At a panel discussion at the Pew Charitable Trusts (captured for posterity by Planet Money), Alice Rivlin floated the idea of breaking up big banks. Luckily for us, Scott Talbott of the Financial Services Roundtable (a lobbying group for big banks) was there to slap that idea down.

Talbott: “We need big companies, and they can be managed, and they are being managed …”

Alex Blumberg (Planet Money): “But why, why do we need big companies?”

Talbott: “They provide a number of benefits across the globe. We have a global economy, and these institutions can handle the finances of the world. They can also handle the finances of large, non-bank institutions like General Electric or Johnson & Johnson. They need these institutions [that] can handle the complex transactions. Simply breaking them up … then you’re discouraging a company from achieving the American Dream, working hard, earning money, producing products, and getting bigger.”

There are two things I object to strongly. The second is easy. The American Dream is for people, not companies. And people dream of working hard, being successful, making money, and having an impact on the world. The American Dream does not imply any particular company size. There are situations in which your products are just so much better than anyone else’s that your company becomes big as a result; Google comes to mind. But Citigroup is the product of no one’s American Dream. When Talbott says “American Dream,” what he really means is “American Bank CEO’s Dream” — because, as we all know, CEO compensation in the financial sector is extremely correlated with assets.

The first is this “we need big banks to serve global corporations” line. I’ve heard this before and I don’t buy it, for a number of reasons.

First (sorry, I have this habit of embedding numbered lists inside numbered lists), how global is Bank of America? Until it bought Merrill Lynch, it was pretty much a midget overseas compared to, say, Morgan Stanley, which was a small fraction of its size. How global is Wells Fargo? Yet those are two of our four biggest banks.

Second, the argument doesn’t pass the test of basic business logic. My company did (and does) business in many countries around the world. We had different alliances and different service providers in each one. There were overlaps — we worked with some consulting firms in multiple countries — but we made the decisions independently in each country, because every country is different. And in each country, you want the people who are the best in that country. Sometimes that will be a division of an American multinational; often it won’t. If I’m “General Electric” or “Johnson & Johnson,” I’m not going to do all my banking with Citigroup out of some misplaced customer loyalty.

Third, what global services is Talbott talking about? Sure, as an individual, it would be nice if my bank had offices in every country I might ever travel to. But that’s because I’m an individual, and I don’t want to have more than a few bank accounts. I would guess that General Electric has, oh, thousands of bank accounts around the world, with dozens if not hundreds of banks. The “one-stop shop” idea applies — barely — to people like me, who would like the convenience of doing all of our financial stuff with one company, but generally figure out that it’s impossible, because my bank offers crappy investment products, and crappy insurance products, and … you get the idea. It’s laughable for a big company, which has hundreds of P&Ls, each of which is different, and has different objectives and preferences.

Fourth, let’s take a big, global transaction — say, a debt offering. Here, arguably, it might be good to have a single bank with global scale, since you want to sell bonds in as many markets as possible in order to get the broadest possible pool of investors. In 2008, J&J issued $1.6 billion (face value) of bonds. Who got the deal? Goldman, JPMorgan, Citi, Deutsche Bank, Bank of America, Morgan Stanley, Williams Capital Group, BNP Paribas, HSBC, Mitsubishi UFJ, and RBS Greenwich Capital. Eleven investment banks based in five countries, including five U.S.-based banks. (In 2007, J&J issued 500 million pounds of debt, using thirteen underwriters — six of whom were not involved in the 2008 offering; two out of three book-running managers were European banks.) So when push comes to shove, our beloved mega-banks are nowhere near up to the task. What this tells me is that it’s the big companies that call the shots, and they like parceling out business to lots of banks. This is another basic principle of business: it’s better to have multiple suppliers than one supplier, so you can keep them in competition.

This whole argument, that global companies need massive banks, is one of those things that sound plausible until you actually start thinking about them. Is there something big that I’m missing here?

By James Kwak

Good for Deputy Treasury Secretary (and YLS alumnus) Neal Wolin for wading into the American Bankers Association to defend the Consumer Financial Protection Agency. According to FinReg21’s article:

Wolin firmly rejected the argument made by American Bankers Association chief executive Ed Yingling in recent congressional testimony that responsibility for consumer protection should not be separated from the responsibility for safety and soundness. . . .

