[R-G] [BillTottenWeblog] Real Capitalists Nationalize

[Bill Totten]

Sorry, zombie banks. The laws of the market dictate that we should own
your ass.

by Kevin Drum

Mother Jones (March 15 2009)


The titans of Wall Street may not have done a bang-up job of running the
American financial sector over the past few years, but would a bunch of
politicians in Washington, DC, do any better? We're probably about to
find out - and to understand how we got here, and why it suddenly
doesn't seem like such a bad idea, you've got to start at the beginning.
The very beginning.

In America, it's the stock market that gets all the headlines. If you're
sentient enough to fog a mirror, you know that stocks have dropped by
half in the past eighteen months. It's been a disaster for 401(k)s and
pension funds across the country.

But the fact is that this is a sideshow.

The total size of the US equities market - the value of every single
share of stock traded on US exchanges - is about $10 trillion. The size
of the US credit market is more than $30 trillion. What's more, credit
is more important than equities. As the saying goes, credit is like
oxygen: You don't realize how much you need it until it's gone. When
credit dries up - as it has recently - the economy grinds to a halt.

But why has credit dried up? Let's back up again. The main providers of
credit are banks, and the amount of money they can lend depends on two
things: their capital stock and their capital ratios. Say that you and
some friends decide to start a bank and you pitch in $1 billion to get
things rolling. That's your capital. And say that your bank makes a
profit of $1 billion for nine years in a row. Your capital is now $10
billion.

The amount you can loan out depends on your capital ratio, a number
that's set in the US by the Securities and Exchange Commission. If
you're required to have, say, a five percent capital reserve, that means
your loan portfolio can be as high as twenty times your capital. That's
$200 billion - and if you fudge things a bit, say through the creative
use of off-balance-sheet vehicles, maybe you can loan out as much as
$300 billion. If the average return on your loan portfolio is five
percent, that means you're making about $15 billion per year with only
$10 billion of your own money at stake. Not bad.

But then a crash comes. Homeowners start defaulting on their loans, and
you have to write off the losses. That cuts into your capital; plus,
with the economy falling, it's prudent to reduce your leverage. Instead
of thirty to one, maybe you'll cut back to twenty to one. The end result
is that you're lending way less money than you used to.

This is, roughly, what's been happening to the global financial system.
Loan losses have reduced capital. Everyone is hoarding money. It's
called deleveraging, and in plain English it means that credit markets
are broken.

But things can still get worse. What happens if your capital is wiped
out completely by loan losses? Then your bank is insolvent. The lights
are still on, people still come to work, and bills still get paid, but
there's no lending at all. And without lending, you aren't really a
bank. You're a zombie.

So is the American banking system insolvent? It's probably pretty close.
But this doesn't mean that every bank is insolvent. It just means that
the overall average is neutral: Some banks are doing fine, while others
are deeply in the hole. And the ones who are in the hole, which include
some of the country's biggest, need to be dealt with. But how?

We could, of course, simply let the bad banks fail. But that's what the
government allowed to happen to Lehman Brothers last September, and the
results were catastrophic. Markets went wild, credit froze, and there
was a run on money market funds that stopped only when the Fed stepped
in to guarantee them. When a really big bank fails - and some of the
banks currently in trouble are a lot bigger than Lehman - it can cause a
cascade of defaults that ignites a global firestorm and destroys entire
economies. So no matter how appealing it sounds on poetic-justice
grounds to let the banks that got us into this mess simply go under, the
infuriating fact is that we simply can't afford to let that happen.

Aside from allowing banks to fail, then, there are four main options.
The first is to muddle through. The US banking system is still
profitable, after all, and this means that over time insolvent banks
will build their capital base back up and start lending again.
Unfortunately, "over time" could mean years, and nobody wants a broken
banking system for that long. (Japan tried this after its banking crisis
of the early 1990s, and the result is popularly known as the "Lost Decade".)

Option Number Two is for the government to set up what's called a "bad
bank" that buys up the banking system's "toxic waste", loans that have
gone bad and are likely to get even worse, eating up bank capital along
the way. Unfortunately, the reason this stuff is called "toxic" is
because the eventual losses from these loans are impossible to forecast.
Are they worth seventy cents on the dollar? Fifty cents? Twenty cents?
Nobody knows, and without knowing that, it's impossible to buy them up.
There's still a plan on the books to attempt the purchase of toxic
assets, but most observers give it little chance of success unless it's
so heavily subsidized by the government that it amounts to little more
than a massive giveaway.

That leads us to Option Number Three: recapitalization. Last year, after
former Treasury Secretary Henry Paulson realized that buying up toxic
waste wouldn't work, he decided to provide direct capital infusions to
banks. The idea here is simple: If the banks don't have enough capital,
then give them some more. Even with big losses, if you give them enough,
then they'll be able to lend money once again.

One problem, though: There's no reason for taxpayers to simply give
money to banks. We need to get something in return. But what?

Paulson's answer was preferred stock, a weird hybrid entity that counts
as equity but is really just a thinly disguised loan. There's nothing
inherently wrong with that, except that Paulson bought the shares on
giveaway terms. Take Goldman Sachs, for example, which received $5
billion in new capital from Warren Buffett last September. In return
Buffett received a dividend yield of ten percent per year and, according
to an analysis by Bloomberg, warrants worth $3.6 billion.

And Paulson? He gave Goldman $10 billion a month later, and in return
received a dividend of five percent for the first five years and
warrants worth less than $1 billion. Eight other big banks got similar
terms at the same time. It was a sweetheart deal deliberately designed
to not put additional stress on the banks, but the flip side is that
taxpayers got robbed. Simon Johnson, a former research director for the
International Monetary Fund, said at the time that the transactions were
"just egregious". Paulson seemed to be spending more time figuring out
how to spend taxpayer dollars in ways that wouldn't offend the delicate
sensibilities of the folks getting the checks than he was in getting a
good deal for the taxpayers.

