A fundamental principle in any emerging market crisis is that not all of the oligarchs can be saved.  There is an adding up constraint – the state cannot access enough resources to bail out all the big players.

The people who control the state can decide who is out of business and who stays in, but this is never an overnight decision written on a single piece of paper.  Instead, there is a process – and a struggle by competing oligarchs – to influence, persuade, or in some way push the “policymakers” towards the view:

1. My private firm must be saved, for the good of the country.
2. It must remain private, otherwise this will prevent an economic recovery.
3. I should be allowed to acquire other assets, opportunities, or simply market share, as a way to speed recovery for the nation.

Who won this argument in the US and on what basis?  And have the winners perhaps done a bit too well – thinking just about their own political futures?

On who must be saved, we see the new dividing line.  If you have more than $500bn in total assets, post-Lehman, you make the first cut.  If you’re below $100bn (e.g., CIT), you can go bankrupt.

On remaining private, the outcome is more complicated.  Citigroup had the best political connections in the business, but turned out to be so poorly managed that the state essentially had to take over – in a complicated and ultimately unsatisfactory way.  Bank of America’s relatively weak political connections meant that the impulse purchase of Merrill Lynch could go very badly – and also led to a bizarre form of government takeover.

The prevailing idea and organizing principle for this new sorting is not Lloyd Blankfein’s “we’re the catalyst of risk” – investment banks are peripheral, rather than central, to nonfinancial risk taking and investment in this country.  It’s Jamie Dimon’s idea: just don’t demonize the competent bankers, let us take things over and we’ll smooth it all out. 

The problem with this approach is its “success”, from the point of view of the remaining bankers – their market share is up so sharply that it’s embarassing.  Of course, they can still argue that banking is a global industry with many competitors (some of which are even bigger, with more state assistance, promising much craziness in the years ahead).

But the real issue now is concentration in the political marketplace.  Hank Paulson dealt with a dozen big banks/similar institutions with deep connections to Capitol Hill and a very powerful small banking lobby.  Tim Geithner is looking at just a couple of big banks that are still independent .  Probably we should start to divide our big banks into the “nationalized” and the “nationalizers”.

The small banks still have clout – and you’ll see them in force on the regulatory reforms debate this fall – but they know now that they don’t get bailouts, and access to contigent state capital-on-amazing-terms is the ironic basis of modern financial power. 

We are looking at a concentration of political power in the US banking system that we haven’t seen since the 1830s: Shades of Andrew Jackson vs. the Second Bank of the United States.  We put up with a lot from our banking elite in this country, but historically we draw the line at financial power so concentrated it can confront the power of the President.

The logic for reform and for breaking up the big banks begins to build.  Bank of America’s fall was, in some senses, a fortunate accident for Goldman and JP Morgan.  But it has also given them an excessive and unsustainable degree of political power.

Of course, you also have to ask: Who can break that power, when, and how?

By Simon Johnson

Surowiecki makes three points about our recent long post on nationalization:

1. If the government were to take over a large bank like Citigroup, it would not be able to sell it into the private sector quickly, but would most likely own it for several years, which constitutes nationalization.
2. Recent U.S. history, by which he means the S&L crisis, shows that the right strategy is “exercising regulatory forebearance, cutting interest rates sharply (which raises bank profit margins), and helping the banks deal with their bad assets” – not bank takeovers.
3. We were misleading in citing the IMF’s $4.1 trillion number instead of the lower $1.1 trillion number for U.S. financial institutions. “I assume they used the $4.1 trillion number because it’s much scarier, and offers a much gloomier picture of the state of the U.S. financial system. Unfortunately, it also offers a much more misleading picture of the system.”

Sigh. I guess it’s impossible to make everyone like me.

I’ll take the points in reverse order.

3. I plead partially guilty to this one (I wrote that section of the post). $4.1 trillion is the IMF’s aggregate estimate of all writedowns by all financial institutions globally. To be honest, I used it because that was the number I remembered, and I was writing fast and late at night. (I do this in my spare time, remember?) The point I really meant to make was that the IMF’s estimate was going up, because the problem had spread into all sorts of lending. You’ll note that I didn’t actually compare the $4.1 trillion to any other number – now that would have been misleading.

