Nouriel Roubini lays out the four ways to fix insolvent banking systems. Then he explains why the first three–the ones we’re using–are lousy:
There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:
1. recapitalization together with the purchase by a government “bad bank” of the toxic assets;
2. recapitalization together with government guarantees – after a first loss by the banks – of the toxic assets;
3. private purchase of toxic assets with a government guarantee and/or – semi-equivalently – provision of public capital to set up a public-private bad bank where private investors participate in the purchase of such assets (something similar to the US government plan presented by Tim Geithner today for a Public-Private Investment Fund);
4. outright government takeover (call it nationalization or “receivership” if you don’t like the dirty N-word) of insolvent banks to be cleaned after takeover and then resold to the private sector.
Of the four options the first three have serious flaws: in the bad bank model the government may overpay for the bad assets – at a high cost for the taxpayer – as the true value of them is uncertain; and if it does not overpay for the assets many banks are bust as the mark-to-market haircut they need to recognise is too large for them to bear.
Even in the guarantee (after first loss) model there are massive valuation problems and there can be very expensive risk for the tax-payer (an excessive guarantee that is not properly priced by the first loss of the bank, the fees paid and the value of equity that that the government receives for the guarantee) as the true value of the assets is as uncertain as in the purchase of bas assets model. The shady guarantee deals recently done with Citi and Bank of America were even less transparent than an outright government purchase of bad asset as the bad asset purchase model at least has the advantage of transparency of the price paid for toxic assets.
In the bad bank model the government has the additional problem of having to manage all the bad assets it purchased, something that the government does not have much expertise in. At least in the guarantee model the assets stay with the banks and the banks know better how to manage and have a greater incentive than the government to eventually work out such bad assets…
Thus all the schemes that have been so far proposed to deal with the toxic assets of the banks may be a big fudge that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.
So much for all the plans put forth so far, including Tim Geithner’s latest brainstorm. Now on to the solution.
Note that Nouriel is not recommending the alternative that Geithner and Summers always invoke when someone suggests this route: permanent government ownership and operation of the banks. We all agree that would be a disaster. What Nouriel is talking about is temporary receivership and restructuring.
Thus, paradoxically nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – most certainly – even the unsecured creditors in case the bank insolvency hole is too large; it provides a fair upside to the tax-payer. It can also resolve the problem of avoiding having the government manage the bad assets: if you selling back all of the assets and deposits of the bank to new private shareholders after a clean-up of the bank together with a partial government guarantee of the bad assets (as it was done in the resolution of the Indy Mac bank failure) you avoid having the government managing the bad assets. Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold back in a re-privatization scheme, the government could outsource the job of managing and working out such assets to private asset managers if it does not want to create its own RTC bank to work out such bad assets.
Nationalization also resolves the too-big-too-fail problem of banks that are systemically important and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-to-fail problem as the current approach has lead weak banks to take over even weaker banks. Merging two zombie banks is like have two drunks trying to help each other to stand up.
The JPMorgan takeover of insolvent Bear Stearns and WaMu; the Bank of America takeover of insolvent Countrywide and Merrill Lynch; and the Wells Fargo takeover of insolvent Wachovia show that the too-big-to-fail monster has become even bigger. In the Wachovia case you had two wounded institutions (Citi and Wells Fargo) bidding for a zombie insolvent one. Why? Because they both knew that becoming even bigger-to-fail was the right strategy to extract an even larger bailout from the government. Instead, with nationalization approach the government can break-up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller good banks.
This “nationalization” approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze. Japan ended up having a decade long near-depression because of its failure to clean up the banks and the bad debts. The US, the UK and other economies risk a similar near depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.
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