By Simon Johnson
This week’s moves by the British government have created the impression that bank nationalization is inevitable. It is certainly the case that small-scale bank recapitalization, partial balance sheet clean-up, and various forms of financial engineering (e.g., insurance schemes for bad debt) are not only no longer enough, but may even be destabilizing. The problem is that once the market thinks you are on the move to a decisive solution but have not quite mustered the political will needed for complete resolution, it will assume that the final destination involves zero value for equity holders (and perhaps some bumps in the road for bank creditors).
The same logic is now being applied in Ireland and, to varying degrees, in other weaker eurozone countries. And the knock-on effect from assumed nationalization of bank losses to fiscal sustainability is immediate. Quoted Credit Default Swap spreads for some European sovereigns were wider than for investment grade corporates today, which of course makes no sense - but it does indicate extreme pressure in markets and deep confusion (or perhaps great clarity) regarding the impact on government balance sheets.
Nationalization is not the answer in the United States.
The state is not good at running banks anywhere and we really do not want to add politically directed credit as a cause of massive financial losses - the pressure already evident from some quarters to increase loans to consumers and small business, regardless of credit quality, should be taken as an early warning.
Banks need capital, without a doubt. Banks also have troubled assets and there is great uncertainty about their value. But, at least in the US, it would be reasonable for the government to help clean balance sheets and provide new capital at a price - which can be paid in terms of warrants, i.e., options to buy shares, on terms favorable to the taxpayer. This price should be considerably higher than charged in the TARP I funding provided by Mr Paulson, and banks will certainly want to hang back and let others go first - there is a great incentive to free ride here.
But a mixture of carrots and sticks can still bring banks into a full-scale recapitalization and clean-up program (technical design suggestions are here). This could be run directly by Treasury, but it would make sense - and also have political appeal - to create a Resolution Trust Corporation (RTC)-type structure to manage the government’s portfolio with a great deal of transparency and accountability. The goal of this RTC would be to dispose of government warrants quickly and in such a way as to maximize taxpayer value; it can also manage the toxic assets that are taken up, aiming to minimize fiscal losses. There is plenty of private equity money, currently waiting on the sidelines, that would be keen to buy the government’s warrants, exercise the option to take controlling stakes in banks, and break them up - although antitrust safeguards should be strengthened to make sure banks are not sold for their monopoly rents. And it seems likely that many of the banks’ current top executives would be replaced in this process.
From the second half of the TARP you could use $250bn (i.e., TARP II minus funding promised for housing and money already committed), plus another budget appropriation of around $250bn, to provide $0.5trn for capital. The RTC could then leverage itself by borrowing from the Fed, aiming for a total balance sheet in the $1trn to $1.5trn range.
Bank nationalization in the US is not inevitable. At least, not if a credible, very large recapitalization/balance sheet clean-up program is put in place quickly, to complement both the coming fiscal stimulus and the promised housing refinance package.