Bank Nationalization: It's Just Plain Wrong

Includes: BAC, C, JPM, USB, WFC
by: James V. Baker

The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets thereby wiping out, as needed, the equity of common shareholders followed by the interests of preferred stockholders and then the bond owners.

The bad assets would then become assets of the FDIC or a special entity established by the federal government. The new owners could then keep them or sell them to private investors, who are reportedly waiting anxiously to acquire these bad assets.

Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy and it provides just punishment for making stupid decisions.

Nationalization is neither a necessary nor a sufficient condition to solving today’s problems. The treatment of Continental Illinois in the 1980s and the purported success of the RTC are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the US currency and our US government debt.

The truth is that de-leveraging by financial institutions, corporations, and individuals takes time. The bad assets on the books of the banks will disappear as they either heal, are liquidated, or are charged off through earnings. The debt of corporations will be reduced as corporations either take bankruptcy or use their cash flow to reduce debt. Individuals will similarly de-lever by either erasing debt through bankruptcy or curtailing consumption. During this period the level of economic activity will be negatively impacted unless the government expands its expenditures and levers its balance sheet. Nationalization of banks will not prevent this process from occurring.

The fact that “vulture investors” are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closures of financial institutions in the 1980s and 1990s. They can’t wait to once again be the beneficiaries of a large transfer of wealth courtesy of the federal government.

While fans of the RTC cover it in accolades, the beneficiaries of its largess chuckle. Here is what one person had to say about the RTC:

When working on a mortgage-backed trading desk back in the '80s, the RTC went to the street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff so they can once again buy distressed assets at fire sale prices. It is the way of the street.

Bank nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going concern basis has no place in their playbook. Calling these investors “vulture investors” gives vultures a bad name!

Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.

There are two issues that merit careful consideration before being swept up in this drive for nationalization. First, who determines what “bad assets” need to be excised from a bank being nationalized? Second, who determines the price of a bad asset at the time of its removal?

In the case where a loan is determined to be a bad asset and is transferred to another entity, that borrower loses their right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than they would otherwise be, since the new holder of the loan would either be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.

Recent events with securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of a bank that made it is greater than the intrinsic value of that loan when it is housed and administered elsewhere. Furthermore, an original lender is far more likely to advance additional funds to borrowers, thus extending the economic life of a borrower.

Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are greater than the comparable values if they are held by most private investors. This is so because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available thanks to expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve. The intrinsic values of assets on the balance sheet of a bank today are understandably greater than what non-bank investors claim.

We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs; their cost of funding is plummeting; they have very favorable interest spreads; and, their earning assets exceed their paying liabilities.

The truth is that almost all of the banks and savings and loans that were closed during the past 30 years would have survived if they had today’s deposit guarantees, deposit rates, and were given some time. The exceptions are those institutions that were caught by persistent negative interest rate spreads when interest rates soared and those banks closed because of fraud and malfeasance.

The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.