Insolvent Banks?

Wow this issue won’t go away. Just two days after Obama tells us he does not consider nationalization a viable cure for our banking problems, because of our culture, this article pops up quoting all sorts of ‘experts’ with various degrees of advocacy of exactly that: News Analysis – Large Banks on the Edge of Insolvency

What makes this so much fun to watch is that no one really has any idea of what the banks are worth. That includes the banks themselves. There are plenty of yahoos, including one or two academics, on the internet claiming that the banks are pillaging taxpayer money and are not telling the truth about their situation. There are far fewer saying that the banks are safe. Even the banks are loath to say anything publicly for fear of setting in motion a run against them.

The central problem is that while the market for real estate backed derivatives is frozen up, or at least while it has little activity, no one can quite tell what those assets truly are worth. There is no market benchmark. So this is not a case of the legendary opaqueness of banking accounting. Banks deserve a terrible reputation for lack of transparency, but at the moment our lack of information is an honest assessment of the truth. This is why Geithner’s plan to ‘stress test’ the banks is important. It would force the revelation of their worth. It is also one of the reasons his plan lacked detail: the Treasury Department is trying to figure out how to undertake the valuation.

Meanwhile the drumbeat supporting nationalization goes on.

It is very easy for professors of economics to sit around and make sweeping statements about the system being insolvent. It is quite another to be responsible for fixing the mess. Rash statements could destabilize the markets even more. So there has to be a steady and careful phase of analysis while we take stock. Trying to grab headlines in the manner Roubini, Johnson, and others are doing is counter productive. Roubini’s statement that “The United States banking system is effectively insolvent” is irresponsible and seems only designed to support sales of his books. It doesn’t help find a solution.

A further complication is that the value of the assets will change as the economy changes. The stimulus package, if it works quickly, may well support a bank recovery. So low value today might imply a particular bank is insolvent, but a year from now an improved value could equally imply that the same bank is perfectly healthy. So we must beware of jumping to conclusions. A panicked market wants to know what the banks are worth right now, to which there is no straight answer. That reinforces the panic and thus devalues the assets even more. We want to avoid finding ourselves trapped in a slow spiral down to valuations well below what the assets could fetch in a year which would create an unnecessarily bleak picture of the bank’s medium term solvency.

Having said all that, as you know I am an advocate of temporary nationalization. Not of the entire system, but of selected large banks. My original thought was that the best candidates would be Bank of America and Citibank. Their combined assets represent a very high percentage of American GDP – about 20% – so taking those two into a forced restructuring would give the Treasury Department huge sway over the market place. It would also remove two of the more shaky and less well run organizations.

The problem is that the longer we wait to act the more likely a big bank is revealed to be obviously insolvent. In that case the government would be forced to step in, just as it has many times over for smaller bank failures already this year.

There is no doubt that on a current market valuation many of our large banks have severely depleted capital. Their ratios are well below regulatory minimums. One or two are almost certainly insolvent. So we must have effective policy options at hand.

In that regard, it is wrong to take nationalization off the table as a solution: it is a proven method of rescue and looks to me as if it might be the only effective solution. But we need to be sure about those asset values too, because we don’t want taxpayer money to be used unwisely. Especially given scope of the problem.

I think it is foolish to talk idly of systemic insolvency which risks disturbing an already unstable market. But it is equally foolish to ignore the best option we have for solving the mess.

Nationalization must remain in the forefront of our potential choices.