Bank Nationalization - The Max Holmes Proposal

In Sunday’s New York Times, Max Holmes offers a variation on the “bad bank” and “bank nationalization” debate. Mr. Holmes is an adjunct professor at the Stern Graduate School of Business at New York University, chief investment officer of an asset management firm, and a former analyst at an investment bank.

His proposal essentially involves a process of creating a “bad bank” spin-off for any insolvent bank. His proposal is based on two bank rescues in which he played a role in his investment banking days. He proposes:

Instead of printing up money to create a huge, unwieldy “bad bank,” I would recommend creating separate bad banks for each of these four institutions (and perhaps some others), and financing them by having the government assume an amount of each good bank’s corporate debt equal to the value of the troubled assets put into the bad banks.

It would work this way: The managements of each of the four banks would be given a one-time opportunity to sell any assets (from vanilla domestic corporate bonds to the most exotic foreign derivatives) to a new bad bank owned entirely by the government. The only condition would be that the four big banks would have to convey the assets at year-end, audited book values, not at some guess of what they might be worth down the road.

Mr. Holmes predicates his proposal on a commonly held belief that the “toxic” assets ultimately have value that is not recognized by current accounting standards. This is the basis for all good bank –bad bank and bank nationalization proposals. If this assumption is untrue, then classic bankruptcy is the only solution to bank insolvency. This assumption leads Mr. Holmes to state:

While these assets are “toxic” to the banks right now because they are illiquid, volatile and at depressed prices, the government can hold on to them until they regain value, making it an investment for the taxpayer that could pay off handsomely in the end. The public would have transparency, as it would know what the assets are and how they are liquidated over time.

What is good about this proposal? Here are a few things:

1. This is a nationalization process that does not involve taking over the entire structure of any individual bank.

2. This is a nationalization process that could involve private capital investment in any or all of the “bad banks”.

3. This is a process that involves complete separation, on a bank by bank basis, of the risks to future viability. The government super structure involved is minimized.

4. It is a process that can be structured with management independent of government. In other words, it is a process that can have government ownership (or partial ownership), but avoid government management. This has been a key requirement I have been pushing in my discussion arguments. This is discussed further later.

5. The government does not have to take on additional debt or print additional money on day one of the reorganization. As Holmes wrote:

Most important, however, the government would pay for these troubled assets not by printing new cash, as under most current bad-bank proposals, but by taking on an equal dollar amount worth of each bank’s “liabilities” — that is, notes, bonds and other obligations that the bank owes to other lenders or investors.

This does lead to a question, (3), discussed below.

What are the possible problems or questions about this proposal? Here are a few things:

1. Do “toxic” assets really have higher future value? This is a rhetorical question if, in fact, we have gone so far down the current road that we can not avoid government underwriting of these assets.

2. Can solvent banks actually remain after the new “bad” banks are formed? In other words, is enough known at this time to effectively sort out the “good” and “bad” assets. If this is a process that will take a few years, how does this proposal get implemented in 2009?

3. What happens if “good” assets turn bad in 2010 or 2011? Is there a way for the 2009 “good” bank structure to contain sufficient loss provisions for such eventualities? Doesn’t this process risk extending a period of restricted credit for several years?

4. How much future liability does the government assume if the hasty partition of “good” and “bad” assets in 2009 turns out to have been much in the “good” bank’s favor? If that happens, the banks could prosper at the expense of future government expenditure. The taxpayer (as investor) would have made a very bad investment and the “bad guys” made good would benefit at taxpayer expense. Mr. Holmes assumes the government would be able to avoid this by proper selection of liabilities to offset “bad” assets:

The government, not the banks, would choose which liabilities it would take responsibility for. Presumably, federal officials would assume notes and bonds with maturities roughly in line with the real durations of the troubled assets they are taking off the banks’ hands, mainly 3 years to 10 years. This would allow the government to pay down these liabilities through the cash flow that will be generated from the troubled assets themselves. The bad banks would have a proper match between assets and liabilities, a critical ingredient for managing any investment pool.

If proper evaluation of assets in a short period of time is problematic, is evaluation of liabilities problem free?

