Over the weekend I took part in a brainstorming session over at Yves Smith’s naked capitalism about the financial crisis and ways and means of nationalizing the banks that are in trouble. Something that I don’t think that most of the commenters appreciated is that the scale of the problem makes this situation quite different from the savings and loan debacle for which the Resolution Trust Corporation was created back in the 1980’s.
The banks that are in trouble, especially Citibank and Bank of America, have a market share in the United States greater than the next five largest banks put together.
If by “nationalizing” one means doing something like what was done in the savings and loan crisis, it means taking the banks into receivership, something that’s commonly done under our FDIC system, and selling off the assets. In this case there are several problems with that.
First, the number of qualified buyers isn’t particularly large. Even if you’re talking about selling off the assets piecemeal, you’re really only talking about Wells Fargo and U. S. Bank. Can those two carry the freight by themselves, particularly under the current circumstances?
Second, whether you’re talking about banks or jellybeans if you dump enough of something into the market fast enough the price will fall. And when the price of banks’ assets fall that means you’re going to reduce the value of the assets of the healthy banks, too. Can they stand the strain?
Well, can’t you just keep the bank operating while you sell off its assets in an orderly manner, possibly over a period of years? That may well be what’s in the offing:
Citigroup Inc. is in talks with federal officials that could result in the U.S. government substantially expanding its ownership of the struggling bank, according to people familiar with the situation.
While the discussions could fall apart, the government could wind up holding as much as 40% of Citigroup’s common stock. Bank executives hope the stake will be closer to 25%, these people said.
Any such move would give federal officials far greater influence over one of the world’s largest financial institutions. Citigroup has proposed the plan to its regulators. The Obama administration hasn’t indicated if it supports the plan, according to people with knowledge of the talks.
And that, my friends, is how one creates a zombie bank, the problem that Japan has had for more than two decades. I don’t know what else you call it when you trade $45 billion for 40% of a bank with a total market capitalization of $19 billion. The bank will continue to exist as long as we’re willing to shovel money at it. This is why people are talking about creating “good” banks. The old ones are so over their heads they’re not worth saving.
I think that we need to face the reality that there is no good, painless solution to this problem. Rather than trying to protect the stockholders of banks or even salvage the old system it might be prudent to start thinking what sort of banking system we’re going to have moving forward and how to shield the people who are most vulnerable from the problems created by the coming shakeout.
The first problem with the S&L RTC comparison is that the nature of the S&L crisis was that its business model was failing (lend long-term and borrow short-term) and being overtaken by well-capitalized banks. The business was going elsewhere and the question being raised was do we really need thrifts when we can bank elsewhere? We don’t currently have an “elsewhere.”
The second problem is that the bank assets to be collected are somebody else’s liability. That raises the possibility of forcing lenders into less desirable terms. The S&L crisis did not hit many borrowers hard because by the back end of the crisis interest rates had gone down substantially, so RTC could either find willing buyers for the mortgages or many people were refinancing to lower rates anyway. I suspect that interest rates will be going the opposite direction.
Also, I disagree with the notion that the RTC model is nationalization. The anonymous FDIC commentor at Naked Capitalism is not articulating the FDIC’s position during the S&L crisis, which was that the FDIC is a sui generis blend of public and private concepts. In it’s private role, it is doing what a private insurer would do, via claim subrogation, to collect funds in the event of a pay-out.
I am not aware of any time in which the RTC decided not to collect on a debt for non-pecuniary reasons, such as that the business was operating in the public interest. That’s the concern with nationalization, that the government will start mandating social benefits (like green cars for Detroit) that start seeming like political benefits (like payoffs to Acorn) that are unlikely to improve the businesses economic viability.
Which kind of nationalization are you urging, Dave?
Nationalizing in order to liquidate not nationalizing in order to operate. That’s what a lot of the econbloggers mean when they talk about it.
I have flogged this point of practicality (to no avail) with anyone who will listen, including a chase your tail discussion with Bernard Finel over at OTB.
Its easy to talk about “liquidating” banks and creating “new” banks. Its an almost insurmountable task when you think about the magnitude of the new bank task.
Similarly, selling off Citi and BOA assets sounds great over brandy and cigars……….but to whom? Middle Eastern oil barrons??
