Banks: Nationalize, Cleanse and Get It Over With

Washington is doing what Washington does best. Resurrecting old ideas and dressing them up as a new solution. The latest is the “aggregator bank”. Some sort of financially engineered solution to the ongoing problem with our banking system. It’s just new lipstick on the old TARP pig.

The concept is the same one they have tried to sell since the beginning. Buy the bad assets from the banks and do something, anything with them. No plan except to get them out of the banks. Logically, some sane minds outside the Beltway have said from the outset, “Yes, but what price do you intend to pay for these assets?” The newest proposals try a bit different spin but still ignore the essential question. Do the banks, their managements and their shareholders get a sweetheart deal or do we buy these at market and probably tank the banks?

Into the fray comes our old buddy Willem Buiter. Fortunately, he is less verbose than usual and gets to the point quickly. His solution is to simply nationalize the banks, set up a clearing bank ("bad bank" in the terminology of the day) to take the toxic stuff and then reconstitute the rump institutions and sell them off. Along the way he gets lost in trying to do too much in terms of using the concept to spur lending but we can talk about that another time.

The beauty of his proposal is that he diffuses the argument about how to pay for the bad stuff. Here is his logic:

In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.

Note that the guarantee component of the Bank of America package (like the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets. The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended - for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets. There is a valuation embedded in the guarantee or insurance offered to Bank of America and Citigroup: the state will compensate the banks if the value of the securities falls below a certain level. But the valuation is rather well hidden, and may not be revealed unless the guarantee is actually invoked. Also, guarantees are off-balance sheet, and politicians, like bankers, like that.

The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established. This may never happen, in which case the bad bank would hold the toxic assets to maturity.

The publicly-owned banks would be reprivatised when financial markets stabilise and the economy recovers. It would be good if a better regulatory and supervisory regime for banks and other highly leveraged entities were in place by that time.

Ironically, by partially nationalising some of the banks, by making this injection of public capital expensive financially and as regards other conditionality, and by holding the threat of possible future (partial) nationalisation over the remaining banks, the authorities created an incentive structure that is biased strongly against bank lending, and against bank risk taking generally. The best escape from this unfortunate halfway house is to go to temporary full public ownership of all the banks. It would be cheap. It should not cost more than £50bn for the state to buy the rest of the UK high street banks. It could wait a while and get them even cheaper - possibly for nothing. But time is more precious than money in this case.

I excerpted more of that than I originally intended but his proposal deserves the space. Buiter argues that his proposal will also encourage or facilitate lending. I personally think that is something we need to be careful about but, again, we can argue that in another post.

Brutal medicine, no doubt. Sometimes it has to be taken and now would seem to be one of those times. Unless we move towards a comprehensive solution, not half-measures, we risk a loss of confidence among the rank and file. Already there is a sense that the pain is not being felt equally. Left to fester, that can become an ugly thing.

Comments

[Peter D. Co...:]

is fine as far as it goes, but what is needed is to just close these banks. all the government is doing now is subsidizing the big banks, making it more difficult for a well run bank to make a profit.

we need profitable banks, we don't need banks that are bankrupt, and we don't need to resuscitate them once they are that way.

for these big banks that are in trouble, tough luck.

Jan 19 10:00 AM

[mikeg3:]

So Tom, are you short any banks and just talking your book?

BTW,I notice in your profile that you didn't have a good experience as a banker. Which bank?

Jan 19 11:01 AM

[Anne:]

All the aggregator bank has to do after purchasing these bad assets (mortgages) is to pull them all off the market and rent them out on 1, 2 or 5 year leases and/or lease option contracts, thus stopping this free-fall in its tracks.

They can use local rental agencies to do the job which will keep these people employed as well. There are plenty of families that can rent or lease a house that are currently unable to purchase. In 2 years or less, the problem is solved.

Easy.

Jan 19 11:42 AM

[Tom Lindmark:]

mikeg3,

No book to talk. Not short or long any banks.

I had great experiences as a banker just didn't play the political game well. I spent most of my banking carreer with BofA and BNP-Paribas.

