by Adam S. Posen, Peterson Institute for International Economics
Commentary on Google News on the news story "Nationalization Fears Dominate BofA, Citi," (foxbusiness.com)
February 23, 2009
This commentary first appeared on Google News.
Many important US banks are currently in a dangerous halfway house between public and private, fragile and failed. This is unprecedented in scale, but not in situation. The United States faced a very similar problem with our Savings and Loan crisis of the mid-1980s, Japan and Sweden had systemic banking crises during the 1990s, and a host of less advanced economies have suffered from this type of problem. Some colleagues and I examined the common attributes of these situations in Japan's Financial Crisis and Its Parallels with US Experience, and there is a large literature that comes to the same conclusions as we did: It is better to temporarily nationalize undercapitalized banks and remove the uncertainty that hangs over the financial system than to put in more public money without adequate control over what is done with it. Otherwise, losses mount on the taxpayer bill, and the financial system is no healthier—that is in fact what has happened in the United States over the last several months. Temporary nationalization assures taxpayer control and strict evaluation of the reality of banks' balance sheets.
The ongoing accumulation of nonperforming loans and the resulting continued decline in solvency of many American banks has been a significant drag on growth and will only get worse absent government action. Properly capitalized banks will face losses from the recession no matter what, but will not roll over bad loans because they would have enough of their own capital at risk and can bear the costs of writing off bad loans. The costs to the US economy of leaving its financial system undercapitalized are enormous in terms of lost growth, missed investments in new firms and projects (due to the bias towards rolling over old loans to avoid write-offs by undercapitalized banks), and low returns on savings.
The Obama administration has announced that it will do strict examinations of the 20 biggest banks' balance sheets starting this week. If anything close to current asset values are used to evaluate those books, and they should be, many of these banks will need public capital injections or closure. The reluctance to pull the trigger appears to be based on the fact that such forced write-offs would require the unpopular steps of another injection of public funds and/or round of closures, either way involving government ownership of those banks, a.k.a. nationalization. Failing to be so strict and leaving current shareholders and top management in control will just lead to further losses and repeated suspicions about some banks' viability, as we saw in the stock market last week.
Implementing the write-off of the bad loans should follow what is now a reasonably standardized sequence from other countries' and past-US banking crises. See for example what I recommended for Japan in 2001, which was largely and successfully implemented by Japanese financial services minister Heizo Takenaka in 2002–03. I would note that many current senior US economic officials, such as Geithner and Summers, advocated much the same for Japan and for the Asian countries hit by the 1997–98 financial crisis in response to those banking crises. The only thing that makes the United States different is that we are rich enough to be able to engage in fiscal stimulus to soften the blow to the real economy while the bank cleanup is done—the logic of how to deal with a banking crisis, and the evidence for what works, is relevant to here and now.
First, supervisors truly count and publicly recognize the extent of the bad loans, using market signals about the worth of various assets—those banks whose losses exceed their capital are shut down, with bank shareholders losing all their equity and depositors being reimbursed up to deposit insurance limits. Those banks that have positive but too little (i.e., below prudential standards) capital after taking loan losses, are either sold or merged with other more viable banks or are recapitalized by an infusion of public funds, which are conditional on certain performance requirements— private shareholders again take a loss through dilution, with some equity shifting at least temporarily to the public sector. Also, foreclosed collateral (land) is sold off.
On purely economic terms, the undercapitalization, the nonperforming loans, and the fact that we are coming off of an unsustainable bubble in intra-financial sector debt issuance should prompt the Obama administration to close or merge many of the United States' largest banks. Though the political reality may prevent this occurring, the Treasury and FDIC (and Federal Reserve) must make clear to the public that the American banking sector must shrink. The surviving banks, including those with public funds, will be forced to pay off the loan losses over several years, absorbing most profits. American taxpayers will in the end have to pay the lion's share of capital injections into the banking system and the deposit insurance payouts, though they will get back much of the money from the sale of currently distressed bank assets.
That is why the Treasury is right to set up some sort of purchase program for bad assets. I don't see any reason why it shouldn't be a publicly owned entity, like the Resolution Trust Corporation (RTC) was in the United States during the Savings and Loan cleanup. In fact, the additional complexity, and thus toxicity or illiquidity, of today's securitized assets give an additional argument for having them all be bought by the US government: Then a single entity would have a supermajority stake in various asset classes and be able to reassemble sliced and diced securities, going back to the underlying investments (such as mortgages). This would detoxify most of these assets, making them attractive for resale by unlocking their underlying value, and thus offering the possibility of some upside benefit for the taxpayers when sold back to the private sector.
In theory, a set of private sector investors or public-private partnership could do this kind of reassembly voluntarily, but in practice the coordination problems are insurmountable, as seen in the complete lack of market for these assets at present. Just as the EPA can go to a Superfund site, on which no one can live and no private entity is willing/able to clean up, detoxify that real estate, and then have it come back on the market at a good value, the Treasury and FDIC can do the same with these currently toxic securities—if it has ownership and puts up the funding and effort to do the cleanup.
None of this is open to dispute. The bottom line is the same for all countries facing banking crises. It is based on the same immutable logic about the incentives of undercapitalized banks and the therefore negative effects of leaving current shareholders and top management in place. If the Obama administration forces the write-offs without public capital injections and bank consolidation, meaning temporary US government voting and management control, the undercapitalized US banks will persist in their bad behaviors. The uncertainty this leaves over the entire US banking system, including the viable well-capitalized good banks that remain, will erode the system's functions as either a safe repository of savings or as an allocator of investment. If the Obama administration allows the undercapitalized banks to wait for the distressed assets to come back to value possibly someday, or overpays for the bad assets instead of writing them off strictly, the US government would simply give these failed businesses a further transfer of public funds. This would add to the bill American taxpayers will pay, while diminishing the upside that the American taxpayer could get back from resale of detoxified assets.
Nationalization is a very unpopular word, but like most taboo words, when you look at the reality behind it, it isn't quite so scary. The key is that government control is temporary, with sell-offs of distressed assets and viable bank units back to the private sector to commence as soon as possible, some of which can begin almost immediately. No one in their right mind wants the United States or any government owning banks for any longer than absolutely necessary. The Mitterand government nationalized French banks in the early 1980s as a matter of socialist ideology, not necessity, intending to keep the banks in the public sector—and that was a huge mistake. The resultant misallocation of capital interfered with innovation and discipline in the French economy and led to a few tenths of a percent lower annual rate of growth in productivity and GDP, which over several years makes a huge difference. But that was an unneeded governmental takeover of viable banks kept in place for a long period.
The United States right now, in contrast, has an undercapitalized banking system which, if left under current ownership and management with the incentives and uncertainty that fears of insolvency create, will accumulate more losses of national wealth on the order of several percentage points of GDP within a year. And the allocation of capital by the halfway publicly-guaranteed, halfway private, major US banks system is like that of the formerly hybrid Fannie Mae and Freddie Mac: poor, even by comparison to clearly publicly controlled institutions. And this situation harms the viability of those well-capitalized fully private banks we still have in the United States through unfair competition and spillovers of uncertainty. So on balance, nationalization will cost us less, and spare us things getting worse, than will allowing the banks to get capital without sufficient conditions or write-offs.
I will be testifying on this issue before the Congress' Joint Economic Committee on Thursday, February 26. Please look for my posted testimony at 10 a.m. that morning, which will provide more detail.
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