When I dealt more specifically with U.S. bank capital levels in another post, I did use the relevant IMF number: $275-500 billion in capital needs. $275 billion is a much bigger number than $75 billion, the bottom-line total of the famous Table 3 of the stress test results. Surowiecki attempts to deal with this in his post called “The Fed and the I.M.F. Agree,” where he reconciles these two numbers. His reconciliation is correct as far as it goes. However, the stress tests were supposed to be for a “more adverse” scenario, meaning more conservative than the expected scenario; the IMF numbers, by contrast, are their expected scenario (see mainly PDF pp. 27-28 and 32-34). Who’s right? Well, Calculated Risk has a chart showing clearly that unemployment is already running slightly worse than projected in the “more adverse” scenario (see the second chart in that post), indicating that the “more adverse” stress test scenario/IMF expected scenario (which are similar, as Surowiecki notes) should be thought of as an expectation, not a conservative forecast. So if you believe that the stress tests were supposed to buffer against the possibility of a worse-than-expected outcome, they aren’t doing it.

There is another major difference between the stress tests and the IMF that deals not with the forecasting question, but with the capital adequacy question. The stress tests calculate capital requirements as a percentage of risk-weighted assets, while the IMF uses total assets (confusingly defined as “total assets less intangible assets” (PDF p. 34, note 39)), which ordinarily will be significantly higher (risk weights are generally less than or equal to one). So 4% of one does not equal 4% of the other. (The IMF’s $275-500 billion range reflects 4% and 6% thresholds.) Citigroup, for example, had total assets, excluding intangibles, of $1,897 billion as of December 31 (the snapshot used by both the stress tests and the IMF), while according to the stress tests it had risk-weighted assets of $996 billion. Who is right I will leave to others to debate, but the stress tests are allowing banks to get by with much less capital than the IMF report implies they should.

2. I am confused by Surowiecki’s interpretation of recent U.S. history. The “regulatory forbearance” he mentions happened early in the 1980s when, among other things, thrifts were allowed to invest in a broader set of assets and were allowed to offer higher interest rates to depositors, deposit insurance ceilings were raised, and capital adequacy requirements were relaxed for thrifts facing insolvency. This may have helped banks survive but, according to a later FDIC report, it also postponed and amplified the later crisis: “With respect to commercial mortgage markets, this legislation set the stage for a rapid expansion of lending, an increase in competition between thrifts and banks, overbuilding, and the subsequent commercial real estate market collapse in many regions.” The early 1990s saw precisely the opposite; the FDIC Improvement Act of 1991, for example, limited regulatory discretion in dealing with struggling institutions.

Forbearance can work, but it is not a cure-all. The FDIC report later contrasts beneficial and harmful forbearance programs, but it criticizes large-scale forbearance programs in no uncertain terms:

Longer-term, wholesale forbearance as practiced by the FSLIC was a high-risk regulatory policy whose main chances of success were that the economic environment for thrifts would improve before their condition deteriorated beyond repair or that the new, riskier investment powers they had been granted would pay off. The latter type of forbearance, which the FSLIC adopted against the background of a depleted insurance fund, is widely judged to have increased the cost of thrift failures.

In addition, the policies of the 1980s played out in a very different economic environment. The assets in question were primarily loans, rather than the complex securities we are dealing with today. And the global economic climate was considerably better than today, which helped banks earn their way out of their problems.

In any case, the bottom line of the S&L crisis was over 1,600 FDIC interventions between 1980 and 1994. (We’ve had 33 so far this year.) The Resolution Trust Corporation was charged with managing the assets of banks and thrifts that had become insolvent, not “helping the banks deal with bad assets.” One can argue about the lessons of the 1980s – particularly about what they mean for large banks – but it’s by no means clear that the policies Surowiecki highlights forestalled the need to take over banks.

1. I think this is one of the more serious criticisms of government takeover of a large bank – namely, that it would take a long time before it could be returned to the private sector.  But that doesn’t mean prolonged political control over lending decisions. The important thing about a takeover is that you can clean up the balance sheet, for example by transferring the toxic assets to a separate entity, without having to negotiate with anyone. Once you’ve done that and the bank is recapitalized (no one is saying this will be free), the government’s stock can be put into a trust with an independent board of trustees with long terms. This would insulate the bank reasonably well from political pressure, since the trustees’ legal obligation will be to run the bank for its own long-term benefit, and to privatize it when possible at the highest possible price for the taxpayer.

