Stress Tests and The Nationalization We Got

The post was co-authored by Simon Johnson and James Kwak.

When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.

What happened?

Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.

As a starting point for thinking about this issue, there are good reasons to be skeptical about nationalization, meaning indefinite state ownership of the banking system.

Government ownership of banks or any other company can go badly wrong. Anyone growing up in the United Kingdom during the 1960s and 1970s experienced first-hand the problems that occur when the government runs major industrial and infrastructure companies – particularly when they have powerful unions. Margaret Thatcher came to power in 1979 in part because the state-run parts of the U.K. economy were not doing well, and the wave of deregulation that she started (and the financial boom it triggered) was a reaction to that context.

Similarly, people working in Eastern Europe and the former Soviet Union in the 1990s got a close-up view of wasteful and unproductive state ownership at work.  Privatization was not handled well in some situations, particularly when it led to the emergence of powerful oligarchs. But the state had been a dreadful owner in almost every respect – quality of service in stores, productivity in manufacturing companies, resource management in oil and gas companies, and massive pollution by energy and transportation systems.

All of these nationalized industries had something in common. When companies did badly, the losses were borne by the state. As a result, there was little incentive for company managers to improve their performance. Some years they would get lucky and even make a profit – but at those moments, most of the benefits would go to the insiders, in higher wages, bigger perks and the like.

Direct state ownership of industry has proved disappointing almost everywhere.  It turns out to be an arrangement in which a small group of people – whoever has power at or around the state enterprise – get the upside, while society as a whole gets all the downside. There is a prominent role for government in the modern economy: setting rules, enforcing contracts, supporting longer-term research and development, and trying hard to continually upgrade education. But managing banks is not part of that package, primarily because politicians should be kept away from credit. Once the allocation of loans becomes politicized, you get all kinds of pathologies and, most likely, more inflation as the central bank loses the ability to cut back on credit. 

However, this does not mean that the state has no role to play in the banking system.

In every developed country, the financial industry is closely monitored and regulated – on paper at least – because of its crucial role in the economy. That regulation has two major objectives that almost no one disagrees with. The first is protecting depositors. There is no simpler scam than accepting deposits, paying them out to bank insiders (or “investing” them in insiders’ money-losing projects), and then going bankrupt. Even in the absence of fraud, mismanagement can lead to the same result. If people do not trust banks to hold their money, they will hold onto cash instead – increasing the cost of everyday life, and starving the economy of credit.

The second, related objective is preventing bank failures, when they do occur, from causing major damage to other institutions. At any moment, a reasonably complex bank will own a diverse portfolio of assets, owe money in different forms to many different investors, and have open trading positions with many counterparties. Unwinding these relationships through a traditional bankruptcy process could cut off liquidity to other financial institutions and cause a ripple effect of successive failures.

In the U.S., the solution to this problem was defined in the Great Depression and has never been seriously questioned. Deposits are guaranteed by the Federal Deposit Insurance Corporation (FDIC), which receives insurance premiums from banks. In return, federal and state regulators have the right to monitor banks in order to minimize the losses that the FDIC could suffer. This is analogous to a workers’ compensation insurer auditing its customers’ workplaces to make sure they meet prescribed safety guidelines.

Under this system, if a bank is at risk of failure, the regulator can demand that it increase its capital. If it cannot find additional capital, or if it is insolvent, the FDIC will take over the bank. Most often the bank’s assets (loans, securities, buildings, customer base, deposit accounts, etc.) are transferred to another bank, insured deposits are protected, losses to uninsured deposits are minimized, and operations continue nearly seamlessly. By most accounts, this process runs very smoothly. And it happens regularly – 25 times in 2008, and 29 times through April this year.

Even when the FDIC has to operate a bank for some time before it can find an acquirer or wind it down, we never talk about the FDIC “nationalizing” a bank. An FDIC intervention is typically called a conservatorship or a receivership, depending on whether the bank will be liquidated or not. Although insured depositors are protected, uninsured creditors such as bondholders are not; how much they get depends on what the FDIC can sell the assets for. And shareholders are almost entirely wiped out.

Although this process includes a period of government control, there’s a good reason why no one calls it nationalization: the process preserves the incentives of free market capitalism. Shareholders, who took the most risk for the highest expected returns, lose their money. Bondholders, who took some risk for modest expected returns, lose some of their money. Managers lose their jobs. Healthier, better-run banks claim the assets, grow, and make more money.

The recent nationalization debate has this precisely backwards.

The problems of the banking sector are clear, although reasonable people may disagree about their magnitude. America’s biggest banks suffered massive financial losses due to bad loans and worse risk management, while reducing their capital to the legal minimum and then lobbying Washington to reduce that minimum. The crisis began with unexpected losses on complex securities, but has since spread to every type of financial asset, as the deepening recession undermines the ability of all types of borrowers to repay their loans. The IMF has boosted its estimate of aggregate losses by financial institutions to $4.1 trillion, only a fraction of which has been written down on balance sheets.

As a result, some of our largest banks are either insolvent – their assets are worth less than their liabilities – or are short on capital, and confidence in them has been preserved solely by the government’s willingness to provide capital injections, loans, and debt guarantees as necessary to keep them in operation.

In most countries, the course of action would be clear. The government would take over banks, remove “bad assets” from their balance sheets, inject fresh capital, and put them bank into the private sector. This is essentially what the FDIC does when it takes over a bank. There is some debate about whether the government currently has the power to do this for bank holding companies – Tim Geithner says no, Thomas Hoenig says yes – but if not, this is certainly something the Obama administration could press for.

In fact, this is usually the approach suggested by the U.S., both directly and through its influence at the IMF. For example, the U.S. repeatedly and publicly pressed Japan to do exactly this during the 1990s.

If the government were to implement this type of policy, the recent stress tests would be a reasonable first step. The stress tests would determine which banks were failing, and then they would be put into conservatorship. This is what investors were afraid of in February, because when a bank goes into conservatorship, its common shareholders are effectively wiped out – which, again, is what is supposed to happen in a free market system when companies mismanage themselves into the ground.

Since February, however, the government has clearly communicated that it has no such intentions, for example in Geithner’s insistence that “the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.” Even as the capital shortfall numbers have leaked out over the past few days, the government has emphasized that no banks will actually be allowed to fail, or even be allowed to be put into a conservatorship; instead, they will first attempt to raise capital from the private sector, and failing that they can convert their TARP preferred stock into common stock. Even if this results in significant government ownership, there is no evidence that shareholders or creditors will be forced to take losses. As rfreud said in a comment here, “The stress tests results are confidence-building in that they signal the low likelihood of nationalization or seizure. Reform at the moment seems a distant prospect.”

The strategy, in short, is to continue to prop up our existing large banks in place (no such consideration has been granted to small banks) through a lengthening list of bailout measures. Why?

