Why We Were Right Not To Nationalize the Banks

Normally, when I admit that I was wrong, I don’t get a lot of responses basically saying “no, you were right the first time round”. But this time, when I admitted I was wrong about bank nationalization, I’ve received a lot of pushback along those lines. Charles’s comment is representative:

Really ? How did you come to that conclusion? As far as I can see, the “saved” banks are retreating on lending to SME and retail, stuffing their balance sheet with safe bonds (mainly govies) and recapitalizing themselves by taking advantage of the steepness of the yield curve. This has enormous opportunity costs for the taxpayer (these long bonds coupons will have to be paid one day…), depresses the “Real” economy, and is as close to “free lunch” for the banks than anything. The government, and the taxpayers, bear the burden of banking sector losses and get nothing in return. A nationalization has the same risks, but enjoys the potential upside.

One key point of my post was that the Obama administration is very good at tempering its initiatives with a clear-eyed view of what is possible and what isn’t. In the case of the decision not to nationalize the banks (which, it’s worth emphasizing, is different from a decision never to nationalize the banks), I think we’re seeing a real appreciation of the breadth of the possible unintended consequences, as well as the practical impossibilities involved in the government trying to run such an enormous banking book with so many different and competing parts.

How much of the decline in bank lending to individuals and small businesses is due to a drop-off in demand, and how much is due to banks’ increasing risk-aversion? It’s hard to say, but the former is clearly important, and having government-owned banks wouldn’t change that. Such lending is normally much more profitable than the big wholesale loans which banks have increasingly been keen on extending of late; that says to me that they’d be perfectly willing to make smaller loans if only there were reasonably high-quality demand out there. I might be wrong, but even if I am, it’s hard to see how government ownership would change things: government simply doesn’t have the ability to micromanage bank lending at that level.

The reason why I wanted to nationalize the banks is that they were suffering from a major liquidity crisis, and they were insolvent on a mark-to-market basis. In that situation, the government essentially has two options, when the banks are too big to fail. It needs to provide liquidity either way; the only question is whether it does so while taking ownership, or whether it leaves the banks to continue in their existing form, in the hope that the markets will recover and they will no longer be mark-to-market insolvent.

The latter is much easier, and is pretty much what happened. It also has the added advantage that you don’t have government ownership driving out private-sector risk capital. As an anonymous Treasury official says in Lizza’s piece, “People had money to put into banks. The nationalization crowd would have had the government putting all that money in.”

It’s true that when the government determines that a certain bank is too big to fail, and then lowers interest rates to the point at which the yield curve becomes steep, the result is a recapitalization of that bank through easy profits. And yes, those profits go to the bank’s private shareholders. You can call that a free lunch. The alternative, for taxpayers, is the possibility of a very expensive lunch indeed. Here’s Lizza again:

Furthermore, Summers said, there was a medium-term risk that nationalized banks would lose value, in the same way that the act of foreclosure decreases the value of a home. Summers pointed to the example of Sweden, which was regularly cited by economists who favored nationalization. But Summers noted that Sweden didn’t nationalize for two and a half years, by which time the situation had become so severe—interest rates had reached a hundred per cent—that there were no other options. In addition, Nordbanken, the largest bank nationalized in Sweden, was already eighty per cent government-owned. Summers concluded by emphasizing that nationalization was a strategy that governments turn to only after it is very clear that nothing else can work.

One of the problems facing Summers and Geithner when they made this decision was how to get the wholesale market in bank debt moving again. (Remember the TED spread?) Given that they couldn’t nationalize thousands of banks at once, and given that nationalization was tantamount to an admission that the banking system was insolvent, non-nationalized banks would have found it pretty much impossible to find funding at any level, and there might well have been a much larger number of bank failures than we’ve seen to date.

The fact is that nationalization is a negative-sum game. Just because banks are making large profits now, doesn’t mean that they would have made just as much under government ownership. And the political noise surrounding just about any decision that any nationalized bank made, especially as regards pay and bonuses, would have made any other kind of reform (healthcare, financial-regulation, you name it) even more difficult than such things have turned out to be sans bank nationalization.