Mr. Holmes recognizes that the government is not equipped (or staffed) to handle the money management tasks necessary to operate the “bad” banks and dispose of the assets over time:

The bad banks would then be able to work out their troubled assets over time rather than sell them in a fire sale — similar to the successful solution imposed on the savings and loans that were taken into the Resolution Trust Corporation in the 1990s. The government could hire professional money managers, working under an incentive-heavy compensation plan, to oversee the liquidation. (Disclosure: firms like mine might be potential candidates for such a job.) This would be far wiser than leaving it to government bureaucrats, who might simply seek to sell as many assets as quickly as possible and close the files.

I would go further, as discussed previously in other articles. The entire management structure, including board of directors, would have to be separated from the government by a firewall. One area that occurs to me is the question of mortgage resets. While government support of mortgage resets may or may not be a good policy, whatever is done in that area must be done with isolation from the management of these “bad” banks. If mortgage resets are a correct business practice for a bank (and, in many cases, they may be) that should be a business decision and not a political one.

Government ownership of banks, for a time, may be an acceptable circumstance. Government operation of banks is fraught with peril.

Not withstanding all the questions and problems I have raised, Max Holmes has added some excellent perspective to the bank nationalization debate. Read his Op Ed in full. He details a number of interrelationships that can be beneficially resolved if this process is done correctly.

Comments

[D. McHattie:]

"The taxpayer (as investor) would have made a very bad investment and the “bad guys” made good would benefit at taxpayer expense."

This is my main concern and the main reason I prefer full take-over of insolvent banks. If we let our conscience be our guide we have no choice but to take these banks over in their entirety.

Feb 02 07:32 AM

[brando:]

Something we taxpayers need to "get over" is this feelling that Wall Street and bank equity is getting a free ride on our backs. We taxpayers elected the Congressional officials who enabled and arguably caused this meltdown through their cozy relationship with Fannie and Freddie, thier adamant refusal to consider stricter oversight of the then politically correct GSEs (hearings documented and visible on YouTube), and the ill-conceived vote-garnering imposition of the so-called Community Reinvestment Act which forced lenders to extend credit based on demographic profiles rather than sound lending standards. Wall Street has taken a beating in terms of job losses and equity devaluation, but for some reason displaced finance workers are ignored or portrayed as being less human than union members. Voters who elected the politicians who enabled and compounded this mess need to take the medicine. If our democratic republic properly functions, voters will learn their lesson and stop electing populist socialist politicians with little or no understanding of economics.

Feb 02 08:58 AM

[Beam me up ...:]

Failed banks due to failed administrators should be allowed to fail with no net. Elsewise we're going to have a bad auto company where all the low mpg SUVs are deposited for later non-sale and a bad airline where all the low and no profit routes go to one bad carrier and a bad casino in Atlantic City where all the unbooked rooms go to a bad casino to continue being unbooked etc etc.

Feb 02 09:37 AM

[You're Kidding:]

brando - your right wing bias is disgustingly obvious.

The CRA act is not responsible for this meltdown we are in. Most of these loans are doing just fine (see Wikipedia and Business Week Mag:
www.businessweek.com/i...

Its not the "socialists" who don't understand economics, its your neo-con friends and their supporters who have forever fought for deregulation and who have been in charge of the executive dept. for the last 8 yrs (say "no oversight" a few times why don't you?)

Finally, we have an executive that cares more about the health and well being of all the people in this country rather than just the rich and powerfully placed.

Please say goodbye to unregulated, scumbag capitalism for hopefully forever. The rest of us have had enough of your lunatic, money grubbing, criminal excuse for government. I'm afraid its best this way for the vast majority of people in this country. Take off your rose colored glasses. You're blind as a bat.

Feb 02 09:38 AM

[kruser53:]

brando, Fannie and Freddie are a problem, but they are not, by any stretch of the imagination, the cause of the problem. The cause of the problem with mortgages was lending at 100% of grossly overvalued houses. To the extent that Fannie and Freddie were complicit, they are part of the cause. With as many as 50% of all mortgages (an estimate I have read - no attribution remembered, sorry) estimated to be under water in the next couple of years, the bubble in housing valuations is the substantial cause of the mortgage crisis.

The mortgage crisis is the proximate cause of the financial crisis. A financial crisis might have occurred from some other cause anyway, because we allowed unsustainable leverage and extremely high counterparty risk to accumulate in the system.

