Friday, January 16, 2009

Why It Would Make Sense to Nationalize Banks

Today's government bailout of Bank of America (Part Deux? Part Trois?) illustrates why nationalizing the troubled major banks would make sense. Beginning with last spring's acquisition of Bear Stearns by J.P Morgan Chase, heavily subsidized by the United States, until today's just-another-$20 billion-bailout of Bank of America, it's become clear that we have already nationalized the financial system's losses. The government does not, however, control what the banks are doing. When credit is badly needed to boost the economy, the banks aren't there for us. When a serious restructuring of the financial sector is needed, little progress is seen. Yes, there have been some emergency consolidations. But, when the Merrill Lynch acquisition started going sour on Bank of America, B of A went back to the table--the one where the government sits--and asked for, and got, a larger welfare check. The Bush administration nationalized the financial system's losses in order to stabilize it. However, the financial system hasn't been stabilized; and credit remains frozen.

The major banks and other major financial institutions have become latter day Fannie Maes and Freddie Macs: institutions where private parties get the profits and gains, and the public takes the losses. This assymmetry of profits and losses undermines free enterprise dynamics. Fannie and Freddie failed to manage their risks properly, because they and their investors figured, correctly, that Uncle Sam would bail them out if they were reckless.

Today, the managements of the major banks have similar incentives. They're under relatively little pressure to face the music and truly write off their losses There's always a chance Uncle Sam will help them out. Another government bailout program might improve the value of some of the bad assets on their balances sheets, or even purchase them from the bank, thereby boosting management's bonuses and stockholdings. They don't seem to notice that all the government bailouts to date--which came with a price tag now running in the trillions--haven't turned things around. If they don't bear the losses, they don't have to notice.

Thus, bank managements have every reason to avoid hard decisions and put off painful, but needed restructurings. At the same time, the government doesn't run the banks and isn't making the tough decisions, either. No one's in charge and nothing definitive is being done to clean up bank balance sheets. Granted, Citigroup has just announced plans for a restructuring. But have they truly made the hard, hard decisions? Or do we think that they might ask Uncle Sam for at least a few tens of billions more before all is said and done?

Nationalizing troubled major financial institutions would clear things up. The government would be in charge, which would mean it's responsible. It would have to find solutions. Having both the responsibility and authority would give it the incentive to do just that. Don't assume the government would get it wrong. Government officials have done a pretty good job after nationalizing Fannie and Freddie--we know that because Fannie and Freddie are no longer in the news. Mortgage loans have become harder to get; but it's actually good thing that borrowers now need more than a pulse in order to qualify.

Nationalization also paves the way for crippled banks to be recapitalized by private investors and eventually returned to the private sector. How? Because the government could turn the bank around and make it an attractive investment. Right now, the government is taking preferred stock in exchange for bailout money because it doesn't have control of the bank and preferred stock gives it the potential to secure some gains for the taxpayers. But the government's taking preferred stock discourages private investors from infusing capital, because they might be diluted by a subsequent government bailout. If the government nationalizes a bank, cleans it up and gets it back on its feet, private investors would have a much easier time buying the bank (or at least its good parts), at a price that could be fair to everyone. The bad parts of the bank would have to be held by the taxpayers, but they're on the hook for the losses anyway. Restructurings along these lines are already happening with AIG and IndyMac, which were nationalized last fall.

The financial sector won't recover from its current disfunction until its balance sheets are cleaned up. What's clearly unacceptable is more of the Bush administration's ad hoc, back of the envelope, 70-yard Hail Mary pass style policy, carefully tailored to its 2:00 a.m. perception of whatever the problem might be. Sometimes, after they announce a policy--such as the use of TARP to buy toxic assets--they then decide, in the full light of day, to back away from it. A few months later, buying toxic assets has returned as the policy du jour. The width of ties doesn't change as quickly. The current mixed private-public financial sector, whose balance sheets are opaque even on sunny days with clear skies, seems condemned to a slow, agonizing death of a thousand quarterly writedowns. Only animal torturers would enjoy what's going on. Nationalization shouldn't be forever. Nationalized financial institutions should be privatized, in whole or in part, as soon as is reasonably feasible. But to restore the financial sector's health, someone has to take charge, make the tough calls and administer the tough love. The only realistic candidate is the government, and we might as well get on with it.

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