The industry has argued that prudential regulators are careful to preserve a profit margin on financial products, to keep financial institutions sound.

This is a staggeringly cynical argument. Basically it says that you should combine prudential (solvency) and consumer safety regulation because otherwise the consumer safety regulators will reduce profits to the point where banks will not make enough money to be healthy. This logically implies that if there is a banking product or practice that is unsafe for consumers, but whose elimination would threaten banking profits, you should allow that product or practice. Is this really what the industry means?

I couldn’t believe anyone would actually say this, so I tried to find a source. I looked in the most obvious place, which was Ed Yingling’s July 14 testimony before the Senate Banking Committee. To his credit, I couldn’t find that argument in all its brazen glory. However, I did find torrents of partial truths like this one attempting to make the same argument:

Consumer protection and financial system safety and soundness are two sides of the same coin. Poor underwriting, and in some cases fraudulent underwriting, by mortgage brokers, which failed to consider the individual’s ability to repay, set in motion an avalanche of loans that were destined to default. Good underwriting is the essence of both good consumer protection and good safety and soundness regulation.

Note in passing that the spokesman of the American Bankers Association places all the blame on “mortgage brokers.” More importantly, what Yingling leaves out is that from the perspective of the individual bank there is no contradiction between fleecing customers and making lots of profits (which is what makes you safe and sound). (a) Originate bad loans; (b) pocket fees; (c) sell bad loans to an investment bank for distribution; (d) repeat. What threatened to bring down banks was the fact that they held on to too much of the risk of those loans, either on their balance sheets or in their off-balance-sheet entities.

Yingling’s testimony is page after page of that. This is going to be a real battle.

By James Kwak

The Wall Street Journal (via Calculated Risk) reports that a group of large banks has announced that it will not accept IOUs issued by the state of California. The group includes the four horsemen of the financial crisis: Citigroup, Bank of America/Merrill/Countrywide, JPMorgan Chase/Bear Stearns/WaMu, and Wells Fargo/Wachovia.

Write your own ironic commentary.

By James Kwak

For a snapshot of what’s wrong with our banking policy, look at the front page of the business section of today’s New York Times. On the left side: “U.S. in Standoff with Banks over Chrysler.” On the right side: “Banks Show Clout on Legislation to Help Consumers.”

On the left side, a consortium of banks holding Chrysler debt is refusing to agree to the current restructuring plan, which involves bondholders holding $6.9 billion in secured debt getting about 15 cents on the dollar – roughly where the bonds are currently trading, according to the Times.* The banks are playing the ongoing game of chicken with the government, betting that the government will cave and give them a better deal rather than take a risk on a bankruptcy.

On the right side, the banks are using their lobbying clout to block the administration’s proposals to help consumers and households, including the mortgage cram-down provision (which would allow bankruptcy courts to modify mortgages on first homes) and added consumer protections for credit card customers. They currently have all 41 Republican votes in the Senate tied up, which means nothing can pass.

The banks leading the charge over Chrysler: JPMorgan Chase and Citigroup. The banks opposed to cram-downs: Bank of America, JPMorgan Chase and Wells Fargo. The banks blocking credit card protections: American Express, Bank of America, Capital One Financial, Citigroup, Discover Financial Services, and JPMorgan Chase. All or almost all are bailout beneficiaries. But don’t blame them: they’re just doing what they can to maximize their profits at the expense of the taxpayer, which is perfectly legal (and even ethical, depending on your conception of shareholder rights). Instead, you should be wondering why they are in a position to be maximizing profits at the taxpayer’s expense.

If you’re Tim Geithner or Barack Obama, you’re probably thinking that now would be a nice time to have a controlling interest in these banks so they would stop blocking your efforts to help the rest of the economy. But the government has consistently bent over backward to avoid gaining control over the banks. It began with Henry Paulson (Bush administration) taking non-convertible, non-voting preferred shares last October; it continued with the Citigroup and Bank of America bailouts in November and January (during the transition period), in which the banks got underpriced asset insurance in exchange for more non-voting shares; and it peaked in the third Citigroup bailout in February, when the Obama administration insisted on forcing other investors to convert preferred shares into common, precisely to avoid getting a majority stake.

