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Free Market Bank Nationalization
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.
Posted by Alex Tabarrok on February 17, 2009 at 07:31 AM in Current Affairs, Economics | Permalink
Comments
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.
Posted by: Morten at Feb 17, 2009 7:46:04 AM
Great post, but don't normal business only go bankrupt when they actually can't pay the bills, not just when some people call their balance sheet insolvent?
The confusion seems to stem from the idea that we are going from free banking to government nationalization. We don't have free banking. It's regulated, government insured, subsidized and and incentivized.
Posted by: Andrew at Feb 17, 2009 7:47:58 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.
Posted by: fusion at Feb 17, 2009 7:55:58 AM
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. 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? 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.
Posted by: Tyler Cowen at Feb 17, 2009 7:57:03 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.
Posted by: Jason (the commenter) at Feb 17, 2009 8:00:19 AM
Yeah! My comment meant what Tyler said. The difference between bankruptcy and nationalization is that facts decide bankruptcy and the government decides nationalization.
Posted by: Andrew at Feb 17, 2009 8:39:44 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.
Posted by: Richard White at Feb 17, 2009 8:53:18 AM
The debate on nationalization is somehow misleading. Nationalization means "the act of taking an industry or assets into the public ownership of a national government or state". Now pay more attention to the words public ownership. In fact this may refer as well to common (full-community) non-state ownership. This is to say that, in my proposal of "GOOD BANKS", there might be a public ownership in the sense that taxpayers, whose money is largely being used for recapitalization of banks, will possibly own the new good banks (private-public partnerships?).
It makes sense to start breaking up the largest banks and selling off individual operations to the public sector. This is also a way and a process to create GOOD BANKS and avoid strictu sensu nationalization.
Posted by: M.G. in Progress at Feb 17, 2009 8:56:50 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.
Posted by: David Heigham at Feb 17, 2009 9:05:23 AM
This is why I have been advocating nationalization of insolvent banks. Although I am generally against government intrusion into the private sector, large banks are quasi-public institutions. Due to government guarantees, such as deposit insurance, covering banks losses are already the taxpayer's responsibly. The sooner we nationalize and liquidate the assets of insolvent banks (essentially a form of bankruptcy), the sooner we will have a functioning private financial sector. Once we have restored private banking, we can debate the moral hazard and free-riding practices introduced by government guarantees.
Posted by: Ian P at Feb 17, 2009 9:21:04 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.
Posted by: Bob Murphy at Feb 17, 2009 9:32:27 AM
Notice that we do not call a bankruptcy procedure, nationalization, even though it typically occurs under the auspices of a government employed judge.
That's because they're different things. Nationalization involves the state taking ownership of a going concern and running it. Bankruptcy involves legal oversight of the unwinding of the credit process, but it's rare that the government will actually set prices, order supply, pay wages, etc.
Posted by: Joshua Holmes at Feb 17, 2009 9:41:55 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.
Posted by: Ironman at Feb 17, 2009 9:42:20 AM
"Speed Bankruptcy" can work pretty easily because the U.S.'s biggest banks have about $1 trillion in long-term debt on the books. Wiping out those bond claims would probably take us most of the way to solvency.
See the link in my name for details---my last slide has long-term bond data from the 10-q's of the biggest TARP recipients. $1 trillion total.
And even if you have to dip below long-term bonds, depositors are still probably fine, though it would take a couple of accountants a half a day to run the numbers: Citigroup has $2 trillion in ostensible "assets," but only $700 billion in worldwide deposits. So more than half of Citi could be junk mortgages, etc., (unlikely) and Citi would still have enough assets to pay off 100% of depositors.
Indeed, as Alex and Luigi Zingales have noted, our dithering over speed bankruptcy/receivership/pre-privatization reveals the power of the banking lobby.
A good time to read my colleague Carlos Ramirez's paper: "The $700 billion bailout: A public choice interpretation!" He showed that the GOP House members most likely to switch their votes on the bailout were those who received PAC contributions from the American Bankers Association....
Posted by: Garett Jones at Feb 17, 2009 10:16:49 AM
Wrong assumption: in most Chapter 11 bankruptcies I have worked on, the current management survives largely intact.
Posted by: Norman Pfyster at Feb 17, 2009 10:36:25 AM
What's the hurry? It seems the people who don't believe in liquidations in a recession want to liquidate the banks lickety split.