One reason is that taking over banks has somehow been redefined as “nationalization,” with the images it conjures up of forced confiscation of property. Yet there are no guns involved here. Ordinarily, when an investor puts a large amount of new capital into a bank, it gets some measure of control in return. Yet Treasury has bent over backward to minimize its voting shares, beginning with the initial round of recapitalizations and continuing through the latest Citigroup bailout in February.

Perhaps after fighting off charges of “socialism” from the McCain campaign, the Obama administration is wary of any steps that could be described as nationalization. And so instead of insisting on its well-understood duty to shut down failing banks for the public good, it has tied its hands by taking this option off the table.

But what are we getting instead? Increasing government support for the financial system, and increasing government influence over the flow of credit – or nationalization by another name. 

Instead of the government taking over and sorting out banks transparently, the big banks are receiving massive government support:

  • $700 billion in Troubled Asset Relief Program (TARP) money is flowing to no fewer than eleven separate programs, as documented by the TARP Special Inspector General, including preferred share purchases, asset guarantees, purchases of asset-backed securities, and subsidized purchases of toxic assets. 
  • The Federal Reserve has committed trillions of dollars to lend against and purchase securities of all kinds from the banking sector.
  • The FDIC is guaranteeing hundreds of billions of dollars of newly issued bank debt, and is set to guarantee loans to private investors to buy loans from banks under the Public-Private Investment Program (PPIP).

In exchange, the government is deciding how credit is allocated in the economy, albeit on the wholesale rather than the retail level. In addition to direct loans to automakers, programs such as the Term Asset-Backed Securities Loan Facility are effectively distributing money to support specific types of lending (credit cards, auto loans, etc.), and the Fed is purchasing over $1 trillion of mortgage-backed securities in order to push mortgage rates down to historically low levels.

In addition, there is anecdotal evidence that the government, while renouncing official control of any banks, has intervened in management decisions for some of the weaker players. According to Bank of America CEO Ken Lewis, he was threatened with removal if he failed to complete the acquisition of Merrill Lynch. And unnamed sources recently reported that federal regulators are considering removing Vikram Pandit from Citigroup.

In short, relationships between the government and the large banks have never been closer, with large amounts of money flowing in one direction, and complete co-dependency going in both directions. Those relationships are not entirely friendly, which is not surprising. In any crisis when public resources are called on to bail out the private sector, not all of the oligarchs will survive; Bear Stearns and Lehman have already vanished. But the winners – which should include Jamie Dimon of JPMorgan Chase and Lloyd Blankfein of Goldman – will emerge even more powerful and influential than before.

In rejecting “nationalization” (regulatory takeover and conservatorship), the government has not ensured a private, properly functioning banking system. Instead, it has muddled into a broken-down, undercapitalized system that is nominally in private hands, but is able to tap the state for apparently limitless support. And to date, that support has flowed on one-sided terms, with the taxpayer accepting downside risk but limited upside potential. No wonder bank shareholders are comfortable with this outcome.

As a result, the banks have largely preserved their existing management teams and bonus plans: on Wall Street, first-quarter accruals for bonuses returned to the levels of the glory years of 2006 and 2007. Creditors and counterparties have been kept whole, most notably through the AIG bailout. And shareholders have seen their share prices supported by the promise of sustained government support. The incentives we have ended up with are more similar to those of a nationalized system than those of a free market. Instead of state-owned coal mines run for the benefit of miners (the U.K. in the 1970s) or state-owned oil and gas companies run for the benefit of bureaucrats (the Soviet Union in the 1980s), we have state-backed banks in the U.S. run for the benefit of bankers and their creditors.

The smart economists in the Obama administration must know what is going on. But having insisted that large bank takeovers are tantamount to nationalization and therefore off the table, the administration is betting that the financial system will repair itself – or “earn their way out,” as StatsGuy put it.

This is possible. With the competition in both investment banking (Bear Stearns, Lehman) and mortgage lending (most of the specialist mortgage lenders) gone, the survivors all enjoy larger market shares and higher prices, contributing to their somewhat healthy profits in the first quarter. Even the large banks that receive the lowest grades in the stress tests will be given relatively cheap capital by the government; Treasury will use its resulting stakes to apply behind-the-scenes pressure to the banks (more government influence), but without taking decisive steps to clean up bank balance sheets. Instead, it will hope that the PPIP will do the trick, using cheap government financing.

But success is by no means certain. And we cannot know for how long the government will have to continue propping up weaker banks, at growing taxpayer cost, while they absorb funds that could otherwise help the economic recovery.

In the end, when a financial system is dominated by banks that are too big to fail – and they do fail – the only options are an FDIC-style takeover or the kind of public-private co-dependency that we see today. As far as the current crisis is concerned, the die is cast and the big banks won.

For the future, however, the question is how to avoid a situation where banks cannot be made to fail gracefully without creating systemic risk. As a starting point, we believe that banks that are too big to fail are too big to exist. Only then will we be able to maintain the incentives necessary to manage risk, punish failure, and reward success.

78 responses to “Stress Tests and The Nationalization We Got

  1. You make far too much sense to be taken seriously in The Village.

  2. Agree fully. Were did the idea come from that takeover of large banks in a crisis = nationalization for ever. Look to Norway, during the previous banking crisis the three largest banks were taken over, shareholders wiped clean, new management installed and government stake managed on “arm length”. Shares sold gradually with a total profit to the taxpayer, see table 3 in central bank publication http://www.norges-bank.no/upload/import/publikasjoner/skriftserie/33/chapter3.pdf

    The recent UK Treasury committee report on the banking crisis has also an interesting chapter on how to manage the governments newly aquired stakes in RBS and Lloyds, see Chapter 6 in
    http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/416/416.pdf

  3. The incentives we have ended up with are more similar to those of a nationalized system than those of a free market. Instead of state-owned coal mines run for the benefit of miners (the U.K. in the 1970s) or state-owned oil and gas companies run for the benefit of bureaucrats (the Soviet Union in the 1980s), we have state-backed banks in the U.S. run for the benefit of bankers and their creditors.

    Yup – it’s simply three different facades of corporatism. The fundamental similarity is overwhelmingly more real than the merely cosmetic differences. Those who inveigh against “nationalization” as some Bolshevist bogeyman are simply corporate crooks and waterboys trying to cover up their own Chicago Bolshevism.

    One point which bears repeating about governments being lousy bank managers is that it’s at least as proven that the private sector cannot manage these big, ramified structures. There’s no evidence at all other than to the effect that disaster is inherent to big banks, and all their activities are always headed in that direction.

    This is the other reason (besides TooBigtoFail must equal Too Big to Exist) why we must permanently break up these structures and return banking back to its proper smaller, dowdy, frumpy, sleepy place.

  4. By converting to common stock, the government is surely sharing in the upside, in proportion to its stake.
    The government could also reduce its impact by pledging to use its voting shares “in proportion with other shareholders votes” or similar, thereby abdicating control, but maintaining the possibility of reclaiming it when they deem it necessary.
    Shareholders should be more grateful for having been saved at all; after all, it was only a few months ago that the “Geithner put” was worth more than the banks themselves.

