Against Bank Nationalization

With options, we often talk about them being in, out or at the money. When options are in the money, there is a high probability of receiving a payoff. When options are out of the money, there is a low probability of receiving a payoff. When options are at the money, it could go either way.

The same is true of banks. There are some banks that were cautious during the boom era, and their underwriting stayed conservative. There are others that were so aggressive that once the results of their sloppy underwriting / investing begin to be realized, it will be obvious that they are deeply insolvent. Then there are those banks that hang in the balance. Which way will they fall? Will they survive or not?

I’m not in favor of blanket nationalization of banks. My best example is the stupid move by Hank Paulson where he forced bailout money on a bunch of big banks, with no attention to whether they needed the money or not.

Who could use the capital? The banks that have big holes in their balance sheets can’t use the capital, because it will just plug holes, and maybe it will not be enough. Those that are healthy don’t need the money, and there is a public policy reason why the government should not forcibly buy stakes in solvent companies. But those that are on the brink could really benefit from a capital injection. Anything to remove the uncertainty, and the high cost of incremental capital due to uncertainty over survival.

My point is that our dear Government, should it decide to intervene in the banks at all, should aim its capital injections toward banks that are on the cusp of creditworthiness. (On the cusp assuming that assets and liabilities are fairly valued). Those that will likely eventually be dead should be declared dead, the assets absorbed by RTC 2 (in concert with the FDIC), and the liabilities absorbed by other local banks. Those banks that are healthy should continue on. Giving them more capital in order to lend more is a cute idea, but really, why should the government get involved if there is no crisis? Many solvent banks are looking for quality borrowers now, and finding few of them.

An aside: Why are we giving money to bank holding companies? If there is trouble in the regulated subsidiaries there might be a reason to help there directly, after cutting off the subsidiaries’ ability to dividend back to the holding company (and watching transfer payments — a good transfer pricing accountant is worth his weight in gold.) Let the unregulated subsidiaries die, and the holding companies too. If there are excess assets of these entities, let them be distributed through chapters 11 or 7 of the bankruptcy code. I understand exceptions for systemic risk reasons, but if the operating regulated banks are firewalled, that shouldn’t be as big of a problem.

I’ve been a critic of the industry that I grew up in for a long time, but the state insurance regulators have a better handle on their companies than the banking regulators do from a solvency standpoint. The insurance risk models work better, even though the companies are more complex. Imperfect as the insurance risk-based capital models are, they captured much of the action. The banking regulators did not get as much data, and did not see the damages that could occur in a real credit bust, because many were obscured by securitization and derivatives.

There is no need to nationalize the banking system. Set up RTC 2. Let the regulators look at the banks on an asset-by-asset basis, and analyze what the hard-to-value assets are worth. Compare values across companies to make fair comparisons. Do triage then. Send the insolvent to RTC 2. Pump some money into the operating banks that are marginal, after cutting off dividends to the holding companies. Let the healthy banks look for opportunities on their own.

Our existing legal framework can deal with operating bank solvency problems. We did not need something as big as TARP 1 to solve issues at the operating banks… but if we are profligate in handing out money to bank holding companies, then even TARP 2 might not be enough to deal with all of the mess.

-==–=-==–==-=-=–=-=-=

One more note: There have been times in insurance regulation where the regulators looked the other way and said to themselves, “Meh, the company is insolvent if we marked it to market today, but if I just give them a few years, operating profits will bail them out. We didn’t pay close enough attention to the issues involved in the new assets they bought or new liabilities they issued, so I will be embarrassed in front of the Governor, legislators and media if this company goes down. I will forbear for now.”

And, about half of the time, that strategy worked. Half of the time it didn’t, leading to a deeper hole and deeper embarrassment. In more than a few cases where it worked in the short run, in the long run, the management culture of a firm that survived did not learn the lessons of undue risk taking, and blew it up again. Part of fixing the system is weeding out bad management teams.

So, when I see arguments that say, “Let the banks in trouble borrow at low rates. The positive carry will bail out their balance sheets over a period of years,” I say, “Been there. Done that. Got the T-shirt, and a Polaroid of them drinking the Kool-aid.”

Why provide a subsidy in such a haphazard way? Many banks have spent a great deal of time and effort developing low-cost deposit bases, and rotten managements should now receive a low funding cost? If banks know that the regulators will forbear, and even subsidize their incompetence, why shouldn’t they take the free option, and continue to speculate? Let the RTC 2 deal with the problem, and let them borrow at Treasury rates.