I’m sticking by my original point – you do the classic financial restucture:
1. fresh money (govt) comes in and washes out the old equity
2. you get rid of the CEO and his top 2-3 reports, and bring in new senior mgmt
3. you leave all of the infrastructure and worker bees in place
4. you pre-paper the deal. close on Friday, back in the business of making loans with a healthy balance sheet on Tuesday.
5. three years from now you IPO the bank back into private hands
Operationally practical. No zombie banks from drip, drip, drip capital infusions. The old money loses, the taxpayer new money gets the benefit, if any.
Is this that hard?
Drew, the problem is that the banks have a fatal wasting disease of the balance sheet. How much fresh money do you need to put in to wash out the old equity? Nobody knows.
Dave –
I know numerous commentators view the notion that bank’s (bad) assets cannot be valued as a reason to dictate a certain course of action. But let’s think that through.
1. For those who advocate hiving off bank’s “bad” assets into a bad bank, they will have to go through this exact valuation process in deciding what and how much to hive off.
2. For those who want to “liquidate” a bank and sell off the portfolio in pieces to “responsible banks”…. you again are implicitly asking third parties to value and price the assets….from pristine (par value)……to risky (discounted)…….to unsaleable. One could argue that process has the positive attribute of a market test, but the analytics are not proprietary. The valuation issue still pertains, and can be performed.
3. And clearly (to me, anyway) just liquidating banks and letting “new” banks fill the void is the neanderthal approach. Fiduciarily unsound, for the priors, and the new banks will become operative in about 2012…. A fools errand.
So. How have we avoided the valuation issue – and therefore the “how much new equity” issue – in alternative approaches to what I advocate? Further, my proposed solution avoids some very relevant and difficult operational issues.
Now, my personal biases, based upon the banking and PE history that is the last 18 years of my career. Do people not know that financial portfolios are valued all the time? Financial portfolios are sold all the time. Its not rocket science. It can be judgemental. It takes experience. It can be contentious. But it is done in the normal course of commerce. All the time.
So I have to ask: why do people balk when confronted with this valuation issue?? Could it be other issues and motivations are at play?
PS – Did anyone see Greg Mankiw’s comments re: creating a good bank/bad bank without new money? Basically creating two balance sheets.
I’d really like to hear PD’s and Dave’s comments.
I fell (figurateively) out of my chair.
Drew, If it’s the Mankiw comment I am thinking of, then it kind of points to the problem with your step #1. How you deal with step #1 depends on whether banks are insolvent. If it’s insolvent, then the government can do just about anything to equity holders — their property interests are illusory or at the very least hypothetical. They can then go on to rewrite contracts and cancel debts because the creditor’s, employees, etc. all have illusory or hypothetical claims as well.
If it’s not insolvent, then I assume the stockholders would need to be bought out. If such a plan were announced ahead of time, I’d probably buy me some Bank of America stock. If it’s not clear whether the bank is solvent or insolvent, then the government needs to institute a standard for determination. IIRC about a third of the S&Ls were insolvent when the FSLC started closing them down and there weren’t any difficult financial issues. These S&Ls were only being kept in business by loans from banks. Of course, this just leads back to issues of valuation of troubled assets.
Otherwise, I like steps 2-5, though I’m not a stickler for firing management, but that might be a political necessity.
PD –
I should have said Mankiw linked to the proposal, by Woodward and Hall. You can find it Here: http://woodwardhall.wordpress.com/2009/02/23/the-right-way-to-create-a-good-bank-and-a-bad-bank/
The proposal to remove a banks bad assets and enough liabilities to the banks holding company such that the bank would be sufficiently solvent and could go about its business. The holding company (a “bad bank”), and its stakeholders, would then get whatever financial result it got.
They advocate this approach it to avoid fresh (taxpayer) money being put into the bank. And if the holding company ultimately fails, so be it.
I wanted to get a reaction because implicit in his maneuver is again having to value assets, because that would dictate which assets and how much liability you sent to HoCo.
Thanks Drew, I didn’t follow that link (I usually don’t when the blogger doesn’t comment on it). Most of it’s above my paygrade; it seems simpler and easier to accomplish than long-term plans to reorganize a company in bankruptcy or receivership. Though it looks conspicuously to me like the makings of a pre-packaged bankruptcy.
And I personally don’t see a big problem with valuing these troubled assets. PIMCO has said it could do it from the beginning and I only gather that that avenue wasn’t fully explored because the valuation, if done fairly, would probably result in bad news.