Fannie and Freddie have been mismanaged and are, at the moment, insolvent. That is a problem, but it is a serious error to propose that they are a cause, and definitely not the cause, of the current financial crisis.

Feb 02 09:47 AM

[kelm:]

Using a set of bad banks is what Germany is apparently planning. It does have the advantage of attacking the problem in bite sized pieces so to speak. While I agree that our elected politicians and regulators set the stage for the problems the fact is that the executive leadership of these banks should have looked ore deeply into what products they were laying in and what the assumptions in the models were. There were more than enough commentators and academics raising a red flag over derivatives for some years not to have done due diligence and reviewed ones positions from stem to stern looking for worst case scenarios. Even Rubin stated he really didn't understand these products.

Bank managements and boards need to be rebuilt with new blood. We are on a path where no sense of culpability is expected from anyone for this. That sows the seeds for future crises. The fact hat everyone was doing it and Washington was culpable does not absolve individuals from being party to catastrophic errors in judgment.

Feb 02 10:20 AM

[CaptainJJack:]

I realize that having govenment involved in the workout of problem banks creates a whole set of new problems, but the idea that their managements should be left alone to continue with paying bonuses and buying private jets as they wish is hypocrisy.

Can you imagine ANY of these same banks NOT being involved, when THEY are the creditor, with their own troubled borrowers?

I can tell you that reducing compensation and cutting back on private jets would be the LEAST of the actions these same banks would require of their troubled borrowers.

Feb 02 11:18 AM

[brando:]

Of course, Fannie, Freddie and the CRA are not solely responsible for the subprime fiasco. Certainly, lenders and Wall Street were complicit. But for the most part, the private sector was responding exactly as directed, prescribed and expected -- facilitating a secondary mortgage market that appeared to accommodate subprime borrowers by spreading the risk among parties who thought they knew what they were buying. If not for government interference encouraging too much credit, market forces would have rationed credit more, shall we say, rationally. Wall Street was acting perfectly rationally under the circumstances promulgated by our government's enabling institutions and legislation. The issue isn't so much over-regulation or under-regulation as it is misplaced and misguided regulation, much of which is directly or indirectly the result of corruption. Why is Franklin Raines never mentioned in all this? Do a little research and learn about his political affiliations and the amount of money he walked away with. He's just as worthy as John Thaine, Dick Fuld and countless other luminaries in the reprobate CEO hall of fame. This is not a right or left issue. It cuts in all directions and ultimately falls on all voters who continue to vote for the corrupt and incompetant egomaniacs and sociopaths that gravitate toward "careers" in politics.


On Feb 02 09:38 AM You're Kidding wrote:

> brando - your right wing bias is disgustingly obvious.
>
> The CRA act is not responsible for this meltdown we are in. Most
> of these loans are doing just fine (see Wikipedia and Business Week
> Mag:
> www.businessweek.com/i...
>
>
> Its not the "socialists" who don't understand economics, its your
> neo-con friends and their supporters who have forever fought for
> deregulation and who have been in charge of the executive dept. for
> the last 8 yrs (say "no oversight" a few times why don't you?) <br/>
>
> Finally, we have an executive that cares more about the health and
> well being of all the people in this country rather than just the
> rich and powerfully placed.
>
> Please say goodbye to unregulated, scumbag capitalism for hopefully
> forever. The rest of us have had enough of your lunatic, money grubbing,
> criminal excuse for government. I'm afraid its best this way for
> the vast majority of people in this country. Take off your rose colored
> glasses. You're blind as a bat.

Feb 02 01:10 PM

[da!:]

Lending money to people who can't pay it back to get bonuses comes from greed. Borrowing money you can't pay back because you want it comes from greed.Alowing it to take place to get elected is the state of the union. Now tell me who's fault is this?

Feb 02 02:06 PM

[Tom Armistead:]

The proposed solution - transferring equal amounts of liabilities and assets from the troubled banks to the "bad bank" or government makes good sense in that no money is actually spent and it will work if the assets do not deteriorate further.

The government can deal with further market value reductions of the assets, something many banks cannot handle with their current capital and credit ratings. The Max Holmes proposal is another way of permitting the assets to be held to maturity rather than sold at fire sale prices.