Part of the need to collapse bad banks is a need to eliminate bad management teams. Without that, the system will not reset properly as bad debts get cleared. They will get cleared eventually, but what will the nation look like when it is done? Will we still have the same level of property rights and the rule of law? Will we have a currency that is worth anything? If the last century changed the value of a dollar from a dollar to a few cents, what will happen with this century?

Comments

[Jason Rines...:]

Great points. I'll generalize a bit: RTC worked with the regulatory safeguards that were still in place stemming from the lessons learned of the cause of the Great Depression. The deregulation and re-regulating, new regulations, building the governments teams of qualifed people to manage RTC 2 all take time. Scale of 1987 S&L/Junk Bonds is far different then now and vastly more complex. So was market pyschology of confidence in the financial community & political system which was bad then for a short time but seems DESTROYED now. My point? We do not have the time to properly establish RTC 2 at this point without further prolonging depression and further permanant real wealth creation destruction.

Nationalizing hurts sentiment a bit further for a quarter or two until the market sees the new leaderships teams but to me nationalizing would have a much bigger confidence boost to the market and with far less litigation. It would also allow the country to decide on a future role of the Fed and faster re-regulation in the process. Pros and cons indeed.

What would be great is if the public and government could collaberate in a month to put forecasted estimates in numbers behind either choice. I was attempting to build such a technical system of actionable plans, quantifying of numbers, voting, screening of talent by category etc but it's not ready yet. A pity. Those emerging leadership with tools and knowledge base don't have the funding/resources to execute so quickly and current leadership with funding has no tech tools to expidite the process.

I have some credentials in Washington but only a little. I picked up the phone many times but the current leadership said 'the benefits and value proposition sound great but we dont know you enough so we won't even bother to look at a plan'. This fact further quantifies your article point of 'management must go' Mr. Merkle. I don't take it personally, I was just attempting to serve. Market Intelligence Software is a bi-product of what I do which is Consumer Healthcare and Higher Education marketing.

I agree that leadership in Washington and Financial community is poor and agree the reason is the incentives are gone or there is no real fear of loss (socialized losses). I have observed in my businesses over 15 years that it doesn't matter why an employee becomes ruined, they are ruined for good at YOUR organization. They relearn values the hard way in the free market or retire. Mis-managers must be expunged radically and quickly to regain confidence. There's some early confidence with the new President (despite me personally not agreeing with some of the members of the financial leadership team), the financial community management reflecting positive change would really boost confidence.

Jan 23 12:31 PM

[Yankee Runn...:]

All of this inside the box thinking will only lead to a bigger mess. How about getting rid of the fractional reserve banking that has created this mess. Allowing banks to create money from thin air at a 10 to 1 ratio is an obvious Ponzi scheme. As long as things are going good, everything works fine. As soon as confidence is gone (take a look around), there is nothing quite like a run on the bank when everyone realizes that their money was produced by air. Right now, the only ones entering money in the Ponzi scheme are the US taxpayers. It is not a good position to be in, the last one in. Maybe a better question for today is who exactly is taking the money out of the scheme today.

Jan 23 01:40 PM

[SW Richmond:]

Credit Default Swaps make nationalization impossible, as nationalization would certainly trigger payouts and cause more Lehman-like troubles.

That IMO is why TARP was created, and the resultant chaos from CDS collapse is the martial law event which Paulson famously threatened.

Damned if we do, damned if we don't. The Fed's long-term solution is going to be monetizing Treasuries and using the money for endless "capital injections". But there will be no nationalization.

Jan 23 02:37 PM

[Bill Thompson:]

Although i dont think anyone wants it, i dont know how banks will survive the rest of the year, good read here crashmarketstocks.com

Jan 23 02:44 PM

[jsc173:]

First, Paulson's "take the money or you can't leave the room" approach with the first nine banks was just his way to create greater leverage over those banks. As a shareholder, the Treasury can make more noise. He knew they didn't need it, but he wanted them to be more accountable than they would otherwise be.

Of course, a couple of them have now proved that, not only did they need it, they needed much more.

I still feel we will not see a true "bottom" unless one of the big banks still remaining is (given time to prove they can't survive) allowed to fail, their assets truly marked to market, viable businesses sold, toxic residue liquidated.

