Bank Nationalization and the TARP

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 (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.

Comments

[ironpants:]

You're right but the shrill cries of the shortsellers and CNBC will opine that the banks need to be nationalized (to maximize their puts).

Mar 02 08:07 AM

[pacman1947:]

How much cash is invested in Citi through money market funds, CDs, and other cash equivalent accounts? FDIC covers these to $250k each. Just what is gained by buying stock in the bank vs. guaranteeing the cash assets? Why is the number trillions when it is more likely billions?

Are we backing the fraud or the honest investors? Can somebody offer a concrete answer?

Until I see a true revelation of what we are buying, I cannot support these "nationalization" concepts. Too many working and retired people are suffering while these banks and insurance firms suck up all of our children's future savings.

Mar 02 08:35 AM

[Lea Cabrerra:]

You said, "Even Paul Krugman is saying 'Nationalize'!"

Why does this surprise you?

Paul Krugman is a socialist. He is the anti-thesis of economic reasoning. To call him an economist is an oxymoron.

Mar 02 08:38 AM

[Dave Wrixon:]

Sounds fine in principal as long as you assume that the Treasury has its own money tree.

What is in fact at stake is the stability of the monetary system itself. Sure the US Government can print all the dollar it wants, but it has to convince people that the monetary units still have some value.

Yes, we know that the dollar it the World's Reserve currency, but in reality all that means is everyone is in a postion to dump it when the fear really sinks in.

Each dollar represents a stake in the US economy itself, which has shrunk to an alarming degree not just in the revenues it can generate, but also in the intrinsic value of its gross assets, much of which is in foreign hands anyway. Given that you have a share in an enterprise that can distribute additional shares at will without giving existing holders any rights to subscribe for the free handouts, would you continue to hold stock in Uncle Sam? Or would you scramble for the door?

Holders of dollars and potential bidders for T-Bonds are watching every move. It seems China is spending a lot of her dollars on mineral resources which is subtle way of off-loading without freaking the market.

The problem is that if the dollar itself becomes worthless as with Zimbawe, then the whole US economy is worthless. Consequently, You had better hope they figure out a way to make that 1 inch bung fill that 2 inch hole. This side of the Atlantic we are just hope that we don't get swamped by the wave from the sinking ship.

Mar 02 08:41 AM

[Speedspirit:]

Why do we feel the need to give money to these hopeless banks. Cover the fdic guarentees and give the 1 trillion to entreprenuers to find productivity in the hope of rebuildind America

Mar 02 08:53 AM

[anarchist:]

Cabrerra, are you you old enough to remember the McCarthy era where all one had to do to discredit a person you disagreed with was to call them a "communist"? 'Tricky Dick Nixon' did really well with that technique. Now the catch word for defaming is "socialist", Obama is a socialist? Krugman is a socialist? Get off it!


On Mar 02 08:38 AM Lea Cabrerra wrote:

> You said, "Even Paul Krugman is saying 'Nationalize'!"
>
> Why does this surprise you?
>
> Paul Krugman is a socialist. He is the anti-thesis of economic reasoning.
> To call him an economist is an oxymoron.
>

Mar 02 09:54 AM

[jasonjim:]

A good article which tries to present a positive alternative to today's banking crisis, and pans nationalization as an easy way out of the situation. We need more writers of this caliber.

Mar 02 10:06 AM

[Stimpy:]

NATIONALIZATION IS A MIRAGE.

These banks no longer exist as discrete entities. The OTC derivatives market is 500 TRILLION (interest, currency and credit swaps).

That is what is being propped up via the "zombie" banks
.
Basically you need a certain number of players at the table in order to have a game at all.

You can do it with a few, but it gets volatile in ahurry.

That is why we all watch the "world series of poker:" when it gets down to heads up.

Mar 02 01:12 PM

[Mad Hedge F...:]

Good Idea! Bank of America’s (BAC) Ken Lewis says that he won’t resign until he pays back the $45 billion in TARP money he owes the government. So paying $50 billion for something that is really worth a negative $170 billion is a bad career move? That’s a revelation! I can see that secrecy is a concept that is forever banished from the investment community. CEO’s won’t be able to make an acquisition, nor fund managers raise a single nickel from here on, without a complete undressing, and a full proctologic exam!

Mar 02 02:04 PM

[Lea Cabrerra:]

Words do indeed mean something and so do labels. I have provided DICTIONARY.COM's definition of socialist and socialism below. These definitions certainly apply to Krugman and Obama, so Im on firm ground in calling them socialist.