  5. Coates,

    Charlie Gibson explained all this within two minutes on ABC World News With Charles Gibson tonight. (5/6/09)

    No wonder Americans have no idea what is going on. This explains why Bank of America’s stock went up despite the stress test results. It tells me there are enough people in the Market that knew, as you put it, the big banks won.

    Sandy

  6. By definition, “too big to fail” means that a bank’s counterparty and debt obligations are implicitly insured by the U.S. taxpayer. So imagine if, for example, FDIC deposit insurance were available completely free of any premiums or regulatory oversight. “Too big to fail” is just like that, but for all obligations of the bank.

    Does anybody who is not a bank think this is a good idea? Is it not utterly obvious to everyone that too big to fail is too big to exist?

  7. Coates,

    I just have to add that was so well written and explained that an adult with a reasonable education should understand the seemingly unexplainable. I may have to read it a couple more times as I love to have a full grasp of the facts that the news can’t possibly convey in even an hour on Sunday mornings. I loved it.

    Sandy

  8. Coffee Boy

    A year ago, I had the great fortune to hear Jeremy Grantham (the great contrarian investor of Boston’s GMO) speak at a class of mine titled “Current Issues in US Financial Market Regulation.” He made a point that has forever altered my view of the investment world – more than anything, decisions are made based on career risk.

    The perfect example is that of a junior hedge fund or investment banking trader…suppose he has one view on the market and his boss another. If he goes against his boss, but he gets it right, he’s safe, because he made money. However, if he goes against his boss, and he gets it wrong – he’s fired. If he goes along with his boss, and they both got it wrong, it’s not the trader’s fault, so his job is safe. Nash equilibrium states that he will always go along with his boss, regardless of his view.

    It’s a crude example, but I think everyone understands my point. Unless you are nearly 100% sure of your conviction (ie, you’re boss is trying to convince you that 2 + 2 = 5), you are more likely to take the action which most protects your job, rather than what is universally “right.”

    If we superimpose this example on the current debate, we see the reason why the US govt is acting as it is. They have essentially two options – 1) put insolvent banks into receivership and work things out “cold turkey,” or 2) muddle along as they have been. Unfortunately, this is one of those uncertain situations such as predicting the stock market, not one of those situations where there is a definite right or wrong ( 2 + 2 = ? ).

    Now, while the outcome of both options is unclear, the path that they take is pretty certain. In the first choice, we’ll most certainly see headlines around the world of Citigroup, and probably BoA being put into conservatorship/receivership/whatever. Regardless of the long term benefits of the plan, the markets will be spooked. -777 on dow aint nothing…we might have a repeat of the slow-motion crash we saw in October. Fair enough, equities are overvalued anyway, and we’re not here to protect investors from their mistakes in the market.

    More worryingly, credit markets will be deathly afraid. I’ve talked before about the credit market being completely dysfunctional after the Bear Stearns intervention. When it comes to financial sector bonds, investors aren’t betting on the creditworthiness of individual companies – they’re betting on whether or not the gov’t can guarantee all the liabilities. The Bear Stearns incident told the markets that creditors were safe. Fannie and Freddie did the same, to a greater extent. Then Lehman happened, and all hell broke loose. Not because of the difficulty of unwinding and liquidating an investment bank (most derivative trades were either netted or cancelled within a few weeks), but rather because of the AMBIGUITY OF THE GOVERNMENT’S POSITION ON CREDITORS. Shortly thereafter, the government decided that it made a mistake, and implicitly decided to back everyone else, Citi and BoA included. Now, if the government puts these banks into receivership/conservatorship, the credit markets will completely collapse. The ambiguity has returned, and investors aren’t willing to bet on the whims of a president/secretary.

    Now, the destruction in equity and credit markets is troublesome, but most worrying would be the impact on depositors. We’ve talked a lot about underfunded liabilities in the form of Social Security and Medicare, but that’s nothing compared to the underfunded liability that is the FDIC. Unlike a normal insurance scheme (where you wouldn’t expect all the people covered to get a heart attack in the same week), the FDIC would be woefully undercapitalised in trying to protect all the depositors of Citi and BoA. No, the scariest part isn’t the stock market crash or the bond market disappearing. The scariest part is the modern day bank run….made even more swift and decisive by electronic money transfers. And as we all know, bank runs lead to financial Armageddon.

    Now compare this with strategy two, where the government spins and spins and prints a few billion to allow the system to keep going as it should. The end result is unclear (how many years before we have a functioning privately owned banking sector? 2? 5? 10? 20?). However, the “mark to market” as it were, or the ride, is much smoother. Along the way we may lose a few percentage points of GDP, and we may end up with a crap system, but we (Obama) can blame it on Bush anyway.

    Personally, along with the authors SJ and JK, I’m in favour of strategy one, in a carefully managed format. The catastrophic scenario that I painted is possible, but there are relative probabilities of each one actually playing out, and I think we might be able to manage through that if we do it carefully. However, let’s look at the career risk of Messieurs Obama and Geithner (Geithner is tied to Obama, so really, let’s look at Obama). He wasn’t elected because of his deft capability for financial wizardry. No, he was elected because people genuinely like him, and they thought that he would be best suited to fight for them.

    Now how does he protect his job? “Fixing” the banking sector via method number 1 might be the right answer, but it is by no means 100% guaranteed. But, along the way, he knows that the ride won’t be pretty, and if he messes it up, its his head that will roll. On the other hand, by staying the course and “muddling along,” there’s a chance the economy is fixed WITHOUT all the death and destruction. If he pulls it off, he will be a hero, cited in history books the world over about his leadership and political skill. If he fails, its everyone’s fault but his: Bush, bankers, Bernanke, Blankfein, etc. Talk about a political call option.

    Now we see why the government’s hypocrisy vis-à-vis banking crises makes sense. When the they are strong-arming the IMF about Asia, or Sweden, or some other country’s banking crisis, its not their own jobs on the line. But when it comes to our own crisis, we see that career risk is skewing the incentives of our politicians just as it has done our traders and workers for decades. Banker’s influence aside, tell me, how do we deal with Obama’s call option?

  9. Simon and James, this was a great post!

    If you would like to see CHANGE I suggest focusing on the Democrats’ incentives for the 2010 election and President Obama’s reelection in 2012. What I have in mind here are the impact on senior citizens regarding the near-zero interest rates (to help banks “earn their way out “out of financial distress) on their retirement savings and the forced budgetary decisions on Social Security and Medicare [1] — and more significantly, the impact of raised FDIC insurance premiums through skyrocketing bank service fees to replenish what could be a $1 trillion FDIC loss from PPIP loan guarantees (note that in the latest update Treasury has opted NOT to participate in any upside [2]).

