Why We Should Nationalize Now

Joe Nocera says he’s looking for a bold new plan to tackle the financial crisis — but the one he spends essentially his entire column talking about is the creation of a government-owned "bad bank" — an idea which is neither bold nor new. (It’s essentially what the TARP was first intended to be.) He concludes:

In past financial crises, it has often been the bold and brilliant stroke that has restored confidence and revived the financial system. During the German hyperinflation of the 1920s, the government actually created a new currency. During the Latin American crisis of the late 1980s, the United States government created so-called Brady bonds, which cleverly allowed banks to get their Latin American debt off their balance sheets by turning it into tradable instruments.

And here we are again, in need of bold action and strategic thinking and the restoration of confidence. Inauguration Day can’t come a moment too soon.

Nocera has mentioned the idea of nationalization — which is rapidly becoming the cleanest, boldest, and most compelling solution to the problem — but only in passing, in a blog entry, and with the caveat that it "cuts against the American grain — and leaves shareholders with nothing".

I’m not sure what the American grain is, but it’s hard to see how nationalization cuts against it while a trillion-dollar bailout doesn’t. And yes, shareholders of insolvent banks should be left with nothing: that’s capitalism, that is. Although the government is free to pay them some small amount for their equity if it wants.

It’s also worth examining Nocera’s examples of "bold and brilliant strokes". Creating a new currency during a period of hyperinflation? Not sure how that’s relevant, or even brilliant — that’s what normally happens during hyperinflation. And the Brady bonds, far from being bold and brilliant, were in many ways the opposite of what most people are looking for today.

In the early 1980s, when a slew of overindebted Latin governments defaulted to their bank creditors, a lot of big global banks, Citicorp foremost among them, became insolvent. If they marked down their LDC debt, as it was known, to anything approaching its true market value, they would have large and negative net worth.

What happened was not a bailout. Instead, the banks kept those bad loans on their books at par, and sat down for an endless series of negotiations with the countries in question. The negotiations were never going to go anywhere: the countries couldn’t afford to pay back the debt in full, and the banks couldn’t afford to take a large haircut. But by maintaining the fiction that they were negotiating in good faith, the banks managed to avoid having to write down their bad assets.

This went on for so long that eventually the banks managed to build up their capital cushions from other operations — at which point the US government stepped in to help create the Brady bonds. The existence of the Brady bonds put a price on the banks’ debts, but most of the banks didn’t sell their debt immediately: they continued to hold on to it, in the hope that the price of the Bradys would rise. (Which, in fact, it did.)

We can’t do something like that today: the world has changed too much for insolvent banks to be able to hold toxic assets on their balance sheet at overinflated values and operate indefinitely as a going concern. Bankers who rail against mark-to-market accounting are essentially indulging in nostalgia for the 1980s — but we can’t go back there. Instead, the insolvent bank has to be nationalized. Eventually it will go public again, either with the bad assets excised from its balance sheet and moved to some other arm of the federal government, or else after those bad assets have recovered in value enough for the bank to be worth a positive amount of money.

As Steve Waldman notes, nationalization is (contra Kevin Drum) what the Nordics successfully did in the early 1990s; it can work here, too. The only real question is how much to pay: my gut feeling is that shareholders should get nothing, holders of preferred stock should take a serious haircut, and that if there aren’t very many of those, then unsecured senior creditors should take a modest haircut too. The point of the exercise is to minimize the degree to which the banks’ bondholders are bailed out, while at the same time minimizing the systemic consequences of a massive bond default by the likes of Citigroup and Bank of America.

But that decision is secondary. The big decision is whether or not to nationalize — or, rather, whether to nationalize now, and get it over and done with, or to continue to construct ad hoc responses in a desperate and probably doomed attempt to avoid having to nationalize at all. Surely we can all agree that if it’s going to happen, it’s better it happens sooner rather than later.