Nationalizing the U.S. Banking Sector: There's No Choice

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Includes: BAC, C, IYF, JPM, KBE, XLF
by: Rob Kellogg

I wish Mr. Geithner would just do us all a favor. Please, just tell us what we already know. And that's this: the American financial industry is functionally insolvent. Don't mince words. Just admit our banking institutions are on the brink of death.

The traditional money flow in the global financial system has ground to a halt. The normal players - holding banks, hedge funds, private equity funds, commercial lenders - are either broke or too scared to lend. The only players who still have any real liquidity are the foreign sovereign wealth funds and their central banks and many of them have already been burned once by this crisis.

Despite what we hear in the mainstream media, the problem isn't that there are no buyers for the so-called "distressed assets." Quite the opposite. The investment bankers who still have jobs will tell you that there are plenty of buyers out there. The problem is that there are no sellers. But why wouldn't banks jump at the chance to get this junk off their balance sheets? One simple reason: if the banks holding toxic assets took the full hit that this would involve, they would be put out of business. Why would they want to do that?

So instead, the Treasury Department wanders aimlessly in the twilight zone of denial and delay, postponing the inevitable. That "inevitable" is the full nationalization of our banking sector. Nouriel Roubini, the New York University economist who correctly predicted the current financial crisis and has been one of the leading critics of the TARP bailout, recently endorsed the idea of nationalizing the banks. Other well-respected economists like Paul Krugman have also joined in the chorus.

What's clear is that our financial institutions are too stressed right now to absorb these losses. It's like a doctor telling a patient: "You could go through another round of chemotherapy that might put the cancer in remission, but the treatment would likely kill you." Instead, our banks cling to the hope that things will improve, hold onto the assets and pray that they can sell them down the road when the storm clouds lift. If they sell now, they are actualizing the loss and they aren't prepared to do that because that would be an admission of failure for many institutions. Doing so would also mean the end of a high paying job for many executives.

We all know that there are a lot of functionally insolvent banks out there but, unfortunately, there is no incentive right now for any bank to admit the vast discrepancy between the book and market value of the assets they hold on their balance sheet. Put another way, what these institutions say these assets are worth for accounting purposes is much higher than the value of what someone will pay for them out in the open market.

Geithner's concept to establish an "aggregator bank" that would partner the government with the private sector might do the trick to deal with some of this bad debt. But it probably doesn't go far enough, as critics of the latest plan warn. One potentially beneficial outcome emerging from Geithner's external "stress testing" process is that it will provide the hard metrics for regulators to fully measure the problem at hand (and not as it is presented now on the balance sheets of individual banks). This evidence can then be used to do what needs to be done politically on Capital Hill. But what Geithner must avoid doing is having taxpayers pay a premium for toxic mortgage-backed securities, as his proposal to insure private investors against possible future losses would seem to allow.

At this point, I'm not so sure that private investors can be counted on to set the price for the simple reason that these assets will never regain their pre-crisis value, unless of course another bubble arises which we obviously don't want to encourage. If the present value of future returns of the toxic assets is greater than the current market value then more buyers would be entering the market and more institutions would be selling. The fact that this isn't happening shows that these mortgage-backed securities are as worthless as a pair of Bermuda shorts in the Artic.

Moreover, one of the main reasons the toxic assets are difficult to value - and thus sell - is because of the challenges in forecasting future default rates which determines the future cash flow of these securities which, in turn, ultimately sets the price. Understanding this, the task the Treasury Department should be focusing on at the moment is to come up with a comprehensive foreclosure plan targeting homeowners around the country who are underwater with subprime loans. The ability of at-risk borrowers to make their monthly mortgage payments is the single biggest determinant in the value of toxic assets held on the balance sheets of zombie banks. Keeping people in jobs in important but so is realigning current income levels more realistically with estimated mortgage payments.

Sure, there are some investors out there willing to buy the assets, but only at a price much less than what the potential sellers are willing to accept. There is no way around this log-jam. The government should acknowledge that the assets are basically worthless and stop using a failed whac-a-mole strategy to manage the crisis. It is time to move on with long-term remedies which address the structural deficiencies of our capital markets at the heart of this crisis.

The good news is this: most policymakers agree that letting the banks fail is an unacceptable outcome. This is a start. The alternative to the Treasury's latest plan for solving the mounting financial crisis is to nationalize its insolvent banks. While that initially involves a government takeover of the banks, the government intervention wouldn't be permanent. The toxic assets would be purged, the banks reorganized and then sold.

But first things first. Someone needs to eat the loss. Who will that be?