    Regarding the issue of NATIONALIZATION that demonizes “government control of banks” and “indefinite state ownership of the banking system,” President Obama could have considered Nicholas Kristof’s idea [3] of gifting the shares (including voting rights to resolve the issue of CORPORATE CONTROL) to every man, woman and child in America–and then contributing them to the Social Security and Medicare trust funds to help cure their $56 trillion fiscal exposure (75 year horizon) through common stock dividends and capital appreciation (as Albert Einstein said, the most powerful force in the Universe is compound interest!). To remedy near term funding problems, Congress and President Obama could have also allowed the federal entitlement trust funds to invest in AAA-rated TALF asset-backed securities (which with Fed leverage could produce up to 20% returns [4]).

    Simon and James, something tells me that one of the assumptions that the 19 financial institutions were allowed to make was to offload now-performing-but-soon-to-be toxic assets [5] to the FDIC under PPIP. By some miracle, Geithner’s stress test is way below what Roubini, the IMF and others estimated. Question: Under PPIP, has Geithner designated the FDIC as a toxic waste to dump for toxic assets (including those that are now performing?). In terms of putting the Democrats’ Congressional majority at risk in the 2010 election, what do you think would be the impact if the FDIC were to raise its insurance premium to replenish a $1 trillion loss, which would than be passed on as skyrocketing bank service fees for shareholders and depositors (including senior citizens). Is this be fair to healthy banks that made prudent loans during the credit bubble? I don’t know about you but I would be furious, especially if it were brought to Congress’ attention (and its oversight committee and the TARP inspector general) in spring 2009.

    For President Obama’s 2012 reelection campaign, what if OMB Director Peter Orszag’s hypothesis that he could substantially cut health care cost to reduce the cost of Medicare was laughable (particularly since he would need to substantially cut physicians’ incomes)–and hence President Obama and Congress would have to commit political suicide by touching the third rail of politics by either raising taxes or cutting Social Security and Medicare benefits to cure their $56 trillion fiscal exposure. If like killing two birds with one stone for which the same issuance of now low-interest federal debt could have been used to first bail out the banks and then contribute their common shares to the federal entitlement trust funds (think of this as what Yale Chief Investment Officer David Swensen calls an “equity-oriented” endowment fund), as a senior citizen or baby boomer I would be furious!!! And how about funding universal health care? [Common stock investments in ultra-clean new banks like government recapitalized CitiGroup and BoA with zero legacy loans could have brought significant federal budget relief by curing the $56 trillion fiscal exposure.]

    So Simon and James, if you want CHANGE, I suggest you frame your commentaries in terms of the Congressional 2010 elections and President Obama’s 2012 reelection. Has President Obama made a Faustian bargain with the Wall Street oligarchs and the unsecured bank creditors–and Republicans, David Alexrod and Valerie Jarrett, are you listening?

    [1] Pear, Robert, “Social Security Benefits Not Expected to Rise in ’10,” The New York Times, May 3, 2009.
    [2] Christie, Rebecca, “FDIC May Let Investors Buy Toxic Assets Without Treasury Stake,” Bloomberg, April 30, 2009.
    [3] Kristof, Nicholas D., “Escaping the Bust Bowl: America’s horror of ‘nationalization’ could be defused by handing out shares to all American households,” The New York Times, February 12, 2009.
    [4] Vikas, Bajaj, “U.S. Tries a Trillion-Dollar Key for Locked Lending,” The New York Times, February 20, 2009 (“Investors who borrow from the Fed could enjoy annual returns of 20 percent or more.”)
    [5] Gopal, Prashant, “Good News: Option ARM Resets Delayed; The bad news: Low home prices and high unemployment could still punish borrowers when the reset happens sometime next year,” Business Week, April 16, 2009.

  10. Funny how threads of thought like this grow. I woke up this morning with exactly these same thoughts before I read this. We’re all coming to the same conclusions. When the government declares that they will cover all losses at any institution without allowing it to close — no matter what, full stop — what name can there be for that other than nationalization? The interests of the banks are now the interests of the government. Sadly, I think it is more than clear these are not the interests of the vast majority of taxpayers in the country. What a perfect ‘parent’ the government is: “You nearly burned down the house, kids? Really, you shouldn’t play with matches, but we still love you. Oh, you want my pin number to my investment accounts? Okay, be good. That 0.5 billion dollar candy bar for you, AIG? Okay. Chrysler, your 8 billion dollar toy? Okay.” The problem comes when those kids do exactly what they have already done once again. People don’t change. They will do it again. I will bet on that outcome in a flash. The coming time, it’s not their balance sheet that is destroyed, it’s ours. I’m strangely calm as the dust is settling, but there is no doubt of the transfer of risk. Our country’s economy has just been placed on the table for the banks to bet. When they lose that bet, we lose our economy. Time to change course. Too late? I sure hope not. Any change in direction would sure be welcome!

  11. Re incentives backwards and upside down I’m afraid you’re probably right. But at 5 today after Sec Geithner announces life is good, Chairman Bernanke will announce all Fed rates at zero ensuring 100 per cent no gimmicks sharia compliance and Chairwoman Bair will say Tim congratulations on your graduation from Groton and by the way we’ve just seized B of A and Citi holding co or not

  12. Oops, I flubbed a punchline with a grammatical error:

    “Under PPIP, has Geithner designated the FDIC as a toxic waste to dump for toxic assets.”

    The punchline should be:

    “Under PPIP, has Geithner designated the FDIC as a toxic waste dump for bank toxic assets (including those current and now performing but soon to default)?”

    Simon and James, could please keep on top of this?

  13. Pingback: Coates Bateman - Paper Jam - Stress Tests and The Nationalization We Got - True/Slant

  14. Charles C.

    Please — WHO is Coates? (new readers need the name association for understanding)

    ….and, I do think the whole bailout, TARP, TALF, etc. is continuing the mockery of working people in America,…. the citizen taxpayers, which make up 99.9% of us. When I read about hedge managers Mr. Flowers, Michael Dell, Geo. Soros… all the rest of the investor class billionaires who are buying up almost free assets, creating partnerships, owning banks and massive equity shares with the “chortle” that: They own the upside, taxpayers own the downside”, and “gravedancers like themselves will be making obscene profits” (Sunday NYT’s) I am really disgusted with the “solution” that Obama has decided on.

  15. James Twiner

    FDIC protection HAS been, de facto, without premium, or at least without proportionate premium, for at least the last 3 years. Just so you know …

  16. Pingback: Morning Skim: How the Banks Won the Stress Test - The Opinionator Blog - NYTimes.com

  17. The authors argue that the FDIC bank conservatorship model is good way for the government to handle insolvent financial institutions. THE FDIC model is an established and relatively uncontentious model with a track record of success. So why not use this model to address distressed bank holding companies?

