Free Market Bank Nationalization

by on February 17, 2009 at 7:31 am in Current Affairs, Economics | Permalink

I believe that bank nationalization is now very likely.  It may even be desirable.  The term nationalization, however, clouds judgment on both sides of the debate.  It's better to think of what we want to do as bankruptcy.  Many of the major banks are insolvent.  When the liabilities of an ordinary firm exceed its assets the firm enters one of a variety of types of bankruptcy procedure during which management is often removed, the firm is sold or reorganized and liability holders take ownership or are paid off at a discount.  Notice that we do not call a bankruptcy procedure, nationalization, even though it typically occurs under the auspices of a government employed judge. 

When it comes to the banks the issue is more complicated than with an ordinary firm because the major liability holders are depositors whom the government has guaranteed.  As a result, the ultimate liability holder is the government.  But now, as a thought experiment, imagine that we had private deposit insurance.  What would a private insurance firm do in this situation?  Would it pander to the current bank management and carry the zombie banks on its books, hoping and waiting for a miracle?  Or would it step in, remove current management, pay off the depositors, reorganize and then sell the banks to recoup its losses?  I believe a private insurer would follow the second path, the fact that the government is not yet ready to do this indicates how powerful bankers are in Washington.  Thus, given deposit insurance the procedure most consistent with free market principles is bankruptcy, preferably a speed bankruptcy procedure under the auspices of the FDIC which has significant expertise in this field.

A speed bankruptcy;  1) punishes current management reducing moral hazard, 2) will be less politicized if done under the auspices of the FDIC than if done piecemeal with congressional involvement and 3) will get the banks working again as soon as possible.

Notice how the term nationalization confuses the issue.  First, it suggests government ownership of the banks which would indeed be a disaster.  People in favor of free markets will rightly want to avoid any such outcome but ironically it's the current situation of "wait and see," and "protect the banker," which is likely to lead to an anemic recovery and eventual government ownership.  Second, it confuses people on the left who think that nationalization is a way to insure that taxpayers get something on the upside.  That idea is a joke – there is no upside.  Taxpayers are going to have to pay through the nose but the critical point is that the taxpayers must pay the depositors whom they have guaranteed not the banks.

The debate so far has been framed between a "bailout" and "nationalization." But the public rightly sees the bailout as a way to protect bankers and thus we get pressure for government ownership, which has already happened in part through government control over banker wages.  Bankruptcy in contrast is a normal free market procedure, it emphasizes that the firm has failed and current management should be removed.  Framing the issue in this way, for example, makes it clear that only the depositors should be protected and under reorganization there should be no control over wages on future management (wages are going to have to be high to get anyone to take on the task).  Finally the idea of bankruptcy makes it clear that the goal is to get banks solvent, under new management, and back under private control as quickly as possible.

Addendum: Garett Jones nicely lays out the case for doing the normal thing.

Morten February 17, 2009 at 7:46 am

So, the depositors are insured. But not all I guess? And what about other debtholders? One would think that even if the banks are insolvent, many would have enough assets to cover the insured deposits? Or maybe I am completely mistaken.

So in my mind, it is useful to think of it as a nationalisation where tax-payers seize the asset, and hence whatever ‘upside’ there is.

fusion February 17, 2009 at 7:55 am

Speed bankruptcy, FDIC receivership, whatever. This is clearly the correct path and the sooner we recognize it the better.

As Alex says, using the word nationalization just confuses the issue.

There is no upside for taxpayers to seize.

Jason (the commenter) February 17, 2009 at 8:00 am

Nice to see you’ve finally been converted Alex. Do you think we will see nationalization anytime soon? Right now the government seems happy to “loan” the banks money every few months, have hearings where elected officials get to grandstand, and plan out ever more complex rules for the banks to follow. None of which seems like a good way for the banks to return to profitability anytime soon.

