Stop Rearranging Deck Chairs on the Titanic and Nationalize the Damn Banks
The painful but unavoidable reality of the financial crisis is that every dollar spent trying to prop up a failing bank is just good money thrown after bad; a taxpayer rip-off, short and sweet.
But in Washington, many are trying to avoid that fact nonetheless. Economist Paul Krugman wrote that the political establishment has "become devotees of a new kind of voodoo [economics]: the belief that by performing elaborate financial rituals we can keep dead banks walking." Goldman Sachs' economists estimate that those rituals might cost up to $4 trillion to perform.
It's time that the government stops flailing around with piecemeal bailouts and loan guarantees, takes over these institutions -- takes them out of private ownership -- sells off their good assets in an orderly way, trashes the toxic stuff and then resells them to the private sector down the road as leaner institutions that are dedicated to the primary purpose of banking: making loans and holding deposits.
In economic circles, that's the "N-word" -- it isn't a racial epithet, it's "nationalization," and it was unheard of in mainstream discourse just a few short months ago. But it's remarkable how a crisis as deep as the one we face today can change which ideas are considered mainstream.
In a way, nationalization is the approach that most closely adheres to "free market" principles, which dictate that poorly managed firms should go under, freeing up their human and other capital to be absorbed by well-managed businesses.
Sometimes, the market works. Wall Street's titans lobbied like hell to get regulators off their backs, they figured out elaborate ways to "launder the risk" out of high-risk debt, and then they engaged in a furious push to get lenders to make more and ever-shakier loans -- the raw materials of those "innovative investment vehicles" that are now known as "toxic securities."
They did that based on an entirely irrational idea that the housing market would continue to grow dramatically forever, and they did it while ignoring voices of sanity which warned that they were steering those fancy "investment vehicles" right off a cliff. Now, many are teetering on the brink of collapse, and classical economic theory says they should crash and burn.
But with financial giants like Citi or AIG, the common argument against that course is that regardless of their complicity in creating the global economic meltdown, they're simply "too big to fail" because their collapse would have a ripple effect through the economy.
This is probably accurate; a sudden crash of an institution with hundreds of billions of dollars -- or even trillions -- on its balance sheets would have far-reaching effects. When Lehman Brothers went belly-up last fall, it came close to bringing down the entire global financial system with it.
But a major problem with all of the approaches tried so far -- and those being discussed in connection with the future of the dubious Troubled Assets Relief Program -- is they're all premised on the idea that these faltering institutions can, and should be propped up and remain in the private sector. Their investors' stakes, while worth a fraction of what they were a year ago, are being protected (and many ailing institutions are still paying out dividends).
And while Capitol Hill has been flush with largely symbolic gestures to cap executive pay or limit the shininess of management's golden parachutes, most of the people who ran these institutions into the ground -- as well as the global economy as a whole -- are holding onto their cushy jobs.
Nationalization is a radical move, but there are real and practical problems with trying to prop up falling banks that are fundamentally unsound. So far, several broad approaches have been bandied about in D.C. All have similar flaws, and all represent an elaborate dance around the N-word.
The first is to buy up the banks' toxic assets -- the original concept behind the TARP. The government would fund the creation of a "bad bank" to hold onto those assets in the hope that they would increase in value down the road and maybe return some cash to the taxpayers. The argument is that the government can buy and hold that junk with money the private sector can't raise, and also pays less for the cash in the first place.
But there's a big problem with the idea of creating a "bad bank." Asset prices are so low right now that either the government overpays for them, providing a huge subsidy to shareholders in companies that are on the shakiest of ground, or it pays a fair value for those assets, in which case banks holding large amounts of debt-based securities would have little incentive to participate. If they did, they'd go belly-up anyway (if they could simply sell off their crappy paper at current prices -- however one determines what those prices are in a market that's essentially shut down -- we wouldn't be in this mess).
Another proposal -- one that has gained currency since the first round of TARP money was dished out -- is to "recapitalize the banks" by buying stock in the firms. The government would basically become an investor, and assuming that the institutions in question rebounded, it could later sell its shares and recoup some or all of the dollars taxpayers threw at them.
Here, there's a similar problem. The value of bank stocks are at rock bottom, and there's a reason for that: they represent a terrible investment, and that would effectively make the U.S. taxpayer the sucker of last resort -- a chump who would buy into a failing institution.
Yes, it's possible that somewhere down the road, these banks would return to health, but it's important to recall that the financial sector has become bloated with excess capacity, so that outcome is anything but guaranteed, and at the very least would take years to realize.
The U.S. government has already taken this approach, "partially nationalizing" several banks. But when the feds only go partway, we get ripped off. In the case of Bank of America and Citigroup, the Fed pumped more money into those banks than their entire market value, and in exchange taxpayers got a 6 percent stake in BofA and 7.8 percent of Citi. As econ-blogger Barry Ritholtz noted: "How 120 [percent] of a company's market [value] yields a single-digit ownership stake is beyond my comprehension."