There is actually an example of this right now: AIG is majority-owned by the government, but the government’s stock is controlled by three trustees who are independent of Treasury and the Fed. This is why the Treasury is forced to negotiate with AIG like any other private party that is looking out for its own interests. On the other hand, Treasury had zero voting shares in Bank of America back in December – yet it felt able to threaten Ken Lewis with replacement if he didn’t close the acquisition of Merrill. My point is that you get government influence either way, regardless of the legal structure. With Bank of America, the source of the influence was the likelihood that B of A would need assistance from the government in the future. With AIG, the source of the influence was yelling and screaming through the media, plus the fact that AIG also needed additional assistance.

I’m not saying that the AIG situation is perfect, just that it is possible to insulate a government-owned entity from political meddling – as the government found out, to its frustration. The mistake with AIG, I believe, was giving it that independence without having fixed its fundamental problems – the ones that cause it to keep coming back for more money. Were the government to take over a large bank, it should clean up the balance sheet and recapitalize first – without negotiating – and then turn it over to an independent set of trustees.

This “big banks are different” issue is a serious one and worthy of consideration. But it doesn’t necessarily justify the application of a completely different set of principles than the ones that are routinely applied to smaller banks.

Update: There’s another difference between the stress tests and the IMF: the type of capital – TCE (IMF) or Tier 1 common capital (stress tests). I was suspicious of this but didn’t have time to look into the impact.

Update: James Surowiecki’s response below.

By James Kwak

If you want to end up with the economy of Pakistan, the politics of Ukraine, and the inflation rate of Zimbabwe, bank nationalization is the way to go.

Most others who recently advocated a managed bankruptcy process – or FDIC-type intervention – for big banks (with or without the injection of new government capital) were careful, at least initially, to avoid using the word nationalization.  And many took pains to explain in detail why their proposals were quite different from nationalization.

But at some point this became a debate in which informed bystanders perceived the sides as being for or against “nationalization” - a semiotic transition that has obviously helped the big bankers, at least in the short term.

This weekend’s comment competition is in two parts.  Who first made “nationalization” the central word for the U.S. bank discussion?  And who was most influential in establishing that the national debate be defined in these terms?

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible.

Hoenig provides a list of arguments in support of this position. He starts with moral hazard, which would not have been at the top of my list. But I particularly like these:

So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role.

A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable.

Here’s a link to the whole thing again.

By 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.

Brad Delong, for example, is moderately in favor of the plan, even though he thinks it is insufficient. In his words, “I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul [Krugman] thinks that the longer Obama delays proposing bank nationalization the lower it’s chances become.” (“Voinovich” is DeLong’s hypothetical 60th senator, whose vote would be needed in the Senate.) In other words, DeLong thinks that if this plan fails, the administration will be more likely and able to go forward with nationalization.

Paul Krugman, by contrast, is strongly against the plan, first because he thinks it has no chance of succeeding, and second because he thinks there is no Plan B. “I’m afraid that this will be the administration’s only shot — that if the first bank plan is an abject failure, it won’t have the political capital for a second.”

I think the plan is likely to fail, or at least to be very insufficient, for reasons described elsewhere. I am also worried that the Obama administration has committed itself so strongly against taking over large banks that it cannot reverse course, at least not unless it sacrifices Geithner. So I expect Plan B to be more generous to the banks – which means it will have little chance of getting any money out of Congress (and the $700 billion will run out at some point). The increasingly friendly stance toward Wall Street also implies this course of events.

On the other hand, today’s reporting on what Bernanke and Geithner were actually asking for yesterday is a little bit promising. From The Wall Street Journal:

The bill, said Treasury, would cover financial firms that have the potential to severely disrupt the U.S. financial system. That would include bank holding companies and thrift holding companies as well as companies that control broker-dealers, insurance firms and futures commission merchants.

On my read of this passage (I haven’t seen an actual bill yet), the proposed legislation would enable regulators not only to supervise bank holding companies, which they can do today, but to take them over and wind them down just like the FDIC can do with depository institutions. If Treasury and the Fed have this power – and I think they should have it -  it could improve their negotiating position relative to the big banks. It could also indicate that the administration wants to have this power in its back pocket just in case it needs to use it. (Using the AIG scandal to get this power is a clever political move.) I still don’t think this is Plan B, but it could mean that they want all options open.

