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Turn the news on or read a Roubini blog and you'll never hear the end of how we must nationalize our banks to get out of the mess we are in. Even Paul Krugman is saying 'Nationalize'!

Stepping away from the immediately obvious deficit of shareholder equity in these insolvent bank institutions, it is clear two things are happening independent of the status of bank valuation (yet perpetuating the feedback loop of insolvency): credit is tight, and asset values are thus forced down.

A true nationalization of a top 5 bank (or two), where debtholders are wiped out, would be less than optimal considering many debtholders are generally other banking institutions. Here counterparty risk (i.e. AIG) is revisited. Why force the issue?

The present Obama administration manifestation of TARP 1, one where money was blanketed over banks (instead of toxic assets being purchased above market), is being improved by the latest Treasury-Citibank (NYSE:C) agreement to convert preferred shares to common. Without the banks possessing a payment liability (free of dividend), their equity position genuinely improves.

In the end, though, if the bad bank is still truly insolvent, it will not lend as it knows it is insufficiently capitalized. Again I ask (from previous blogs), does it matter if Citi is technically bankrupt if it is somehow sustaining itself on a cashflow basis? If its assets are actually worthless in the end and the business can not maintain cashflow, there will be a day where it will have no choice but to fail. When the overall credit system is healthy enough (10 years from now?), I think it is reasonable to think we will be able to absorb a failure of Citi and allow an old-fashioned bankruptcy. Right now, however, the system is too fragile. So for now, we have a zombie bank.

Why can't we have zombie banks and healthy banks run concurrently? Why push the issue of nationalization, causing more systemic risk and further asset write-downs (perpetuating the negative feedback loop) when the alternative may be simply to leave the presently insolvent institutions alone?

We know two things: 1) The Fed through its control of Fed funds or any other arbitrary credit device it creates can capitalize banks at will (if the Fed loaned $20T to Citi tomorrow at 0% interest, it could quickly recapitalize at zero cost) and 2) Mark-to-market on long term bank assets just does not work, mainly because it serves to reinforce the negative feedback loop that we experience in downturns. From an interesting linked paper below, William Isaac, head of FDIC under the Reagan administration says:

"If we had followed today’s approach during the 1980s, we would have nationalized nearly all of the largest banks in the country and thousands of additional banks and thrifts would have failed." (p.6)

Asset prices are a function of real aggregate money out there, and the credit multiplier is a key part of that. Our entire financial system is based off of price relationships that are sustained by the total real money (credit+currency) being a certain amount. We also know the Fed's mandate is towards price stability. In the end, we have to collectively agree if we want the real effective credit multiplier back to where it used to be. The Austrian "economists" calling for Schumpeterian creative destruction miss the point - the aggregate long run result will be less jobs, less real wealth, less trade, less consumption possibilities. Labor and capital will all be victims of the slaughter. The "creative" part of this type of destruction is just a misplaced ounce of optimism.

To fix the credit multiplier, I propose Fed/Treasury will have to more aggressively fund banks, in the order of several trillion dollars more to completely offset the void created by current asset write-downs. Although unpopular as it enriches the common shareholder if nationalization is to be avoided (to keep treasury under majority stakeholder), broad indiscriminate TARPing to increase common equity is probably the best way to do it. I suggest 'broad', because healthy banks will naturally lend the funds they receive, despite the insolvent ones holding onto the funds. The TARPing needs to be broad to increase the multiplier effect as well. Fractional reserve banking does not work if only one bank is viable.

Here is an idea to perhaps improve (or simplify) on the latest manifestation of TARP: Treasury agrees to buy 'common shares' above market price of the bank, maintaining a minority stake (as in the Citi deal we just saw). In 10 years (or laddered in some way), Treasury must sell its 'common shares' back to the bank at the same price (or a negligibly higher one, to include a small amount of interest, i.e. 1%/year).

Think of it as a reverse repo with a 10 year duration at below market price, but kept on bank balance sheet as simple common equity. This accomplishes capitalization, does not nationalize the bank (avoiding instability and wipeout of stockholders), and self-neutralizes the money giveaway. Because of this, the TARP money should come from the Fed creating a new liability ("printing"), versus the treasury selling debt. This will help avoid tying up investment capital at a time we need more money in the system, not less. When the credit multiplier is judged to be at target levels, the TARP money can be pulled back in.

Disclosure: long BAC and XLF.

Source: Bank Nationalization and the TARP