Is QE turning into "stealth nationalization"?

I am surprised this has not generated the level of discussion it merits. The Telegraph (via FT) reports of the new Shinzo Abe government's plan to lift the Japanese economy out of its long-slump,

Premier Shenzo Abe is to spend up to one trillion yen (£7.1bn) buying plant in the electronics, equipment, and carbon fibre industries to force the pace of investment... The plan to buy plant involves leasing back the assets to firms in trouble. Analysts say it is a means of funnelling industrial aid, a move sure to raise the hackles of global rivals. It may violate World Trade Organisation rules on subsidies.

As FT writes, this is a "stealth nationalization" of the economy. And it argues that this is a logical culmination of quantitative easing itself,

Whether it’s QE or government-debt funded stimulus, the two amount to the same thing. Both offer support to industries, companies and banks which might otherwise collapse. QE is simply a more generic funnel. Stimulus, on the other hand, involves strategic government choices with respect to which industries, companies and banks to invest in and support. Take this trend along its natural course, however, and you only get to one result. The nationalisation of almost everything.

Amazingly, for the last two years, in a last gasp attempt to revive the economy, the Japanese Central Bank has been priming the equity markets by purchasing exchange traded funds (ETFs), so much so that it is now "en route to becoming a majority holder in the country's primary equity ETF". 

This transformation of monetary policy has been stunning. A simple credit infusion program by opening a liquidity injection window, shifted gears to different versions of quantitative easing by initially purchasing government securities and then private bonds with increasing dilution of credit standards. The credit expansionary interventions moved into a different plane by then purchasing ETFs in the equity markets and is now echoing nationalization by proposing to directly take stakes in private firms.  

With governments reluctant or paralyzed from taking the strong steps required to reverse the course and preferring to take the easy route by passing on the buck to central banks, there will be increasing pressure on them to incessantly keep printing money so long as inflationary pressures remain invisible. If the economy does not recover with conventional QE, as looks increasingly likely in most parts of developed world, then the pressure on central banks to indulge in, apparently "costless", Japanese style "nationalization" will rise. Is the Fed and ECB going to follow the Bank of Japan?

Dangers associated with Geithner bank bailout plan

The Geithner Treasury, despite all talk of stress tests, has sought to drip feed the ailing banks with TARP and other credit assistance, in the hope that the financial markets would soon recover and normalcy would get restored. The preferred stock route of government bailout seeks to retain the existing share holders and creditors, without the government taking any direct equity stake in the banks. The problems associated with this approach, as against the more interventionist nationalization approach, has been discussed earlier here, here and here.

It is in this context that Thomas Hoenig, President of the Kansas Fed, has added his voice in favor of a more interventionist approach. He advocates that the tax payer should be made senior to all existing shareholders, and it should determine the circumstances for both managers and directors. He suggests that, similar to what was done in Sweden in the 1990s, the "non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible". He finds the following problems with the current approach

1. Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened, especially with the "too big to fail" firms.

2. The "too big to fail" firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised into becoming more economically and politically powerful. The CFO of Goldman Sachs admitted so much, while explaining Goldman's performance in the first quarter.

3. The US government has poured billions of dollars into these firms without a defined resolution process, adding to the national debt. The longer resolution is postponed, the greater the losses and the larger the debt burden.



4. As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.

5. The "too big to fail" institutions will continue to exist, with all their system-threatening externalities. Ironically, despite all the knocks taken, they would have become even more powerful than ever. Systemic risks will get perpetuated.

Why the case against nationalization may be flawed?

In one of the more convincing cases made against nationalization, Alan Blinder says that the complexity of the US banking system and financial markets militates against it. Unlike the Swedes who had to deal with just a handful of banks, there are more than 8300 banks in US. He points to essentially two main concerns,

1. Domino effect on other banks - Nationalization of a few banks would leave the others vulnerable on two counts. First, especially in such times of deep uncertainty about counter-party risks, the remaining banks would need to pay much higher interest rates to attract depositors and other creditors, and consequently their profitability would suffer. Second, the share prices of the remaining banks would fall, and short sellers would only drive it down even further.

2. Management challenge - The challenge of managing the massive and complex financial behemoths and their transition back to the private ownership. And the strong possibility of political interference and corruption, a feeling exacerbated by the numerous examples of greed, coprruption and cronyism that led to the sub-prime mortgage crisis, only complicates the task.

While the objections are very real and valid, these are not unsurmountable. The domino effect can be overcome if the nationalization is comprehensive, both in its coverage of assets (instruments) and institutions. This means that the stress tests should be universal and standards rigorous enough, and the take-overs should be swiftly done in one stroke.

