– Paul Danos is the dean of the Tuck School of Business at Dartmouth College. The views expressed are his own. –

A major question in the government response to the banking crisis is choosing between the “evils” of nationalization of banks that would however provide stability, versus the “benefits” of saving of the private banks that would innovate and compete in a market system.

As the dean of the Tuck School of Business I’m privileged to speak with a wide range of economists, bankers, Wall Street executives and our own students, and what I’m interested in is finding an answer somewhere in the middle ground:

* First decide what major businesses absolutely need in banking services and then set up a ‘facility’ to assure that that those prime banking services will be available. This facility would initially be owned by the government but with an explicit goal of going to full private ownership as soon as feasible.

* Make that facility a separate legal entity from private banks.

* Let the private banks operate these “franchised” facility under close scrutiny.

* Have a process by which the private banks ultimately benefit from the operations of the ‘facility’ by having them acquire an increasing ownership in them.

* Though managed by private banks after absorption, the facilities would remain legally separate.

The trick is to be able to absorb the facility into the private banks after the crisis and not along the way destroy the private banking system as we know it, which means that the private banks must seen as benefiting from the scheme. To the extent that the facility does well, the banks would benefit in that they would have the ultimate ownership; and if the facility does poorly the government would have to absorb the losses, at least in the initial stages.

If the government did set up an initial $200 billion facility it could then be leveraged to say $2 trillion in loans. The “good” facility would be available to all companies for a limited list of transactions for the duration of the crisis, with say a minimum of five years. We could then let the markets settle the bad assets issues in the private banks. Some would fail and some would survive.

After the absorption of the facility the resulting private banks would have two parts, one highly regulated that would provide on-going assurances to the business community, and one relatively unregulated that would allow innovation and society would glean whatever benefits we are supposed to get from that kind of activity.

The government would over time get compensated by the investments made by the payment for the ownership of the facilities.

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

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. –

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

Like 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.