"Regulators plan to assess the potential losses a bank could face over the next two years, rather than the typical one year,"
"The government is also expected to look at banks’ exposure to derivatives and other assets normally carried off their balance sheets, and make sure that banks also carry an additional capital cushion."
It boggles my mind that the gov't continues to propose the opposite of what makes sense to me. Nothing new, of course, but this is just algebra, not philosophy. The time for extending the outlook, increasing capital requirements, and checking to see if banks are in trouble was BEFORE they got in trouble. If this situation is going to last two years, then they better put more thought into the stimulus. If it's not going to last two years, then the enhanced stress test is going to flag false positives. If it lasts two years, it will be over.
"Their assumptions will be guided on a “worst case” basis."
Do they really think things are going to get worse? Really?
The problem with zombie banks is lending, right? Are people borrowing?
The problem with bankruptcy is systemic risk, right? Are people not aware of counter-party risk at this point?
The market is bad at pricing right now. The government is worse even when they use the market to do it and call it mark-to-market. Just don't prop up the trash assets for a decade. But, why force the issue until the issue forces itself?
Why pro-actively punish the management that got into this mess when all the managers did it? I don't think the management is about to relax lending standards too far. Is there a pool of unemployed finance managers that can be tapped for their specialty in rescuing bad banks? Why not leave the 'experienced' ones in place?
"The future losses for some banks are staggering by CreditSights’ estimates: Wells Fargo, $119 billion;"
Wells Fargo has $128 billion in cash. Of course, bank assets can go poof faster than average, but who didn't know this?
A banking system collapse is an opportunity for change, but not the kind of change that is just more of the same. Keep the tinkering, and keep the change. BANKruptcy, it's right there in the word!
Posted by: Andrew at Feb 17, 2009 10:52:26 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.
Posted by: Don the libertarian Democrat at Feb 17, 2009 10:54:17 AM
A much better analysis of the situation from someone who understands the banking system.
http://brontecapital.blogspot.com/2009/02/bank-solvency-and-geithner-plan.html
The plan by Garret Jones would not only wipe out all the money that SWF's have put into the banking system it would essentially destroy every major bank in the United States.
Posted by: bill at Feb 17, 2009 10:56:38 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.
Posted by: CapVandel at Feb 17, 2009 11:57:35 AM
“I believe that bank nationalization is now very likely. It may even be desirable.”
Tell us exactly why it “may even be” desireable. What is your criteria?
By the way, while You are at it, please let us know where, in that ignored document we call the constitution, do we find the authority for the federal government to nationalize banks.
Even if we assume the government could run banks more effectively and efficiently than it does its own enterprises (the VA, USPS and all those agencies that routinely fail GAO audits in ways that would subject private managers to SEC sanction come to mind),the evidence is wanting- a sense of exigency among the political classes does not provide for authority for them to declare economic martial law.
“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.”
Oh please. If you are saying bankruptcy is the economic substance of the transaction-then we have bankruptcy laws and courts to effect an orderly liquidation of insolvent enterprises. What you are saying is inherently unviable businesses can somehow be (or appear to be) made capable of being resurrected by virtue of government ownership.
Yet there is substantial evidence the present situation was caused because the government attempted to allocate capital according to political, rather than economic concerns.
If it looks like a duck and quacks like a duck, it’s a duck. I’m reminded of the old comic skit where (Rob Schneider?) said, “steroids are like vitamins, only better”. The result will be the same-electoral hypogonadism. Only fools will be fooled by wordplay.
Every day we get conflicting prescriptions from academic economists. The more they are examined for effectiveness, clarity, consistency and other attributes one would expect in a truly knowledgeable series of commentaries, the more it is obvious that those prescriptions are alchemy, not chemistry.
I’m guessing that it “marginal revolution”, you are the advocate of revolution.
Posted by: Superheater at Feb 17, 2009 12:14:23 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.
Posted by: Federalist at Feb 17, 2009 12:14:52 PM
Now I see what you're grumpy about (and you should be). FWIW, sometimes the things said at MR are more shocking given who is saying them.
Posted by: odograph at Feb 17, 2009 12:16:37 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.
Posted by: DocMerlin at Feb 17, 2009 12:43:26 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.
Posted by: mickslam at Feb 17, 2009 1:17:29 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.
Posted by: mickslam at Feb 17, 2009 1:19:13 PM