The management challenge may not be as difficult as it appears since a few large institutions dominate the US banking sector. As Paul Krugman points out, the four biggest US commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – possess 64% of the assets of US commercial banks. Further, banking take-overs into receivership is an ongoing process and the FDIC has enough experience in managing such banks. In any case, as James Kwak and Simon Johnson point out, the government is already responsible for a large portion of bank liabilities, through insurance on deposits and new bank debt and is the only source of new capital for banks.

It needs to be borne in mind that the choice is between all bad alternatives to private management. To para-phrase Chiurchill, nationalization appears to be the worst option except all the others under consideration. The case in favour of nationalization is laid out here, here, here, here, and here.

Finally, Blinder proposes the "good bank - bad bank" solution, which would break each sick institution into two. The "good bank" gets the good assets, presumably all the deposits and a share of the bank’s remaining capital. As a healthy institution, it can presumably raise fresh capital and go on its merry way as a private company. The "bad bank" inherits the bad assets and the rest of the capital — which, after appropriate markdowns of the assets, will not be enough. The tax-payers will have to cough up the required capital.

This proposal runs up against a few serious objections. How do we split the bank capital between the good and bad banks, especially given the difficulty of valiung the bad assets? Using the same complexity arguement (both political intereference and compex shareholding patterns), is there not a serious danger of shareholders benefitting at the cost of tax-payers, leaving open to charges of shareholder bailout? How do we differentiate the good from the bad assets? Is there not a moral hazard dimension, as the management tries to minimize its risks and off-load all risks into the bad banks? Further, given the fact that many of the bad assets are virtually worthless and cannot be expected to yield anything even in the future, is there any point in keeping them in the balance sheets of the bad banks? In such uncertain times, can anybody be even remotely sure about the "markdowns" the assets of the bad banks will have to suffer from?

And all this presupposes that the financial markets will rebound in the medium term. If as Nouriel Roubini suggests, the recovery is L shaped, the tax payers may end up paying virtually all the liabilities of the bad banks. In other words, the greedy Wall Street managers and their shareholders will have the last laugh - heads I win, tails you lose! Or a classic case of privatizing the gains and socializing the losses!

Update 1
James Kwak sums up the debate on reviving the banking sector. He writes, "I think there are three main positions in this debate:

A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover."

Kwak feels that A2 is the best alternative, and is in keeping with the best traditions of capitalism. The Obama administration is following B.

More banking bailout proposals - Bebchuk Plan

As all the semantic jugglery, witness the pre-privatization nomenclature, would appear to suggest, nationalization continues to remain anthema (Greg Mankiw sums up the reasons nicely) to policy makers.

In keeping with semantic play, Arindrajit Dube sums up the three options - Darwinian Liquidation (or "Natural Selection"), Organized Liquidation (or "Intelligent Design") and Bailouts with Temporarily-Soft Budget Constraints (or "Zombies on Life Support"). While the first, preferred by many of the market fundamentalists, may end up liquidating much of the economy itself, the third, being practiced as Geithner Plan, may only postpone the inevitable. Which leaves us with the second, which is nationalization (sorry, pre-privatization!) in some form or other.

The latest proposal (more details here and here) for bailing out troubled institutions comes from Prof Lucian Bebchuk of Harvard Law School. He has proposed a two-level plan to leverage private capital to facilitate price discovery and create a market for troubled assets. Instead of creating a large "aggregator bank", as is being planned under the Geithner Plan, the government should first focus on establishing many competing privately managed funds, financed with both private and public capital, to buy up the distressed assets. Then the bailout money can be allocated to these competing funds using an appropriately designed market mechanism, so as to ensure that the tax-payers get the best deal possible.

This could generate a competitive market at optimal cost to the tax-payers - the "profit share captured by the funds' private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets" and "the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets".

He proposes a market design where either "the participating public capital assumes more downside risk or captures less of the upside". One way would be to involve provision of non-recourse loan, to the extent of a specified fraction of the capital of each participating fund, with these terms - loan will be re-paid first from the payoffs of the private fund; will be paid only from those payoffs (being non-recourse); and will carry a low interest rate. He writes,

"Suppose that the government wishes ultimately to (purchase) $1 trillion in... troubled assets, it will begin with a "pilot" round in which private funds with an aggregate purchasing power of $100 billion are established. The government should invite bids from private managers seeking to participate in this round. Each bid should indicate first the maximum fraction of the fund's capital that the private side commits to contribute as private equity capital (rather than using debt financing from the Investment Fund for this purpose) and second, the size of the fund the private side seeks to establish... The government can also set... a minimum level of equity capital contribution, say 10% of capital, below which bids for establishing a fund may not be submitted.

