To Save The Banks We Must Stand Up To The Bankers

The Financial Times has just published an op ed by Peter Boone and me, arguing that aggressive bank recapitalization and toxic debt clean-up is essential in the U.S. – and that this can be done with strong protections for taxpayers and without nationalization.  The FT did a great job cutting our draft down to fit their print edition (of Tuesday, January 27th); I don’t think they took out anything crucial.  But, just in case, after the jump is the full article as submitted.(Note: newspapers usually like to choose their own titles for op eds, and the FT is no exception.  But I like their choice and I’ve used it as the heading for this post.)

If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say when confronted by the current situation of the United States: nationalize the banking system.  The government has already essentially guaranteed the liabilities of the banking system (and no one can risk a Lehman re-run), bank assets at market value must be massively lower than liabilities, and a severe global recession may yet turn into the Greatest Depression.

Nationalization would simplify enormously the job of cleaning up the balance sheets of the banking system, without which no amount of recapitalization can make sense.  An asset management company would be constructed for each nationalized bank, and loans and securities could be clearly divided into “definitely good” and “everything else”.  The arbitrariness of this procedure is not a worry when it all belongs to the government in any case.

The good loans would go into a newly recapitalized bank, where the taxpayer not only holds all the risk (as now) but also gets all the upside.  Careful disposal of the bad assets would yield lower losses than feared, although the final net addition to government debt would no doubt be in the standard range for major banking fiascos: between 10% and 20% of GDP.

As soon as you reveal that the country in question is the United States, the advice has to change for three reasons.  First, nationalization is an anathema in the U.S.  Second, there is good reason for this – the government here really has no track record of running successful business enterprises.  Third, most important, think about what would happen if the American political system gets the bit of directed credit between its teeth, with all the lobbying that entails.  If you want to end up with the economy of Pakistan, the politics of Ukraine, and the inflation rate of Zimbabwe, bank nationalization is the way to go.

Yet no one other than the government is available to recapitalize the banking system, and without sufficient capital, lending cannot be stabilized and any incipient recovery – based on the fiscal stimulus and the pending large mortgage refinancing program – will be strangled at birth.

The problem is not just pervasive financial and macroeconomic instability, it’s the scale of the recapitalization needed to cover the real losses faced by banks – remember Citi and Bank of America required “survival bailouts” and today are valued merely as options.  Additional capital is also needed to support the banks’ (and everyone else’s) desire for higher capitalization in the future. And, with the world economy still deteriorating, we need even more capital as a cushion against the worst case recession scenario.

And these are just the direct recapitalization components.  The asset management companies must pay cash for the distressed assets.  Buying at current market prices should protect most of the taxpayer investment and is the only approach that will find political support.

Adding these together suggests that the government will need to come up with “working capital” in the region of $3trn-4trn.  If things go well, at the end of the day the losses to the taxpayer should be quite limited, with the final cost closer to $1trn.  But this requires that the taxpayer gets enough upside participation.  How is this possible without receiving common equity which, at today’s prices, would imply controlling stakes in the banks (i.e., nationalization)?

We could receive a large amount of nonvoting stock, but a majority silent shareholder is an oxymoron who distorts the incentives of managers towards more bad behavior. And the last thing we need is further political backlash.

The most politically robust solution is to have the government acquire not voting stock but warrants – the option to buy such stock.  These warrants would convert to common stock when sold, and a Resolution Trust Corporation-type structure can manage the disposal of these controlling stakes into the hands of private equity investors.  New owners would restructure bank operations, fire executives, and break up the banks (particularly if some anti-trust provisions are added).

The sticking point will be banks refusing to sell assets at market value.  The regulators need to apply without forbearance their existing rules and principles for proper loan provisioning and for the marking to market of all illiquid assets.  We know they can do this in individual cases – NCC, for example, was forced out of business despite seeming well-capitalized by any publicly available measure.  It’s the big, politically powerful banks that have caught way too many breaks.

The law must be used against both accountants and bank executives who deviate from the rules on capital requirements.  This will concentrate the minds of our financial elite.  Either they will raise capital privately or the government will provide, but this time on terms favorable to the taxpayer.  The banker’s lobby, of course, will protest loudly.  Good thing we now have a U.S. President who can stand up to them, otherwise we would eventually collapse into nationalization.

By Peter Boone and Simon Johnson

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

3 Responses to "To Save The Banks We Must Stand Up To The Bankers"

  1. DocBerg   January 27, 2009 at 5:57 pm

    Why go through all this rigmarole? The tried and true remedy for insolvent businesses has long been the bankruptcy process. This has worked for hundreds of years, ever since debtor’s prisons fell out of style. The banks and credit card companies like it so much that they lobbied for years and got the chance to write up most of the current bankruptcy statute. Hoist them on their own petard. Too big to fail is proof that centralization of the money power into far too few hands has occurred. If a regional bank goes belly up, the regulatory process works fine. It would also work fine for those now deemed too big to fail, that are now too big to rescue. Let the federal courts handle this. We could certainly pay for a lot of new courts, judges, and other personnel with the amount of taxpayer monies slid to the doomed financial dinosaurs of Wall Street, and which is never going to be enough to solve the fundamental problems they have created.

  2. Anonymous   January 27, 2009 at 10:46 pm

    Great post Doc. I couldn’t agree more. We have had a process for failed and mismanaged businesses forever. It’s called bankruptcy. I also think a perp walk seeing Fuld, Thain, Madoff, et al in handcuffs being walked to jail would do wonders to instill confidence in the people that there is justice for all.No problem has been solved without pain. Currently the only pain is being pushed on to the little guy. These high flyers have managed to steal billions and prance around in their mansions and aircraft like they are kings.Let them fail, we all will suffer, but from the ashes better stronger and more socially responsible organizations will rise and we will flourish once again. But only after accepting failure.

  3. Paul Fraser   January 28, 2009 at 3:13 pm

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