Now that the results of the stress tests have been made public and the debt market has recovered impressively, there’s a strong case to be made that the banking system is no longer insolvent. If we could get here without the incredibly drastic measure of nationalization, that’s a good thing. Yes, we might have lost a bit of potential upside on our hypothetical equity stake in the big banks. And yes, it’s very depressing to see a large chunk of that upside going to the very bankers who helped drive the economy into the current recession in the first place. But let’s not kid ourselves that the nationalization option would have been trivially superior in all respects.

Comments

[John Lounsbury:]

Felix - - -

About an hour ago I posted exactly the opposite opinion.

seekingalpha.com/insta...

Oct 05 11:44 AM

[Doc 224899:]

We don't want the same government taxing us that runs the banks where we store our money.

Were it the case that the government taxed us and ran the banks, it would only be a matter of time before the government announced that it would automatically withdraw money from our accounts to pay any tax obligation it could dream up.

By not paying back two thirds of the claims in Cash For Clunkers, the government is likely to bankrupt a good portion of the retail arm of the automobile industry that it purportedly is bailing out to keep it from going bankrupt.

They simply have so much bureacracy, so many convoluted policies, so much administrative complexity and administrative inefficiency that they can't competently execute even small, simple programs like Cash For Clunkers or the Veterans' Tuition Reimbursement Program.

Oct 05 01:21 PM

[Tack:]

Anybody in favor of government-run anything, as an ongoing model, need only look to the overtaxed, under-employed, inefficient European economies over which most liberals get lovestruck. Taken to extremes, they function with the marvelous decisionmaking abilities and efficiencies of the Soviet Union, and we see how well that worked.

The very idea that government-run enterprise is benevolent and privately-run enterprise malicious is a dangerous daliance for anyone who cherishes freedom and propserity.

Oct 05 02:37 PM

[DiggerUK:]

There is a mistaken belief that a lot of west european industries were nationalised at the end of WW2.
They weren't. All that happened was a lot of industries vital to national economic recovery following the war, were clapped out, and unfit for purpose.

They were taken under state control, that's all.
The old owners were paid compensation, not taken outside and shot.

If anybody believes, that any western economy can survive today, without the same exercise being repeated, then it is time you read the writing on the wall.

Oct 05 02:56 PM

[Roger Knights:]

Here's a comment I posted in mid-March, which reprints an excerpt from an article on SA in February that convinced me that nationalization was the greater of two evils:
=========

In mid Feb. there was an article here on SA, "Why Bank Nationalization Will Never Happen” by Stockton Sage, that I think illuminates the thinking of the policy-makers today, and explains why they can't be open and forthright.
Why Bank Nationalization Will Never Happen by Stockton Sage
seekingalpha.com/artic...
Sample:

“The perfect holder of a bank stock, preferred, or bond from about 1950 to 2006 would be a retired person, a pension fund, or even 401k type plans. So why should we wipe them out?

"Did you know that some of the largest holders of preferred bank stocks are other banks? That is how many banks and people create cash flow and income. If you wipe out the preferred stock of BAC and C, you would cause a domino effect in a number of other banks. Cash flow would be impeded, capital would be required to meet current needs, and government assistance would have to step in at some point. Could there be a run on the banks if you wiped out BAC and C equity and bondholders? If the bondholders are other banks that rely on those funds for operations then yes, you could see scary headlines.”

Oct 05 04:26 PM

[casey00001:]

"One key point of my post was that the Obama administration is very good at tempering its initiatives with a clear-eyed view of what is possible and what isn’t."

Felix you are such an Obama tool its outright disgusting.

Oct 06 03:44 PM

[Larrysyr:]

I give you credit, Felix, for rethinking a position you advocated so diligently and admitting you might have been wrong.

All decisions, especially in a crisis like last year's, are risky. I suspect the actions of the federal government during this crisis will be studied for years, and the various opinions about how well the crisis was handled will persist. And I think that all sides of the argument will have good points to make, with lots of lessons we can learn about how to deal with severe financial crises.

