From Meredith Whitney:
C’s core problem is that it simply doesn’t make money in any of its businesses except Smith Barney, which it is in the process of selling.
Well, there’s always consumer banking in Asia. But you’ve got to admit that she has a point.
I’m very encouraged by the breadth and seriousness of the nationalization debate as it has unfolded in the blogosphere in recent days; Steve Waldman, at the bottom of his latest post, has done a sterling job of rounding up most of it in one place. (The post itself is excellent, too, and makes the important point that when we privatize a nationalized bank, we should do so in small-enough-to-fail chunks.)
So far there has been little indication that nationalization is being seriously considered by the Obama economic team, but as Obama said in his inaugural address today, curiosity is key value "upon which our success depends," and I do have faith in his team being open to all good ideas, rather than constrained by dogma.
Let me be clear in response to Jim Surowiecki, then: I am no longer making the argument, if I ever did, that "the only reason people are skeptical of nationalization is because it’s ‘un-American’." Much more substantive reasons are coming out, not least from Surowiecki himself, who today provides some more, which are worth responding to. Here are his first two:
1) Two years of financial crisis does not invalidate the general principle that private enterprise is typically better at efficiently allocating resources than government; and
2) the idea of the state literally determining which companies and individuals do or don’t get credit is, even to a non-libertarian, at least a little troubling.
I quite agree that the private sector does a better job of efficiently allocating resources than government. The reason is very simple: if a private company allocates resources badly, it fails. A government, by contrast, can allocates resources badly indefinitely.
Right now, however, we’re talking about too-big-to-fail banks: failure is really not an option. One look at their share prices tells you all you need to know about how good they’ve been at efficiently allocating resources. The question facing the government is what to do about those banks, given that the normal market disciplines cannot be applied.
Later on in the same blog entry, Surowiecki asks "what investor is going to be interested in putting up money to acquire a bank that has to compete with nationalized, and therefore subsidized, banks". There’s an easy answer, which is that the banks are going to be subsidized in some form or another anyway, whether they’re nationalized or not. And then there’s a bigger answer, which is that lots of investors have made very large amounts of money by successfully competing with state-owned banks. I spent many years covering the Latin American banking sector, where there are many state-owned banks, and where invariably those state-owned banks lose lots of money even as their privately-owned competitors are highly profitable.
Surowiecki’s second argument, about the state determining who gets credit, comes rather late: we crossed that bridge when we took Fannie Mae and Freddie Mac into conservatorship. What’s more, while a state-owned bank can certainly determine who does get credit, it can’t possibly determine who doesn’t. And the state often lends money — as does the Federal Reserve, in unlimited quantities, to private banks. If the state can happily determine that banks should get credit, why can’t it do the same for other borrowers? As Surowiecki himself concedes, "the government is already intimately involved in controlling the flow of credit". And it will continue to be so whether banks get nationalized or not.
Surowiecki then follows up with a second post on the same subject:
Many of the proposals for bank nationalization seem to imply that regulators should start declaring banks that are technically solvent (like Citigroup) insolvent, with the government getting to take all of the banks’ assets as a result of what regulators decide… This, at the very least, does seem like it creates room for political mischief. More important, having the government take over going enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.
Surowiecki should take a look at what the FDIC has been doing for years: exactly what he describes here. By "technically solvent" he just means that loans haven’t been written down to their market price — denial, basically, on the part of the bank’s management. If a bank is actually insolvent, the FDIC steps in, and either takes control of the assets itself or, more usually, finds some other bank to sell them to. The FDIC has been in effect for a long time, now, and I haven’t seen much evidence of "political mischief", and nor have I seen any indication that its existence makes investors less likely to buy shares in banks. Quite the opposite: the existence of the FDIC makes banks more valuable, since it makes it much easier for them to load up on cheap deposits.
None of this, of course, constitutes a reason to nationalize; it’s just arguments against arguments against nationalization. But that’s one of the things that’s great about blogospheric debates: people spend some real time working on the nooks and crannies of ideas. And when there’s an intellectually-curious administration in Washington, there’s finally hope that those ideas and debates might end up being reflected in policy decisions.
The WSJ has two important articles on Bank of America’s acquisition of Merrill Lynch today, concentrating on Ken Lewis and John Thain respectively. Both men were very quiet in mid-to-late December, before the acquisition closed, when they were CEOs of their respective banks and were obliged to keep their boards and shareholders apprised of the massive and unexpected losses at Merrill. Neither did so, and there’s a lingering suspicion that they both kept schtum on the implicit or explicit instructions of Treasury.