Update: More information on the proposed new bill in the WSJ.

Treasury said the draft bill would enable the federal government to seize troubled bank- and thrift-holding companies as well as firms that control broker-dealers and futures commission merchants.

An Obama administration official confirmed that the legislative proposal would also give the government authority to shut down troubled hedge funds, which currently face minimal oversight. The government could potentially use the new “resolution authority” on any nonbank financial firm that is deemed to pose systemic risk, the official added.

By James Kwak

As the New York Times reported today, Geithner and Bernanke were on Capitol Hill to ask for greater power to wind down non-bank financial entities like AIG. During the hearing:

[Representative Barney] Frank said the different fates of Lehman Brothers and A.I.G. illustrate the need for options beyond the “all or nothing” approach. “One was the Lehman Brothers example, where they were allowed totally to fail and there was no help to any of the creditors,” Mr. Frank said. “The other is the A.I.G. example, where there was help for all of the creditors. Neither one is what we should be doing going forward.”‘

Geithner and Bernanke largely concurred. Basically, the key actors want to be able to apply a receivership/conservatorship-type system that currently covers members of the FDIC, Savings and Loan institutions, and Fannie/Freddie to any entity whose financial activity poses a systemic risk to the economy.

James has pointed out that proponents of nationalization for Citigroup and Bank of America have essentially the same thing in mind: have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not. Baseline Scenario has consistently and persuasively argued that such an approach would be prudent. Indeed, it would avoid the awkward political fallout of the type that arose when AIG disclosed that $60+ billion worth of federal aid went directly to its various derivatives counterparties. The problem is, this policy might not be constitutional.

The last phrase of the Fifth Amendment to the U.S. Constitution, known as the takings clause, reads: “nor shall private property be taken for public use, without just compensation.” Its potential application to a significant chunk of the economic recovery programs is straightforward. A facial reading of the above text suggests the U.S. federal government (and state equivalents, similarly bound through the Fourteenth Amendment) cannot unilaterally restructure the contractual obligations of a given entity, summarily dismiss its outstanding debts, or even choose to pay some arbitrary fraction of these while waiving the rest. Curiously, however, there has been precious little commentary on just this point. Laurence H. Tribe, a professor at Harvard Law School, summarily dismissed the issue when evaluating the legality of a 90% tax on bonuses in his email to the Atlantic. Mayer, Morrison, and Piskorski gave it a bit more coverage in their mortgage modification proposal, , but still seemed to be glossing over the main point by citing to a recent Supreme Court case that dismissed a very loose standard for takings jurisprudence without explicitly stating whether a taking took place.

Larry Tribe is more of an expert on constitutional law than I may ever be, but a closer look at the doctrine looks rather ominous, even if one presumes that, pursuant to the controversial Supreme Court decision in Kelo v. City of New London, 545 U.S. 469 (2005), any economic recovery program would pass the public use test.  First, there is a consensus that contractual rights to cashflows constitute property protected by the Fifth and Fourteenth Amendments. See Eastern Enterprises v. Apfel, 524 U.S. 498 (1998), Webb’s Fabulous Pharmacies, Inc. v. Beckwith, 449 U.S. 155 (1980). Stocks, bonds, and most other financial instruments are thus protected from instantaneous nullification.

Second, the Supreme Court has set out two separate theories under which nationalization of financial institutions may constitute a taking. Per the 2005 decision that Mayer relies on (Lingle v. Chevron U.S.A., 544 U.S. 528), regulations that completely deprive an owner of “all economically beneficial use” of her property trigger the Fifth Amendment unless they fall into certain narrow safety and nuisance exceptions. Alternatively, under a test articulated in Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978), judges determine whether a taking occurred based on the type of government action, whether the regulation had an adverse economic impact, and the extent to which the regulation “interfered with distinct investment-backed expectations.” A forcible change in the capital structure of a previously un- or under-regulated entity would certainly look like a taking under either of the two tests.

