Redefining the sacred in the banking rescue
Another week, another set of protestations that U.S. banks will remain in private hands, apparently almost regardless of the consequences.
It is clear that nationalization violates a sacred value for U.S. policymakers, or perhaps they believe it to be a sacred value held by voters. As we know from behavioral economics, when people are confronted by a conflict between material advantage and their ideas of the sacred, they tend to opt surprisingly often for the sacred.
Sometimes that is utterly right, but in this case it is really a false opposition. The Federal Deposit Insurance Corporation takes control of failed U.S. banks almost every Friday, and while taking some of the biggest over would pose huge problems, it should be possible to do it, to speed recovery and to hang on to what is essential: a market-driven system of capital allocation and a credible 3- or 4-year glide path to privatization for those assets and institutions that end up in taxpayers’ hands.
Fed Chairman Ben Bernanke added his voice to those maintaining that the crisis would be contained — no, wait, that was 2007’s line — that the banks wouldn’t be nationalized.
“I don’t see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn’t necessary,” Bernanke told the Senate Banking Committee on Tuesday.
“What we can do is make sure they have enough capital to fulfil their function and at the same time we exert adequate control to make sure that they are doing what is necessary to become healthy and viable over the longer term,” he said.
“Franchise value” is a risible concept for many of the banks in question. Who will choose to do business with a bank whose shares are trading at penny levels, even if their deposits and funding are essentially backstopped by the United States? My guess is that it really only happens where that institution offers better than market terms to its clients, which in essence is a subsidy via the government and exactly the kind of market distortion those who oppose nationalization say they wish to avoid.
And while “legal uncertainties” are regrettable, let’s get real; we are operating in a time of huge and immediately unresolvable uncertainties, legal and otherwise, not least how contracts underlying mortgage backed securities will be handled as part of the effort to stave off foreclosure.
(I GOT THOSE) TANGIBLE COMMON EQUITY BLUES
There appears to be some movement beneath the serene anti-nationalization surface. It is interesting and encouraging that the United States is reportedly considering converting some of the preferred securities it holds in Citibank and American International Group ultimately into common equity. Even better, it may decide to do the same with other past and future equity infusions, with the idea being that banks found wanting under the upcoming stress tests get an infusion of capital that would convert to equity as needed.
I see this as part of the process of the U.S. renegotiating what is and isn’t sacred. The problem with the old preference for preferred shares was that, while it checked the box of providing regulatory capital to banks, it did nothing to entice equity investors into holding their shares or committing new capital. Anyone could see that when the freight train of losses struck the bank’s balance sheet, ordinary shareholders would take the first hit.
Sadly, in their acrobatics to avoid putting banks into government control, the U.S. authorities risk becoming like a hospital that finally decides to use the wonder drug of common equity on patients who have already died.
What the government needs to do is real triage, leaving some to fend for themselves, giving those with genuine hope support — and common equity is the way to do that — and euthanising the zombie banks. Some of those in the middle might just end up with the government as majority shareholder.
George Magnus of UBS points out that there are two key issues that need to be resolved before normal growth can be restored and deflation staved off. First, debt needs to be paid down (or openly defaulted) and savings built up. Second, the financing system needs to be restored to health.
If we don’t hurry up with the second, the retrenching will be deeper and we may long for a scenario akin to Japan’s lost decade.
Remember, we already have the state directing credit into parts of the financial system. If the state supports zombie banks but exercises influence over them, rather than either controlling them directly or having a transparent arms-length relationship, we end up with a very bad scenario: state-controlled lending without transparency or true accountability.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. —