    The answer is that the federal government does not have authority to wind down bank holding companies. The authors mention that this issue of authority is subject to debate. Hoenig says we can. Geithner says we can’t. The fact is there is not debate. The US government does not have the authority. Geithner is the Secretary Treasury of the US, and he was previously the head of the NY FED. If he (or Paulson) thought that the US government had the authority to take large bank holding companies into conservatorship, they would have done so by now. The first institution that they taken into conservatorship would have been Lehman Brothers. Using this authority would have drastically simplified their jobs. It would allow them to let big institution fail in an orderly manner. This weapon (as badly as it is needed and wanted) is simply not in the US Financial authorities’ arsenal at the moment. That is why Geithner has pushed Congress to pass legislation to give them the authority. Unfortunately, Geithner’s pleas have fallen on the deaf ears of Congress.

    If this is so important, why isn’t Geithner and the Obama administration pushing harder for this? In order to push this on Congress, Geithner would need to pound his fist and paint a picture of (more) financial armageddon in order to prompt Congressional action. As he instilled fear in Congress, he would instill fear in the markets and run the risk of destroying the fragile confidence that has returned to the markets. As a politician and the de facto guardian of the markets, Geithner cannot afford to push for what he most desparately needs. This is a damned if you do, damned if you don’t scenario.

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  19. Depressingly enlightening.

    Of course it doesn’t help that there’s a whole army of PR people selling the idea that:

    receivership = nationalism = socialism

    when the truth is what we have now is in fact socialism (but with none of the benefits).

    As usual: private gain, public risk.

  20. This article probably should have talked more about what will undoubtedly happen to the economy if the Obama-Geithner “plan” continues on its merry way. A return to a growing economy WILL be retarded–may be by a little or maybe by a great deal. And growth may be retarded for a considerable length of time.
    The real danger to Obama–to say nothing of the American people–is that a very slow growing economy will absolutely destroy the other plans that have been laid out in his longer term budget. If he gets the spending increases he wants and his bank rescue plan fails, government deficits (federal, state and local) will soar to levels undreamed of heretofore. This WILL impact interest rates and could slow economic growth even further.
    The success of the Obama adminsitration (as well as the future of the Democratic Party) is dependent upon the Obama-Geithner program. You’d think Obama would at least care about THAT a little more as he rubbber stamps everything Geithner and Summers have proposed to him.
    George W. Bush was a totally inexperienced and weak chief executive. Did we get another one of a slightly different stripe in the person of Barrack Obama?

  21. I have a concerns that I hope someone can address.

    We talk about “too big” to fail, but to my knowledge no one has demonstrated that we would be in a distinguishable situation if we had twice as many banks at half their size (or pick your fraction) before the crisis if they had nevertheless made the same bad loans.

    Isn’t part of the problem here that so many banks made similar poor decisions with regards to risky loans and high rates of leverage? That the “me too” competitive forces drove nearly everyone to try and exploit not just the same opportunities, but to conquer as much of the “new terrain” as quickly as possible, and to dive ever deeper into darker, riskier domains of the territory?

    Further, it seems to me possible that with a greater number of smaller players, the situation might have become even more unmanageable by the US government.

    We only have one FDIC, Treasury, Fed, etc… and they’re having enough trouble as it is, but the same bureaucracy would (a) have to be dealing with twice as many entities, boards, ledgers, etc… and (b) the number of first, second, and higher-order interconnections in the counter-party network of interdependency would increase exponentially (factorially?) as the number of nodes (companies) increased, yielding an even more chaotic and unpredictable (and systemic?) risk disposition.

    So, it seems possible at least that more, smaller, banks could have made the situation even worse.

    Where is the argument for how in the better world with stronger, more pro-active anti-trust regulators, we would have avoided this downturn by encouraging different behavior? Each company individually might not have been “too big to fail”, but couldn’t the cumulative effect of scores of essentially identical small failures could still have resulted in a near identical government intervention?

  22. Simon and James – in your discussion of nationalized industries in Soviet-bloc countries, you say:

    “All of these nationalized industries had something in common. When companies did badly, the losses were borne by the state. As a result, there was little incentive for company managers to improve their performance. Some years they would get lucky and even make a profit – but at those moments, most of the benefits would go to the insiders, in higher wages, bigger perks and the like.”

    CAN SOMEONE PLEASE EXPLAIN HOW OUR SYSTEM TODAY DIFFERS FROM THE SOVIET-BLOC MODEL?

    The US financial system was nationalized under Bush/Paulson. Though these banks continue to sit on toxic assets rather like a goose on a now-tarnished egg, they continue to declare “profits” and payout enormous bonuses to the very same people who ran up the debt within their companies.

    With business leaders in multiple sectors primarily focused, apparently, on the amount of their bonus, instead of running their company in ways that sustain profitability, the business environment in America is now very, very sick. (American Airlines, GM, Morgan Stanley, Merrill Lynch…. etc. and so on.)

    And with the US government hovering like the worst kind of helicopter parent over the best-paid people in America, I see no real effort being made to help us regain our economic health.

    Propping up failure is not leading us out of this mess.

  23. Thank you, thank you, thank you for this lucid exposition. Baseline is a true public service.

  24. Thank you Simon and James for this great post.

  25. Pingback: Failure Is Good « The Baseline Scenario

  26. Interesting post.

    If you haven’t seen it yet, this page speaks to some of the points your mention too:

    http://www.rgemonitor.com/roubini-monitor/

  27. Well, using Britain’s nationalization of industries such as their auto and motorcycle companies is just flat a bad example of government ruining businesses. That was more like closing the doors after the horses were out of the barn.

    The British auto and motorcycle manufacturers got their hats handed to them by the Japanese over a period of 15 years, refused to update and improve their products in response to serious competition throughout the 1960s and into the 1970s. By the time the government stepped in, companies such as Triumph, (both car and motorcycle concerns), Norton, BSA, MG, Jaguar, etc, were DOA.

    I remember distinctly that Triumph motorcycles was still marketing a bike called the Bonneville. I owned several from the 1960’s. The design was based entirely on a motorcycle engine from the late 1930’s! Even as the Japanese introduced one reliable, high performance bike after another in the 60’s, the British sat by and twiddled their thumbs. In 7 years, (1965 to 1972), they went from the most desireable bikes on the planet to being unwanted. A strike in 1974 at the Triumph Meridan factory compounded the issues as the end, but the end was already at hand.

    Just a perspective….

  28. Well, using Britain’s nationalization of industries such as their auto and motorcycle companies is just flat a bad example of government ruining businesses. That was more like closing the doors after the horses were out of the barn.

    The British auto and motorcycle manufacturers got their hats handed to them by the Japanese over a period of 15 years, refused to update and improve their products in response to serious competition throughout the 1960s and into the 1970s. By the time the government stepped in, companies such as Triumph, (both car and motorcycle concerns), Norton, BSA, MG, Jaguar, etc, were DOA.

    I remember distinctly that Triumph motorcycles was still marketing a bike called the Bonneville. I owned several from the 1960’s. The design was based entirely on a motorcycle engine from the late 1930’s! Even as the Japanese introduced one reliable, high performance bike after another in the 60’s, the British sat by and twiddled their thumbs. In 7 years, (1965 to 1972), they went from the most desireable bikes on the planet to being unwanted. A strike in 1974 at the Triumph Meridan factory compounded the issues as the end, but the end was already at hand.