Jan 19 12:23 PM

[WanderSF:]

More BS published by seekingalpha.

Jan 19 01:16 PM

[BudH:]

Why save the big boys and let people lose in the hinterlands?

blog.oregonlive.com/fi...

Jan 19 01:38 PM

[fjm48:]

I BELIEVE THAT THIS WHOLE SITUATION COULD BE AVOIDED IF THEY DID THE SAME THING AS AUTO FINANCING. EXTEND THE TERM OF MORTGAGE HOME FINANCING TO 50 YEARS WITH REDUCED INTEREST RATES OF 1-2%. JUST KEEP THE OWNERS IN THERE HOMES SO THAT YOU STABLIZE THE MARKET AND NOT SUCK ALL THE GOOD EQUITY FROM THE REST OF THE GOOD BORROWERS.

THE BANKS WOULD HAVE STABILITY ALONG WITH THE REAL ESTATE MARKET!!

Jan 19 03:01 PM

[scimitar:]

Tom,

I agree - nationalization is the simplest, most cost-effective solution. Instead of giving money to banks to waste, just take them over, fire management, cut the dividend, and wipe out the common shareholders. They may complain, but if you hold the common, that's the risk you take. I would just invalidate the toxic derivatives rather than trying to save them. It may cause pain in the short term but it will be cheaper and easier in the long run.

Unfortunately, I don't see it as being politically feasible, because as soon as you mention the "N word" you invite a whole host of rabid fools who start screeching about socialism. Nevermind the fact that the banks will eventually be privatized again after they're fixed!

Jan 19 04:28 PM

[Bill Herbert:]

It is clear that the banks should be nationalized, for we are already on the hook for a great majority of the losses. Let the equity holders take it in the shorts on this one, I say.

My solution is to nat the banks, fire the incompetent top managers (and bar a number of them for life from ever being an officer at another bank or any public corp) and then install a Board of Overseers at each bank to get the thing back to its original function. That would be making prudent loans at reasonable rates, to those individuals and businesses with a very strong chance of being able to repay the loan.

The corrupt bankers, of course, got us into this horrid mess by intentionally mis-interpreting the CRA to mean that they had been "ordered" to make loans to deadbeats and the jobless, which was never the case. Now their neocon and nincompoop apologists (like Glenn Beck) are screaming socialism, while at the same time trying to make it appear that the Govt was at fault for all the fraud, gross mismanagement, and utter lack of competence by the Bush admin.

Jan 19 08:18 PM

[Bajatexas:]

Yes, and all Intel has to do is start flying airplanes. Great idea, but the banks are not landlords and it's not as easy being a landlord as you make it sound.


On Jan 19 11:42 AM Anne wrote:

> All the aggregator bank has to do after purchasing these bad assets
> (mortgages) is to pull them all off the market and rent them out
> on 1, 2 or 5 year leases and/or lease option contracts, thus stopping
> this free-fall in its tracks.
>
> They can use local rental agencies to do the job which will keep
> these people employed as well. There are plenty of families that
> can rent or lease a house that are currently unable to purchase.
> In 2 years or less, the problem is solved.
>
> Easy.

Jan 19 08:51 PM

[DiscerningWord:]

Definitely written from the right side of the Atlantic. The nationalize midset is natural in an already socialized (or nationalised and socialised if you come from the right side of the Atlantic) set of countries with a futile mindset where opinion does not matter and free speech is essentially humor and overnight Bloomberg reporting. That's it. Why not simply get rid of mark-to-market accounting, let everyone (yes everyone in America) refinance or lock in at 4-4.5% 30 YEAR financing and then allow the loans to mature. The massive majority of loans will work out and cash flows will come in with at most - AT MOST - 5% default/foreclosure/to... default. Every effort thus far - TARP, et al. - is made by politicians to benfit politicians. Since Europe lost its freedoms 100 years ago and became a nation of neutered, albeit neat accent, people, social, national, and state chartered items seem natural to them. Don't let that happen to America. The idea that politicians are changing so much is tragic. Not one leader has stepped up with a pro-people, pro-nation, pro-free markets plan....anyone wonder why?.....or why not?