If the government had simply accepted the ordinary consequences of its actions – majority ownership – it would at least not have to plead for favors from Citigroup and Bank of America, who desperately needed help on any terms the government chose to dictate. Arguably JPMorgan and Wells are in a different situation, since the government was never in a position to buy a majority stake, and they are claiming they only took TARP money as an act of patriotic solidarity. But leaving aside TARP capital, the government has gone to extraordinary lengths to protect the financial system – guarantees on money market funds, increased guarantees on deposits, guarantees on bank debt, massive programs to lend against or purchase securities, not to mention the AIG bailout conduit – without which none of these banks would be in a position to make a profit. Yet it has left the banks in a position to capture the entire surplus from its actions, without getting the kind of concessions that would come in handy now.

Now, there is an ideological position that says that the government should stay out of the private sector, even to the point of making it more difficult for that very same government to achieve its legitimate policy objectives. This is a coherent position, though not one I agree with; it’s basically the “keep government weak” philosophy. I would just be surprised to hear that Geithner and Obama are in that camp.

By James Kwak

It’s a beautiful day today, and after Goldman and JPMorgan, I don’t feel like diving deep into Citigroup’s earnings release. But judging from the Bloomberg article, it’s a similar story, just not as good.

1. All the good news was in fixed income trading: $4.7 billion in fixed income trading revenues; falling revenues in credit cards, consumer banking, and private client.

2. Assets continue to deteriorate: $5.6 billion in new writedowns in trading accounts; $3.1 billion in charge-offs and reserves for bad credit card debt.

3. Accounting fictions save the day (the new bit): $0.6 billion in losses that don’t have to be classified as other-than-temporary (and therefore affect the income statement) thanks to FASB; $2.5 billion in “profits” because of the fall in the value of Citigroup’s own debt. The theory behind the latter is that Citi could go into the market and buy back all of its distressed debt, which would be cheaper than paying it off at 100 cents on the dollar. Also: $0.4 billion in litigation expenses avoided (previously reserved) and tax benefits from an IRS audit.

Point 3 adds up to $3.5 billion, which dwarfs Citi’s $1.6 billion  profit. Why is everyone so optimistic about banks these days?

By James Kwak

In early February, James proposed that bankers’ bonuses be paid out in “toxic assets” – after all, the industry was arguing that these would definitely rebound (“it’s just a liquidity problem”) and that their “true” value was substantially above current market value.  The idea was well received by our readers but not so much by the banking or insurance industry.

Someone quickly pointed out that – back in December – Bloomberg reported Credit Suisse would actually use a version of the same idea.  And, in the whirlwind of the fall, I now vaguely remember this same point coming up even earlier in some bigger discussion.

So in the spirit of proper attribution (also because a reader asked and I’d like to know the answer), here is our first ever weekend “comment competition”.

Who really originated this (very good) idea, either in private discourse or – easier to document - in a public comment, blog post, corporate document, or the like?  We’d also welcome updates on where any form of this idea is being used in practice.

By Simon Johnson

JPMorgan Chase reported its quarterly earnings today. The headline was $2.1 billion in net income, beating analysts’ estimates. Behind the headlines, it was similar to the story that Goldman told earlier this week: a huge jump in fixed-income trading, status quo everywhere else, and continuing writedowns. For example, if you look at the breakdown of revenue by type of activity (not line of business) on page 4 of the supplement, you’ll see that revenue was flat or down in every category except one: principal transactions, where it jumped from a loss of $7.9 billion to a gain of $2.0 billion. That $9.9 billion improvement more than explains the entire increase in pretax profit from negative $1.3 billion to positive $3.1 billion.

As with Goldman, it was clearly a good quarter for JPMorgan; making money beats losing money any day. But the question to ask is whether it is sustainable, either for JPMorgan or for the banking industry as a whole. To answer that question, here are some pictures.

First, if you look at the net revenues on a line-of-business basis (page 8), you see that virtually all the improvement came from investment banking, which improved from negative $0.3 billion to positive $8.3 billion. Here’s that $8.3 billion in historical perspective. (All the charts below are on the same scale.)