Once the bids are made, the government will set the level of its participation under the program at the lowest level that can be set while still allowing for establishing funds that collectively have the total target capital for the program's initial round. Thus, for example, the government will set the equity contribution percentage at 40% and the government's debt financing at 60% if, given the received bids, the 40% level, but no higher level, will result in establishing private funds that collectively have the target level of aggregate capital."

It now appears, as Felix Samon points attention to, that the Obama administration too may be going along similar lines to the Bebchuk Plan.



Under the Financial Stability Plan (FSP), announced to spend the remaining $350 bn of the original TARP, the Treasury had already proposed a Public Private Partnership initiative to leverage private funds to clean up or create liquidity for the distressed assets. The Bebchuk Plan provides a model to implement this initiative.

In any case, it cannot be denied that the Bebchuk type proposals are an attempt to stave off what is perceived as the last resort measure - nationalization. While supporters are convinced that a market in such distressed assets can be created, opponents of such "half-measures" argue that such assets are virtually worthless and is only delaying the inevitable and prolonging and thereby exacerabating the pain.

Update 1
Lucian Bebchuk responds to critics of his plan.

Update 2
In many ways, the Bebchuk plan is a varaint of the "good bank" plans, floated by the likes of William Buiter, Paul Romer, and James Kwak. As Kwak rites, "Romer suggests using government capital to create new, healthy banks that can essentially compete with the existing banks, which can then be treated under existing rules and regulations - if they become insolvent, they get taken over; some of their liabilities (like FDIC-insured deposits) are guaranteed, and some aren’t - and that’s that. Buiter goes a step further and recommends taking away banking licenses from the legacy bad banks and making them institutions that just run off their existing assets, in part by selling their good assets to the new good banks.

Romer proposes creating wholesale banks (the kind that only have businesses as customers) because they can be created more quickly (they don’t need huge branch networks), which would then buy good assets from legacy banks. Buiter also says that the new good banks will buy assets, such as deposit accounts and presumably branch networks, from the legacy banks."

More analysis of the credit crisis

Two recent NBER working papers examined the reasons that led to the sub-prime bubble and its bursting and the resultant credit crunch and the spill-over of the financial market crisis into the economy, and offers conjectures to overcome and prevent such crises.

Markus K. Brunnermeier claims that the the extent of securitization, which led to an opaque web of interconnected obligations, and leverage, which magnified the losses, have bene characterisitc of the present financial market crisis. He identifies four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets, starting with increase in mortgage delinquencies due to a nationwide decline in housing prices.

First, as asset prices dropped, the massive bad loan write-downs on borrowers’ balance sheets caused two "liquidity spirals" - financial institutions' capital declined and had a harder time borrowing because of tightened lending standards. The two spirals forced a massive chain of deleveraging. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.

Second, lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. Third, runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.

Fourth, the mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties’ credit, liquidity gridlock can result.

Raghuram Rajan and Douglas Diamond find three proximate causes - the US financial sector mis-allocated resources to real estate, financed through the issuance of exotic new financial instruments; a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets(originate-to-securitize); and these investments were largely financed with short-term debt.

Recognizing the critical challenge as that of enabling the removal of all the illiquid assets from the balance sheets of both banks and non-banks, they offer three possible suggestions. First, "the authorities can offer to buy illiquid assets through auctions and house them in a federal entity, much as was envisaged in the original TARP". Second, "the recapitalization of entities that have a realistic possibility of survival, and the merger or closure of those that do not. This would mean moving illiquid assets, of those entities closed down, into a holding entity that will dispose them off slowly over time."

The "third approach is some mix of the first two, where the authorities buy illiquid assets, even while cleaning up the regulated financial sector, focusing particularly on resolving entities that are likely to become distressed".

The problem with the approaches adopted by the Obama administration is that they treat the issue in parts, thereby leaving other parts of the crisis-ridden market un-repaired. The fundamental issue is that till all the toxic assets are cleansed out of the system and the market apprehensions about counter-party risks cleared, there is little chance that banks will lend and investors will invest. In other words, any approach to come out of the credit crunch has to be a comprehensive solution, covering all financial instruments and all institutions/agents (including the "shadow banking" system), and which removes all traces of illiquid assets overhang.

