Tuesday, January 27, 2009

To save the banks we must stand up to the bankers

By Peter Boone and Simon Johnson in the Financial Times:

If you hid the name of the country and just showed them the numbers, there is no doubt what old International Monetary Fund hands would say when confronted by the current situation of the US: nationalise the banking system. The government has already essentially guaranteed the system's liabilities, bank assets at market value must be massively lower than liabilities and a severe global recession may yet turn into the Greatest Depression.

Nationalisation would simplify the job of cleaning up bank balance sheets, without which no amount of recapitalisation can make sense. An asset management company would be constructed for each nationalised bank, and loans and securities could be clearly divided into "definitely good" and "everything else".

Good loans would go into a recapitalised bank, where the taxpayer would not only hold all the risk (as now) but also get all the upside. Careful disposal of 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 banking fiascos: between 10 and 20 per cent of gross domestic product.

As soon as you reveal that the country in question is the US, the advice has to change. First, nationalisation is an anathema in the US. Second, the government has no record of running successful business enterprises. Third, think about what would happen if the American political system got the bit of state-directed credit between its teeth, with all the lobbying that would entail. If you want to end up with the economy of Pakistan, the politics of Ukraine and the inflation rate of Zimbabwe, bank nationalisation is the way to go.

Yet no one other than the government is available to recapitalise the banking system. Without sufficient capital, lending cannot be stabilised and any incipient recovery will be strangled at birth. The problem is the scale of the recapitalisation needed to cover the real losses faced by banks. Additional capital is al- so needed to support the banks' (and everyone else's) desire for higher capitalisation in the future. With the world economy still deteriorating, we need even more capital as a cushion against the worst-case recession scenario. These are just the direct recapitalisation components. Asset management companies would have to pay cash for the distressed assets. Buying at current market prices should protect most of the taxpayer investment and is the only ap- proach that will find political support.

The total of these figures suggests the government will need to come up with working capital in the region of $3,000bn-$4,000bn. If things go well, the losses to the taxpayer should be quite limited, with the final cost closer to $1,000bn (€766bn, £723bn). 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 - that is, nationalisation? We could receive a large amount of non-voting stock, but a silent majority shareholder is an oxymoron who distorts the incentives of managers towards further bad behaviour.

The most politically robust solution is for the government to 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 could 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 were 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 the marking to market of all illiquid assets.

The law must be used against 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 favourable to the taxpayer. The bankers' lobby, of course, will protest loudly. Good thing we now have a US president who can stand up to it.

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