Now what was behind that super quarter? Here is the historical performance of all the investment banking business except fixed income trading:

And here’s fixed income trading:

So for JPMorgan to reproduce these results quarter after quarter, it would have to have unprecedented, exceptional, super-duper fixed income trading revenues quarter after quarter. Now, JPMorgan’s prospects may be better than they were before the bust, since two major investment banks are gone, one of them absorbed into JPMorgan itself, meaning less competition and higher fees all around. But we also know that last quarter was a bit unusual because of the massive unwind at AIG, which hopefully will not be repeated.

And here’s the dark side of the story: quarterly provisions for credit losses.

Note that these are income statement figures, so they are not cumulative: these are the provisions set aside each quarter, which should reflect the quarterly change in expectations about credit losses (defaults). The question is whether these big investment banks can make enough money from trading and fees to make up for the money they are still losing on credit exposures.

Note: I got my data from the financial supplements on this page. There’s a small discrepancy in the Q1 2006 numbers, depending on whether you look at the Q1 2006 release or the Q1 2007 release. But it’s only about $100 million, so I didn’t bother looking into it.

Goldman Sachs released its quarterly earnings yesterday, and the headline was  net income of $1.8 billion, doubling analysts’ estimates. I would say this is definitely good news for Goldman; whether it’s good news for the banking sector as a whole is more uncertain.

First, as Bruce Wayne, one of our readers, pointed out, the quarter-over-quarter comparisons left out December. Because Goldman just changed its fiscal year end, its previous quarter ended in November and its latest quarter ended in March. December was reported separately and – surprise, surprise – Goldman took a net loss of $0.8 billion. So if they had mashed December into Q1, they would have had a four-month “quarter” with $1.0 billion in profits.

Second, the positive results probably reflect a better mix of businesses than other banks enjoy. Although Goldman has made big one-sided bets, its trading operation traditionally hedged many of its positions and made a lot of its money on volume. Its positive Q1 results were largely due to strong performance in fixed income, currencies, and commodities (FICC) trading, which reflects the fact that Q1 was a busy quarter – in part because of the massive unwind at AIG – and, as Goldman’s CFO politely said, “Many of our traditional competitors have retreated from the marketplace.” With fewer players in town, the oligopoly profits go up – another reason why the big banks are even more powerful than they were before the crisis.

When it comes to the value of its own investments, Goldman seems to have done less well. Its net revenues for principal investments, mainly “Other corporate and real estate gains and losses,” were negative $1.4 billion in Q1 and negative $0.8 billion in December. While Goldman was able to more than offset this with trading gains, I wonder what the implication is for commercial banks that are not dominant players in trading.

(The FT also raised an eyebrow at the fact that per-employee compensation in Q1 was much higher than in the year-earlier period. That actually doesn’t worry me, because I’m guessing those compensation expenses are bonus accruals – the better the quarter you have, the more money you have to set aside for year-end bonuses.)

By James Kwak

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

Leaving aside the question of subsidies, which has gotten piles of attention on the Internet, Simon and I are skeptical that the Geithner Plan will achieve its basic objective: getting enough toxic assets off of bank balance sheets to restore the financial system to normal functioning. We discuss this in today’s Los Angeles Times op-ed, although our regular readers could probably fill in the blanks by themselves.

Update: At 2:30 PM Eastern today, I’ll be on a live chat at Seeking Alpha with Felix Salmon and possibly Brad DeLong and Mark Thoma discussing the Geithner plan. Salmon is strongly against, Delong is moderately (strongly?) for, Thoma is moderately for.

Update 2: At The New Republic, Simon discusses one plausible scenario under which the Geithner Plan is the first step in a comprehensive bank rescue strategy. But he’s skeptical that we will see the other necessary steps.

Update 3: Chat is done; replay is here.

By James Kwak

Mark Thoma does a nice job comparing government purchases, public-private partnerships, and nationalization, and gets the concluding paragraph exactly right. It won’t help you through the complexities of whatever Geithner will announce in the morning, but it explains the basic concepts.

If I had infinite time, I would respond to all reader questions and suggestions. Unfortunately, I can’t. But I’m hoping to occasionally post some in-depth responses to some of the tougher questions we get.