Third, just because the government can currently force banks and thrifts into receivership, doesn’t mean that it can constitutionally do the same to any other enterprise. Decisions evaluating shareholder claims for regulatory takings of the type governed by Penn Central often revolve around the degree to which an entity that suffered economically because of government action knowingly did business in an area fraught with complex, changing rules. For example, a 2003 federal court of appeals case focused on the right of both public entities (former RTC/subsequent FDIC) and private owners to recover a surplus allegedly lost when a change in accounting practices brought about by Congress in 1989 (FIRREA) forced regulators to seize Security Savings, a previously viable S&L organization. Bailey v. United States, 341 F.3d 1342. The court held that the alteration of the accounting rules was not a per se taking under the theory that the S&L voluntarily participated in and reaped the benefits of the deposit insurance system, articulated in a seminal 1996 case Branch v. United States. Problematically, the opinion then dodged the question of whether such an administrative move nonetheless constituted a distinct, regulatory taking by holding that a statutory cost recovery hierarchy for liquidated thrifts would have prevented the private parties from seeing any cash in the first place. In other words, Bailey explained that shutting down an insolvent entity operating in an environment of pervasive government control would not itself constitute a taking, but did not fully resolve how one should treat a sudden administrative change that led to this insolvency in the first place. Indeed, an earlier case in the same court allowed a taking claim to go forward on the grounds that a 1991 law similar to FIRREA reneged on a signed promise by the FDIC to consider a bank’s capital reserves adequate. See First Hartford Corporation Pension Plan & Trust v. United States, 194 F.3d 1279 (1999).

The legal doctrine in these areas is quite complex and there are probably several ways to apply it to various existing and future economic recovery programs. I do believe, however, that entities negatively affected by nationalization/conservatorship/receivership brought about under a brand-new program occur could make a very good argument that they are entitled to restitution under the Fifth Amendment. If that is the case, Congress can’t do anything to change the outcome. Of course, courts would still have to decide on the extent of “just compensation” that would remedy an otherwise illegal seizure. Historically, such awards have been based on market value, but the inquiry could get quite muddled in the financial arena. Yet any judicial decision that would force the government to pay something close to market value for the liabilities it wrote off would by definition render such restructuring moot. Perhaps this is the reason why the Obama Administration had previously adopted the wait-and-see/just-in-time approach to bank rescues.

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

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 I see it, there are at least five different meanings of nationalization.

1. Owning more than 50% of the bank, by which people typically mean owning more than 50% of the common equity

This is a red herring, despite Treasury’s complicated efforts to keep its ownership stake in Citigroup below 50%. One entity can have effective control over another with less than 50% of its equity – through stock with special voting rights, or simply by being the largest shareholder. Conversely, one entity can own over 50% of another’s equity, yet not have any control, perhaps because it holds non-voting stock, or perhaps because it simply chooses not to exercise control.

2. Consolidating the bank onto the government balance sheet

Above 80% ownership, things do get serious: at that point, the bank becomes part of the government balance sheet (unless there is some special treatment for the U.S. government that I’m not aware of). This means, among other things, that the bank’s debt becomes U.S. government debt, which increases the potential liability of the taxpayer. This is why, for example, all of Iceland’s banks defaulted on their debt just before being taken over by the state; otherwise Iceland’s citizens would have become responsible for their debts. This is also why it is unlikely to happen here.

3. Turning the bank into a government agency

In this scenario, banking becomes a government service, like getting a driver’s license or going to the unemployment office. Banking decisions – how much to pay depositors, who gets credit, on what terms, etc. – become the province of government bureaucrats. This would most likely be a bad idea, because these decisions – which, collectively, shape the flow of capital through the economy – are best entrusted to the free market. This is why no one is seriously considering this option here. However, when people argue against nationalization, this is often the straw man they are aiming at.

4. FDIC-style conservatorship

This is what the FDIC does when a bank it insures fails. FDIC bank supervisors determine that the bank’s assets are worth less than its liabilities. The bank itself is shut down and its assets are transferred to a new entity controlled by the FDIC. The FDIC attempts to maximize the value of these assets, typically by selling them to another bank or banks. From the customers’ standpoint, little changes during this period: the branches, ATM machines, web site, and so on remain in operation during the transition, except that customer may not be able to withdraw amounts above the insurance limits. If the proceeds do not cover the bank’s liabilities, the creditors lose out, but the FDIC makes sure that all the insured deposits are paid back. Note that going into conservatorship does not mean that the bank is consolidated onto the government balance sheet; the liabilities are not automatically guaranteed.

#4 is what most proponents of nationalization mean.