    Just a perspective….
    Oops…forgot to say great post! Looking forward to your next one.

  29. What is most interesting about the array of Government programs is the difference in amount between; 1) what the Feds have proposed and; 2) what has actually been done.

    For example, the TARP program is $700 billion. But only $328 billion of Funds have actually been spent. Basically, it is the Bank preferred stock ($200 billion) and AIG ($70 billion) which is the program.

    The Federal Reserve balance sheet doubled in the late Fall from $ 1 Trillion to $ 2 Trillion and has essentially held constant since. Functionally, it has replaced the asset backed security market, while it is also the Government’s “carry trade” vehicle. The Fed continues to hold $225 bil of commercial paper–why is beyond me. It also holds $367 bill of ABS securities–does it still need to?

    The FDIC guarantee of certain bank debt is the third major action taken–a few hundred billion of guarantees, not cash.

    One could say the cash committed to Fannie and Freddie are part of the program, but then one would be wrong. This is the most absurd of fictions as it would be the equivalent of saying the Feds are bailing itself out. The moral hazard and corruption (i.e., the so called implicit guarantee of their debt) which was F2 has been there forever–otherwise no one would have ever purchased their debt to begin with.

    Everything else has been “noise”, creating costs, confusion, and as you point out, de facto quasi nationalization. One would almost think it a conspiracy.

    This is the most under reported story of this “worst crisis since the great depression”. If financial conditions are so horrible, why have we been able to get by with so much “promised” but so little done? A great example of the size of the “noise”, besides TARP itself, are the TALF and PPIP programs. The Fed Balance sheet has $6 bil of “TALF” assets—but is committed to buy $1 trillion. The PPIP is another .5 to 1 tril of commitment—but does anyone believe either of these 2 programs will ever get off the ground? No, because they are not necessary.

    This is not to say these programs are irrelevant. There are 550 banks with TARP money–each a potential hostage if they are ever asked to do patriotic lending or some favor (“and that day may never come”–said the Godfather to Bonasera–yeah right).

    This whole thing is an utter fiasco. This has been a regional real estate crisis which was screamingly advertised and hawked as the “worst crisis since the great depression”, and massive funds were committed to save the day. But little has ended up needed after all. The peasants (“we the people”) are slowly coming out of our bunkers and realizing the world has not yet come to an end–but the infernal noise machine makes it hard to think clearly.

    A cottage industry of economists and commentators and the new administration needs and/or wants this crisis mentality to continue. Time is short as the administration seeks to expand the power and size of Government in unprecedented ways–all in the name of fixing this, “the worst crisis since the Great Depression”.

    This really is absurd.

  30. “There is no simpler scam than accepting deposits, paying them out to bank insiders (or “investing” them in insiders’ money-losing projects), and then going bankrupt. Even in the absence of fraud, mismanagement can lead to the same result. If people do not trust banks to hold their money, they will hold onto cash instead – increasing the cost of everyday life, and starving the economy of credit.”

    By far, the best, simpliest explanation I’ve seen yet of our “financial crisis” EXCELLANT!!!!!!!!!!!!!

  31. Pingback: The Bellows » Strawman Constructed; Point Missed

  32. Pingback: Hope & History Rhyme » Blog Archive » Stress Tests and the Nationalization We Got

  33. donthelibertariandemocrat

    Sheila Bair gave a speech yesterday in which she made some excellent points because, well, quite frankly, I agree with them. Here’s one:

    “In the case of a bank holding company, whether systemically significant or not, the FDIC has the authority to take control of only the failing bank subsidiary, thereby protecting the insured depositors. However, in some cases, many of the essential services for the bank’s operations lie in other portions of the holding company and are left outside of the FDIC’s control, making it difficult to operate and resolve the bank. When the bank fails, the holding company and its subsidiaries typically find themselves too operationally and financially unbalanced to continue to fund ongoing commitments. In such a situation, where the holding company structure includes many bank and non-bank subsidiaries, taking control of just the bank is not a practical solution.”

    This turned out to be true. I credit it because, for one thing, they’re admitting a huge gap in seizing banks: Namely, they had no means of seizing large banks. Since that’s the FDIC’s job, they’re essentially admitting incompetence. As well, there are many good arguments as to how complicated and messy this would be.

    However, the Govt has in fact submitted a plan to do this:

    http://www.treas.gov/press/releases/reports/032509%20legislation.pdf

    I’m not sure what more you’re asking for. As for the current mess:

    “Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.”

    We’ve been left with Hybrid Plans, all of which lead to what you have described. We began discussing this outcome in September, which is why a Swedish Plan made sense.

    The real question seems to be about what kind of reform of the banking sector that we want. I want Narrow/Limited Banks, which is going nowhere.

    Here:

    “In short, relationships between the government and the large banks have never been closer, with large amounts of money flowing in one direction, and complete co-dependency going in both directions. Those relationships are not entirely friendly, which is not surprising. In any crisis when public resources are called on to bail out the private sector, not all of the oligarchs will survive; Bear Stearns and Lehman have already vanished. But the winners – which should include Jamie Dimon of JPMorgan Chase and Lloyd Blankfein of Goldman – will emerge even more powerful and influential than before.”

    I don’t agree. The fear of nationalization and the terms of TARP have caused banks to try and avoid govt largess now. That’s what I wanted. Didn’t you?

    Here:

    “The stress tests results are confidence-building in that they signal the low likelihood of nationalization or seizure. Reform at the moment seems a distant prospect.”

    It’s the opposite. CAP, read it, was intended to guarantee the solvency of the banks by the govt. That’s what I’ve wanted since Sept. That’s the Swedish Plan. As well, that’s how you stop debt-deflation.

    “But having insisted that large bank takeovers are tantamount to nationalization and therefore off the table, the administration is betting that the financial system will repair itself – or “earn their way out,” as StatsGuy put it.”

    It’s not off the table, read the legislation, and it wouldn’t be better if they earned their way out. wouldn’t it? It doesn’t mean we can’t push for reform.

    “Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.”

    Last disagreement. Stocks are up for many reasons, but one important one is QE, and the diverging tracks of shorter term and longer term bonds. There’s a good post this morning about this on Alphaville. I admit my view is a minority view explanation of this rise in stock prices.

    We can still change the banking system. Sadly, few are willing to change it as much as I’d like.

  34. I want to bring to bear the perspective of having worked inside distressed banks. It is just awful. You have to spin your story to your counter-parties and your creditors to live to fight another day. With asset values and cash flows of your borrowers imploding, and every other lending hunkering down just as you have done, you are trying to get money out a stone, or out of the sky. If you off load your problem assets at their true market price–meaning to someone who wants to make a 20% IRR on the risk, min–your realized loss will wipe out your capital. Your only hope is that somehow you can make enough profit to be able to absorb the losses. You are looking to Washington to make that happen directly or, as in previous not-so enormous crises, indirectly.