Richard White February 17, 2009 at 8:53 am

I object to speed bankruptcy though I agree with the principle. I prefer that the government offer to guarantee, i.e., insure, a bank’s asset portfolio at some substantial percentage, say, 75%-80% of carrying value, i.e., the amount reflected on the institution’s financial statements.
If the proportion of toxic assets is believed to be substantial, the bank(s) will purchase the insurance (at some modest premium).
The moral hazard of liquidating the portfolio to collect the governmental insurance is reduced (but not eliminated) since the bank will share in 20%-25% of any realized losses of the portfolio. Meanwhile the insurance will permit banks to avoid mark to market writedowns which reduce capital and its ability to make loans prospectively. Because (1) there is a reasonable likelihood that today’s toxic asset valuation is understated, i.e., the natural unwinding over time will not yield losses equivalent to what is perceived today, and (2) the bank takes the 20%-25% hit to income and equity, it will be incented to work out these assets to maximize their value.
Such a program protects the equity holders which represent substantial holdings in 401(k) and pension plans. It also promotes bank solvency which somewhat balances earlier governmental initiatives that contributed to, if not promoted, today’s insolvency or near insolvency, e.g., CRA, Fannie/Freddie. Perhaps as important, this initiative avoids or at least lessens the potential for increased fear, panic or other draconian results that might result from wholesale liquidations of our financial institutions.
Finally how about the taxpayer who will ultimately finance the governmental insurance? Obviously this plan implicitly says that on net she is better off exchanging her immediate loss of wealth either directly by today’s “speed liquidation” or indirectly by the effects of loss of confidence in the financial system for a future series of calls on her wealth vial increased taxes. I understand that is a policy judgement in which reasonable people may disagree.

David Heigham February 17, 2009 at 9:05 am

And the USA has an agency, the FDIC, which is experienced, competent and likel yto do it right. We in Europe have similar problems but no FDIC.

Bob Murphy February 17, 2009 at 9:32 am

I think the government should just quit hoping things work, and instead order all the unemployed people back to work in whatever jobs Barney Frank thinks best. I mean, we already have a draft, so this doesn’t involve unprecedented powers for the government. Call it free market conscription.

Ironman February 17, 2009 at 9:42 am

Tyler asked:

I’m the first to admit I don’t have a better idea but I have at least three major concerns. First, by what standards does the government decide which banks are insolvent? Under mark-to-market we probably have far more insolvent banks than current institutions can process.

This wouldn’t eliminate the problem, but the regulatory agencies could buy themselves time here by switching to cash-flow accounting, which would push the mark-to-market valuation issue down the road to whenever the underlying assets are transacted. Financial institutions would see immediate benefits in their equity positions since many of the owners of these underwritten assets with distressed valuations are still making their scheduled payments.

The regulators could then at least schedule the resolution of the crisis given their available resources. Ultimately however, the balance sheets are going to have to be fixed according to the mark-to-market rules.

Second, won’t speed bankruptcy for some banks prevent the recapitalization of others, leading to contagion effects and perhaps even collapse of the entire banking system into speed bankruptcy?

See above. The establishment of an orderly and effective process could mitigate much of this risk. Another approach would be to encourage the dissolution of institutions that are “too big to fail” into smaller units. Here, bailout recipients would be required to divide themselves into sustainable entities that are “small enough to fail,” with assets held by the legacy institution divided among the new entities. These entities should then be freed of salary and other operating restrictions imposed by the government in providing bailout assistance to the legacy firm.

The division of assets among the newly created smaller firms would also resolve much of the information problem associated with those assets (the problem where nobody knows how much to value them), as the internal negotiations for the division of assets of the legacy institution would effectively create an information market for them. I wouldn’t imagine that any of the newly created entities would want to have a lot of bad assets on their books, so the incentives to get them right would be rather powerful.

Third, the real question is what the government will do with *non-depositor* creditors to the banks. Not paying them off means more contagtion but paying them off costs probably trillions. I think it is unwillingness to face that expenditure, not the lobbying power of banks, which prevents this outcome from coming about.

Well, they might be compensated with equity positions in those new, smaller institutions…. More seriously, it’s difficult to see how one gets around this situation – compensation with equity could well be the best outcome they could hope to see.

Alex wrote:

What would a private insurance firm do in this situation? Would it pander to the current bank management and carry the zombie banks on its books, hoping and waiting for a miracle? Or would it step in, remove current management, pay off the depositors, reorganize and then sell the banks to recoup its losses? I believe a private insurer would follow the second path, the fact that the government is not yet ready to do this indicates how powerful bankers are in Washington.

That’s why this is the perfect T-shirt for our time! I think the message it would send to certain powerful bankers is an essential one for them to get.

Norman Pfyster February 17, 2009 at 10:36 am

Wrong assumption: in most Chapter 11 bankruptcies I have worked on, the current management survives largely intact.

Don the libertarian Democrat February 17, 2009 at 10:54 am

I like calling it nationalization for moral hazard reasons, since the banks began hoarding money and thinking seriously about going it alone when it’s mentioned. But, you’re correct, a lot of us are just talking about a form of bankruptcy, and getting the monster back in the private market as soon as possible. Quite frankly, that’s how I’ve always seen the Swedish Plan. No one ever said we have to follow their plan exactly. However, the takeover threat needs to be credible.