Unfortunately none of the approaches, including the third suggested by Rajan and Diamond, may help achieve the desired objective of restoring confidence and normalcy back. The extent and depth of the crisis is such that the only solution appears to be to subject all balance sheets to some evaluatory "stress tests", declare those insolvent and seize them, clean out stockholders, remove or shuffle its top management, pay off some of the debt, inject some equity, and re-privatize the entity. Siphon off the worst assets into a so-called bad bank (like the RTC) — pooling them with toxic assets from other nationalized banks, and hope they have some value after the crisis blows over. Call it "bankruptcy-receivership" or "nationalization", the substance of the aforementioned may be unavoidable!

(HT: Freakonomics)

Stress test semantics and the fight to stave off the N-word!

The request by Citigroup for additional capital which would raise the government stakes from the present 8% to about 40%, and also the conversion of the non-voting preferred share stake of government into common stock, has triggered off a debate about the exact nature of how government capital infusions should be classified. The always incisive James Kwak sets the stage superbly here, and goes right at the heart of the matter - define capital in a manner that the "zombie banks" can somehow be continue to be propped up with capital infusions till the markets get back to normal!

As Kwak explains, capital can span the whole spectrum from common stock to preferred stock to deferred tax assets (credits you gain by losing money in one year, which you can apply against taxes in future years where you make money). Whereas Tier 1 capital includes all the three, Tangible Common Equity (TCE) consists of only common stock. Since the latter is smaller than the former, the capital adequacy ratios calculated using the latter is smaller.

The stress tests will seek to evaluate the strength of banks based on among other things, their capital adequacy ratios. Capital adequacy (ratio of capital or equity to the total assets) measures the "ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised" or how much "my assets could fall in value by upto and still I would be able to pay back my depositors". Regulatory requirements specify certain minimum standards for capital adequacy ratios. The Treasury Secretary has declared that the stress tests being dones as part of TARP II will assume TCE as capital. This raises interesting challenges for those receiving bailout money in the form of preferred shares, as the Citi's predicament shows.

The government has so far put into Citi $45 billion in cash and got $52 billion in preferred stock (the $7 billion difference was the fee for the guarantee on $300 billion of Citi assets). The preferred stock was designed to be much closer to debt than to equity - it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years.

The present interest in converting the preferred stock stake of the government into common stock stems from a need to boost the TCE, and thererby increase the capital adequacy ratio to meet the minimum standard. Further, it would relieve Citi from the close to $3 bn per year dividend payouts and the the obligation to buy-back the preferred shares in five years. All this would benefit the bank’s bottom line, and hence its common shareholders, even with the attendant dilution of stakes as the government stake squeezes the existing owners. But with the current market capitalization of Citi's shares at just $12 bn, a conversion of all of the $53 bn government preferred shares to common stock would leave the government holding 80% of Citi! As Kwak explains, any purchase at higher than the market price, would be a straight subsidy to the existing shareholders.

However, as Kwak argues, the more important issue for consideration may not be the minutiae about how the government stake should be classified or which measure of capital should be considered, but how the government can manage its stake with management control but without controlling day-to-day operations, while at the same time ensuring that tax-payers money is most efficiently deployed. And the experience with AIG, where government owns 80%, shows how the government ends up with the worst of both worlds by dilly-dallying on the crucial aforementioned issues.

Or more preferably when faced with a banks with more liabilities (debt) than all capital (Tier I), as Paul Krugman says - seize the bak, clean out stockholders, pay off some of the debt, and re-privatize the entity - same as FDIC receivership or nationalization!

There is one another thing which lends credence to the view that these semantic quibbles may be irrelavant. The Modigliani Miller theorem claims that under certain conditions, it does not matter if the firm's capital is raised by issuing stock or selling debt, or what the firm's dividend policy is. All these debates about the exact nature of government stakes also assume (or hope) that the share prices will rebound once normalcy is restored to the markets, so that government can exit without too much cost to the tax payer. So the issue at hand is to get the normalcy restored by getting confidence back in the banks and thereby stem the decline in asset values, and not debating capital structure!

One cannot but help concluding that in the final analysis, all this gymnastics about conversion of preferred shares and stress test details is an exercise in avoiding nationalization and continue propping up zombie banks. Ben Bernanke, (full text here) in his testimony before the Senate two days back, had ruled out nationalization or anything where "the government seizes the bank and zeros out its shareholders". Simon Johnson and James Kwak sums up the context in light of Ben Bernanke's ambiguous and hope-filled testimony and the confusion surrounding the bailout dynamics,

"This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

The government's percentage ownership of a bank is a red herring. The key economic realities are: the government is already responsible for a large portion of bank liabilities, through insurance on deposits and new bank debt; the government is the only source of new capital for banks; and the government stress tests will determine whether banks are allowed to continue in operation and under what terms. The only purpose served by artificially minimising government "ownership" is to limit the potential upside available to taxpayers."

