Nationalization by autumn, bank on it

By J Saft
February 13, 2009

– James Saft is a Reuters columnist. The opinions expressed are his own –

jimsaftcolumnLike it or not the United States will be forced to nationalize large swathes of its banking system by the time the leaves fall from the trees in Washington.

The tragedy is that we will have to wait that long and that the costs will mount.

The plan to rescue the banks, or, er, the people, as enunciated by Treasury Secretary Geithner, is no plan, only an apparent set of contradictory principles: an ideological one not to nationalize and a political one not to subsidize too obviously.

The plan will fail unless the administration comes out in favor of either subsidy or seizure of failing banks. Either the United States will be forced to nationalize when that becomes apparent or perhaps it is waiting until that failure makes nationalization more politically palatable.

In either event, it is a terrible mistake and the cost will only grow, both in direct terms for taxpayers and more broadly for the growing number of people with too little income to pay tax.

Geithner laid out a plan to apply stress tests to large banks and require those that do not pass either to raise capital (from whom exactly, I hear you ask) or to accept an injection of convertible securities from the government on terms that have not been defined. Banks that take government coin will have limits placed on their compensation and other actions.

There is $500 billion to $1 trillion to fund an aggregator bank which will “partner” with private capital and set prices for distressed bank assets, presumably with some sort of insurance wrapper to limit private capital’s downside. There are also measures intended to generate lending directly to consumers, house buyers and businesses.

All in all, it’s a bit like watching a man trying to eat a steak without using his teeth.

“The financial system needs at least $1 trillion in tangible common equity to be sufficiently capitalized — the capital holes on financial balance sheets are just too large to be plugged with convertible securities with vague terms,” Paul Miller, an analyst at FBR Capital Markets who has been very prescient, wrote in a note to clients.

“Another concern … is that it does not adequately address the toxic assets on bank balance sheets. It does include a variation of a public/private aggregator bank, but private investors will want to buy assets at distressed prices and the banks will only sell assets at above-market prices.”

Those two points form the crux of the issue; for the banking system to work without widespread failure and nationalization we either have to hand out huge subsidies to banks directly, in the form of cheap capital, or indirectly, by giving a subsidy to investors who will pass on part of it to banks as a condition of getting their share. The first is unfair, the second unfair and inefficient.

PLAYING THE LONG GAME IN A SHORT LIFE
Of course, it could have been worse. We seem to have escaped calls to magic solvency up by suspending mark-to-market accounting, which would have worked as well as making “six” the new “zero.”

And in fairness we don’t know how the stress tests will work or if it is possible to fail one. But President Obama did tell ABC News that nationalization “wouldn’t make sense” because of the scale and complexity of the U.S. economy and capital markets would make it too tough to manage and oversee. He’s right and government will do a terrible job of managing banks, but it will be forced to and may as well get on with it. They seem now to be hoping that the economy turns and bails them and the banks out of their pickle, but that is a dangerous bet.

By the time we figure out that it’s not working, when whatever capital we have injected is swamped by falls in asset prices — and remember deleveraging and asset price falls go hand in hand — things will be that much bleaker and the United States will have less room to maneuver.

But ironically, maybe the most hopeful sign yesterday was the negative way in which the stock market and shares in banks reacted. Bank investors clearly thought that this raises the chances of them having their equity extinguished or at the very least their share of future profits diminished.

And Obama is not FDR coming in after a depression was already entrenched, he is leading a country which is only beginning to wake up and to suffer. It is just possible, though not likely, that the administration realizes it will have to take more drastic steps but needs more time to prepare the ground and make that politically possible.

One factor which may come into play is international pressure not to nationalise. What is just about possible in the United States would be far harder in economies such as Britain’s with larger banking systems relative to their size and borrowing power.

109 comments

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I should add the idea of nationalization is usually of barbaric Nazi socialist type control … keeping the populous uninformed and uneducated … which is what elitists privatization tried to do , snow jobs as long as you feed their monster .. a double sided hypocrisy .

there is a great mind base struggling out of all this now , at the moment a little to much information … but a potentially great US leader able to communicate our way thru … trust , also confirm and verify the steps .

a new form of nationalization could be , rather than black or white … to be more like government caretaker acquisition … subsidized support for proven reformers .. like auto companies intelligently restructuring and retraining employees for alternate technology … eg . for updating the huge auto stockpile for later use .

incentive for financial entities and corporations to change method and direction … once stable and dynamic again .. a new place in the free market , but with $ obligations of repaying government support.

flexible , but controlled and regulated .

if the rot is to bad desolve the entities and fill the vacuum with co-operatives of better potential.

free market survival is the ideal to work towards but with view of supporting the social holistics … rewarded by the government in tax incentives.

find the right models it would spread globally into developing countries too.

the way corporate CEO’s have behaved it’s like child psychology …. show responsibility they get the fun and reward … but now they have their allowance cut off and grounded.

