Friday, March 6, 2009

Martin Wolf: To Nationalize or Not?

By Rolfe Winkler (Option ARMageddon):

Martin Wolf’s latest column is a fantastic analysis of our thus-far-impotent bank “rescue” strategy…

Much of the debate [about "nationalization"] is semantic. But underneath it are at least two big issues. Who bears losses? How does one best restructure banks?

Banks are us. Often the debate is conducted as if they can be punished at no cost to ordinary people. But if they have made losses, someone has to bear them. In effect, the decision has been to make taxpayers bear losses that should fall on creditors. Some argue that shareholders should be rescued, too. But, rightly, this has not happened: share prices have indeed collapsed. That is what shareholders are for.

Yet the overwhelming bulk of banking assets are financed through borrowing, not equity. Thus the decision to keep creditors whole has huge implications. If we accept Mr Bernanke’s definition of “nationalisation” as a decision to “wipe out private shareholders”, we can call this activity “socialisation”.

This is a huge point that few grasp. When the government took control of 36% of Citi’s common equity in its latest rescue, many thought the government was 36% closer to nationalizing the bank outright. That is false. Citi’s equity is now worth close to $0. 36% of $0 is still $0. The folks who haven’t absorbed any losses yet are Citi’s creditors. Their ownership stake in the bank remains entirely intact b/c the government keeps running interference by plugging equity into the balance sheet and “guaranteeing” certain assets against loss.

Typically when a bank becomes insolvent, FDIC uses its remaining assets to pay off depositors and then uses whatever’s left to pay back creditors. Creditors take losses while shareholders are wiped out.

An insolvent homeowner who can’t make payments on an upside-down mortgage gets foreclosed on and the bank sells his house for whatever it can get. The bank is the creditor in this equation. And it is forced to eat the loss for whatever amount the final sale price of the foreclosed home falls short of the remaining principal on the prior owner’s mortgage.

The banks are insolvent. Their assets are worth less than their liabilities. Depositors should be paid off and creditors should split whatever scraps are left at the table. If creditors have to eat losses, so be it.

It’s important to remember that when they are forced to eat those losses, it’s going to be painful for everyone. Most of society is a creditor to the banking system. If you have a bank account, this includes you. To bail all of us out, the government will likely have to borrow substantially more than it has in order to bail out depositors, which means higher future taxes. Not to mention that lending will fall even more dramatically. Insurance companies and pension funds, which are among the largest bank creditors, will be hit very hard and may themselves turn up insolvent. Those that rely on them will be forced to eat substantial losses as well. The problem will cascade seemingly without end.

And yet, despite all of this, we have no other choice. The banks are insolvent and have to die. Delaying the inevitable will only multiply the cost.

What are its pros and cons [of the government's current policy to protect creditors]?

The biggest cons are two. First, loss-socialisation lowers the funding costs of mega-banks, thereby selectively subsidising their balance sheets. This, in turn, exacerbates the “too big to fail” problem. Second, it leaves shareholders with an option on the upside and, at current market values, next to no risk on the downside. That will motivate “going for broke”. So loss-socialisation increases the need to control management. The four biggest US commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – possess 64 per cent of the assets of US commercial banks. If creditors of these businesses cannot suffer significant losses, this is not much of a market economy.

The “pro” of partial socialisation is that it eliminates the risk of another panic among creditors or spillovers on to investors in the liabilities of banks, such as insurance and pension funds. Since bank bonds are a quarter of US investment-grade corporate bonds, the risk of panic is real. In the aftermath of the Lehman debacle, the decision appears to be that the only alternative to disorderly bankruptcy is none at all. This is frightening.

Fearful of the consequences of a disorderly bankruptcy, policy-makers are trying to avoid them altogether. In effect, they are burying their heads in the sand hoping the problem will simply go away. It won’t, of course. So the longer we wait, the more disorderly the inevitable bankruptices are likely to be.

If it is impossible to impose losses on creditors, the state could well own huge banks for a long time before it is able to return them to the market. The largest bank restructuring undertaken by the US, before last year, was that of Continental Illinois, seized in 1984. It was then the seventh largest bank and yet it took a decade. How long might the restructuring and sale of Citigroup take, with its huge global entanglements? What damage to its franchise and operations might be done in the process?

We are painfully learning that the world’s mega-banks are too complex to manage, too big to fail and too hard to restructure. Nobody would wish to start from here. But, as worries in the stock market show, banks must be fixed, in an orderly and systematic way. The stress tests should be tougher than now planned. Recapitalisation must then occur. Call it a banana if you want. But bank restructuring itself must begin.

Wolf is under no illusions that restructuring the entire banking system is going to be easy. It won’t be. But we have no choice.

There is much more in Wolf’s column.

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