My take is that both the Bush and Obama administrations reacted relatively well under pressure none of us would like to bear. They made many mistakes but managed to restore stability to the financial markets way faster than I thought possible.

How well or quickly the economy recovers is an open, longer-term question. Without the financial markets stabilizing, however, there would be NO recovery.

Oct 07 12:32 PM

[sst381106:]

Can we call "Education for Felix Salmon" ? I have newly found respect for the author. Very few people a capable of admitting to their mistakes and clearly laying out why.

I always considered Mr. Salmon a very good financial writer, but I found some of his previous articles including subject of "Bank Nationalization" to be very naive in areas of motivation and moral hazard. US has very limited experience with state run enterprises compared to the rest of the world. Looking at state run enterprises or private companies with large government influence, we can see that top management cases mostly about their individual jobs and not common good or taxpayers. And with their future dependent on government bureaucrat residing in White House, Downing Street or Kremlin, keeping him happy will be priority number one at expense of shareholders, taxpayers or economy overall.

I am glad that now we can compare year-to-date performances of GS vs C, GM vs Ford, Aon vs AIG and clearly see how private run enterprises are outperforming their government controlled piers.

Oct 07 01:00 PM

[Buckoux:]

I remember your article on the logic of nationalizing the banks. And now this article on your logic that it would have been wrong (read disastrous).

Felix, maybe you're just too f-ing smart to be allowed to think!

Charles Norris.

Oct 07 01:05 PM

[Pat C:]

I still firmly believe that breaking-up the big banks and re-implementing Glass-Stegall is essential. I know that this is going to require them to do a realistic evaluation of their loan portfolio's and investments. This should be done immediately with a goal of maximizing shareholder and bondholder interests. The government may end up with a few of the smaller pieces but such is life.

Oct 07 01:36 PM

[Bill L.:]

The problem with ___________ is that those with the power and money always want more and more until the system becomes one sided and corrupt... now quick, did I describe capitalism or socialism?

Oct 07 01:40 PM

[Gary A:]

Felix you are wrong. Unemployment is now, according to Pimco, a leading indicator because many jobs are gone forever. That means that the workers need a bailout. There is no money left unless you want gold to soar. They gave the money to the cronies of government already. We should have taken over the banks and bailed out workers or done real infrastructure work that counted.

Oct 07 01:57 PM

[a fat panda:]

Felix,

We are nationalizing banks - only it is called the FDIC. We are now at 100 banks nationalized or whatever you want to call it in 2009.

It is obviously your belief that we can initiate a program like TARP and not affect the banks which are not included. We have taken capital out of the system, and given it to the large banks on terms with which no smaller bank can compete.

Oct 07 02:26 PM

[manya05:]

Tack: "..need only look to the overtaxed, under-employed, inefficient European economies over which most liberals get lovestruck.."

You have all the right to think that way, but I wonder if you ever lived and worked in Europe (rather than just visit, read about it, or heard it in Fox News). I believe I there are probably 300M+ Europeans that probably disagree with you and: 1) do not feel too overtaxed considering what they get in return, and 2) have had it very easy on this "crisis" and would not want to live in the US for anything in the world.

The way Europe has gone through the Great Recession is a cakewalk compared to the US.

Oct 07 02:49 PM

[Fourpenny Guy:]

Suppose a year ago, both Citi and Morgan Stanley had failed. Would anyone have noticed? Probably not. Citi, for all the boasting it does about having a presence in 160 countries, fails to mention that a tiny detail-they needed government assistance to survive. In a normal economy, Citi would have failed, and the stronger banks would have gathered up the assets. Even now, with the government's 34% stake, Citi is still weak, so weak, it sold half its brokerage to a firm that nearly failed last fall. Both firms would have investors believe that near failure means nothing. Well...it does. Morgan and Citi almost failed because each was and is poorly managed. Had Morgan been sold to JPM, that would probably been a better deal than giving it free rein over Smith Barney.