Chris Uregian, one of our readers, sent us three questions by email. In summary, he thought that we were overlooking some of the problems with nationalization and the reasons why Treasury might be moving more slowly than we would like. I originally answered him in email but we later decided this would be good to post to everyone, and Chris gave us his permission. I am going to copy his questions here and add a response after each one.

1. Question:

We have heard plenty about the Swedish model. But how about the US model. The last time a bank was nationalized in the US, it was Continental Illinois in 1984 – 1994.  That was the 7th biggest bank at the time.

If we nationalize Citi (ideally only Citi, although no one outside the Treasury, even Simon or Paul Krugman have any idea how many banks we need to nationalize), that is X times larger than Continental, how long do we have to hold it for? What is the cost to the taxpayer?

If we have to nationalize even 2 out of the 4 biggest banks in the US, that is around 30% of total banking sector assets according to Martin Wolf. So the US Government will officially be in charge of at least a third, more likely half the US banking sector for anywhere between 5-10 years.You guys do excellent forecasts, so tell me is that a reasonable forecast of what nationalization would look like? If so, and you were Tim Giethner, wouldn’t you try to avoid this at almost any cost? Shouldn’t nationalization be your very very LAST resort?

Roubini, for all his gloom, is currently the most reasonable of our nationalization crew. He recognizes that the Treasury really wants to avoid nationalization for political but also genuine economic reasons, but that is why their plan gives banks 6 months to find private capital. His argument is that in 6 months time,’ in the depth of the recession, we will really know which banks are really insolvent, and which ones could be solvent with a little government help. The notion that there is a clear distinction between insolvent banks and illiquid banks is a little strange to me given my experience… there’s a grey area with many shades and defining clearly which banks are insolvent in this economic environment is not easy. Again, that suggests caution and moving slowly, not jumping at solutions Paulson style.

Guessing how long the government would be in charge of these banks is basically impossible, but I think 5-10 years is not an unreasonable guess. I don’t think that means it should be the last resort, however. The problem is the real economy. The longer we have uncertainty, the worse the real economy gets. On the one hand, I agree with you and Roubini that time will give us a clearer picture. On the other hand, I think that the banking sector is not going to fix itself on its own, and the longer we wait the bigger the output gap (and the higher the unemployment rate) will be by the time the economy does recover. So I think reasonable minds can disagree on this.

2. Question:

Further, I think Simon’s point about if you covered the name of the country, then your IMF officials would give the same advice to the US as for any emerging market economy strikes me as missing one crucial detail. Citibank is not your typical Latin American bank – if a Latin American bank goes bankrupt, that doesn’t carry the risk of freaking out markets globally the way Lehman’s bankruptcy did due to counterparty risk, it does not have the number of creditors, bondholders fearing they will get a massive haircut that Citi has; You simply cannot tell me that if 2 out of 4 largest banks were nationalized overnight, that would not carry a very serious risk of freaking out the markets at least as badly as Lehman’s bankruptcy did, and potentially lead to the collapse of the stockholder confidence in a whole bunch of financial institutions that may well be healthy.

I think market freakout depends on the form of the takeover. As I have written (maybe since you sent this email), the main determinant of market freakout will be how creditors are treated. One possibility, which Krugman somewhat hesitantly endorsed, was to guarantee the bank liabilities. Another, which Bebchuk suggested, was to guarantee the liabilities up to some level (which could vary by type of creditor), where that level was engineered to minimize the risk of major collateral damage. I think with sufficient time to study the situation, it seems like you should be able to force some degree of debt-for-equity swaps without causing a huge domino effect. But a blanket guarantee is still an option.

3. Question:

Finally, let me remind you that Peter and Simon wrote a piece in the FT just over a month ago arguing AGAINST nationalization. Now, they are all for it. Yes, when the facts change, we change our minds…. but recognize that Tim Geithner  and Ben Bernanke do NOT have the option to change their minds. And they are NOT suddenly sell-outs or economic illiterates. But maybe they know too much about how close we came to the precipice and have become excessively risk averse. Perhaps. But quite honestly, I am not sure I blame them for wanting to be extra prudent. Back in  September, the vast majority of the financial commentariat said  Paulson made the right decision to let Lehman fail – it was not too big to fail. Now it’s the biggest mistake since Mellon liquidated the US banking sector. In such a crisis, certainty is not justified and should be left to the Rick Santellis of this world. At a time when Paul Krugman is disagreeing with Alan Blinder, maybe each side needs to listen more to the arguments of the other.