Perhaps the biggest problem with this approach is that while the public gets a stake in the banks' future, so far it's given the government little or no say over how the banks do business while they enjoy the public's largesse. Banks are reportedly hoarding money to beef up their balance sheets, using TARP funds to pay out dividends and bonuses, or buying up smaller, sicker institutions.
There's plenty of talk in Congress about requiring greater transparency of firms receiving TARP funds -- along with talk of requiring them to lend money (stupid talk; making banks lend to maxed-out individuals and cash-strapped businesses that aren't creditworthy is the epitome of doing the same thing over and over and expecting a different result), of caps on CEO pay and all the rest -- but it is virtually impossible to fully account for those funds when they're ultimately being doled out by corporate managers. "Leakage" is inevitable; there's really no way to guarantee that a TARP dollar doesn't end up being spent on purposes other than for those which it was intended.
Another tool in the kit is to guarantee the value of the banks' holdings -- essentially making the government an insurance broker (this was part of the bailouts for Citi and BofA, and has been done aggressively in the U.K.). But this may be the worst solution, for much the same reason: as the underlying assets tank -- and most analysts say we're not near the bottom in real estate -- the cost to taxpayers will be enormous, and they'll get nothing in return.
The premiums required to make that insurance business profitable (or a break-even) for Joe and Jane TaxPayer would be exorbitant, so banks taking advantage of the program would give the government equity in return -- again, that's partial nationalization.
Nationalizing the banks outright is another story. "The case for full nationalization is far stronger now than it was a few months ago," Adam Posen, the deputy director of the Peterson Institute for International Economics, told the New York Times. "If you don't own the majority, you don't get to fire the management, to wipe out the shareholders, to declare that you are just going to take the losses and start over. It's the mistake the Japanese made in the '90s."
Nationalizing failing banks outright would be expensive, and comes with risk, but it's a way to address most of the crucial flaws in the ad hoc approach taken so far.
How would it work? The government would put teetering institutions deemed too big to fail under trusteeship. Many among the current management teams would join the ranks of the unemployed, shareholders would get wiped out -- an important piece of tough love that might dissuade people from following the herd into the next speculation-fueled bubble.
And then the government would liquidate the institutions' assets in an orderly, gradual way. Then, finally, it would sell back smaller, leaner institutions -- without the burden of piles of bad paper on their books -- to the private sector at a later date.
Proponents of the plan argue that taxpayers might even see a profit from the transaction, but that's far from a given. The reality is that while it's probably the least bad plan, and would likely result in the lowest ultimate cost to the taxpayer, a similar approach, but far smaller in scope, was used in the 1980s to bail out the savings and loans and ended up costing taxpayers $150 billion.
Perhaps the best rationale for nationalization is that the bursting bubble that precipitated this crisis wasn't in tech stocks or commodities -- it was a bubble built largely on people's homes. The New York Times, which continues to ignore the underlying collapse of the housing bubble, notes that one of the flaws in the plan is that "if the government is perceived as running the banks, the administration would come under enormous political pressure to halt foreclosures."
But what they call a bug is obviously a feature of nationalization. The foreclosure crisis is spreading, and foreclosed properties fuel a vicious cycle, dragging down real estate prices in the areas where they're concentrated, which in turn puts more homeowners "under water" -- owing more on the mortgage than their houses are worth -- which in turn increases the number of foreclosures.
If the banks were nationalized, the government could declare a moratorium on foreclosures for the properties it controls, and move to restructure mortgages -- perhaps at subsidized rates -- for homeowners on the bubble.
This is an important part of the puzzle. So far, government efforts to bailout homeowners have had little success, in large part because privately held institutions have an obligation to their shareholders to avoid writing down the principle of loans made on assets whose values have tanked.
So far, all of the government's attempts to bailout homeowners have been structured as voluntary programs, and the terms that the banks require before deciding to bite have been too costly for most distressed homeowners to afford.
It appears that the idea of nationalization is gaining steam in policy circles, but the Obama administration has been hesitant to use the word, perhaps wary of the reaction the proposal might get from conservatives.
The New York Times reports, "President Obama's top aides have steered clear of the word entirely," and the Washington Post notes, "Administration officials are … trying to offer federal assistance to financial firms without nationalizing them outright, according to a source who has been in contact with senior Treasury officials." Obama's Treasury Secretary, Tim Geithner, told Congress, "We have a financial system that is run by private shareholders, managed by private institutions, and we'd like to do our best to preserve that system." But they may not end up with much of a choice. The Post adds: "The problem is the price of banks shares is so low now that a major investment of taxpayer money [in a recapitalization effort] would leave the government with a majority ownership stake."
Barack Obama has promised a pragmatic approach to the crises facing the country. Nationalizing big, failing banks may smack of "statism," but the consequences of tinkering around the edges of the crisis are simply too dire; we've got to leave all options on the table.