The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets, thereby wiping out, as needed, the equity of common shareholders, followed by the interests of preferred stockholders and then the bond owners.
The bad assets would then become assets of the Federal Deposit Insurance Corp. or a special entity established by the federal government. The new owners could then keep the assets or sell them to private investors, who are reportedly waiting anxiously to acquire them.
Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy, and it provides just punishment for making stupid decisions. Nationalization is neither a necessary nor a sufficient condition to solving today's problems.
The treatment of Continental Illinois in the 1980s and the purported success of the Resolution Trust Corp. are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the U.S. currency and our government debt.
The truth is that deleveraging by financial institutions, corporations, and individuals takes time. The bad assets on bank books will disappear as they heal, are liquidated, or are charged off through earnings. Corporate debt will be reduced as corporations file for bankruptcy or make use of their cash flow. Individuals will delever by erasing debt through bankruptcy or curtailing consumption.
During this period the level of economic activity will be hurt unless the government expands its expenditures and levers its balance sheet. Nationalizing banks will not prevent this process from occurring.
The fact that "vulture investors" are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closings of financial institutions in the 1980s and 1990s. They can't wait to be the beneficiaries once again of a large transfer of wealth courtesy of the federal government. Fans of the RTC cover it in accolades, but the beneficiaries of its largess chuckle.
An acquaintance of mine offered the following observation casting cold water on the much-touted success of the RTC: "When I was working on a mortgage-backed trading desk back in the '80s, the RTC went to the Street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff, so they can once again buy distressed assets at fire-sale prices. It is the way of the Street."
Nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going-concern basis has no place in their playbook. Calling these investors "vulture investors" gives vultures a bad name!
Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.
There are two issues that merit careful consideration before being swept up in this drive for nationalization. Who determines what "bad assets" need to be excised from a bank being nationalized, and who determines the price of a bad asset at the time of its removal?
In the case where a loan is determined to be a bad asset and is transferred to another entity, the borrower loses the right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than it would otherwise be, since the new holder of the loan would be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.
Recent events regarding securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of the bank that made it is higher than the intrinsic value if the loan is housed and administered elsewhere. Furthermore, the original lender is far more likely to advance additional funds to the borrower, thus extending the borrower's economic life.
Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are higher than the comparable values if they are held by most private investors. This is because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available because of expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve Board.
The intrinsic value of assets on a bank's balance sheet today are understandably higher than what nonbank investors claim.
We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs, their cost of funding is plummeting, they have very favorable interest spreads, and their earning assets exceed their paying liabilities. The truth is that with the benefit of hindsight, almost all of the banks and savings and loans that were closed during the 1980s and 1990s would have survived if they had received today's deposit guarantees and deposit rates and had been given enough time. The exceptions are institutions that were caught by persistent rate spreads when interest rates soared, as well as banks that were closed because of fraud and malfeasance.
The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.