Those are four different versions of what it might mean to nationalize a bank. In addition, there is another type of nationalization that must be discussed and that, in fact, has largely occurred:

5. System-level  nationalization

Banking in the United States, as in all advanced economies, has always been a public-private partnership rather than an unregulated free market. Banks play a critical role in the economy and therefore enjoy certain protections – such as FDIC insurance – and certain constraints – such as regulation. If the government had failed to act as the financial crisis unfolded, things would probably have gotten much worse, very quickly: not only Lehman Brothers but also Bear Stearns, Fannie Mae, Freddie Mac, AIG, Morgan Stanley, Citigroup, and probably Bank of America would have collapsed, causing trillions of dollars of losses for creditors and counterparties and bringing down other banks in sequence.

Instead, the government, primarily through the Federal Reserve, stepped into the breach. The government is the only source of capital for the banking system; it guarantees a large proportion of bank liabilities, including virtually all deposits and new bank debt; it implicitly guarantees all large banks under the Too Big To Fail doctrine; it ensures the liquidity that keeps the system afloat, both by providing cheap money and by lending against illiquid assets; and it has stepped up buying of various securities on secondary markets in order to encourage lending. In short, the government is where the money comes from, and the government decides on a high level where it goes, through capital injections, loans, and securities purchases. And the government bears the vast majority of the risk.

The net result is we have a semi-nationalized banking system largely made up of some very sick but private banks. As Thomas Hoenig put it:

We understandably would prefer not to “nationalize” these businesses, but in reacting as we are, we nevertheless are drifting into a situation where institutions are being nationalized piecemeal with no resolution of the crisis.

I am all in favor of debating to resolve the crisis. And I think that nationalization should be on the table, rather than being written off as some fundamental denial of the laws of physics.

In some important and not good ways, we have already nationalized the financial system.

There’s the direct ownership that the government received through TARP and the reupping with Citi, BoA and some others.  These stakes are obviously not (yet) voting stock, but the taxpayer certainly has capital at considerable risk.

Then we have the lines of credit provided by the Federal Reserve which, without a doubt, were instrumental to the survival of almost all major banks during the fall – and arguably remain critical today.  The taxpayer has further downside risk here.

And, most importantly perhaps, we have the expansion of the Fed’s balance sheet as it seeks to step in to replace the weakening banks and the drying up of credit markets.  In effect, the Fed is becoming a commercial bank as well as a central bank. 

The government is essentially taking over the role of intermediation – take funds in and lend them out – for the US economy.  This is a form of nationalization, and it will lead to all the lobbying and politically directed credits we have seen in other nationalized financial systems; taking away this credit once the economy starts to recover will not be easy.  We have state control of finance without, well, much control over banks or anything else – we can limit executive compensation (maybe) but we don’t get to appoint directors (or replace entire boards) and we have no say in who really runs anything.  Responsibility without power sounds accurate.

Why have we de facto nationalized?  Because the private credit system – particularly large banks – is weakened and not getting any better.  Attempts to deal with the problem banks are apparently blocked by the political power of influential bankers.

How then do we really privatize?  By exercising leadership: take over insolvent banks and immediately reprivatize them.  The new controlling owners can replace the boards of directors (tell me: why haven’t they resigned already?), and these boards can decide who to keep and who to let go from existing management.  The taxpayer retains a significant number of shares (or the option to buy common stock) as a way to ensure upside participation – the economy will one day recover, and that will be a very good day for owners of the remaining banks.

Above all, we need to encourage or, most likely, force the large insolvent banks to break up.  Their political power needs to be broken, and the only way to do that is to pull apart their economic empires.  It doesn’t have to be done immediately, but it needs to be a clearly stated goal and metric for the entire reprivatization process.

1. The White House and Treasury have fallen behind events.  When and how do they try to regain control of the situation?  Is there a relatively early and decisive move up their sleeves?  This seems difficult, as they have committed to doing stress tests first and foremost, and presumably any meaningful tests take at least a week (probably they were intended, when announced, to buy more than a month).  But these are resourceful and imaginative people, with lots of connections and some big friends to save, and they fully understand the importance of retaking the initiative.  Watch for a major announcement Sunday – always good to act before the Tokyo market opens – or early in the week.