About the argument against nationalization back in January: I think the honest answer is that the thing we proposed then would have been preferable to nationalization, but it had very little chance of working. We made the mistake of describing an economically elegant solution that did not take political realities into account. Our proposal was for the government to buy toxic assets at market value (or something close to it) and then recapitalize the banks directly, at the same time. This would remove balance sheet uncertainty from the banks while minimizing the taxpayer subsidy. The mistake was in overestimating the power of the government to force such a solution. The problem that I have since realized is that as long as the banks can negotiate on their own, they will win that particular game of chicken. They will just say, “no, I won’t sell to you at that price” and wait for the government to propose a sweeter plan – because the government can’t walk away, because it’s responsible for the economic well-being of the country.

At the end, Chris wrote: “I fear you have not been as clear on the downsides of nationalization as you have been on the benefits, which might help explain why the Administration is ‘dithering’.” I think that’s a fair criticism. Hopefully I’ve helped redress that.

By James Kwak

According to The New York Times and the The Wall Street Journal, the Treasury Department is set to announce its plan for troubled assets early next week. It will include three components. The details aren’t clear since these are anticipatory news stories, but it will be something like this (combining bits of information from the two stories):

1. The FDIC will create a new entity to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide non-recourse loans* for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.
2. Treasury will create multiple new investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.
3. The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities** (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy “legacy” assets – those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Instead of coming up with one plan to buy troubled assets, it looks like the government has come up with three. (As Calculated Risk said, however, ” More approaches doesn’t make a better plan” (emphasis in original).) For now, I think the concerns I expressed last month still hold. If we take as given that the government will only negotiate at arm’s length with the banks (meaning the banks can decide at what price they are willing to sell the assets), then the most important thing is for the plan to work. But it’s not clear if the degree of subsidy offered will be enough to close the gap between what investors are willing to pay and what banks are willing to sell at. Having multiple buyers and using cheap Fed financing will increase the willingness-to-pay for these assets, but we won’t know a priori if it will exceed the reserve price of the sellers.

In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks.

Most encouragingly, the headline in the Times was “Toxic Asset Plan Foresees Big Subsidies for Investors,” indicating that the mainstream media have figured out the game. (By contrast, the Times headline announcing the bank-friendly terms of the Capital Assistance Program was “Government Offers Details of Bank Stress Test.”) I may soon be out of a job. (Wait a sec, no one is paying me for this . . .)

* A non-recourse loan is made for a particular asset or set of assets. If the borrower fails to pay off the loan, the most the lender can get is the asset (he cannot go after the borrower’s other assets or income streams), so the borrower’s loss is capped at the amount he pays himself. Mortgage loans are non-recourse loans where the borrower’s loss is capped by his down payment.

** Technically, the Fed would loan money to financial institutions and take asset-backed securities as collateral. However, these would be non-recourse loans, so the financial institution could pay off the loan simply by ceding the collateral to the Fed. (It seems to me that because these are loans, if the assets appreciate in value, the financial institutions could choose to pay back the loans and take the collateral back, thereby getting all the upside, but I’m not certain about that.) The TALF will be capitalized by some money (10-20% of the total) coming from Treasury, which will absorb the first losses.

By James Kwak

This is my last post on nationalization for at least a week, and hopefully a lot longer than that. I’m tired of writing about it. But I was listening to Raghuram  Rajan on Planet Money, and things became a little more clear to me.

Rajan was saying that he had some concerns about nationalization and didn’t think it was necessary to fix the banking system. His concerns were sensible, I have counter-arguments for them, and I don’t want to get into a detailed debate here. More importantly, he agreed with the nationalizers that the system is broken, hasn’t been fixed, and needs to be fixed – he just thinks you could do it a different way.

We’ve talked and talked about it but never actually taken action. We need to take some of the bad assets off the balance sheet. We need to recapitalize the banks to the extent that is needed after that, and that might mean more and more government ownership, that’s a possibility. . . .