    The debate as Simon and James describe it leaves out consideration of the immense practical problem of what to do. Think about it as a loan by loan problem, with an humanely complex counter-party to every transaction, down to the minimum credit card payment. Imagine that there is no plausible single buyer for one of these systemically too big to fail financial conglomerates or the ten of them that need an additional capital buffer per the stress test results.

    In some situations, it is best to shrink the tumor before attempting surgery.

    At the top of my list of criticisms of the Federal regulatory response would be failure to push for less concentration in the banking industry. Instead, it has been a bonanza for larger firms to grow larger by accretion, validating what I think of as the Citigroup business model.

    Banks today are what–deposit to loan intermediation businesses, securities brokers, investment bankers, arbitrage traders, mortgage brokers, hedge funds?

    What is the proper measure of financial health for these businesses?

    What really happened in the capital account of the counterparties when Barclays sold iShares to Citigroup Venture Capital with hefty carryback financing?

  35. Terrific post. As you say, the die is cast.

    I think the long term question now becomes: how will this course of action with respect to the banking system affect the rest of the Obama agenda? Will it undermine many of his other objectives? Will Obama’s choice of Geithner and Summers to run Treasury, in other words, the choice to follow Rubin and Goldman and their ilk, ultimately prove the most important decision Obama ever made? It remains to be seen.

    Remember: Herbert Hoover was actually considerably more activist than most people imagine. He tried many things to deal with the economic crisis. But he made a few truly catastrophic decisions at the outset, which set the tone for the rest of this presidency.

    We have been apt to think of Obama as a new FDR. But is he in truth a new Hoover?

  36. I’ve been wondering exactly the same thing. I count myself an extremely disappointed former Obama supporter. I was never that strong in my support, but I credited him with being intelligent and on some level hoped that he indeed had it in him to bring real change. This is not change. We are continuing to the letter a path that was laid down thirty years ago (Reagan = debt is good, ignore the future). Obama was handed a genuine opportunity to change this, given that crises are the times when change is actually possible. To have wasted this opportunity makes me really really disappointed. Change in the end was indeed just a campaign slogan. That depresses me.

  37. Your comparison to the old Soviet states recalls the work of the Hungarian economist Janos Kornai, who studied the effect of “soft budget constraints” on centralized economies. In these, many industries were not allowed to fail by the central government, engendering predictable problems of shortages, management failure, inefficiencies, and systemic economic dysfunction. It’s time to recognize that, as far as banking goes, we too now have a centralized system with its own “soft capital constraints.” Economists can now analyze just what are these are, how to measure them, and their expected functional role for our financial markets and the economy as a whole.

  38. Coffee Boy

    The problem is, its much easier for a lawyer to pontificate on change in the areas that he understands: national security, torture, gay marriage, stem cell research, etc. The analysis of the pros and cons are a combination of personal morals and political appeasement. Relatively easy if you have a strong sense of morals and a good sense of your constituency.

    Economics is incredibly difficult, and Obama is too scared of f***ing up. The notion that macroeconomics is difficult to predict is the primary argument FOR capitalism, and AGAINST things like Fannie, nationalised banks, and even a god-like central banker. No one knows how the business cycle will react to specific policy decisions, so its generally best to let the market unfold as it should.

    Obama is staying the course because he is scared, and doesn’t have a handle on “what’s right” in the same way that he does regarding the war on iraq and other such political subjects. Remember, he started this campaign in early 07…back in the go go days of banking, before even the Bear Stearns hedge funds blew up.

    For someone to stand up for “change” with any sense of conviction, he’d better know what he’s talking about. Unfortunately, the people most knowledgeable about this subject, generally make for horrificly boring and unelectable politicians, especially in comparison to the rock star status obama has enjoyed.

  39. David Nowakowski

    I repeat, this should not really surprise anyone with knowledge of American History. See http://tinyurl.com/phillips-w-d

  40. I am suspicious that the reason for the reluctance to place these large problem institutions into receivership and close them the way FDIC has been doing with so many of our community banks, is that there is simply insufficient money to guarantee all of the deposits. It would have been responsible for FDIC to increase banks’ fees for deposit insurance-which FDIC tried to do; however the banks apparently fought tooth and nail and actually obtained a decrease in the payments, at the same time as they got the cramdown provision killed. How in the world would the FDIC be able to see that depositors at B of A, Wells, Citibank, etc. got their deposits back, when these same banks do not want to pay insurance fees? The answer is, not in this universe. If the large banks are insolvent, then there is no way FDIC can close them and make good on all these deposits, so the tactic has been to stall any meaningful action (receivership) and hope that we are all too stupid to yank our deposits. Could someone more experience critique my interpretation?

  41. blarvindible

    power elites run the world arrogantly and always have.

    the rulers are NOT righteous and will be overthrown soon enough.

    peace

  42. Coffee Boy: “more than anything, decisions are made based on career risk.”

    Absolutely.

  43. I agree. “Too big to fail” is not the essential problem. And the cure-all is not necessarily the rejoinder “too big to exist.”

    Competence and reliability as financial institutions are the keys — and that means scrupulous regulation and timely execution of punishment when standards are breeched.

    The so-called little banks — if they were so cynically minded — could team up and create a hyda-headed monster of similarly irresponsible institutions. They could all take outrageous risks, garner unearned rewards, and if they all go belly up at the same time they’ll simply turn to to the US taxpayer for a bailout — now, sadly, an industry standard.

  44. What is the structure of the Canadian banks which assures they are so much healthier than American ones?

  45. tomaso spingardi

    I am Tomaso Spingardi, and i sit on the investment committee of several institutional investors. stress tests. what an embarassment for risk control groups of financial institutions, populated bu PHDs and researchers from some of the best universities. I guess LTCM didn’t teach us much.

    As a practitioner, I do find hard to beileve that government run tests are going to shed any further light on the risk position of the book of any financial institutions.

    at this point it goes beyond the concept of whether size matters or not. both in terms of scale efficiencies and of too big too fail.

    recent experience seems to suggest that we all kind of fooled ourselves by thinking that we had it all under control.

    Tomaso Spingardi

  46. Indy: “We talk about “too big” to fail, but to my knowledge no one has demonstrated that we would be in a distinguishable situation if we had twice as many banks at half their size (or pick your fraction) before the crisis if they had nevertheless made the same bad loans.”

    Well, as I understand it, the base problem was bad loans, but the main problem lies with securitization and derivatives that amplified the problem of bad loans. To be sure, we might be in the same fix if several smaller banks had made the same mistakes. But the problem would probably have been more tractable.