Until then, we will see the merry-go-round of coming back periodically for another dose of whatever the acronym is of the moment -- TARP, CPP, whatever.

The criminal part of it is many of the banks that have completely "fessed up" and marked their assets to market and are adequately (but not necessarily well) capitalized, are the ones still lending while the big banks aren't. The TARP money wasted on the big/bad banks would have ensured the "borderline" banks' survival, which is now in doubt.

Jan 23 02:49 PM

[John Lounsbury:]

jsc173 - - -

I think the original force-feeding implementation of TARP was done specifically to protect CitiGroup from scrutiny. The leverage aspect you mention is another possibility. Maybe both were in mind.

SW Richmond - - -

If a bank is nationalized by simply buying the equity at current market price and retains its structure, including its name, the CDS exposure is a non-factor. The bank still exists, just with different management. The process requires the bank, now owned by the government, to have independent management (not the current management) and an independent board of directors, with a firewall between the bank and the government. In other words, until the bank's assets are sorted out and a viable commercial entity created that can be put back in the market via IPO, the government would own the bank, but not run it.

We are already doing this with a lot bigger investment (C BAC AIG) than just buying the equity, but, so far, we are keeping the miscreant management who destroyed these companies. It can be done cheaper and probably more efficiently, by management not trying to hide the skeletons.

There is a lot of discussion about various aspects of "nationalization" going on this week. I think there may be a lot more sorting out of the options before we get a complete picture. Hope you can keep looking at this and continue to weigh in with your opinions.

YRDog - - -

Fractional banking with proper underwriting is not a problem at 10/1. Fractional banking leveraged up to several times 10/1 is what got us in trouble, and the high leverage with inadequate underwriting got us into a disaster.

IThinkBig - - -

Good points about weighing pros and cons. I particularly found your point about the time required to set up an RTC2 being too long pertinent.
Simply having the government buy a failed bank, clean out the management and have the new management sort out the assets (described in my discussion with SW Richmond) before taking the bank public again through an IPO could be a lot quicker and cleaner, with much lower cost. The biggest problem might be the firewall needed between the bank operation and interference by politicians.

David Merkel - - -

Valuable article. I don't think we are at a solution yet, but the more ideas we discuss, the closer a solution is. As YRDog suggests, thinking outside the box may yet come up with something valuable. If several think outside different sides of the box and then discover they meet at some point out there, there may be a eureka moment. Each of the ideas (outside the box) may not stand on their own, but maybe they can come together constructively.

The discussion I see on this subject in the past couple of weeks is so much more creative and constructive than what was going on late last year. Let's keep pounding on this.

Jan 23 03:43 PM

[Jason Rines...:]

Lack of price discovery and as you said, endless 'capital injections' is killing the economy and any potential for real recovery that doesn't take a decade or more.

Nationalize, set all CDS contracts in the U.S. at .50 cents on the dollar so the market has the floor, then investigate the legitimacy of the contracts (yes, I know that will take years). The outright fraud is investigated and the rest priced to market conditions of 2011 or 2012 (how long takes price discovery would take). As for Paulson, we know where his loyalties lay and that is not with the 200 M working Americans that are the pillars for the elite. And to me, it's not martial law situation that Paulson stated would happen, it's the other sovereign debt holders that would punish us geopolitically. Damned if you do, damned if you don't. You are correct sir. But the American citizenship will have it there way, it simply takes time for the Joe6pack to do there own 'discovery process'.


On Jan 23 02:37 PM SW Richmond wrote:

> Credit Default Swaps make nationalization impossible, as nationalization
> would certainly trigger payouts and cause more Lehman-like troubles.
>
>
> That IMO is why TARP was created, and the resultant chaos from CDS
> collapse is the martial law event which Paulson famously threatened.
>
>
> Damned if we do, damned if we don't. The Fed's long-term solution
> is going to be monetizing Treasuries and using the money for endless
> "capital injections". But there will be no nationalization.

Jan 23 03:58 PM

[Jason Rines...:]

Great point from Richmond on the firewall. Agreed, need to keep pounding this out. That think tank tech will be ready in less then two weeks and I'll invite the owners and top rated bloggers from SA, Mish and Naked Capatalism.

We may not have the tech ready to run simulations through the forecasting of the various proposed solutions but perhaps I can get in touch with someone like Menzie Chinn and get some help on that piece. While this work may not ultimately matter to the decision makers in Washington immediately, it will be highly relevant and useful soon enough. Excellent that collaberation has begun in earnest from emerging leadership. You gentlemen give me encouragement that this is still our country, not just a kleptocracy.