I personally take the view that a great deal of the hue and cry in favor of rigid application of mark to market accounting comes from the vultures, jackals and hyenas who expect to feed richly on the ensuing financial carnage, as if they were not already sufficiently gorged with the fruits of naked short-selling, rumor mongering, and naked CDS manipulation.

I favor any solution that avoids the fire sale and deprives the vultures of their feed.

Feb 02 02:51 PM

[henarl:]

Da!: "Who's fault is this?" - Everybody's! The real question is, who is going to have to suffer the most from it? It's not going to be the politicians, or the big shot bankers, or the Wall Street Masters of the World, or the good old boy network of corporate board members and executives. And it's not going to be the people who had nothing before and still have nothing. Guess who's left - the small businessmen, small investors, middle class workers who've lost their jobs, retirees who've lost their savings, in other words, you and me.

Feb 02 04:22 PM

[brando:]

Roger that.


On Feb 02 02:51 PM Tom Armistead wrote:

> The proposed solution - transferring equal amounts of liabilities
> and assets from the troubled banks to the "bad bank" or government
> makes good sense in that no money is actually spent and it will work
> if the assets do not deteriorate further.
>
> The government can deal with further market value reductions of the
> assets, something many banks cannot handle with their current capital
> and credit ratings. The Max Holmes proposal is another way of permitting
> the assets to be held to maturity rather than sold at fire sale prices.
>
>
> I personally take the view that a great deal of the hue and cry in
> favor of rigid application of mark to market accounting comes from
> the vultures, jackals and hyenas who expect to feed richly on the
> ensuing financial carnage, as if they were not already sufficiently
> gorged with the fruits of naked short-selling, rumor mongering, and
> naked CDS manipulation.
>
> I favor any solution that avoids the fire sale and deprives the vultures
> of their feed.
>

Feb 02 04:48 PM

[Steven Hansen:]

" What happens if “good” assets turn bad in 2010 or 2011? "

this is the crux of the problem. the banks are currently zombies. more and more of their paper is turning bad.

we are trying to solve these problems too quickly without being in a position to adequately identify the problem. my solution is simply to keep the banks afloat (pick your poison on how) for now. once the economy stops falling we can debate and implement a solution which does not have to keep being revised as conditions change.

Feb 02 06:12 PM

[Jim Hawthorne:]

This is a good thread that tends toward the pragmatic rather that the ideological!
It seems that the really thorny problematic issues center around the difficulty (perhaps impossibility) of realistic asset evaluation both now and it terms of realistic potential future valuation, coupled with the dangers of faulty assessment and timing down the road.
If 'toxic' assets are improperly values now, with the impact to the taxpayer many of us fear, have we any reason to be optimistic that we will get a better deal when those assets are to be returned to the private sector somewhere down the road???
Do we not run the grave risk of being taken for a ride both now and in the future???
How can we have much trust and confidence that anyone is seriously looking out for the taxpayer???

Feb 03 08:44 AM

[Obama is Bu...:]

While this plan has a few second order detail changes, it still doesn't address the big problem with all good bank / bad bank ideas:

What price do we put on the "bad" assets?

We know they are not worth par. Its pretty reasonable to say they aren't worth what the lying CEOs claim they are worth. But if there was true price discovery -- if we knew what the proper prices were-- we wouldn't be having this discussion.

The prices assigned are going to be one of two scenarios:

(1) the bad bank (aka the taxpayers) pay too much. The inept bank CEOs get a massive windfall, while the taxpayers take a massive loss

(2) the bad bank pays a fair, or too small, price. In this case, the insolvent bank is still insolvent. The CEOs know this, and have zero reason to participate in the plan. It could potentially have legal issues as well, as bond holders would sue claiming that their interests were not protected in the restructuring (shareholder equity is clearly negative, so there is nothing to protect -- but they might sue also).

Overblown CEO egos is a big reason bank insolvency hasn't been fixed yet. Everyone knows the major banks are insolvent -- but accepting that would mean the CEO would have to admit he is a professional failure.

At some point, the regulators are going to have to admit what everyone already knows but won't say out loud. The big banks are insolvent. They need to be shut down. The only real question is whether to shut each bank down overnight (a la Lehman) or to nationalize it and wind it down over a year or two (as was done years ago with Continental Illinois).