I also think that we should attack this insurance paid for by lobbying problem, by not allowing the end result to reinforce the conclusion that it worked.

I think that the contagion I really fear is massive unemployment, as a result of being in Debt-Deflation.That’s why I wanted a version of the Swedish Plan from the beginning. There’s no easy way out, but not facing up to the choice because there are possible drawbacks doesn’t seem wise. We have to get this banking crisis under control, otherwise Debt-Deflation will continue to spiral downward. Just my opinion.

CapVandel February 17, 2009 at 11:57 am

None of this makes sense until people start looking at actual banks, required accounting practices, and the difference between investment banks and traditional banks.
First — Loans are never marked to market. Mark to market is fundamentally derivative accounting and MUST occur in the trading portfolios of investment banks and firms that are heavily into credit derivatives. Loans are always held at amortized cost less a provision for loan losses.
Second, all the issues with structured financial products are investment bank problems, although we have unfortunately merged some of them with traditional banks.
Traditional banks have problems, but the types of problems that are normal with business and credit cycles and we have processes to deal with them.
The investment banks are highly unpopular, the guys that make over 1/2 million per year, etc. Wall Street.
The problem is that a huge part of our financial system has migrated away from banks into a securitization model. People want to bail out this system because they believe it is essential to getting things back to normal quickly. I agree (unfortunately). However, there is huge public resentment over this, and it will be politically impossible to put much more money in them without visible punishment.
Meanwhile, traditional banks are getting wiped out all the time. Most of it has been done via regulator engineered mergers, but they are effectively nationalization.
Final point — zombie banks are those that become reckless because their only viable strategy is to lend their way out of a problem. Like S&L #1 in 1980. The banks had too many low interest, long duration loans and too many higher cost deposits. Temporary solution — raise insured limits, allow brokered insured deposits, and the final result was the meltdown in the late 1980’s.
We don’t have these types of zombie banks. We have banks that are actually doing about what they were doing before. Maybe being more cautious, but thats why we have bankers — to make loans that will have a good chance of being paid back.

Except for the investment banks, that can’t sell securitized loans.

Geithner has a plan to get securitized lending going again, and wants to keep the investment banks around if he can.

The idea of a massive liquidation is bad, and a guarantee to start a deflationary spiral.

I suggest that people that care look at an actual regional or smaller bank. You won’t find mark to market issues, level 3 assets, credit derivatives, etc. You find loans. Most of them are paying. They write them down as they fail, and generally build reserves faster then the loans fail. They don’t and can’t predict what will happen in 2 years or even a year, but do have a pretty good idea of what will happen in the next six months and try to deal with it. Banks with huge portfolios of trashy mortgages are already gone. IndyMac and CW.

Some of the bigger, non investment banks or those without a big investment bank subsidiary are pretty simple and like big versions of small banks.

The real problems all stem from financial innovation, trying to run the financial system based on capital markets, derivative trading principles, etc.

Federalist February 17, 2009 at 12:14 pm

Alex, I assume you’re weighing the alternatives of “bailout” and “nationalization” as solutions to the financial crisis. You do a good job explaining why “nationalization” is a confusing term here, since properly done an apolitical “nationalization” would just be “bankruptcy.”

But you may not fully appreciate the “bailout” alternative. Properly done (again, in an apolitical fashion), the original “bailout” would simply have been a measure to inject liquidity into the markets. Since the U.S. government has effectively unlimited (and free) liquidity, it could afford to come into distressed markets and unlock them by buying assets at a significant discount. This is a net win for everyone involved since in such a scenario the treasury ultimately would realize a profit.

In principle the government should behave like any super-liquid profit-seeking entity: Willing to first provide bailouts (when it can be done at a profit), and when that is insufficient be willing to take losses on its guarantees and put banks through bankruptcy as you suggest.

DocMerlin February 17, 2009 at 12:43 pm

Alex, you are confused about a few things. A bank is legally insolvent when it is leveraged more than 10 to 1. This has nothing to do with actual bankruptcy or insolvency and can come as a surprise to those involved. A good example is Wacovia where the CEO didn’t know his bank was insolvent. It was paying its bills etc, but its marked to market assets dropped in value enough to make the bank insolvent.

Here is an example, I Bank of MR am leveraged 5 to 1 and most of my assets are cookie company stocks, but then a new type of cookie makes my cookie company stocks 2/5ths as much. Now suddenly I am insolvent and I get sold to Wells Fargo.