Adam Posen (and here) sets the historical context by drawing parallels with the Japanese lost decade,

"The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch."

Update 1
Economix has a nice sum up of the stress test scenarios here, and the "more adverse" case scenario is by no means as bad as being predicted by many. Does this mean that the stress tests will let off many banks lightly and then see them come back repeatedly for more assistance?

Update 2
NYT reports that the Treasury is considering conversion of the government’s existing loans to the nation’s 19 biggest banks into common stock, and give the government a large ownership stake in return. Paul Krugman and James Kwak feel that this conversion is only a "swap among the junior stuff, with no impact further up the line". And an analogy on the conversion here.

Arms-length nationalization or bankruptcy?

After the initial opposition and debate, the voices supporting nationalization are getting louder. The latest to join in support is Alan Greenspan, once an ardent supporter of the fiction that modern financial markets are self-correcting.

Even some of the shrillest initial opponents of nationalization are now switching sides, albeit grudgingly and with some semantical gymnastics. Alex Tabarrok of Marginal Revolution feels that nationalization may now be "very likely" and even "desirable", but prefers to use the term "bankruptcy" instead to describe the process. He argues for a bankruptcy takeover wherein the "government steps in, removes current management, pays off the depositors, reorganizes and then sells the banks to recoup its losses". This, he says, is the capitalist solution to bank failure, since the presence of deposit insurance effectively makes government the guarantor of all the liabilities of a bank and a government takeover would be the capitalist way to punish the owners of the failed banks.

Andrew Rosenfield draws attention to the crucial distinction between a normal firm and a bank, "Banks are rather special firms; they are so highly leveraged that their operations heighten the possibility of contagion and "systemic" risk. As a result, the government itself provides insurance against imperilment and failure to certain investors - depositors and buyers of special debt instruments called certificates of deposit issued directly by a bank (but not the debt issued by a bank holding company) to prevent runs and build trust. In return, banks are not subject to the general bankruptcy statute. Instead, the government enjoys special contractual control rights that allow it to simply and swiftly take over banks it regulates whenever they become imperiled. Those rights include "receivership," which gives the government license to treat bank failures economically and expeditiously."

Both Rosenfield and Tabarrok make the case for separating ownership from day-to-day management of the banks so taken over. They write that the government should install a new CEO of its choice, along with senior executive management, then provide the bank with fresh financial capital, and let it undergo the required restructuring process. They also feel that this arms-length takeover and management should preferably be done through the FDIC.

In any case, whether it be bankruptcy or arms-length nationalization, the result is same - government takes over the institution, seizes all assets, removes the existing management, restructures it and then runs it for some time before exiting its stake.

Update 1
James Baker feels that America may be following Japan's unsuccessfull example of trying to keep "zombie banks" on life support, and thereby risk losing a "lost decade". He therefore prefers nation alization in another name - "a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible"!

He suggests that all banks be subjected to stress tests under the worst case scenarios and then divided into three groups - the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds.

He writes, "The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment. After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations."

He also feels that the FDIC or an institution like the Resolution Trust Corporation can manage the transition. And all the decisions should be taken in one go, so as to avoid bank runs.

Geithner Put and nationalization!

Paul Krugman draws attention to the fact that the combined market capitalization of Citi, Bank of America, Wells Fargo, and JP Morgan is only $200 bn, whereas their potential losses (a guide to the amount of capital the federal government needs to put in to make these banks viable) are estimated by CreditSights to be $450 bn! This difference, or a major part of it, constitutes the Geithner Put, which will have to be met by the tax payers in the hope that assets prices will recover in future so that atleast a share of it can be recouped. The only thing certain with this course of action is that it will bailout the existing shareholders of these banks!

Krugman says that the stress tests proposed under FSP will only get more such alarming numbers out into the open, and given the political opposition to bailing out greedy shareholders, there will be no option but nationalization!

Nationalization is best option...