2. The strategy alluded by the Senators is: the devil take the hindmost.  This implies two big banks are in the line of fire; both, of course, are strenuously denyingthat anything of the kind is true (we could call this the Irish Ministry of Finance line; it also worked for Northern Rock and Iceland, at least for a while).  But the banking system problems are likely to be much deeper, and any attempt to deal with just two banks is likely to founder fairly quickly.  Probably our financial leadership will for now dig in around “two and only two,” but when the consensus is so fragmented, anything can happen.  Follow the public statements of Lloyd Blankfein closely; use the hubris in his February 8th, 2009, Financial Times op edas a benchmark (remember: this was timed to appear upstage on the morning Secretary Geithner was supposed to present his financial system plan).

3. How does the designated government leadership communicate that credit probably needs to contract for all banks, including anything taken over by the government, given the declining willingness to borrow by creditworthy individuals and firms?  Some of the language used in and around the House Financial Services Committee hearing with bankers demonstrated a worrying misperception – just because banks are taken over does not mean they should, could, or would increase lending.  If we get a substantial increase in government directed credit, our problems will get much worse before, if ever, they get better.  This is definitely a media blitz assignment for senior political nominees at Treasury.  Will we learn more of their names this week?

4. There is no panacea, and that includes taking over banks.  We face a pervasive global confidence problem for consumers, firms and – in some countries – governments.   The government takeover of failed banks with systemic importance is the worst of all possible strategies, apart from all the alternatives.  Decisive action on the banking system is necessary but not sufficient for the economic recovery. Will this message be communicated clearly by the architects of the bank strategy, to keep expectations at reasonable levels?  Could someone, please, have a word with the official forecasters (yes, I’m looking at the Federal Reserve).  It is hard to focus the world (and Congress) on forestalling Financial Armageddon when your crack modellers publicly predict something close to a V-shaped recovery near the end of the forecast horizon.

5. Will there be a clear, upfront commitment to reprivatization, with a promise that large banks will be broken up in the process?  Changing the industrial structure of banking is essential for altering the political economy of the sector.  Community bankers – influential in the Senate – need to be brought onside with aggressive FDIC-type interventions, and this is more likely to happen if they sense that that the era of megabanks is drawing to a close (the dinosaurs are finished; someone notify the mammals).  Watch also for supportive body language among private equity investors.  If the banking lobby breaks into small pieces, politics could become a lot more interesting.

Yet it is exactly this kind of nationalization that we – or, more specifically, Hank Paulson – already did.

It is true that there has been no change of control and bank shareholders have done remarkably well under the circumstances.  And it is also true that the amount of new capital, from the original TARP funds, is relatively small for most banks (Citi and Bank of America are exceptions).  But, make no mistake about it, the Federal Reserve and the Treasury – acting on behalf of taxapayers – saved the banking system in late September/early October 2008 through making available large and extraordinary lines of credit, as well as key injections of capital.

Of course, this was not formal nationalization – but it placed us on the hook for most, if not all, of these banks’ liabilities.  In effect, we provided a massive cheap insurance policy to the banks, the people who run them, and their boards of directors.  Focus on these boards for a moment; they are very much part of the problem.

Corporate boards are supposed to represent shareholders, but to a large degree they do not.  Most board members are appointed by the CEO or hold their position due to the CEO’s tacit support.  The idea that these board members effectively oversee the activities of these large banks seems almost quaint.  While I am sure they are all fine, upstanding citizens, many of them seem considerably out of their depth.  Others seem too deeply intertwined with the company executives, with other boards, and with the corporate elite more broadly.  Strikingly few of them have stepped forward to take any kind of responsibility.

Fannie Mae and Freddie Mac were “taken over” by the government – placed into conservatorship – in summer 2008 because the Treasury determined that they did not have enough capital, so there was a risk they might need to draw on the government.  Both boards of directors were removed at the direct instigation of Secretary Paulson.  He had the legal right to do so precisely because these institutions had special access to the public purse.  Note, however, that Fannie and Freddie had not actually drawn on the Treasury at the time they were taken over.  It was the view that there was a prospect of drawing that entitled the Secretary to act.