Even if I have enough cash to keep paying my bills and give people their money when they ask for it, I am still legally insolvent and face FDIC style bankruptcy proceedings.

mickslam February 17, 2009 at 1:19 pm

Bill,

Almost every major bank has already been destroyed. They destroyed themselves. The only reason they are standing is we have given them a few hundred billion dollars cash money and loan backstops of a few trillion, with a promise of unlimited additional capital if necessary.

Lord February 17, 2009 at 2:10 pm

The free market solution would be bankruptcy, but it would also be depression. I don’t see that as much of a solution.

DocMerlin February 17, 2009 at 3:20 pm

Bubbleman,

I wasn’t talking about investment banks, but about regular banks.
Investment banks are much like ordinary business and become insolvent when they can’t pay their bills.

Lehman and such are investment banks, Wacovia and many of the “nationilization” targets (CITIBANK) are actual banks, not investment banks.

Free Market Referee February 17, 2009 at 9:57 pm

Tabarrok and Cowen regularly obfuscate their statism by the use of copious details. But the Orwellianism of “Free Market Bank Nationalization” is rather obvious. Do they want jobs helping Franklin Delano Obama managing the economy via ‘short-term’ emergency powers? I wonder if, for all T&C’s erudition, they have the guts to make advice based on the full implications of moral hazard (and calculation problems of endeavors under govt management)? Well, the title of the post reveals their answer.

Steve van Emmerik February 17, 2009 at 11:07 pm

I think what some people don’t understand is that without the Fed stepping in many of the banks would have gone bankrupt by now. The FED did stepped in to prevent contagion. Look what happened when they just let Lehmann go down – the whole system of interbank lending froze up and took ages to thaw out and only then with more FED assitance. So letting them go to the wall is the alternative to artifically continuing to prop them up.

I think bankrupcy has to be threat that is there to try and bang the heads together of management, creditors, employees, stockholders etc to each take some pain if they want the bank to be a going concern. At the moment it’s all the downside pain is on the government/taxpayer at some unspecified future time. Management, creditors, employees, stockholders need to take the pain now to stop this occuring.

I don’t think you need to unduely rush the process but you need to make some clear ground rules. Hopefully the stress test does this.

Andrew February 18, 2009 at 1:27 am

I’m not an expert, but I understand that the banks got help already. But, banks enjoy a privileged position and that is what the Fed is for.

As for Lehman, one problem was the ad hoc approach, in addition to the fact that they were let go. Do it one way, or do it another, but don’t do it helter skelter.

Banks are basically intermediaries, and a speed bankruptcy should be able to reroute counterparty contracts and deposits. I’m a Wachovia depositor. Now I’m a Wells Fargo depositor, I guess. Who cares?

My main point is this. The trash assents are not of negative value. Why would anyone want to get rid of something of positive value? Is it because the government requires banks to have certain reserves of KNOWN value, so they have to keep them and give them a value even though noone knows what they are?

So, is the government forcing these banks into insolvency at the same time it is wringing its hands over the consequences and standard procedure?

donjuan February 18, 2009 at 9:25 am

What about regulation? Who is going to jail, no one?

Allison February 18, 2009 at 8:58 pm

If nationalization is “just a form of bankruptcy”, then try again to explain why “let them fail, and let the depositors be bailed out by the FDIC” wasn’t working.

Because you said it wasn’t, right? The credit market fiasco and the money markets breaking below a dollar was all scary to you, right, Alex?

Yes, the banks are insolvent. If nationalization means letting the banks stay as zombie banks, it’s a terrible idea. If it meant bankruptcy and FDIC backstopping of depositors, you need to explain why that wasn’t enough the first time around. Where are the bondholders here? are they out of luck or not?

Finally, where is the “temporary” part of the nationalization plan?

Your idea of private insurance is hilarious. That’s what AIG was. Remember? We had private insurers insuring counter party risk. They didn’t take the tack you thought they did, did they?

mahmay February 23, 2009 at 1:31 pm

Question: Can someone who has a solid, ‘non-emotional’ understanding of this issue, please paint a picture for all of us of what we will experience – short-term, mid-term, long-term – when the US gov’t nationalizes the major banks that are obviously insolvent, at least according to the market’s view, which is all that really matters. Thank you.

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So, the depositors are insured. But not all I guess? And what about other debtholders? One would think that even if the banks are insolvent, many would have enough assets to cover the insured deposits? Or maybe I am completely mistaken

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