    J P Morgan, I have read, had a lot to do with the innovation of the financial instruments that are at the heart of this mess. However, they avoided getting into mortgage-based instruments, and remain relatively unscathed. By contrast, AIG bet the bank and lost. With many institutions involved, we would have had a similar spread of risk. Suppose that 10% of banks would go under. That’s a lot. However, there would be plenty of healthy banks that could absorb the assets of the failures. We would still have a mess, but the clean-up would probably be easier to effect. Also, several of the AIG level losers would probably have failed a year or two earlier, so that we would have had more time for the clean-up. We would probably have had a stock market crash earlier, and would be further along on the road to recovery.

    Besides that, there are probably political implications to having many more smaller banks instead of having a few huge ones. Power corrupts.

    My high school physics teacher liked to say, “It is not the fall that kills, it’s the sudden stop.” ;) There is safety in numbers. A large number of small failures, spread over time, is less likely to do as much damage as a small number of huge failures happening all at once.

  47. Thank you for this excellent article!

  48. anne: “CAN SOMEONE PLEASE EXPLAIN HOW OUR SYSTEM TODAY DIFFERS FROM THE SOVIET-BLOC MODEL?”

    We call it free market capitalism. ;)

    And we do it better. :)

    Seriously, both capitalism and socialism, in practice if not theory, have relied upon commonizing costs and privatizing profits. We tend to let private entities run things while they let the state run things. Our way does work better, but it’s the same game.

  49. Mike Rulle: “What is most interesting about the array of Government programs is the difference in amount between; 1) what the Feds have proposed and; 2) what has actually been done.”

    Which reminds me, whatever happened to the stimulus? Are shovels at the ready, or are people just leaning on them?

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  51. Actually good point–I think the last number I saw was the stimulus spent so far is $100 billion–another article I saw said $10 billion—so yes–not there yet.

  52. My question is where do we go from here? The fundamental problems still remain. The recent profits reported by banks are temporary. The consumers and home owners do not have the means or resources to support healthy consumption as they continue trapped by high mortagages, predatory lending and lower wages. One seriously has to question the extent of the new credit card reform and the effectiveness of the Obama administration on how it has handled its relationship with the financial sector. Assuming a rosy scenario as they want us to believe, i.e. the economy is improving and moving out of the recession. Is this sustainable, I really doubt. We continue with an automotive industry that is struggling to find definition and solvency. We are also depending on foreign lending to finance private and public spending. We also depend on the service sector to generate employment. I suspect that whatever recovery we get will be shorter than the two previous ones. I also suspect at some point we will see high levels of inflation as the excess of money in circulation clearly exceeds what we are producing.

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  54. DesolationRow

    “According to Bank of America CEO Ken Lewis, he was threatened with removal if he failed to complete the acquisition of Merrill Lynch.”

    What a joke! The govt threatened to remove Ken Lewis for wanting out of the ML deal basically after discovering the roof leaked, the cabinets had been ripped out and the toilets didn’t work. Well, maybe not ALL the toilets…i’m guessing the $35K commode Thain bought for himself on Merril’s dime probably still worked.

  55. Thanks for the response. I would point out, however, that there are moral issues here which seem quite clear as well: i.e. moral hazard. Aside from the practical effects, which as you point out are intensely difficult to know, the current policies have represented a transfer of wealth ever more tightly into a single industry. That seems to be right up Obama’s alley, IF he were truly trying to follow some moral compass. No, in the end, he is a politician, and fundamental change is beyond him. He wants to go back to the same system we had. It is, after all, the system in which he cut his teeth and where he found his success.

  56. “Perhaps after fighting off charges of “socialism” from the McCain campaign, the Obama administration is wary of any steps that could be described as nationalization. And so instead of insisting on its well-understood duty to shut down failing banks for the public good, it has tied its hands by taking this option off the table.”
    or: Perhaps, they are every bit as beholden to the banks as they appear to be. which answer is more obvious?

  57. Pingback: The Gold Standard » Game over. Banks have won.

  58. Min – I think we’ve moved beyond “commonizing costs” with this situation. As the financial firms on Wall Street piled catastrophic amounts of debt on their books, they paid themselves handsomely.

    When the house of cards collapsed, they continued to pay themselves handsomely – out of TARP funds.

    But the failed business models they followed caused the collapse of the economy – which destroyed the savings of millions of Americans. Students cannot go to college; retirees can’t retire; people’s down payment for a house (yes, people still save for such things!) have vanished into the black hole of Wall Street.

    We’re letting private entities bankrupt the country – not run things. Socialized capitalism is dreadful blow to our country, IMHO.

  59. Pingback: Stress Tests and The Nationalization We Got | Wealth Education - Investment Ideas Personal Financial Advice

  60. GotLife Too

    Management styles can range from micromanagement to laissez faire and it is unclear to me which extreme or spot on the continuum characterizes Obama’s preference. However, with the large number of projects he has placed on the table without clear plan (Gitmo closing for example) and a propensity to hit the campaign trail when the temperature in the kitchen gets warm, there appears denial that there is even a need to participate. My personal experience with a highly charismatic CEO, in a DOW component company, leads me to believe he may be uncomfortable in any role that may tarnish his brand or reveal less than godly attributes. Face it, operations is a bitch to deal with every day.

    George W. on the other hand failed in business at first only to later succeed. He failed as a campaign manager. And, he failed to control his drinking for a great period of time, an addiction he finally overcame. I remember him repeatedly stating during the early years of the Iraq war that, “This is hard,” leading me to believe he was continuously engaged, probably without allusion of invincibility.

    History will record which, if either, was effective at managing the Federal Government or winning at the international game of monopoly that is played out every day. In the business world, I had better experiences with a humbled, unglamorous man as CEO than the rockstar persona. And the two rockstar CEO’s I have always admired, Steve Jobs and Larry Ellison, are intimately, and coldly, involved with every aspect of their firms and their mark shows. Hope I get surprised..

  61. Don,

    That’s a great find from Bair. But to me it is more revealing that regulation hasn’t kept pace with corporate progress. If the FDIC has no authority to seize the holdco, and the bank is dependent on the holdco for basic functions, what should they do? The problem it seems to me is authority, not competence.

  62. Curious reader

    Any comments on James Surowiecki comments on your argument over at the New Yorker?

    http://www.newyorker.com/online/blogs/jamessurowiecki/?xrail

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  65. Have they nationalized the banks or privatized the treasury? Is that a rising or setting sun?

  66. Here’s an idea! The Fed Should buy a “Credit Default Swap” from A.I.G. to protect their investment.

  67. Pingback: The Irish Economy » Blog Archive » Baseline Scenario on US Banks

  68. As numerous others are pointing out this is largely nonsense and immature at that which coming from a couple of bright guys is disturbing. Those of us who were against nationalization were against it for a host of reasons which were never addressed by the folks who favored it. We do not now have bank nationalization and all this chicken little hyperbole is totally misplaced.

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  70. Ben Franklin used much the same metaphor during the Constitutional convention, wondering if the replacement for the failed Articles of Confederation would provide a secure foundation for our new nation. If only today’s leaders had the perspective of our wisest founding fathers who gave some thought to posterity, not just the next election.

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