Since then, of course, all banks have received similar access – through TARP and the Federal Reserve, to be topped up by further such support announced last week by Secretary Geithner.  Some might still argue that accessing liquidity from the Federal Reserve is not the same thing as the Fannie/Freddie arrangement, as the Fed supposedly never takes credit risk.  But this is not a widely held position, particularly after the second round bailouts of Citi and BoA.  And Secretary Geithner, following in the footsteps of Secretary Paulson, clearly indicated that the Treasury would provide risk capital in all the schemes involving the Fed, i.e., the bookkeepers may quibble about the details, but you and I will be providing extraordinary financial support to the banking system for the foreseeable future.

Why did Secretary Paulson therefore not seek the legal authority to remove or change boards of directors when a bank drew – or potentially could draw – on the government?  Presumably, he did not want to upset the banks’ executives.  Perhaps there were other reasons. 

In any case, the issue today is not whether we should nationalize.  Mr Paulson effectively nationalized the liabilities of major banks without putting in place any effective supervision of banks’ operations.  This is not a winning combination.

What we really need is to reprivatize – to return the banks to real private owners, preferably with strong voices on boards, and perhaps with controlling ownership stakes.  And we must, above all, make sure those owners have the incentive to break the banks into smaller, more manageable pieces, none of which are “too big to fail.”  As part of this process, some boards of directors will either have to go or be reshaped dramatically.  And new boards can decide who should or should not run these greatly restructured banks.

1) If there is a “once and for all” audit of the banking system, as President Obama seemed to say yesterday, what do we learn about the toughness of the rules under which this will be conducted?  Annoucing an thorough assessment is potentially a positive step, but vagueness spells trouble (for us, not the banks) down the road.  We need this audit to force major banks to use market prices to mark down fully their portfolios; anything else is evasion and procrastination. 

2) Are there any indications that the Treasury will pursue other policies that are tough on the bankers?  We already know that in terms of executive compensation, Mr Geithner argued for – and won – very weak limitations (or, you might say, a generous insurance scheme for their future bonuses).  And the NY Times is reporting that he also prevailed on whether bank executives should lose their jobs or bank shareholders suffer further losses.  Is there anything at all in the speech that would at least make the CEO of a major bank frown?  Writing in the Financial Times yesterday, Lloyd Blankfein (head of Goldman Sachs) essentially said that it is “business as usual” – is there any sign Secretary Geithner will call his bluff?

3) Is the Secretary using private equity to reform or to shore up the banking system?  Any hint that Treasury will send private equity in to clean up banks and clean out their managers would be most welcome.  But if today’s proposals bring private equity’s interests into line with the bankers, e.g., because they both gain from hidden government subsidies in a private-public toxic assets acquisition, that is not helpful.  The financial lobby is powerful and our only hope is to split it and use, for the time being, some of the Finance Oligarchs against the others. 

4) Then, of course, we have to figure out how to contain the power of the Oligarchs who win big.  It would be would be a major breakthrough for the Secretary recognize, in any fashion, that the largest banks are “too big to exist.”  Is there even a hint that he thinks the size and concentration of our banking system is a problem, and that our new regulations and supervisory structures should take this on?  Does he make any move that would create incentives or pressure for large banks to break up (or to be broken up by new owners)?

5) What is the market reaction?  If the stock prices of the largest, most troubled US banks are up after his announcements, that means the market is expecting further generous handouts for these compananies and the people who run them.  This is a rare instance when a Treasury Secretary’s words should aim to push down at least some prominent stock prices. 

I’ve talked over the past few days with people with extensive financial market experience, with journalists who’ve covered every angle of this story, and with academics who think about these issues all day and night.  And I’ve had remarkably similar conversations with each.  After a short warm up on the depth of our predicament and the excess of our bankers, the person looks at me and says: “of course, we should just nationalize.”

Personally, I don’t favor nationalization in the sense of the government trying to run the banking system.  But I increasingly feel that, ultimately, the government will have to (a) properly recapitalize the banks, (b) as a result, acquire the right to determine who are the next private owners of these banks, and (c) bring in private equity and other financial interests to clean up the banks (yes, oligarch v. oligarch).  I don’t know how long it will take to get there, but I’m afraid most of the time between now and then will be wasted.

Unless Secretary Geithner can lay out an alternative path with convincing detail today, my expectation remains: the banks will not be fixed with the current approach, and the true reckoning still lies before us. 

(Along these lines, our detailed proposed questions for Secretary Geithner’s Senate hearings, this afternoon and tomorrow morning, are here.)