Nationalize, Cleanse And Get It Over With

Washington is doing what Washington does best. Resurrecting old ideas and dressing them up as a new solution. The latest is the “aggregator bank”. Some sort of financially engineered solution to the ongoing problem with our banking system. It’s just new lipstick on the old TARP pig.

The concept is the same one they have tried to sell since the beginning. Buy the bad assets from the banks and do something, anything with them. No plan except to get them out of the banks. Logically, some sane minds outside the Beltway have said from the outset, “Yes, but what price do you intend to pay for these assets?” The newest proposals try a bit different spin but still ignore the essential question. Do the banks, their managements and their shareholders get a sweetheart deal or do we buy these at market and probably tank the banks?

Into the fray comes our old buddy Willem Buiter. Fortunately he is less verbose than usual and gets to the point quickly. His solution is to simply nationalize the banks, set up a clearing bank (bad bank in the terminology of the day) to take the toxic stuff and then reconstitute the rump institutions and sell them off. Along the way he gets lost in trying to do too much in terms of using the concept to spur lending but we can talk about that another time.

The beauty of his proposal is that he diffuses the argument about how to pay for the bad stuff. Here is his logic:

In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks.  The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks.  If all the banks, and the bad bank, are publicly owned, this problem goes away.  The toxic assets are simply moved to the balance sheet of the bad bank.  They could be valued at anything from zero to their notional value or historic cost (or even higher).  It would be a redistribution of wealth from one state-owned entity to another state-owned entity.

Note that the guarantee component of the Bank of America package (like  the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets.  The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended – for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets.  There isa valuation embedded in the guarantee or insurance offered to Bank of America and Citigroup: the state will compensate the banks if the value of the securities falls below a certain level.  But the valuation is rather well hidden, and may not be revealed unless the guarantee is actually invoked.  Also, guarantees are off-balance sheet, and politicians, like bankers, like that.

The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established.  This may never happen, in which case the bad bank would hold the toxic assets to maturity.

The publicly-owned banks would be reprivatised when financial markets stabilise and the economy recovers.  It would be good if a better regulatory and supervisory regime for banks and other highly leveraged entities were in place by that time.

Ironically, by partially nationalising some of the banks, by making this injection of public capital expensive financially and as regards other conditionality, and by holding the threat of possible future (partial) nationalisation over the remaining banks, the authorities created an incentive structure that is biased strongly against bank lending, and against bank risk taking generally.  The best escape from this unfortunate halfway house is to go to temporary full public ownership of all the banks.  It would be cheap.  It should not cost more than £50bn for the state to buy the rest of the UK high street banks.  It could wait a while and get them even cheaper – possibly for nothing. But time is more precious than money in this case.

I excerpted more of that than I originally intended but his proposal deserves the space. Buiter argues that his proposal will also encourage or facilitate lending. I, personally, think that is something we need to be careful about but again we can argue that in another post.

Brutal medicine, no doubt. Sometimes it has to be taken and now would seem to be one of those times. Unless we move towards a comprehensive solution, not half-measures, we risk a loss of confidence among the rank and file. Already there is a sense that the pain is not being felt equally. Left to fester, that can become an ugly thing.

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