> IThinkBig - - -
>
> Good points about weighing pros and cons. I particularly found your
> point about the time required to set up an RTC2 being too long pertinent.
>
> Simply having the government buy a failed bank, clean out the management
> and have the new management sort out the assets (described in my
> discussion with SW Richmond) before taking the bank public again
> through an IPO could be a lot quicker and cleaner, with much lower
> cost. The biggest problem might be the firewall needed between the
> bank operation and interference by politicians.
>
> David Merkel - - -
>
> Valuable article. I don't think we are at a solution yet, but the
> more ideas we discuss, the closer a solution is. As YRDog suggests,
> thinking outside the box may yet come up with something valuable.
> If several think outside different sides of the box and then discover
> they meet at some point out there, there may be a eureka moment.
> Each of the ideas (outside the box) may not stand on their own, but
> maybe they can come together constructively.
>
> The discussion I see on this subject in the past couple of weeks
> is so much more creative and constructive than what was going on
> late last year. Let's keep pounding on this.

Jan 23 04:07 PM

[Jim Myrtle:]

"Nationalize, set all CDS contracts in the U.S. at .50 cents on the dollar so the market has the floor"

Why? CDS contracts on US government debt are about 50 bp. Holders should suddenly get $0.50?

"then investigate the legitimacy of the contracts"

What do you mean? What is an illegitimate CDS contract?

On Jan 23 03:58 PM iThinkBig wrote:

> Lack of price discovery and as you said, endless 'capital injections'
> is killing the economy and any potential for real recovery that doesn't
> take a decade or more.
>
> Nationalize, set all CDS contracts in the U.S. at .50 cents on the
> dollar so the market has the floor, then investigate the legitimacy
> of the contracts (yes, I know that will take years). The outright
> fraud is investigated and the rest priced to market conditions of
> 2011 or 2012 (how long takes price discovery would take). As for
> Paulson, we know where his loyalties lay and that is not with the
> 200 M working Americans that are the pillars for the elite. And to
> me, it's not martial law situation that Paulson stated would happen,
> it's the other sovereign debt holders that would punish us geopolitically.
> Damned if you do, damned if you don't. You are correct sir. But the
> American citizenship will have it there way, it simply takes time
> for the Joe6pack to do there own 'discovery process'.

Jan 23 05:52 PM

[Steven Hansen:]

"Why are we giving money to bank holding companies?"

this is tip of the iceberg on how haphazard the whole scheme is. the objective is to maintain the banking system. holding companies have non-banking entities. we need a complete reassessment of the goals and procedures being used.

Jan 23 08:50 PM

[morph366:]

There was an interesting remark in one of the UK newspapers this morning about how the way that CDO's were created is similar to sausage making. In order for the forensic accountants that are now being employed in their hundreds to try to estimate how big a black hole we have it is somewhat like having to deconstruct the sausage back into the pigs from which they came.
Not a very pleasant process and it will take a very long time - maybe that's what the policy makers are hoping for i.e. it will take so long to ascertain just how scary the number is that they will have exited their positions and be enjoying their lavishly endowed pension plans.

Jan 24 06:01 AM

[Old Trader:]

I recall reading several times, early last year, about Buffet's experience with CDOs. It seems that he bought a reinsurance co. through BRK, and spent 6 YEARS analyzing and unwinding the various "structured finance" securities it held....and that was just 1 company....That does NOT bode well..

Jan 24 12:43 PM

[Smarty_Pants:]

"The Fed's long-term solution is going to be monetizing Treasuries and using the money for endless "capital injections"." - SWRichmond

I agree 100%. Monetizing is the only 'solution' which ties up every loose end except one. Inflation.

It's no longer a matter of "if", but "when" IMHO.

Jan 25 03:39 PM

[vreporter:]

Nationalization is not even an option - so that far, I agree with you.
Why it has even been debated as an option in the US shows how many misunderstand the US banking structure vis-a-vis UK, for example, let alone Ireland!
The big banks' holes that are only being plugged with govt. funds can be relieved/removed.
There is an optimal compromise somewhere in between since NO solution has a direct fix WITHOUT DOING MORE HARM THAN GOOD.
The big banks stay but their pieces get rearranged amongst themselves, as well as others.

Jan 25 05:53 PM