Nationalizing the Banks Seems Inevitable: How Bad Does It Have to Get First?
There is a bottom-line to the banking crisis which the Obama administration appears intent on trying to avoid: some number of financial giants are simply insolvent. A recent analysis by NYU economist Nouriel Roubini -- known as "Doctor Doom" for his dire predictions about the collapse of the financial trading system, predictions that have since become painfully true -- estimated that the losses facing the American financial sector will reach $3.6 trillion dollars.
In the past, governments, including that of the first Bush administration during the savings and loans failures of the late 1980s, have taken over insolvent institutions that were judged to be "too big to fail." They fired most of the management teams, wiped out the banks' shareholders, protected depositors, and sold off the institutions assets in an orderly way, minimizing the shock to the larger economy.
Following the floundering, piece-meal interventions presided over by former Treasury Secretary Hank Paulson, the chorus calling for nationalization has grown. Once considered a radical move, even fiscal conservatives like Senator Lindsey Graham (R-SC), have suggested that this might be the least-expensive route to saving a financial system on the brink of collapse. On ABC's This Week, Graham said, "This idea of nationalizing banks is not comfortable. But I think we've got so many toxic assets spread throughout the banking and financial community, throughout the world, that we're going to have to do something that no one ever envisioned a year ago." "I would not take off [the table] the idea of nationalizing the banks," he concluded.
But so far, the Obama administration has done exactly that, and while the president has said that his team is loathe to nationalize falling financial giants because of the complexities involved, a closer look suggests that his team is avoiding the move on ideological grounds rather than practical considerations. 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 reporters, "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 having a choice. Contrary to Graham's assertion, many of the "toxic assets" we're hearing so much about these days are concentrated in a handful of institutions, and the first step of the plan outlined last week -- with sparse details -- by Geithner is to dig into these institutions' books and see exactly how healthy or unhealthy they really are. Some see that as a first step to nationalization, even if it were to go by another name -- "restructuring" or "receivership."
But 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. Geithner is proposing a vague "public-private partnership" that will somehow raise enough capital to ease the crunch. Roubini argues that "the plan won't solve our financial woes, because it assumes that the system is solvent." 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.
The Geithner plan is not fully fleshed out. Roubini notes that "establishing an investment fund with private and public money to purchase bad assets," is the cornerstone of the plan.
But unfortunately, the plan won't solve our financial woes, because it assumes that the system is solvent. If implemented fairly for current taxpayers (i.e., no more freebies in the form of underpriced equity, preferred shares, loan guarantees or insurance on assets), it will just confirm how bad things really are.
Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.
However it is structured, the alternative is to keep injecting tax-payers' money into zombie banks, institutions that can't stay in business with their own cash supply. At stake is the length and depth of the recession; failure to act decisively has the potential to mire us in a protracted slump, much like Japan's "lost decade" in the 1990s.
It's time that Congress and the Obama administration stop 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 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."
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 when the feds only go partway, we get ripped off. Either we end up buying up those toxic assets at today's prices, killing the banks (if they could sell them without going belly-up, they would), or we pay inflated prices and give a massive subsidy to those who got us into this mess.
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."
And while we've showered the banks with taxpayer largesse, the public hasn't gotten a stake in the banks' future. Banks are reportedly hoarding money to beef up their balance sheets, using governmnet funds to pay out dividends and bonuses, or buying up smaller, sicker institutions.
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.
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, including now in conservative ones. Obama 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.