Bank Nationalization: The Backlash?

All the chatter in the market this morning is about relief over the ebbing of fears of nationalization. At the end of last week and through the Sunday ‘punditry’ shows the drum beat for nationalization was growing. The culmination of this was the odd sight of George Will and Paul Krugman pretty much agreeing that nationalization was both inevitable and beneficial. The problem has been that the market facing media, such places as CNBC for instance, keep telling us that there is skittishness amongst private investors about that same prospect. Such are the tremors in the market that the market oriented ‘experts’ are fairly unanimous that the Obama administration needs publicly to be more forceful in disavowing nationalization. Only then, apparently, will bank stocks recover and private money be available to help the banks.

So we have two stories running concurrently. Who to believe?

Well not the market analysts.

They have skin in the game. In part they are correct: the reason banks stocks take a hit every time an official or top politician mentions the dreaded ‘N’ word is because under nationalization those stocks would be worth nothing. So the more talk there is of government take over the lower the stocks will go. That makes simple sense. What the market analysts, and the banks themselves, avoid saying is that any plan that does not involve nationalization implies a transfer of wealth from taxpayers to current bank shareholders. Of course they want to remain independent. They get welfare payments and protection from the mess that their managements have created. Whenever the market gets a sniff of this ‘get our of jail free’ card of course it bids up stock prices. I don’t think there’s any magic in that analysis.

At the same time I don’t think that anyone is thinking the government will not have to inject billions more into the big banks. So neither the pundits nor the market analysts are arguing over the prospect of future government largesse. The point of difference is what we, the taxpayers, get in return for our cash. Do we get part of the upside when the banks recover? Or do we simply fork cash over to the current shareholders and hope they do a better job with the capital this time around? The phrase for this second option is ‘Lemon Socialism’ – the taxpayers get all the risk and none of the return, while shareholders get rid of their losses but retain the opportunity for profits. In my vocabulary that stinks.

With the current market capitalization [i.e. the value of existing stocks at market prices] at such incredibly low levels – Citi and Bank of America combined are only worth about $20 billion right now – practically any meaningful injection of cash into either will mean that the government has more at stake than existing shareholders do. In reality it then owns them. We already are aware that the government has made forceful ‘suggestions’ to both bank’s managers about internal management matters, so clearly there is no fear of taking control. The only issue seems to be some political hand wringing. Frankly it’s a little too late for that. These banks, and one or two others, are already dead from a practical perspective, it is time to kill them off and get one with reconstruction. Naturally anyone who still retains a free market sympathy will object, hence the chatter this morning. Tough.

One last thing: much of the defense the banks are putting up against nationalization is based upon arcane accounting interpretations of the value of their rotten assets. Here’s how that works:

Banks can book assets in one of two ways. Both conform with acceptable accounting rules. First: if the bank intends to keep an asset through until maturity, it books the asset at its original value which is never altered even though similar assets may be bought and sold at very different prices during the interim. Second: but if the bank has no such intention and intends to trade the asset before maturity it has to ‘mark the asset to market’ at regular intervals. Some heavily traded assets are revalued hourly. Both of these methods are correct in that they seek to reflect the value of the assets to the shareholders. Obviously a mortgage that sits on a bank balance sheet for the full thirty years produces a value exactly corresponding to its original contractual value. In contrast a mortgage that is sold a year after its origin may have a different value circumstances may have changed [interest rates may have risen, or the borrower may have missed a payment or two etc], so it fair to reflect such changes.

What the banks are arguing is that over the medium to long term their ‘toxic’ assets are worth much more than their current market value. For instance: the economy should improve and when that happens mortgage defaults will fall so the value of the mortgage backed securities will rise. In this the banks are being correct. They then go on to argue that under these circumstances the fact that, as of now, they appear to have more liabilities than assets – i.e. that they are technically insolvent – is merely a temporary phase and will go away in due course. So taking heavy handed action like nationalization based upon such a temporary impairment, they suggest, is not just unnecessary, but punitive to the current shareholders who are entitled to retain an interest in the expected improvement. So goes the tale emanating from Citibank etc.

What’s missing in this is that no one knows how long away the ‘medium or long term’ is. In the meantime, with the uncertainty that will inevitably hang over them, the banks will not be able to acquire sufficient private capital, and so will not be able to rebuild their capital bases. If they can’t do that they also won’t be able to lend significantly, which is what we want them to do as a method of helping get the economy going. So we are stuck in a vicious cycle: the banks can’t lend until they get capital, to raise capital they need a healthy economy [so their asset values don’t scare off investors], but we won’t have a healthy economy until the banks can lend.

That leads us back to nationalization.

The most efficient, and the only proven, way to cut through this gordian knot is to take the banks over. Clean out their bad assets via government funding, restore their solvency, get them lending again which kick starts the credit pump to drive the economy, and then, once all this has happened, sell the banks back into private hands at a premium over the cost of nationalization.

Meanwhile the administration’s political calculation seems to be based on conducting ‘stress’ tests of the banks capital adequacy, starting this week. These tests are mathematical calculations designed to reveal how well the banks balance sheets will behave under a variety of hypothetical economic scenarios. If the tests show that the weaknesses we already know about are fatal from an insolvency perspective and that the banks optimism is incorrect, then nationalization becomes inevitable. But at least after the tests the administration will have political cover.

Everyone has to hope that market volatility doesn’t short cut the process which may take a couple of weeks.

Until then we will be treated to endless chatter from the market types about the equally endless evils of nationalization. Plus we will have to endure more silliness from the managers of these ‘zombie’ banks.

I wish we could get rid of them now. It would save us all so much time and money.

We really have to stop all this pandering to the stock market., it’s part of the reason we’re in all this mess.