Not quite there yet…

Maybe one day I’ll write about something other than the markets, but today is not that day.  Anyway…

A response to E.D.’s last post in this conversation:

I recoginze that bank nationalization as an option is on the table and is more viable than it has been.  The markets are so dislocated (for many reasons) that if an intervention by the government is going to occur (whether I like that or not is irrelevant so I’ll stay off of this), then all options should be considered.

Having the federal government buy bad assets from the banks is problemmatic because 1) the number is staggering (estimates of bad assets now exceed $3 trillion) and 2) I don’t trust government to pay what can be best estimated as market value today (Kip is spot on correct about that).  Getting private equity involved (i.e. my original ill-fated idea) won’t fly not only because of the political unpopularity with what could amount to giving private equity firms a nice guarantee (duly noted Jake) but also because there is, by my lights, only one possible lender that could step into such a position right now in such a way that it could make sense – the Fed.    I take no disagreement with Richardson’s and Roubini’s statement that we are at a dangerous tipping point (frankly, we’ve been at this point for a while). 

That said, I have a few comments:

First, Nourel Roubini’s warnings should not be taken lightly:

First — and this is by far the toughest step — determine which banks are insolvent. Geithner’s stress test would be helpful here. The government should start with the big banks that have outside debt, and it should determine which are solvent and which aren’t in one fell swoop, to avoid panic. Otherwise, bringing down one big bank will start an immediate run on the equity and long-term debt of the others. It will be a rough ride, but the regulators must stay strong.

“One fell swoop” would mean keeping the bondholders, shareholders and the market in the dark about which banks get nationalized until they do it all at once.  I am very skeptical that this will occur.  Given that it does not take much these days to get the markets riled up, I have a lot of worries about how this will affect the markets, especially with respect to the securities of banks and other financial firms.  Rumors can trigger short selling of bonds and stocks, making it difficult for otherwise solvent banks to raise capital, which could in turn cause a run on the bank itself, creating a sort of self-fulfilling prophecy.

I am also concerned about the political implications of managing of these companies.  From A Stitch in Haste:

What an enormous can of worms government ownership of stocks opens up. How should a “federal portfolio” be managed — for income, total return or preservation of capital? Who gets to decide? Should the government use its proxy voting power or stay on the sidelines? Should the government be limited to the (very undiversified) portfolio of stocks it acquires from PBGC-related bankruptcies or should it be allowed to buy equities on the open market to balance out its holdings? Should it be allowed to hedge positions via options or other derivative contracts? Is the PBGC strictly autonomous, or can Congress micro-manage the portfolio? What about “socially responsible investing” — many activist fund managers of state and local government pension funds have shown an eagerness to subordinate the financial interests of government employees for the sake of “making a statement.”

As far the idea that political influence will not be exerted on any company that is brought under the fold of the U.S. government: I’ll believe it when I see it.  Until then, I’m skeptical.

Second, to address a couple of E.D’s points:

Among the many eventual benefits of this plan would be the chopping up of these many “too-big-to-fail” behemoths that are, in fact, simply too big, whether they fail or not.  The free market “solution” of having Big Banks eat up Big Banks in order to save them has proved demonstrably false.  Bank of America was doing fine until they absorbed Merrill Lynch.  Now Bank of America is certainly too-big-to-fail, and yet far closer to the precipice.

On one hand, I don’t fault E.D. for criticizing Bank of America.  As of this morning, BofA’s market capitalization (share price x shares outstanding) is approximately $31 billion, which takes into account the $45 billion of taxpayer funds it received.  It doesn’t say much for how investors view the value of this company at the moment (I think Citigroup is in the same boat as well).  The attempt to acquire Merrill put BofA in dire straits.  No disagreement there. 

That being said, that a handful of acquisitions would bring stability to the capital markets was never in the cards.  The problems are too widespread.  These were solutions to specific problems that, for many reasons, have ballooned into bigger problems.   A free market solution to the broader problems in the market has not, was not nor will ever be considered. 

To Erik’s point, nationalization would deal with this but is not required to do so (although it could end up being a best of the worst set of options depending on how things transpire over the next several months).  For our purpose, I define “too big to fail” as a situation where the failure of a financial institution poses significant overall risk to the financial system (aka systemic risk ).    The concept of a bad bank or something like it in theory can address this simply by replacing the bad assets with cash or other liquid assets.  The other way to address “too big to fail” will have to be through a regulatory regime that prohibits participants in the financial markets from engaging in certain sorts of activities that can destabilize markets.  This will happen independent of how the banks and the toxic assets are ultimately dealt with. 

As I view systemic risk as a negative externality, it does not offend my libertarian sensibilities to suggest that a handful of individuals have no right to destabilize an entire financial system (and should be prevented from doing so).  It is why I feel very strongly about 1) limitations on financial leverage (we should have learned our lesson in 1998); 2) greater transparency is necessary in the credit derivatives markets to help understand counterparty risk; 3) substantial revisions governing how asset backed securities (i.e. mortgage-backed securities) are originated and sold, something that is being driven by investors as we speak.  As an example, I would expect that we would revert back to a system where originators keep the highest risk tranches (the first loss positions) of the loan pools; 4) creating rules that govern the markets as a whole and not specifically limited to certain types of financial institutions.    

Despite E.D.’s assertions to the contrary, I am not convinced that we are at that point of no return.  I don’t know if we will ever be at that point.  I believe that the execution of such a strategy will not be clean.  I worry about political influence interfering with the operation of these companies.  Furthermore, how do we get out?  How long is this going to take?  If and when government decides that it can spin off healthy banks, can they sell 100% of the interest in banks to private investors or will government end up retaining a majority interest in some way?  Will politics influence who gets shares in these newly constituted companies?  It’s a can of worms that I would like to avoid if at all possible. 

As the Sweden situation was a pimple on a whale’s ass compared to what we are facing, I don’t think it serves as a valid data point as to whether or not a nationalization of our banking system.  If we go this route, we are going to flying blind.  Fasten your seatbelts.  It will be bumpy.