... so says Nouriel Roubini, in one of the best cases made in favour of nationalizing banks. He writes,

"There are four basic approaches to cleaning up a banking system that is facing a systemic crisis: recapitalisation of the banks, together with a purchase of their toxic assets by a government 'bad bank'; recapitalisation, together with government guarantees – after a first loss by the banks – of the toxic assets; private purchase of toxic assets with a government guarantee (the current US government plan); and outright nationalisation (call it or 'government receivership' if you don’t like the dirty N-word) of insolvent banks and their resale to the private sector after being cleaned.

Of the four options, the first three have serious flaws. In the 'bad bank' model, the government may overpay for the bad assets, whose true value is uncertain. Even in the guarantee model there can be such implicit government over-payment (or an over-guarantee that is not properly priced by the fees that the government receives). In the 'bad bank' model, the government has the additional problem of managing all the bad assets that it purchased – a task for which it lacks expertise.

Thus, paradoxically nationalisation may be a more market-friendly solution: it wipes out common and preferred shareholders of clearly insolvent institutions, and possibly unsecured creditors if the insolvency is too large, while providing a fair upside to the tax-payer. It can also resolve the problem of managing banks’ bad assets by reselling most of assets and deposits – with a government guarantee – to new private shareholders after a clean-up of the bad assets.

Nationalisation also resolves the too-big-too-fail problem of banks that are systemically important, and that thus need to be rescued by the government at a high cost to taxpayers. Indeed, the problem has now grown larger, because the current approach has led weak banks to take over even weaker banks. Merging zombie banks is like drunks trying to help each other stand up. JPMorgan’s takeover of Bear Stearns and WaMu; Bank of America’s takeover of Countrywide and Merrill Lynch; and Wells Fargo’s takeover of Wachovia underscore the problem. With nationalisation, the government can break up these financial monstrosities and sell them to private investors as smaller good banks."

Update 1
Greg Mankiw (!) too finally appears to approve of nationalization, albeit with any other name! He writes, "If this is the route we go down, the government had better get in and out as quickly as possible. If it is done right, nationalization will be the wrong word to describe the process."

Update 2
More support for nationalization, this time from Andrew Rosenfield, who advocates that in true capitalist spirit, the equity holders who failed their banks should pay for their recklessness and greed and the government should seize insolvent banks and take them into receivership. It should then appoint a new management team and inject equity into them. Steve Levitt agrees.

Update 3
Roubini again on nationalization - is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] - i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector -- it's clear that it's temporary. No one's in favor of a permanent government takeover of the financial system... The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic. Paradoxically, the proposal is more market-friendly than the alternative of zombie banks".

Update 4
Mathew Richardson weighs the case for and against nationalization and favors going for it. David Leonhardt too favours it.

Update 5
Paul Krugman critiques the plan to prop up zombie banks here.

Update 4
Mark Thoma compares the relative merits of government purchases of toxic assets, Subsidies and Public-Private partnerships to get the market in toxic assets going (Geithner Plan), and nationalization, using the parable of toxic cars market.

How to make banks solvent - Nationalization?

Bailouts have become the defining feature of the global economic landscape in the past few months, as a deepening recession leaves an ever increasing number of victims wayside. The debate now appears to have reached its climax, with a growing number of voices now calling for going the full hog - Government take-over!

The whole credit squeeze triggered off by the sub-prime mortgage defaults, assumed alarming proportions with the attendant flight to liquidity by the financial institutions. The massive leveraging (Morgan Stanley boasted $33 of assets for each dollar of capital) during the bubble years magnified the impact of this crisis. The unwinding of positions, with banks scrambling to shore up their steeply depleted reserves, led to massive sell-offs of securities, thereby driving them to bottom levels and leaving many of the asset backed securities virtually worthless and illiquid, without an active trading market. The deleveraging also left borrowers with a shrinking supply of credit and that too accessible at exorbitant prices. This left many of the biggest financial institutions vulnerable to being wiped out and necessitated the government to step in with bailouts.

The original $700 bn Troubled Assets Relief Program (TARP) had sought to identify and then auction the impaired assets on the banks' books and thereby establish a clearing price for them. It was soon abandoned in favour of direct cash injections, in return for some equity stake, so as to enable the banks to recapitalize and then use it to buy some of these impaired assets at a steep discount. With even this not being enough the Fed and Treasury took the extraordinary step of direct interventions of "quantitative easing" through direct purchases of distresed assets and guarantees for deposits and assets, and has so far committed more than $8 trillions for it.