Jan 20 12:55 AM

[Moon Kil Woong:]

To believe banks getting TARP aren't already socialized is delusional. Their actions are more based upon pleasing the Fed and Treasury that are giving away billions like candy at Halloween than acting on market forces.

In fact TARP $ should be going to good banks not bad who can then use the money to help finance taking out the trash the bad firms leave behind through buyouts. Keeping the bad banks alive is silly. We are digging them out of the grave by digging ourselves into one.

Jan 20 01:49 AM

[Jet Pilot:]

The TARP is the biggest scam ever to be perpetrated on the American Taxpayer. "Let's give money the the banksters that caused the world's financial demise." If one dollar of TARP money goes to speculate on oil futures, the banksters should see the inside of jail cells.

I have sent letters to JPM, and Wells, I am asking that my credit card debt be included in the "toxic assets".

The world would be a better place if these greedy banks just went out of business. Any bank that received TARP money, should refund every account holder all the bogus fees these greedy banksters have gouged from account holders over the last ten years.

Jan 20 06:03 AM

[Andrew Hughes:]

Over $8 Trillion has been used to prop up a Banking sector that created it's own destruction. Loving free markets is not just for the good times. If they have bankrupted themselves, let them fail. With regard to holding toxic assets in a "Bad Bank", all that would achieve is postponing the problem to a future date. The Banking sector needs to be cleansed of it's unhinged casino mentality once and for all. The policies of the Fed and Treasury have so far achieved only one thing. Taxpayer funds that could have been put to real use have been squandered in the greatest transfer of wealth in History. The sad thing is the incoming Administration seems hell bent on continuing this lunacy.

Jan 20 08:52 AM

[Chris Butler_:]

Number one, why is "stability" in any market so important? Markets are inherently unstable because the components of these markets - human beings - are not inherently in any kind of equilibrium! "Stability" is a pipe dream.

Number two, why is it so important to have a "comprehensive solution" at all? How about this comprehensive solution: bank that should fail, fail? What happens after that, happens. The system will rebuild and we will learn from previous mistakes.

Number three, if we're scared we'll lose trust in our banking system, the question should not be "how do we restore that trust in these poorly run banks?" but, rather, is the current lack of trust warranted? The answer is "yes." People learn, they move on. If they pull their money out of all banks, and all banks fail, perhaps there was a problem with the current banking model. I bet a better model would be borne from this collapse.

Finally, you state that "we risk a loss of confidence among the rank and file" if we don't go full-bore nationalization. I disagree. Complete nationalization of the banking industry would immediately result in a lack of confidence among the rank and file. Look at thow markets reacted from nationalization fears coming out of Europe yesterday.

Bottom line, if you think bureaucrats can run banks better than the free market, why not let these same bureaucrats run everything? The thing about free markets that people don't quite get is that "free" also means "free" to make mistakes. Either we retain the freedom and allow for the all-too-human propensity to err, and accept the pain that some of these mistakes lead to, or we allow our "mistake free" government to try their best to do a better job by usurping freedom and accept their mistakes that were never supposed to happen. How well do think a central planner can anticipate the next move in a complex adaptive system like our economy? We need only look to the success of economic forecasts in the past. Wethermen have better records.

Sorry, I'll take my mistakes with a heavy does of personal freedom, thank you very much.

Jan 20 09:26 AM

[Ishortyou:]

it is estimated that another 2.5 trillion dollar capital injection in the financial system is needed to stabilize them, so I dont think this is over, even with nationalization.

Jan 20 11:04 AM

[PainfullyAware:]

Power Given Is Not So Easily Taken Back.

To Assume Benevolence Is Foolish.

The Government Does Nothing Well - No incentive to do so.

The System has been nationalized; Just not formally.

The Big Freak-out Continues.