The real issue is the taxpayer, unfortunately, has to put more money into the system; hopefully much of it will be recovered. He has to put more money in in the short run, both in buying these assets off balance sheets, and recapitalizing the banks, so that the banks then have clean enough balance sheets such that they will begin to lend when the system recovers. . . . If you can clean up the system, my sense is whether you call it nationalization, or call it cleaning up by putting more money without nationalizing, cleaning up is the first-order thing.

I think there are three main positions in this debate:

• A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
• A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
• B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

The big divide is not between A1 (Rajan) and A2 (Simon and me). In both cases, you end up with a healthy banking system, at significant taxpayer expense. (A2 should be somewhat cheaper because it wipes out the shareholders, but I agree with Rajan that it is dramatically cheaper only  if the government is willing to restructure some of the liabilities.)

The big divide is between both of these and B, the position of the Bush and Obama administrations – both of which rejected aggressive measures in favor of just-in-time, just-big-enough bailouts. Now the government is conducting stress tests on an industry it has already said is adequately capitalized, and will follow that with a public-private asset-buying program that tries to split the difference between paying real market value and paying enough to keep the banks happy. I’ve quoted these exact words before, but here’s Krugman again: “The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up.”

Now, let’s say you agree that something more needs to be done. Then you have to choose between A1 and A2. A2 is the one people typically call “nationalization.” But which is more consistent with a capitalist system: protecting the creditors who lent money to a failed bank, the shareholders who invested in a failed bank, and the managers who failed . . . or firing the managers, wiping out the shareholders, and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses? Which one better approximates the incentives you want in a free market?

As Simon wrote this morning, the administration strategy is to wait and see if the economy turns around, lifting banks out of the mess they created. How can you tell if this is working? One way is to look at bank bonds.

If the administration is right and the banks are healthy (and to the extent they aren’t healthy, their capital will be topped up with convertible preferred shares), then bank bonds are safe. Even subordinated bonds (the ones that get paid off after senior bonds and insured deposits) are protected by the bank’s capital – both common and preferred shares. So if the administration is correct that the banking system is adequately capitalized, and will be even more adequately capitalized after the stress tests and capital infusions, then banks will be able to pay off all of their bonds.

Even if the administration is wrong and the banks are not adequately capitalized, bondholders are only in danger if the administration decides not to protect them. This could happen in one of two ways. First, the administration could request, as a condition of a future bailout, that bondholders exchange some of their debt for equity. There is no law that says that bondholders have to exchange their bonds for equity just because the government asks, so the threat would be that the government would not bail out the bank otherwise (forcing it into bankruptcy or conservatorship).* Second, the administration could take over the banks; in that case, the regulator might decide not to pay back all of the bondholders – but it certainly could decide to pay them back. It’s just a question of whether losses are borne by the bondholders or the taxpayer (assuing the equity holders have been wiped out).

So what does the bond market think?

According to a Bloomberg article this morning, the bond market is scared. Yields on bank debt overall are 3.6 percentage higher than for industrial companies (before August 2007 they were lower); Citigroup’s subordinated debt due in October 2010 has fallen from 95 cents to 77 cents on the dollar in the last three weeks; Bank of America’s subordinated debt due in January 2011 is down from 99 cents to 80 cents. Here is some color:

“The bond market is getting more scared every day,” said Gary Austin of PDR Advisors in Charlotte, North Carolina, who manages $450 million in fixed-income securities. “At some time, the government is going to say enough is enough, the only way we will give you more cash is if the bondholders have to be hit.” . . .

“The current prices imply that the companies’ equity is worthless, the government’s investment is worthless and subordinated debt holders will lose some of their investment,” said David Darst, an analyst at FTN Equity Capital Markets in Nashville, Tennessee.

In other words, the bond market isn’t buying the administration’s story, and thinks there’s a pretty hefty risk not only that some banks will be taken over, but that bondholders will be made to suffer in the process. Correct or not, this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.

Maybe Treasury or the Fed will start buying subordinated bank bonds in order to project confidence. That would be putting its money where its mouth is. Of course, that would also guarantee that the taxpayer will suffer any potential losses, one way or the other.

* The government tried this with GMAC back in December, with only partial success. Some bondholders, including PIMCO, refused to convert, betting that the government would bail out GMAC anyway, which it obligingly did. Felix Salmon covered this extensively (short version and long version). This means that the government may not be able to go the voluntary route in the future.