As for McCarthy calling Hollywood communist, he may have had a point.

I would encourage you not to subordinate your mind to political correctness. All your sucking up may get you a "that a boy," but thats a small consolation for the hole you suck through your throat. Do-gooders usually end up being done real good!

Thanks for responding to my post though.

so⋅cial⋅ist   [soh-shuh-list] Show IPA
–noun
1. an advocate or supporter of socialism.
2. (initial capital letter) a member of the U.S. Socialist party.
–adjective
3. socialistic.

so⋅cial⋅ism   [soh-shuh-liz-uhm] Show IPA
–noun
1. a theory or system of social organization that advocates the vesting of the ownership and control of the means of production and distribution, of capital, land, etc., in the community as a whole.
2. procedure or practice in accordance with this theory.
3. (in Marxist theory) the stage following capitalism in the transition of a society to communism, characterized by the imperfect implementation of collectivist principles.
On Mar 02 09:54 AM anarchist wrote:

> Cabrerra, are you you old enough to remember the McCarthy era where
> all one had to do to discredit a person you disagreed with was to
> call them a "communist"? 'Tricky Dick Nixon' did really well with
> that technique. Now the catch word for defaming is "socialist",
> Obama is a socialist? Krugman is a socialist? Get off it!

Mar 02 03:59 PM

[Green Eyes:]

I agree with you sir. Please also be aware that FDIC is only increased $250K until 12/09. I don't forsee an upswing before then. Be cautious with your money friends.


On Mar 02 08:35 AM pacman1947 wrote:

> How much cash is invested in Citi through money market funds, CDs,
> and other cash equivalent accounts? FDIC covers these to $250k each.
> Just what is gained by buying stock in the bank vs. guaranteeing
> the cash assets? Why is the number trillions when it is more likely
> billions?
>
> Are we backing the fraud or the honest investors? Can somebody offer
> a concrete answer?
>
> Until I see a true revelation of what we are buying, I cannot support
> these "nationalization" concepts. Too many working and retired people
> are suffering while these banks and insurance firms suck up all of
> our children's future savings.

Mar 03 09:51 AM

[bobgil:]

Alright, I'm confused. After printing trillions of dollars to be sure the rich can keep playing poker, how do we "pull back the TARP money" to ensure that we don't have huge inflation?

How will the baby boomers near retirement age, like me, live on relatively fixed income when a box of saltines cost $50?

Let the rich investors and big banks that bet on a 3-legged dog at the race track take their losses. I didn't receive any of their gains, why should I fund their losses?

Mar 03 06:46 PM

[Michael B. ...:]

Or the flip side: At this rate, you won't be able to buy a box of saltines at .50 because your stocks will continue depreciating, tax revenues will collapse resulting in a repeal of any government income you might consider yourself entitled, and your pension will be worthless because all of the corporate debt it invested in went bad.

Mar 03 07:25 PM

[ebor:]

Maybe I am naive, but I don't understand why nationalization or stock purchase should be discussed at all as primary responses by the government. I am in physics, not finance, so I don't profess any expertise here and please comment with any errors in my understanding. It seems to me the real problem is with over-leveraging of the financial system due to a ballooning market in credit derivatives (most perniciously Credit Default Swaps, CDS), which caused manageable problems in the real economy (tens of billions of dollars in mortgage defaults and more in Mortgage Backed Security devaluation) to cascade into unmanageable problems for banks (trillions of dollars in derivative write-downs and CDS obligations). Specifically, the fact that CDSs are valued as assets but function like insurance policies obligating the banks (as insurance issuer) to pay out in case of default on the underlying asset means CDSs have a huge negative multiplier effect on banks when underlying assets take a hit.

Shouldn't the government start by regulating CDSs, requiring that total value of CDS obligations can only equal the value of the underlying assets and be paid out only to the person who owns that asset (so that it functions like insurance and not a way to bet that assets will go bad)? Simply rendering null any CDS contracts that don't fit this requirement should be fine, as although it destroys wealth on paper it really helps the banks avoid large payouts from defaults and the CDS policy holders are simply no longer insured against an underlying asset they didn't own in the first place. Can't more be done to bring the rest of the derivatives market down to a smaller multiple of the real economy so that movements in the real economy don't have this multiplier effect that causes such huge amounts in bank write-downs? This would also free much of the money in derivatives to be re-invested in the real economy.

Mar 04 12:30 AM