Posted by Harry | Report as abusive

if you have a choice – let a bank collapse or nationalize it, what would you do. Paulson let one bank collapse and that alone triggerred a global recession. No imagine what happens if say Citi collapses? US and UK have already lost a substantial part of its global financial power. Looks like if need financing, you will now have to look to Asian banks. The European banks, except for a few of them, are no longer safe either. A question arises how can you sustain Dollars as the world’s reserve currency, if have no financial system with a global reach to support it.

Posted by dv | Report as abusive

The most important lessons from the crisis are:

Financial markets absolutely have to be transparent. Complex derivatives have to be permanently banned, all financial tools have to be easy to understand with well understood risk.

Consolidation is very dangerous, the more firms the healthier the economy and the lower the chances of a systemic failure.

Posted by Int | Report as abusive

With respect to the fellow contributors, sorry I disagree, please ‘Get your facts right’ – it’s nonsence to think that fall of Lehmann caused this current crisis. Two things caused the LB demise. Both epitomised in their CEO Mr. Fuld. The guy was so arrogant that not only did he spent billions at the top of the market (over-leveraged deal came near the peak of the property cycle), later still stubborn he was unwilling to accept debt-for-equity proposals offered to him to stave off disaster for LB. Now that’s inexcusable for a wall street veteran. That’s not expedient management shareholders expect. His head just got too big yet he had at least 12months to fix it..Sorry I have no sympathy for those like him. The problem is that there have been many similar investments made by others accross the globe that had absolutely no clue about the business they were doing.

Posted by Franz Kafka | Report as abusive

When you say you have no sympathy for “those like him”, you’re pretty much referring to the entire Wall street. Nobody will believe that Mr. Fuld and Lehman Brothers was the only evil who “deserved” to fail. LB was just a small link in the whole system and didn’t deserve any more than other banks who also had plenty of toxic assets in their books. Only that Paulson stepped in just the right time to save everyone except LB. Yes, Mr. Fuld was known for making enemies and it is deeply troubling that an entire company failed for his arrogance. Because his personal wealth didn’t go anywhere. It’s only the investors and employees of LB who lost everything.

Unfortunately, I think this Mr. Saft is right, there will have to be some kind of nationalisation by the fall. At the same time, there will be greater scrutiny on the actions of Wall Street and the banks. Part of what has caused the financial mess is the fact that loans were being created that the bankers knew could not be repaid.

Posted by Brian Bigelow | Report as abusive

a quote from the past:

“Owners of capital will stimulate the working class to buy more and more of expensive goods, houses and mechanical products, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalised, and the State will have to take the road which will eventually lead to communism”

Karl Marx, Das Kapital, 1867

Posted by Chris Ryser | Report as abusive

In the old days when all of a bank’s loans were directly on its books, a sampling and analysis of creditworthiness would give an accurate statistical estimation of default risk of its credit exposure. With the advent of securitization of loans into synthetic investment vehicles, it became virtually impossible to estimate risk. This is because the connections between the security and the loans underlying it, had become so obfuscated and complex due to the synthesis techniques used to create the securities that risk became practically indeterminable.

Sub-prime mortgages were the first class of credit vehicles to encounter problems. We are only beginning to see the effect of a larger class of vehicles – Alt-A and Option ARM mortgages – that are beginning to reset with expected double digit default rates. Then there is credit card debt, student loans and commercial real estate, all of which have been synthesized into investment vehicles and all of which are facing increasing default rates.

The point is, we ain’t see nothin’ yet. So any attempt to create a market for “toxic assets” will be a market of fools, and most of these have been wiped out by now.

It was as if the credit crisis traveled across the Atlantic as a tsunami, triggering the crisis in Europe. The next shoe to fall will be the European banks. That will create a reverse tsunami that will bring about Mr. Saft’s prediction if it hasn’t already occurred at that point.

We are a year and a half into this crisis and we still get a new “Black Swan” event almost every week – this with all the remedial action taken by governments globally, to date. I think Mr. Saft is being gentle in his call so as not to frighten the populace.

Posted by Ian Nunn | Report as abusive

I don’t know how many public leaders have to say it before bloggers, pundits and prophets of doom get the message, but let me spell it out: U.S. banks will not be nationalized.
Ben Bernanke just made it clear in Senate testimony today, saying that in a worst case scenario the federal government will merely buy preferred stock in an over-stressed bank and that the stock could be converted to common stock later, depending on the needs of that bank. That, my friends, is not nationalization in any meaningful sense of the word. It would simply make the federal government a partner with other stockholders which may or may not have a negative impact on the price of common stock, depending on how the markets price it.
Please, bloggers, move on to another topic.

Posted by Ron | Report as abusive