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To your other question, let me try putting it another way. What you want is to create a good bank – one with only good assets, and with enough capital. To get there, you need to take away the bad assets, and then provide enough capital so the bank is healthy. To do this, you don’t necessarily have to nationalize the bank; you could do this through a negotiation between the government and the bank. However, this will involve an argument over how much the government should pay for the assets, and how much ownership the government should get for its capital. If you nationalize the bank first, you don’t have to go through any of these arguments, so it’s easier. (What’s difficult is if you live in a political system where “nationalization” is a dirty word, as I believe it still is here.)

The Swedish government only nationalized one or two banks at most and nationalization occured after shopping the banks around and no buyers at any price were found. The Nordea bank, then called Nordbanken, was shopped to RBS as I recall and they wanted the bank for free plus a generous helping of Swedish public funds as a subsidy.

There were only four large banks in Sweden at the time – Nordbanken, SEB, Handelsbanken, and Föreningssparbenken.

SEB bank, owned by the Swedish Wallenberg ruling class family, survived as did Handelsbanken, owned by its employees, and Föreningssparbenken.

The only bank I recall that was nationalized was Nordbanken and then only as a last resort.

To claim bank nationalization was Swedish policy at the time is a major distortation of the facts. It was more of a last resort, knee-jerk reaction for a single large bank.

The collapsing loans in Sweden at the time were an after effect of the collapsing banking system, which itself was caused by inept currency exchange managment by the Swedish policy makers.

And lest we forget, Sweden did not engineer its recovery in isolation. The tech boom took off around 1993. Sweden rode the wave and the economy recovered. To claim that the Swedish decision to nationalize the banks was the cure to its economic ills is inaccurate.

1. People like to bring up the S&L crisis as a comparable situation to what we have now, but I wonder if they are all that similar.

First of all, I doubt very much there were any S&Ls that were liquidated that came close to the size and importance of the financial institutions we are dealing with now: BofA, JP Morgan-Chase, Citi, Wells Fargo, Wachovia, AIG, Morgan Stanley, Merrill Lynch, Goldman Sachs, etc.

These companies are being bailed out not because it is appropriate for the government to bail out corporations, but because not to do so risks a very adverse effect to the national economy. Can you name one S&L that was liquidated that is comparable to any of the above mentioned banks in size? Probably not.

Certainly to allow creditors of any of the above institutions to lose everything would be an unmitigated disaster. That is obvious from the Lehman fiasco.

The theory I am suggesting is that to allow all shareholders of say, BofA and Citi, to lose everything may likewise have a very negative effect on the financial system. There are about 4.5 billion shares of BofA outstanding and 5.5 billion of Citi. Clearly many, many people would be affected by the nullification of shareholder value, and not just wealthy people. I doubt very much that the S&L crisis can compare to this. (Such a comparison would be an interesting analysis).

One lesson I have learned from this crisis is the degree to which trust and confidence are absolute prerequesites for carrying out a normal flow of commerce. Destroy that confidence and trust and you are up the proverbial creek without a paddle.

I think the above named banks can be made sound and solvent while at the same time protecting value for creditors and shareholders with relatively little cost to the taxpayer. The program for purchasing of toxic assets should be structured with this goal in mind.

2. It is true that equities of financial firms have taken a big hit in value. For Citi and BofA the dividends are close to non-existent (4 cents/share). That is not the same as having the shares completely wiped out. The losses at this point are primarily paper losses. In the long run, the value of these shares will come back again. Likewise, when the banks have paid off the government equity, the dividends will return. Under normal circumstances, these firms have tremendous earning power.

I think you are way off the mark in stating that primarily wealthy people own the major shares of these banks’ common stock. The stock market is no longer the playground solely for the wealthy. Very many people of average means today invest in the market. Retired people in particular like bank stocks because they tend to pay high dividends which are used as a supplement to other forms of retirement income. Indeed, I would guess the major investors are mutual funds and pension funds. In other words, when you wipe out the shareholders of these companies, you wipe out a lot of retirement funds for many people.

3. I would agree that under normal circumstances moral hazard should be avoided. But these are far from normal circumstances. The current crisis is a once in a lifetime event in which we have a broad and far-reaching systemic problem. It is incredibly foolish to worry about moral hazard when faced with a problem of this magnitude. There is little danger that people involved in this crisis will care to repeat the behavior which brought this to bear because the results are so frightening. The severity of the crisis itself is the strongest factor in causing people in the future to avoid improper risk.

Frankly, this entire discussion is purely academic because it has already been decided to make banks healthy (at least the major ones) while maintaining a modicum of shareholder value. Today Tim Geithner stated, “We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system.”

Nevertheless, if you are still feeling miffed that your tax dollars are inapppropriately propping up shareholder value, allow me to make a suggestion. Buy a hundred shares of Citigroup. Then you too can reap the largesse at tax payer expense. You don’t have to be rich. 100 shares of C cost about $420 presently. I keep wondering, if the shareholders of banks are getting such a great deal at the expense of the tax payer, why isn’t everybody rushing to purchase shares of bank stock now?

