted, it’s a better framework, but there is a superior option. Specifically, it makes much more sense to use scarce public funds to immediately establish public banking facilities that can finance economic recovery, and to allow existing firms to fail. There would still be an ugly season of resolving legacy claims and parceling out defaults, but at least we would have a working financial system humming in the background. I have also made the case for the long term desirability of a public banking sector modeled loosely on the German Sparkassen, so the “good new bank” idea can also be a stepping stone to a brighter future.


john c. halasz said...

The problem with forming public "good" banks from scratch is that it requires quite some time and effort to establish a business organization and acquire a depository base. Putting the banks into public receivership, converting the bonds into equity, splitting the banks into good banks, with the depository base and remaining sound assets, owned by former bondholders and public capitalization shares, while the bad bank retains the toxic assets in a depositless holding facility, owned by the former bondholders in first loss position and the government fisc to mop up any remaining losses, would work much more quickly. And since the former bondholders would lose much of their equity, the public fisc would end up owning most of the bank equity anyway, and banks could be re-regulated and broken up under public ownership, before being sold to private interests after the economy recovers, further lowering costs to the fisc.

Peter Dorman said...

This position is not very far from mine. If one hives off the good portions of the existing banks and capitalizes them to a level sufficient to meet the financial needs of the economy, these rump institutions will be near-new. Whether the deposit base moves or not is not very consequential, IMO; this could happen quickly. There is an advantage to working with existing personnel, but if the handwriting is on the wall for existing banks, finding qualified personnel (whole departments even) for a new-new facility would not be very time-consuming. Continuity between old and new could be either an advantage or a disadvantage -- that's a longer discussion. I do not think, however, that it is wise for the government to assume ownership of the bad bank. Unless there were really massive writedowns for the bondholders and counterparties, the cost would be excessive, and I am not optimistic that such writedowns would be imposed. (a) This is the problem we have been having all along with the Fed/Treasury stance. (b) How much leverage would the government have to impose them, particularly if the parties in question are not US-based? What is the threat point?