This is one situation where I’d really like to read one of the WSJ’s detailed tick-tocks on exactly what happened when — with emphasis on the details of when and how the Merrill losses came to light. I still can’t get my head around the idea that between December 8, when Thain told the Merrill board nothing about outsize losses, and December 17, when Lewis had an emergency meeting with Treasury, billions of dollars of Merrill loans suddenly went bad. It’s all still very foggy and in desperate need of sunlight.
Washington’s grandees clearly had better things to do this past weekend than orchestrate another bank bailout. Which is bad news for Ken Lewis: Bank of America is down 17% in early trade, at less than $6 a share — the bank has now joined Citigroup in trading on option value alone. This is not a sustainable state of affairs — as Tyler Cowen says, "banks don’t function well at low levels of capitalization".
Tyler asks "whether government ownership will succeed in building up a greater capital cushion for the banks": the answer, surely, is yes — or, at least, government will be better at that than if the bank stayed in the private sector. For one thing, government won’t feel the need to draw any dividends, and for another, a nationalized bank’s cost of funds falls sharply, and it becomes, overnight, the most trusted counterparty in the banking system. But the biggest reason is that the government doesn’t need to privatize the bank in exactly the same form as it was nationalized.
In any case, Tyler’s questions about the number of years of profits needed to create the cushion of capital which is required for re-privatization are, let’s say, not urgent. The imploding UK banking system and currency? That’s urgent, not that the US government can do much about it. But it does seem that bank failures are washing around the world in much the same way as currency failures did in 1998 — and the more banks that collapse overseas, the more that US banks are going to have to take multi-billion-dollar writedowns they simply can’t afford. And remember too that what used to be Lehman Brothers is now Barclays, whose ADRs are down more than 40% this morning.
Posting is going to be light today: I’m going to be off trying my best to be hopeful while watching and celebrating the inauguration of Barack Obama. But the financial crisis facing him on day one is enormous, and it does rather worry me that we don’t actually have a Treasury secretary right now, and won’t for a while yet. There is a large number of very important decisions to be made, and the decision-makers have to be put in place now. Delay can only cause harm, at this point.
Update: It turns out we do actually have a Treasury secretary: his name is Stuart Levey. But he’s not an Obama appointee, or part of the Obama economic team.
How Obama Really Won the Election: Nate Silver says it was all about the cities.
The Bad News: Is Obama’s presidency doomed before it even starts?
Cost of Borrowing Zooms Up for Corporations: Nabors, for instance, just issued 10-year debt at 9.25%, up from 6.15% a year ago. But Nabors is in the oil industry. Baker rebuts; Krugman rebuts the rebuttal.
The City Where the Sirens Never Sleep: Make the time to read this 10,000-word story on Detroit.
Why not nationalise? "Time to quit mucking around and make with the nationalisations." Says the Economist.
The Grain: "Recall that when cooking, oftentimes cutting against the grain is the right thing to do. Think of banking panics as the economic equivalent of flank steak."
Henry Blodget has convinced himself that he’s worked out "the right way" to fix banks. It’s a big debt-for-equity cramdown, basically, which, he says, will "avoid another Lehman" and involve spending "no taxpayer money".
Which got me wondering: what do we really mean when we talk about banks being "too big to fail"? In the case of Lehman, the single biggest repercussion from the bank’s failure was not the counterparty risk in the CDS market, which everybody was worried about but which turned out not to be a problem, but rather the evaporation of $155 billion in unsecured debt, which contributed to the Reserve Fund breaking the buck and a massive spike in credit spreads.
If we enacted Blodget’s plan for, say, Citigroup, the writedown on Citi’s senior unsecured debt might well be greater than $155 billion, depending on what exactly Blodget is referring to when he talks about Citi’s "debt". He leaves the term (deliberately?) vague, but if you look at Citi’s balance sheet, it has $774 billion in deposits, $105 billion in short-term borrowings, $393 billion in long-term debt, and $646 billion in other liabilities, including $250 billion to the Fed and $118 billion in brokerage payables.
If Blodget is serious about spending no taxpayer money, that implies that the Fed should take no haircut and that the FDIC should not have to step in to guarantee deposits. (He also says that "today’s preferred shareholders would get wiped out", however, which in and of itself constitutes a loss for taxpayers, since we own a massive chunk of Citi’s $27 billion in preferred stock.) But if Blodget really wants to ring-fence not only secured creditors but also depositors, that means that the bulk of the write-downs will be inflicted on Citi’s $500 billion or so of non-depositor unsecured creditors.
