It Is Time to Nationalize Insolvent Banking Systems – Nouriel Roubini

 


Nouriel Roubini | Feb 10, 2009

A year ago I predicted that losses by US financial institutions would be at least $1 trillion and possibly as high as $2 trillion. At that time the consensus such estimates as being grossly exaggerated as the naïve optimists had in mind about $200 billion of expected subprime mortgage losses. But, as I pointed out then, losses would rapidly mount well beyond subprime mortgages as the US and global economy would spin into a most severe financial crisis and an ugly recession. I then argued that we would then see rising losses on subprime, near prime and prime mortgages; commercial real estate; credit cards, auto loans, student loans; industrial and commercial loans; corporate bonds; sovereign bonds and state and local government bonds; and massive losses on all of the assets (CDOs, CLOs, ABS, and the entire alphabet of credit derivatives) that had securitized such loans. By now writedowns by US banks have already passed the $1 trillion mark (my floor estimate of losses) and now institutions such as the IMF and Goldman Sachs predict losses of over $2 trillion (close to my original expected ceiling for such losses).

But if you think that $2 trillion is already huge, our latest estimates RGE Monitor (available in a paper for our clients) suggest that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding will be at their peak about $3.6 trillion. The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 million in the hole, or close to zero even after the government and private sector recapitalization of such banks. Thus, another $1.4 trillion will be needed to brink back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector. So these figures suggests that the US banking system is effectively insolvent in the aggregate; most of the UK banking system looks insolvent too; and many other banks in continental Europe are also insolvent.

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 recognize 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.

The very cumbersome U.S. Treasury proposal to dispose of toxic assets – that was presented by Treasury Secretary Tim Geithner today – can be best understood (subject to the large fog of uncertainty about its many details) as combining taking the toxic asset off the banks’ balance sheet with providing government guarantees to those private investors that will purchase them (and/or public capital provision to fund a public-private bad bank that would purchase such assets). But this plan is so non-transparent and complicated that it received a thumbs down by the markets as soon as it was announced today as all major US equity indices went sharply down.

The main problem with the Treasury plan – that in some ways it may resemble the deal between Merrill Lynch (ML) and Lone Star (LS) – is the following: Merrill sold its CDOs to Lone Star for 22 cents on the dollar; and even in that case ML remained on the hook in case the value of the assets were to fall below 22 as LS paid initially only 11 cents (i.e. ML guaranteed the LS downside risk). But today a bank like Citi has similar CDOs that, until recently, were still sitting on its books, at a deluded and fake value of 60 cents. So, since the government knows that no one in the private sector would buy those most toxic assets at 60 cents it may have to promise a guarantee (formally or informally by putting capital into a public-private bad bank that will receive extra lending from the private sector) to limit the downside risk to private investors from purchasing such assets. But that implicit or explicit guarantee would be hugely expensive if you need to induce private folks to buy at 60 what is worth only 20 or even 11. So the new Treasury plan may end up being again a royal rip-off of the taxpayer if the guarantee is excessive given the true value of the underlying assets. And if instead the implicit or explicit guarantee is not excessive (if the public-private bank truly tries to discover the value of such assets as in the formal Treasury proposal) the banks need to sell the toxic assets at their true underlying value that implies massive writedowns that will uncover the insolvency of such banks. I.e. the emperor has no clothes and a true valuation of the bad assets – without a huge taxpayers’ bailout of the shareholders and unsecured creditors of banks – implies that banks are bankrupt and should be taken over by the government.

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.

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.

So why is the US government temporizing and avoiding doing the right thing, i.e. take over the insolvent banks? There are two reasons. First, there is still some small hope and a small probability that the economy will recover sooner than expected, that expected credit losses will be smaller than expected and that the current approach of recapping the banks and somehow working out the bad assets will work in due time. Second, taking over the banks – call is nationalization or, in a more politically correct way, “receivership” – is a radical action that requires most banks be clearly beyond pale and insolvent to be undertaken.  Today Citi and Bank of America clearly look like near-insolvent and ready to be taken over but JPMorgan and Wells Fargo do not yet. But with the sharp rise in delinquencies  and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit  in a matter of six to twelve months even JPMorgan and Wells will likely look as near-insolvent (as suggested by Chris Whalen, one of the leading independent analysts of the banking system).

Thus, if the government were to take over only Citi and Bank of America today (and wipe out common and preferred shareholders and also force unsecured creditors to take a haircut) a panic may ensue for other banks and the Lehman fallout that resulted from having unsecured creditors taking losses on their bonds will be repeated again. Instead if, as likely, the current fudging strategy – of temporizing and hoping that things will improve for the economy and the banks – does not work and in 6-12 months most banks (the major four and the a good part of the remaining regional banks) all look like clearly insolvent you can then take them all over, wipe out common shareholders and preferred shareholders and even force unsecured creditors to accept losses ( in the form of a conversion of debt into equity and/or haircut on the face value of their bond claims) as the losses will be so large that not treating such unsecured creditors would be fiscally too expensive.

So, the current strategy – Plan A – may not work and the Plan B (or better Plan N for nationalization) may end up the way to go later this year. Wasting another 6-12 months to do the right thing may be a mistake but the political constrains facing the new administration – and the remaining small probability that the current strategy may by some miracle or luck work – suggest that Plan A should be first exhausted before there is a move to Plan N. Wasting another 6-12 months may risk turning a U-shaped recession into an L-shaped near depression but currently Plan N is not yet politically feasible.

But with the government forcing Citi to shed some of its units/assets and the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of  the insolvent banks.

You can expect a similar path and an eventual government takeover of most financial institutions in other countries – such as the UK – where many banks are effectively insolvent.

So while Plan A is now underway today’s very negative market response to this Treasury plan suggest that it will not fly. Markets were expecting a more clear plan but also a plan that would bail out shareholders and creditors of insolvent banks.  Unfortunately that is not politically and fiscally feasible. It is thus time to start to think and plan ahead for for Plan N (“nationalization” of insolvent banks).

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