First, in previous examples of shareholders and bondholders being wiped out on a large scale such as the S&L Crisis, there was no shortage of investors lining up to buy shares in the rehabilitated banks, so that should not be considered a problem at all.

Second, the equities of financial institutions have already been sharply devalued. And the the vast majority of the shares and bonds are held by those in the highest income categories, or those with the lowest marginal propensity to consume. Furthermore it would would primarily affect their wealth and not their income, and the wealth effect on expenditures is quite small. Thus doing so would have an infinitesimal effect on aggregate demand.

Third, not to do so only leads to a gigantic moral hazard problem where you privatize the profits and socialize the losses, and that would be a terrible lesson for the markets. Nothing draws other investor’s attentions to a problem more effectively than for shareholders of an insolvent firm to be told the truth: that the value of their investment is zero. Similarly, nothing teaches the value of good job performance better than seeing those who have performed poorly face directly the consequences of their institution’s corporate failure, rather than to continue to reap the usual rewards.

I think a major lesson from the S&L Crisis in particular is that prompt action to nationalize and consquently wipe out the shareholders and bondholders of insolvent financial institutions is the wisest course (Lehman and AIG were of course mishandled). Right now the zombie institutions are dithering because they are secretly hoping for the steady drip, drip of bailout money to continue. The sooner we take swift, deliberate action, the sooner we can start rebuilding a fully functioning financial sector.

I suppose banks down won’t “name the price” of their assets because they want more than the taxpayer/ government is willing to pay.

Even without such information forthcoming, governments are still throwing money at banks, who are soaking up cash while refusing to lend it out. The consequence is to suck money out of the economy.

The Minneapolis Fed challenged the US administration’s Troubled Assets Relief Programme precisely because it said the governments were overstating the importance of banks.

Minni Fed said banks are (were) directly responsible for only 20% of corporate credit. So why do we risk this huge economic distortion with all the costs piling up for future generations.

You can only have the orderly liquidation of bad assets if banks reveal them.

If the banks cannot identify their liabilities that is a good case for bankruptcy.

Bankruptcy, remember, still allows for the liquidation of assets and payment of creditors. However it is looking like the cleaner path to the same end.

We are happy to discuss Chapter 11 for airlines or car makers. Why not for banks?

Why is it acceptable to allow thousands of companies in the real economy sail into bankruptcy (as they surely are) but not the banks?

As I wrote in the article (unashamedly populist as I don’t believe these issues should be hidden behind the waffle words of politicians):

Eighty per cent of non-financial company borrowing through bond issue takes place outside the banking sector. “The claim that disruptions to the banking system necessarily destroy the ability of non-financial businesses to borrow from households is highly questionable.”

The researchers don’t doubt the U.S. is undergoing a financial crisis and may face recession. However, they say no one has proved the strains on non-financial institutions are anything more than the effect of recession.

The conclusion is damning: Publicly available data does not justify the bank bailout. If the U.S. administration has different data “responsible policymaking requires that they share both the data and the analysis that underlies the need for bold policy with the public.”

http://www.russiatoday.com/Crisis/news/32611

The point made by the Cleveland Fed provides an interesting caveat to the notion that Sweden’s nationalization was a grand success story.

It makes me wonder what would be the effect of wiping out a broad spectrum of investors in the U.S. financial system through nationalization or any other process.

Much has been made of the confidence of creditors as it relates to this financial meltdown. In theory, the crisis began when creditors of Lehman got wiped out and senior creditors of AIG were forced to take a subordinate position. We have been struggling to overcome the damage ever since.

Yet, little has been said (as far as I know) about a crisis of confidence which would come about from wiping out the common shareholders of a number of major U.S. financial institutions.

Aside from the negative effects it would have on the shareholders themselves and the stimulus of their varying degrees of wealth on the economy, I believe wiping out these shareholders would lead to a broad and negative systemic effect on the finacial sector and the economy as a whole that could last for many years.

If investors in banks like BofA, Citi, and JP Morgan lose everything, who is going to want to risk their capital in the banking system anymore, even after the remaining banks return to health? And if private investors are unwilling to invest in the banking sector anymore, who will do it?

Clearly, those who will invest will demand very high returns for the risk they take. This will diminish the amount of credit that is available to lend to consumers and industry. The net effect will be a deterioration of wealth in the country.

The crisis of confidence may not just be isolated to the financial sector. Indeed, all sorts of investors may become leary of investing in any sort of stock. It could well take a number of years to get over this reluctance to invest.

Of course, there are always situations where major companies go under and shareholders get wiped out. Enron is one example. But that differs significantly from a situation where investors in an entire industry lose everything, particularly an industry so vital to the whole economy.

All those people whining and crying about their tax dollars being used to prop up shareholders need to think seriously about what they are wishing for.

I wonder if Citi’s reconstruction would be allowed to be funded, under Marco’s scheme above, by the Chinese government?