Blodget wants to write down Citi’s $2.05 trillion in assets "to nuclear-winter levels". I’m not sure what he considers to be a nuclear winter, but if those assets are written down to 80 cents on the dollar, that’s a write-down of $410 billion right there, and about $285 billion of that sum would have to be eaten by Citi’s bondholders. That’s not avoiding another Lehman, it’s creating a failure significantly larger than Lehman.
Yes, those bondholders would get a bunch of equity in return for their losses, but fixed-income investors aren’t generally even allowed to own equity, and would be forced to sell those shares at fire-sale prices. The resulting valuation for Citigroup, after writing off $410 billion and swapping $285 billion of debt for new equity, would be so low that it would imply that the rest of the US banking system was also insolvent.
Alternatively, you could include depositors among the unsecured creditors — which, of course, they are. But if you even hint you might do that, you start a run on the bank, and on any other bank which conceivably might be declared insolvent. Which is substantially all banks: we might be talking about the mother of all bank runs here. And how do you start giving out equity to, say, small Polish depositors?
I’m sorry, Henry, but there are no easy answers here. Unless you consider outright nationalization to be easy, of course. Which it isn’t — but it’s a darn sight more likely to work than any of the other ideas out there, including yours.
From Robert Peston:
Barclays’ share price has fallen again today. At the current price of 90p, this bank’s entire market value is ߣ7.5bn. And remember, this is a bank that said on Friday night that its profits for 2008 were considerably more than ߣ5.3bn.
Expect more carnage in US bank stocks when markets reopen tomorrow.
Jim Surowiecki provides proof that I’ve been writing too much and too hastily about bank nationalization of late:
At one point, Felix describes nationalization as "elegantly" putting an end to the current morass, while at another he describes it as "messy".
Jim kicks the debate forwards helpfully, describing the obstacles to bank nationalization in the US — not least the sheer number of banks here. "This would be an incredibly complicated process," he writes, "with massive ripple effects (psychological as well as practical) throughout the entire economy." He also ingeniously uses Willem Buiter’s argument as mitigating working against US bank nationalization. (Paul Krugman and I took it much more at face value.)
And while I’m on the subject of reasons not to nationalize, there’s also the question of bankers’ pay. How many US government employees do we really want earning more than the president? Already we’ve seen AIG pay out a massive $619 million (and rising) in retention pay, or about $150,000 per employee — how much money would the government end up paying to stop Citigroup employees from leaving? Some AIG employees are getting as much as $4 million to stay, which is ten times the president’s annual salary.
Meanwhile John Hempton and Kevin Drum put forward a pretty concrete idea of how nationalization might work in practice: Hempton calls it "nationalisation after due process". It still involves trying to work out exactly how much the bank’s bad assets are worth, however — an almost-impossible thing to do in this market — and what’s more, it results, once all’s said and done, in a severely undercapitalized bank: in fact Hempton seems to be happy with a bank at just half the required capitalization. (Or, to put it another way, double the maximum allowable leverage.)
Hempton’s an investor in bank stocks, so I can see why equity in highly-levered banks might appeal to him. But from a systemic perspective, this "solution" seems fraught with the risk that the bank in question will simply fail all over again, sooner rather than later.
On the other hand, I do like the proposal put forward by William Wild: leverage a bank’s existing origination and underwriting infrastructure, but fund new loans with ring-fenced new equity provided by outside investors. Here’s his abstract:
This paper outlines a new structure for lending by regulated banks, under
which the Tier 1 capital required to support a new loan is provided by the
borrower’s own equity-holders. In a downturn cyclical environment this
would secure a new, motivated and informed class of bank capital provider
to counter the pro-cyclicality of bank lending. The new structure would be
competitive in terms of cost to borrowers, nondilutive of existing bank
capital and credit risk neutral. It also has the potential to be an
effective instrument of market discipline in economic upcycles and
regulators might consider adopting it as a pillar in any revised bank
capital regime.
This doesn’t address solvency issues at the legacy institution, of course. But it might well help to get banks lending again, which is one of the main things that Willem Buiter was worried about.
I’m trying out an experiment, here: Paul Kedrosky and I will be chatting live on the subject of sovereign defaults. Feel free to join in!
