Don’t Nationalize … Now What?

I think it’s time we had a look at what happens if nationalization of our major banks is off the table. Since this seems to be the position of the Obama administration we should try to dig into their alternative.

In general the plan goes as follows:

Hand over plenty of taxpayer money to the worst affected banks so that their capital ratios remain in what is considered to be a safe range. Just today Citi announced that its ‘Tangible Common Equity ‘ ratio, which is now the favored capital relationship being used by analysts and regulators alike, is 4.1%. The obvious implication is that Citi has approximately $24 of assets ‘at risk’ for every $1 of capital. Further, also by implication, a 5% drop in value of all those assets would eliminate Citi’s capital rendering it insolvent.

But not all those assets are toxic and so not all will decline in value. Indeed, as the economy recovers much of the bank’s balance sheet will increase in value, and so on a ‘mark to market’ basis the bank will take a profit on the increase in value. This profit will be added, after taxes, to its capital base and the need for further government assistance will diminish.

So the government’s game appears to be to fork over cash as and when needed to keep the bank alive, and hope that rising asset values as the recovery begins, alleviates the capital crunch.

This is the only interpretation I can come up with for what the administration is doing.

So will it work?

Yes. As long as there are few asset losses between now and the recovery, and as long the recovery is strong enough to lift the value of the mix of assets that the banks have.

This is where my concern remains: this is exactly the initial strategy that the Japanese followed in the early 1990’s and it failed them because it ignored the contribution that the banks themselves make to the recovery. It’s one of those dreaded simultaneous equations we all hate to solve.

For the recovery to have any strength we need banks to be lending to assist business expansion. But a bank that is focused on retaining its profits to rebuild capital is not going to be aggressive as a lender. It will be relatively tentative and lend only to its ‘best’ customers. The old adage about only lending to those who already have money actually describes a very sound banking principle. This presents a conundrum to the administration. They are basing their plan on a flow of bank lending that may well not be there. If they are wrong, as the Japanese were in the same circumstances, then they are condemning the economy to a very long period of very weak performance. Not necessarily decline, but extremely weak, if any, growth. More to the point: given the huge amount of money being pumped into the economy at the moment – it is literally being created for the purpose of stimulus and bail out support – we are likely to see an upturn in inflation fairly soon as well as a rise in Treasury Bond interest rates. While, in my wilder moments, I am an advocate of inflation as a method of dealing with debt, that can only work if the economy is growing. Inflation along with weak growth is the worst of all worlds, as anyone who recalls the 1970’s can attest.

Thus it looks very much as if Obama is gambling that an economic recovery will be sufficient for him to avoid nationalization. Which, perhaps, explains why, today, we have been treated to a concerted barrage of upbeat outlooks from Bernanke, Romer, and even Pandit over at Citibank.

In the absence of corroborating evidence I would take this spurt of upbeat news with a massive grain of salt.

One more thing: I think a good question asks why the administration is being so tentative. As I wrote yesterday one plausible excuse is that the political climate just won’t allow nationalization. We Americans don’t resort to that sort of ‘unmanly’ policy. We do everything the hard way. On reflection I think a better reason is outright fear. I think, but cannot prove, that the administration is genuinely afraid of letting another large bank go through reorganization. The fear is of another melt down similar to the one that followed the collapse of Lehman. AIG is a very obvious case in point. The problem with AIG, Citi, Bank of America and so on is that they are far larger in their scope and impact than Lehman. They have vast books of business with counter-parties scattered across the globe. Further: no one, literally, has any idea what sits inside some of these esoteric derivatives. Regulators everywhere haven’t a clue what the derivative market would do were, say, Citi to go into bankruptcy or be taken down by the government. I cannot emphasis that enough: no one knows what would happen. In fact no one has a clue about the Byzantine details of even one of the derivative packages, let alone the whole market of them. No one. Not the regulators. Not the Treasury Department. Not the FDIC. And not even the banks themselves. Our heroic financial markets have created a kind of Frankenstein where not even its creators can its predict its behavior.

This is, of course, a national scandal. The hedge fund and investment bank ‘quants’ who dreamed this monster into life in order to create bonus opportunities for themselves now have the entire economy at their mercy. We are frozen for fear of the damage unravelling the mess would create. So we have to tread lightly, avoid doing sensible short term things like nationalizing the banks.

And that is the predicament that seems to be driving Obama’s ‘go-slow and hope’ strategy.

And you thought this was messy before all that didn’t you!