This week’s moves by the British government have created the impression that bank nationalization is inevitable. It is certainly the case that small-scale bank recapitalization, partial balance sheet clean-up, and various forms of financial engineering (e.g., insurance schemes for bad debt) are not only no longer enough, but may even be destabilizing. The problem is that once the market thinks you are on the move to a decisive solution but have not quite mustered the political will needed for complete resolution, it will assume that the final destination involves zero value for equity holders (and perhaps some bumps in the road for bank creditors).
The same logic is now being applied in Ireland and, to varying degrees, in other weaker eurozone countries. And the knock-on effect from assumed nationalization of bank losses to fiscal sustainability is immediate. Quoted Credit Default Swap spreads for some European sovereigns were wider than for investment grade corporates today, which of course makes no sense – but it does indicate extreme pressure in markets and deep confusion (or perhaps great clarity) regarding the impact on government balance sheets.
Nationalization is not the answer in the United States.
The state is not good at running banks anywhere and we really do not want to add politically directed credit as a cause of massive financial losses – the pressure already evident from some quarters to increase loans to consumers and small business, regardless of credit quality, should be taken as an early warning.
Banks need capital, without a doubt. Banks also have troubled assets and there is great uncertainty about their value. But, at least in the US, it would be reasonable for the government to help clean balance sheets and provide new capital at a price – which can be paid in terms of warrants, i.e., options to buy shares, on terms favorable to the taxpayer. This price should be considerably higher than charged in the TARP I funding provided by Mr Paulson, and banks will certainly want to hang back and let others go first – there is a great incentive to free ride here.
But a mixture of carrots and sticks can still bring banks into a full-scale recapitalization and clean-up program (technical design suggestions are here). This could be run directly by Treasury, but it would make sense – and also have political appeal – to create a Resolution Trust Corporation (RTC)-type structure to manage the government’s portfolio with a great deal of transparency and accountability. The goal of this RTC would be to dispose of government warrants quickly and in such a way as to maximize taxpayer value; it can also manage the toxic assets that are taken up, aiming to minimize fiscal losses. There is plenty of private equity money, currently waiting on the sidelines, that would be keen to buy the government’s warrants, exercise the option to take controlling stakes in banks, and break them up – although antitrust safeguards should be strengthened to make sure banks are not sold for their monopoly rents. And it seems likely that many of the banks’ current top executives would be replaced in this process.
From the second half of the TARP you could use $250bn (i.e., TARP II minus funding promised for housing and money already committed), plus another budget appropriation of around $250bn, to provide $0.5trn for capital. The RTC could then leverage itself by borrowing from the Fed, aiming for a total balance sheet in the $1trn to $1.5trn range.
Bank nationalization in the US is not inevitable. At least, not if a credible, very large recapitalization/balance sheet clean-up program is put in place quickly, to complement both the coming fiscal stimulus and the promised housing refinance package.
The Baseline Scenario 
“Banks also have troubled assets and there is great uncertainty about their value.”
VALUING TOXIC ASSETS
It seems the most difficult problem with the Bad or Aggregator bank is the fact that it is next to impossible to accurately value toxic assets which financial institutions now hold. To be able to do so requires seeing into the future.
This leads to a problem of great inherent risk for the government in purchasing these toxic assets to clean up the banks’ balance sheets. What is a fair value to pay for these assets?
If toxic assets cannot be valued accurately at this point, why should the final value be established now?
I think the assets should be purchased by the government in a conditional manner. Call it CONDITIONAL REIMBURSEMENT.
Under such a system, the government would offer to purchase a questionable asset for the best estimate of what the asset would currently fetch on the open market. This may be considerably less than what it is valued at on the bank balance sheet. To make up for the loss, the government would provide capital injections into the bank in exchange for equity shares.
Over a set period of time, say three years, the government would be obligated to liquidate the asset at the best price it could obtain.
If the government ended up losing money, then the financial institution would be required to reimburse the government for the difference. Because this would happen in the future, the financial health of the bank would likely be much better (the recesssion would be in the past, the housing market would be stabilized) and the bank would be able to make up the government’s loss.
On the other hand, if the government ends up selling the asset for a significant profit, then a certain percent of the profit should be awarded to the bank in the form of a tax credit.
It seems this would be one way to ensure that the government does not end up losing money on the toxic bank assets while it also allows the banks to be made sound and solvent in the here and now.
I admit that I am no economist. But just as I do not have to be a physicist to know that a perpetual motion machines does not work, I do not need much economic training to see that the key question in this crisis is who, exactly, will pay for the losses which have already happened (but have not necessarily been “realized”).
So, Prof. Johnson, could you help me understand your proposal in these terms? Let’s assume most of the banks are insolvent and someone has to eat losses that they will not recoup. In your recapitalization scheme, how much of those losses would be taken by shareholders? How much by creditors? How much by counterparties? How much by taxpayers?
Thank you.
Your comments on the RTC, and similar comments from many others, suffer from selective memory. The RTC worked in conjunction with the FSLIC, who foreclosed on insolvent banks – wiping out the stock and bond holders. FSLIC paid up some of the debt in the foreclosed banks, removed the toxic debt, and resold the banks to new investors who had fresh funds. RTC took the toxic debt from FSLIC and did the best they could to get some value from it to reduce the cost to the taxpayer. RTC was the distressed merchandise distributor for the bankruptcy agent, the FSLIC. In order to talk about a “new RTC”, you have to talk about foreclosing on insolvent banks (we have many today, unfortunately) and wiping out the current stakeholders. Insolvent banks have zero value and this has to be recognized in cash terms, not just words. Otherwise, the “new RTC” is a welfare department to stock and bond holders of companies that have zero value. Excuse me, but not with my taxpayer money.
Nationalizing the banks is a mistake but why not seize inadequately capitalized banks which cannot raise more capital in the marketplace. The bank is split into a functioning financial institution with a clean balance sheet with holders of subordinated debt receiving equity and a trust fund of toxic assets and related liabilities managed by Treasury on behalf of creditors and, if anything is left over, current shareholders. The Treasury’s management objective would be an orderly liquidation of these trust funds over a multi-year period.
Perhaps you’d like to back this up with a more detailed critique of the performance of the FDIC’s performance over the years, or the RTC.
As it is, it sounds unfortunately very like dogmatism of the sort that got us into this unregulated disaster. I’m sure it’s not your intent to sound like one of those discredited ideologues.