But these bailouts ran into problems on many fronts, none of which were addressed by these bailouts. For a start, the deleveraging and the resultant plummeting of asset prices, had left many assets worthless, illiquid, and with no buyers. It did nothing to alleviate the masive credit and counter-party risks that had frozen the credit markets. Though it had hoped that the bailouts would recapitalize the banks and thereby encourage them to buy up the distressed assets on the cheap, this hope did not materialize as the extent of crisis was much deeper than anybody had fathomed.

In this context, three broad models for taking out distressed assets and bailing out weakened financial institutions have emerged. Let us examine the details of all three.

1. Citibank and Bank of America (BoA) model

This arrangement seeks to inject capital into the distressed banks, in return for some form of stake and commitments on dividend payout and executive compensation, and also provide a sharing (between the bank and government agency) of guarantees for the non-performing or illiquid assets.

The Citigroup bailout provides $40 billion in fresh capital and capital relief (in return for preference shares), and it ring-fences $306 billion of illiquid assets on Citi’s $2 trillion balance-sheet. The bulk of any losses on these, beyond the first $29 billion, will be borne by government agencies.

In the $118 bn BoA deal, the US Government decided to supply BoA with a fresh $20 billion capital injection and absorb as much as $98.2 billion in losses on toxic assets, including residential and commercial real estate and corporate loans. BoA will be responsible for the first $10 billion in losses on a pool of $118 billion in illiquid assets, while the Treasury Department and the Federal Deposit Insurance Corporation will take on the next $10 billion in losses. The Fed will absorb 90% of any additional losses, with BoA responsible for the rest.

In both cases, the Fed will buy up the distressed assets by creating specifically funded entities, which will in turn buy up the mortgage backed securities. This will effectively turn the Fed into a direct lender to homeowners.

In both cases, the equity infusion will be in return for preference shares and commitment to cut back its dividend payout, accept a loan-modification program and put more stringent restrictions on executive pay. The preference share route, instead of taking ordinary common stock shares, was to minimize risk (preference share holders come before common stock holders) and avoid playing a role in the day-to-day management of the banks so assisted. In contrast, the British bailout plan sought to take direct equity stake and ownership of the banks assisted, often majority control. However, in both cases, the bad assets will continue to remain in the balance sheet of the banks.

The problem with this model is that it does little to ally investor fears about the health of the bank, since the distressed assets, whose value is itself uncertain, continue to remain within te books of the bank. Further, it also does nothing to establish a clearing price for the impaired assets on banks’ books nor facilitate its trading. Finally, such bailouts, as in the case of the Citigroup, covers only a portion of the distressed assets, mortgage backed securities here, but leaves out the other similarly dubious assets like its huge credit-card and overseas-loan portfolios, and the numerous off-balance sheet exposures. Its piecemeal approach also creates dangerous moral hazard concerns.

2. Bad bank model

Ring fence all the troubled and non-performing assets of each bank separately and set up a "bad bank", a separate entity which takes ownership of these assets and then manages them in order to maximise their value. This is being tried out in UBS now.

The generic variant of this is to set up a universal "bad bank", which would 'buy up' the non-performing assets from different banks at "fair value", and thereby hope that
a) the uncertainty surrounding counter-party risk is eliminated and buyers know what they are buying
b) a price discovery mechanism for distressed assets is established
c) provide liquidity to a market for trading these assets

This example was successfully tried out in Sweden in the early nineties, and its efforts to restructure and resell distressed loans has been acclaimed a success. This cleaning up the books of banks is likely to restore some semblance of normalcy and thereby make it easier for these banks to raise capital or attract buyers. It is thought that this will have a huge psychological impact on the markets, in so far as it signals a clean break with the past.

In the US, it is now being proposed to set up a similar bad bank, or "aggregator banks", created and capitalized by the federal government, with the sole purpose of buying up bad assets and warehouse them in one place. The precedent cited is the Resolution Trust Corporation (RTC), set up in the aftermath of the Savings & Loans banks in the eighties.

The problem with this model of valuing and isolating bad assets, is what assets to be separated and how to value them. Assigning a "fair value" is an almost impossible task. Unlike the earlier precedents, this time we are dealing with fiendishly complicated structured mortgage assets with risks dispersed far and wide, even identifying and locating their risks, leave alone valuing them is virtually impossible. Since many of these assets are not traded in exchanges and others have been not traded for months and are illiquid, there is no way of valuing them with any sense of accuracy.

Any attempt to buy them by assigning them some valuation, will most likely end up adversely affecting the interests of tax payers, as the government is more likely to end up over-paying. Further, since it is not proposed to seize the distressed banks before the "bad bank" is set up (unlike in case of RTC), such bailout will reward the current owners and shareholders, by offering them the possibility of future gains in the good bank, besides encouraging moral hazard concerns. Paul Krugman has described this proposal "Hankie Pankie II" and compares it to the once abandoned Super-SIV plan.