But the reason for those easy terms isn't hard to figure out. Basically,
if Paulson had paid any more, he would have owned several of the banks
he gave money to. Take Citigroup. So far they've received two capital
injections from the government worth a total of $45 billion. But that's
more than the entire bank is worth. As I write this, Citigroup stock is
trading for less than $2; you could buy up the entire bank for less than
$10 billion. But Paulson didn't want to own Citi, and the only way to
make sure he didn't was to give it money on such absurdly favorable
terms that $45 billion only bought a small share of the company. That's
good news for Citi and the other banks that got easy money from the
government, but both politicians and the public have gotten tired of
such handouts.

So, finally, this brings us to Option Number Four: temporary
nationalization. Here, the big problem is, since the banks haven't
exactly been honest about their books, how do you decide which ones are
insolvent and which can keep going on their own? Assessing the capital
position of a big bank with a complex balance sheet is a notoriously
tricky task, as much art as science, and shareholders and creditors have
a legitimate beef if the government takes over a bank and wipes out
their investment when the bank might still be solvent and able to grow
out of its problems on its own. John Hempton, a former bank executive
and Australian treasury official, suggests a solution he calls
"nationalization after due process": A third party is hired to comb the
bank's books, and if they're found to be undercapitalized they're given
a chance to raise the needed capital privately from investors. If
investors aren't willing to pony up even knowing the bank's position,
then it's nationalized, and shareholders can't complain that they
weren't given a fair chance to save their investment.

This specific idea might or might not work, but certainly some kind of
consistent, transparent system is needed to make the process fair and
acceptable. Sweden, for example, which went through a housing bubble
followed by a banking crisis in the early 1990s, created a Bank Support
Authority that forced banks to fairly account for their losses without
the smoke and mirrors common to internal accounting. Two were eventually
taken over.

President Obama clearly has considered the Swedish experience: "They
took over the banks", he said on Nightline last month, "nationalized
them, got rid of the bad assets, resold the banks, and a couple years
later, they were going again. So you'd think looking at it, Sweden looks
like a good model." Yet, he went on, the United States has a "different
set of cultures" than Sweden, and Americans would find nationalization a
hard pill to swallow.

Unsaid but implicit in Obama's statement, though, is that Americans
could likely be persuaded to accept nationalization if they understand
that all the alternatives are worse. In fact, this may have been exactly
the point of the bank rescue plan Obama's treasury secretary, Timothy
Geithner, announced shortly after that interview. A key element of the
plan involves a mandatory "stress test" for the country's biggest banks,
which sounds remarkably similar to Hempton's third-party auditor and
Sweden's Bank Support Authority. It could turn out to have been a smart
PR move as much as anything: Get everyone talking about the stress
tests, worrying about the stress tests, gossiping about the stress tests
- and by the time the results become public, it's hard to imagine any
recourse other than nationalization for the banks that don't pass.

The stress test is also a way to address both of the two big problems
with nationalization. Not only can it fairly decide which banks are
solvent and which ones aren't, but it also addresses the dreaded
"contagion" problem: Since investors are wiped out when a bank is
nationalized, the mere fear of nationalization can scare private
investors away from every bank, even the good ones. But if stress tests
are done on every bank and the bad ones are all nationalized at once,
the good banks are freed from fears that they might be next on the
government chopping block.

And in truth, nationalization is more than the least worst option: It
actually has a lot of benefits. It allows rapid reorganization and
write-down of debts without the associated chaos of a bank failure. It
wipes out shareholders and forces creditors to take a haircut, just as
in a normal bankruptcy. And unlike endless capital injections in return
for small stakes, it's a fair option for American taxpayers, who deserve
to own more than just a minority share if they're investing more than
the bank is worth in the first place.

Nationalization also solves the problem of valuing toxic assets: The
government can simply sit on the stuff until the market turns up and
then sell it off for the best price it can get. There's no need to
immediately value it at all. Most important, with the full faith and
credit of the United States government behind them, nationalized banks
can be recapitalized and made into functional credit providers again.
And as soon as they're back on their feet, they can be sold back to the
private sector, as happened in Sweden. Taxpayers will still lose a lot
of money on the deal - there's really no way of avoiding that at this
point - but nationalization keeps those losses lower than any of the
alternatives.

And there's one more thing about nationalization to keep in mind: We
already do it all the time. The FDIC now takes over small banks every
week, and among bigger institutions the government has already
effectively nationalized Fannie Mae, Freddie Mac, and insurance giant
AIG. And for the most part, life goes on as usual. If Citigroup or Bank
of America were taken over, the board of directors would be dissolved,
some of the senior staff would be replaced, shareholders and bondholders
would take a hit, and the bank would continue running as normal except
with a stronger capital base and government guarantees behind it. Then,
in a few years, it would be refloated and put back in private hands.
It's not as scary as it sounds.

As finance blogger Steve Waldman has put it, "real capitalists
nationalize". The fundamental principle of a free market system is that
ownership and control of failed enterprises should reside in the hands
of whoever buys up the corpse. If that's the government, then that means
nationalization. This may be why temporary nationalization has won the
support not just of mainstream economists like Nouriel Roubini and Paul
Krugman, but of no less a free market acolyte than former Fed chairman
Alan Greenspan. "It may be necessary to temporarily nationalize some
banks in order to facilitate a swift and orderly restructuring", he told
the Financial Times in February. "I understand that once in a hundred
years this is what you do".

A version of this piece will appear in Mother Jones' May/June issue.

http://www.motherjones.com/politics/2009/03/real-capitalists-nationalize


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