Jan 20 11:35 AM

[derryl:]

The Fed is the 'bad bank', buying up nonperforming assets and now seeking to expand its power to lend directly to companies (including commercial banks)and probably states and municipalities whose ability to repay is questionable or whose repayment timeline is not acceptable to commercial lenders. Unlike commercial banks, the Fed's ability to create money and use it to buy and hold assets is unlimited. As conditions improve the assets can slowly be sold back into the market. Or they can simply be written off with no consequence to the 'bad bank' because it operates under different laws than commercial banks.

Everyone who can is deleveraging. Repaying bank loans uncreates the money that was created by the bank when it originated the loan. The rapid rise of leveraging in the 2000's inflated the money supply. Deleveraging is deflating it.

The 'currency debasement' has already happened. The new money was used to inflate prices in asset classes like housing and stocks, and to buy imported oil and other goods. Now ongoing price deflation in those inflated asset classes is 'rebasing' the currency. $400k will buy you a lot more house today than in 2006. $100k will buy you a lot more shares of stock today than is September. Your money is worth more in terms of housing and stocks. We are experiencing a major deflation.

If the Fed, or bank nationalization, or some other form of bad bank, didn't buy up the nonperforming assets, the deflation (rebasing the currency) would be extreme and the banking system would probably fall into systemic insolvency under current banking legislation. Loans were made based on then-current prices and anticipated future prices. When the value of the collateral (e.g. houses) deflates, the indebted borrower is more likely to stop making loan payments so bank assets stop performing and insolvency becomes a looming likelihood. We need functioning banks.

Look what happened to shipping when letters of credit were being withheld by buyers' banks. Goods piled up in ports and economic flows stopped in their tracks. We do not want our banking system to fail. Our economic life depends on functioning credit markets.

The commercial banking system micromanages credit flows by analyzing each and every application for a loan. This system operates under legislation and recent experience shows that some changes and some firming up are required to temper the system's tendency to exaggerate inflations and deflations.

One new rule will be countercyclical asset:capital requirements. In a rising market banks will be allowed to make less loans on existing capital; in a falling market they will be allowed to make more loans from their capital base. Expanding credit fuels rapid inflation and bubbles. Expanding deleveraging fuels rapid deflation and depressions. We can't stop the business cycle, but we can certainly temper its gyrations by the use of intelligent banking laws.

Jan 20 12:42 PM

[akapital:]

what do people think about letting people borrow against their Social Security?

What it effectively does is used future soc sec entitlement as default insurance and would get a serious injections of money into the economy. So when people are paying off their house they are also putting money back into their retirement?

Jan 20 01:23 PM

[Duude:]

It seems to me it would be far less expensive and much more manageable to temporarily reform would be to drop mark to market accounting for some period of time, rather than nationalizing the banks. Of course, I'm assuming that any nationalizing of the banks would carry with it intention to recapitalize and spin them back off into private hands. If we're talking about permanently nationalizing, no way no how should we even talk about such a bad idea. If you thought you knew what moral hazard was before, government will be happy to show you how much worse it can get.
I don't like the idea of suspending mark to market but it is much more favorable a choice than nationalizing.

Jan 20 04:32 PM

[User 265729:]

Some of this has the ring of: We need to destroy the village to save it.

I find it somewhat ironic that our country spent trillions of dollars fighting the Soviet Union and the Eastern Bloc with their planned economies, five year plans, state banking system, state production autos (Lada and Tribant), only to take steps to become more like them. So 20 years after the fall of the Berlin Wall look at us.

So little faith in the market system... Too bad... It does work if government gets out of the way.

Jan 20 04:43 PM

[morph366:]

If the ultimate goal is to re-inflate the consumer economy and real estate values then the simple question is how best to achieve that goal.
Seems to me the best solution is to bite the bullet and allow the banks to get rid of all of the illiquid assets and park them for a few years in a public trust. Keep the banks private as they will get the re-inflation job done a lot sooner than waiting for a nationalized banking system and endless infrastructure projects. When the taxpayer sees the value of his/her home going back up and firms hiring again they'll soon forget the fact that the government overpaid for some dodgy pieces of paper at some point in the past

Jan 22 01:33 PM