3. Temporary Nationalization

To the extent that the purpose of all these bailouts is to get the distressed assets off the balance sheets of banks, and thereby re-establish normalcy in the credit markets, there are very serious problems with all these proposals. Stripped off all jargon, the simple reality is that the assets of many major banks are much less than their liabilities. In the circumstances, the only way for the Government purchases to make the banks solvent again is to pay much more than what private buyers are willing to offer (so as to atleast cover up the differential) and also take huge risks on board with the attendant possibility of even more cost for the tax payers.

Paul Krugman has argued that the least painful way to get this done is for the banks themselves to either write them off to zero or to sell them off at whatever price they get. This will penalize greedy shareholders and owners who are likely to get wiped out or have to exit at huge losses.

He has cited the example of the RTC, wherein the Government seized the defunct banks, cleaned out the shareholders, transferred their bad assets to RTC, paid off enough of the banks’ debts to make them solvent and sold the off to new owners. In Sweden, the Government took over whole banks, and then hived off the bad stuff without any kind of valuation at all, and then left them to sit for a while before selling them off. In Ireland in the nineties, the Government had taken over all the bank liabilities, by guaranteeing their unsecured debts, while leaving the assets on the banks' balance sheets, thereby bailing out the debt/bond holders in a massive way. However, the FDIC guarantees in the initial bailouts, along similar lines, was alleged to have been too favourable to bondholders.

All this brings us to probably the bailout of last resort - nationalization! The benefits are many - minimized moral hazard, cheaper cost of capital for the new banks, transparent, least cost to the tax payer, etc. Many influential voices, including even The Economist, have added their weight to nationalization. Awkward Corner and FT Alphavile points attention to the debate on nationalization with links.

Chris Dillow clarifies on the conventional responses against nationalization here. Of all these, Felix Salmon offers the most convincing case in two brilliant posts, where he gets most of the points right

"Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well - i.e., ownership. It's (nationalization) transparent and easy to understand: if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too."

And more here

"Nationalization is what the Nordics successfully did in the early 1990s; it can work here, too. The only real question is how much to pay: my gut feeling is that shareholders should get nothing, holders of preferred stock should take a serious haircut, and that if there aren't very many of those, then unsecured senior creditors should take a modest haircut too. The point of the exercise is to minimize the degree to which the banks' bondholders are bailed out, while at the same time minimizing the systemic consequences of a massive bond default by the likes of Citigroup and Bank of America.

But that decision is secondary. The big decision is whether or not to nationalize - or, rather, whether to nationalize now, and get it over and done with, or to continue to construct ad hoc responses in a desperate and probably doomed attempt to avoid having to nationalize at all. Surely we can all agree that if it's going to happen, it's better it happens sooner rather than later."

Update 1
NYT makes an interesting point, that nationalization has to be an either-or solution - you nationalize all the banks or none at all - since given the wobbly state of all major banks, any nationalization of a few, would see the floodgates open for the others as investors and depositers exit from them.

Update 2
Free Exchange has a nice summary of the two fundamental problems associated with any apprioach that involves asset purchases or ring-fencing off assets, like a "bad bank" - which assets are distressed and how to value them? The closer they get to transparent market pricing, the bigger the capital shortfall in the system will look! The narrower the scope of any bail-out, the smaller the up-front bill, but the greater the risk that more will be needed later—and thus the greater the market uncertainty!

Update 3
The NYT has this article which sums up the central debate in bailing out distressed financial institutions - how to value bad assets?

Update 4
Nouriel Roubini too feels that nationalization is the only meaningful way forward to clean up bank balance sheets without compromising the interests of the tax payers. He has calculated that they need $1.4 trillion in new cash to return their capital levels to where they were before the crisis began.

Update 5
William Buiter, Paul Romer and James Kwak discuss the "good bank" solution - instead of creating a government entity to buy toxic assets from existing banks - or nationalizing existing banks, removing their toxic assets, and then reprivatize them - create brand new, good banks with the same government money, enabling them to lend money unencumbered by previous bad decisions, and then privatize them. David Warsh sums up this debate here.

Update 6
An analysis of the Swedish model here. The authors argue that the Swedish model followed the principles of transparency of asset losses up-front, and honest communication about the extent of public intervention; politically and financially independent receivership; maintenance of market discipline; and restoration of credit flows.