Equally clear: the big banks are really too big to save and too big to manage. If JPM or Citi failed, their assets are far bigger than FNMA or FHLMC. The government could not take on a big bank without jeopardizing its own AAA rating (investors were already doubting the AAA rating even with the GSEs). It is also far from obvious how one management team can be experts in everything -- which is the argument behind universal banks. Most of human history is about increased specialization -- Tiger Woods is a great athlete, but that doesnt mean he should play in the NFL. A bank that is really good at commercial lending probably won't be any good at trading securities. Even if we get better bank CEOs, they cannot be experts in everything finance.

This means the bigger banks need to be split up.

Feb 03 12:15 PM

[Jim Hawthorne:]

Now that our glorious leaders are reported to be thinking of suspending Mark-to-Market, thus tossing aside any pretense of transparency and realism, it's going to fun watching just how the banks will deal with the valuation issue!

Just what accounting standards and metrics will these wizards of finance now invent to clean up those nasty balance sheets?

Feb 05 01:34 PM

[John Lounsbury:]

Jim Hawthorne - - -

You make a good observation. Suspending mark-to-market is similar to what Japan did in their banking crisis. They are still paying the price 20 years later.

Are we smarter rhan the Japanese? I am afraid our policies are confusing saving the players with saving the game. It is possible to save players and destroy the game. Japan came close.

Feb 05 04:28 PM

[VegaVixen:]

I agree with a lot of interrelationships and conclusions that Max makes in his OpEd piece.

However, his proposal does not address why we have to restore confidence in our banking system in the first place. In other words, if the U.S. government effectively takes over "bad assets" from banks, what would prevent us from reverting back to the same situation in another 5 years? I believe that such "bad bank" bailouts are fairly effective - but how do we make sure it does not become a norm? Of course, this could potentially turn into a significant investment for the taxpayer - so are we, as taxpayers, ready for such "investments" every few years, as needed?

Feb 10 03:31 PM

[User 437964:]

Fanny and Freddy had nothing to do with the subprime problems, although it has been an objective for these agencies and prior administrations to secure home ownership for as many Americans as possible.

Given the government’s involvement it is astonishing that the subprime problem, financed primary though the private market became the top of the iceberg of these problems. The lowest rated assets with this type of collateral where securitized in CDO's mostly with credit enhanced AAA debt rating only given as a result of incorrect correlation assumptions.

It is a big problem to resolve these issues, while wrongdoing has primary occurred in the management of these institutions it is unfortunate that the shareholders have ended up liable for most their mistakes. Neither the current nor the previous administration seems to have a problem with the faith of the shareholders which explains the 12 month trailing market performance.

Maybe a better approach in dividing the assets would have been force most key managers with the bad assets and split the two companies equally along the capital structure thus punishing bank debt holders and the higher end of the capital structure whom clearly made the same mistake as common stock investors in determining the risk of these institutions. The treat of fire sale and receivership should make this legally feasible.

Too big to fail should be a post chapter 11 safeguard, where nobody in the capital structure is spared, assuming no prior agreement can be made. After chapter 11 it should be easy for the government to restructure quickly, clean house and maintain the institutions current business without as much capital commitment or any silver lining to the financial community or prior investors.

Failure should be a losing proposition to anyone with an interest in any financial institution, thus decreasing the likelihood that it will occur again.

Jun 28 11:20 PM

[John Lounsbury:]

User437934 - - -

Thanks for your fine discussion. I agree that accountability is a key issue and it must return to our capital markets if we are ever going to get this right.

I am not sure why you mention Fannie and Freddie because they were not mentioned in the article. I know that some research was published last week that indicated Fannie and Freddie were accountable for nearly 25% of subprime mortgages and other (private) institutions initiated over 75% of subprime paper. So it is not exactly correct to say Fannie and Freddie had nothing to do with the subprime problem; it is correct that they were not the major problem.

A further point in the discussion could be made if we knew the default ratios for Fannie and Freddie underwritten mortgages and those from other sources. If that data were available, it would be interesting, because the underwriting may have been more lax in the freewheeling "entrepreneurial" world that ran amuck in 2005-06. I suspect that all subprime mortgages were not created equal, and the inequalities probably had more to do with who was doing the underwriting than any other factor.

Jun 29 01:30 AM