Now, Citi continues to pretend it suddenly cares about risk, and Morgan, without experience running a large brokerage, is suddenly an expert in that business. Clients deserve better than firms that need to be propped up, or whose technology is 19th century.

The facts are that both Citi and Morgan continue to limp along, with Citi shedding assets, selling crown jewels along the way. How could firms that nearly failed be that important to the world economy? Citi would have investors believe they're well capitalized. Ok, well, what about off-balance sheet items? Of one includes those, Citi is still not in good shape. And, finally, what does Morgan Stanley do, exactly? I pity the Smith Barney clients since a joint venture between Citi anmd Morgan Stanley is analogous to handing a blind man a flashlight to lead the way out of the woods. Pretty pitiful.

Oct 07 09:42 PM

[vman650:]

All we have to lose is the perception that our markets are free and not controlled by government. Whats the big deal right?
Once again no volume
Once again 2:30 computer buyins

Oct 07 10:09 PM

[Moon Kil Woong:]

When Enron went bankrupt we didn't call it nationalization. The big banks should have ended up in bankruptcy and their deposits should have moved to more healthy banks. TARP should have gone to the FDIC to pay to clean them up and sell off their rotting carcasses.

Perhaps then, the remaining banking sector wouldn't be sucking on fumes as the too big to fail banks suck up all the cash and sit on it. And perhaps then, the broader market wouldn't be still grappling with tightfisted insolvent too big to fail banks that need interest rates to remain at 0% and have to immediately sell all home loans to FHA, Fannie Mae, the Federal Reserve, or Freddie Mac to stay solvent.

What these banks are doing isn't running a bank in any sense of the word. They are essentially leeches acting as a middleman between the public and government risk-taking to prop up the economy. They take no risk, profit off of wide spreads, treat depositors as sources of fees, and hoard capital. Their actions aren't a public service. They are a public disservice. So please tell me how exactly are they beneficial?

The only beneficial banks are solvent profitable banks not dependent on government handouts that can actually issue and hold loans not churn them through some contorted mortgage system which the taxpayer has to constantly subsidize.

Oct 07 11:40 PM

[ron_paulite:]

The jury is still not out yet. Don't speak too soon.

Maybe the banks needed the bailout to prevent bank runs.
But does the car industry also need to be bailed out?
The government holding 60% of GM shares?

Oct 08 01:12 AM

[Harry Tuttle:]

Banks should have been nationalized because they failed. Period.

If you think rewarding failure is costless I suggest you think about "free lunch" and "perpetual machine." People claim to find them from time to time only to discover they were not taking all the variables into account. Just like leveraged hedge funds that sold puts on a market that could never fall.

Oct 08 10:19 AM

[Michael Clark:]

Amen. If they fail, and require taxpayer money, break them up, distribute their deposits...but don't reward them for failing.


On Oct 07 11:40 PM Moon Kil Woong wrote:

> When Enron went bankrupt we didn't call it nationalization. The big
> banks should have ended up in bankruptcy and their deposits should
> have moved to more healthy banks. TARP should have gone to the FDIC
> to pay to clean them up and sell off their rotting carcasses. <br/>
>
> Perhaps then, the remaining banking sector wouldn't be sucking on
> fumes as the too big to fail banks suck up all the cash and sit on
> it. And perhaps then, the broader market wouldn't be still grappling
> with tightfisted insolvent too big to fail banks that need interest
> rates to remain at 0% and have to immediately sell all home loans
> to FHA, Fannie Mae, the Federal Reserve, or Freddie Mac to stay solvent.
>
>
> What these banks are doing isn't running a bank in any sense of the
> word. They are essentially leeches acting as a middleman between
> the public and government risk-taking to prop up the economy. They
> take no risk, profit off of wide spreads, treat depositors as sources
> of fees, and hoard capital. Their actions aren't a public service.
> They are a public disservice. So please tell me how exactly are they
> beneficial?
>
> The only beneficial banks are solvent profitable banks not dependent
> on government handouts that can actually issue and hold loans not
> churn them through some contorted mortgage system which the taxpayer
> has to constantly subsidize.

Oct 08 12:53 PM