Sweden for Beginners

For a complete list of Beginners’ articles, see the Financial Crisis for Beginners page.

With the regularity of a pendulum, the focus of discussion has swung back to the banking system (September: Lehman and AIG; November: Citigroup; January: Bank of America, and everyone else). And as everyone waits in anticipation for the Obama team’s first big swing, there has been increased discussion of . . . Sweden, including a recent New York Times article and a fair amount of blog activity, with a broad overview by Steve Waldman. (For other accounts, see this Cleveland Fed paper and a review of the crisis published by the Swedish central bank (which, according to Wikipedia, is also the world’s oldest central bank).)

Why Sweden? Because Sweden had its own financial crisis in the early 1990s, and by many accounts did a reasonably good job of pulling out of it. A housing bubble, fueled by cheap credit, collapsed in 1990, with residential real estate prices falling by 25% in real terms by 1995 and nonperforming loans reaching 11% by 1993, while the Swedish krona fell in value by 30%, hurting a banking sector largely financed by foreign funds. As Urban Backstrom said in a 1997 paper, “[the] aggregate loan losses [of the seven largest banks] amounted to the equivalent of 12 percent of Sweden’s annual GDP. The stock of nonperforming loans was much larger than the banking sector’s total equity capital.” In other words, the banking sector as a whole was broke.

So what did Sweden do? If the options on the table in the U.S. right now are (a) additional recapitalization, (b) an aggregator bank to buy up bad assets, and (c) nationalization, the Swedish solution included all three. First, in late 1992, the government guaranteed all bank creditors (but not shareholders), with no upper limit. Because investors did not at the time question the solvency of the government, this meant that they would continue to lend money to the banks, and the central bank provided unlimited liquidity just in case. Although the U.S. has guaranteed new debt issued by banks, and there is virtually an implicit blanket guarantee for at least the largest banks, there is still uncertainty among bank creditors, as witnessed by credit default swap spreads.

However, even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency. As a condition of government support, government auditors reviewed the balance sheets of the all the banks involved, with the goal of taking writedowns immediately and showing the true state of affairs. When it turned out that two major banks, Nordbanken and Gota, were insolvent, they were nationalized (Nordbanken was already largely state-owned), giving the state control of over 20% of the banking system (by assets). Gota was merged into Nordbanken, which only held onto “good” assets, and the “bad” assets were moved to two new entities, Securum and Retriva. These entities were capitalized by the government, and bought 21% of Nordbanken’s assets and 45% of Gota’s assets. This is an example of the good bank/bad bank plan that has gotten so much attention lately. Nordbanken itself (the good bank) was recapitalized by the government, to the tune of 3% of GDP, and become a healthy bank, while Securum and Retriva were told to get whatever value they could out of the bad assets.

Securum and Retriva were run like a cross between private equity firms and asset management companies, both managing and improving assets and also finding buyers for the assets. According to the Cleveland Fed, they managed to return $1.8 billion out of their $4.5 billion in initial capital to the government, for a net taxpayer loss of $2.7 billion. (I can’t figure out if the government also lost money on the loan guarantee, although the sources I read implied that it didn’t.) And Nordbanken, after being run by the government, was eventually privatized (the government’s ownership share is now 19.9%), and the taxpayer recovered the capital put into it in the rescue. As I said above, this is generally seen as a success story, although the Cleveland Fed does have a sobering conclusion:

the cost of the crisis to Sweden was not limited to the capital spent by the [asset management companies]. There have been significant income and output losses associated with the crisis. In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared. Cerra and Saxena (2005) found that the crisis caused a permanent decline in output that can explain the entire fall in Sweden’s relative income. So, even well-managed financial crises don’t really have happy endings.

The Swedish story is usually used as an argument in favor of nationalization, and that’s not an implausible inference to draw. But another lesson you can draw is that it’s not the nationalization per se that matters, but the pricing of the bad assets. The key was that the banks were forced to write down their assets in one shot and then to sell them to the bad banks at realistic prices. That cleaned up their balance sheets and, once they were recapitalized, allowed them to operate as healthy banks. As we said a long time ago, TARP was a fine idea as long as it paid fair value for assets and was combined with recapitalization to fill the resulting hole in bank balance sheets. The same holds for an aggregator bank. The problem would be letting the banks decide which assets they want to sell, and then letting them unload them on the aggregator bank at inflated prices. That solves nothing.

19 thoughts on “Sweden for Beginners

  1. The outcome for Sweden was not all sunshine and roses. They lost their lead in living standards. To the degree that they did not let shareholders and bondholders take their losses they forced taxpayers to pay for corporate welfare. Let’s not repeat their mistakes. The way the U.S. handled the S&L Crisis (nationalization) is a better model of an effectively handled financial crisis. Make the shareholders/bondholders pay, or the taxpayers, and the long term growth prospects of the economy, surely will.

  2. In Europe, the Swedish story continues to be presented by many economic commentators as a panacea for all of our current banking woes. It is good to see a more critical analysis here.

    While the Swedes did make a very strong recovery from what was a terrible position to be in, these economic commentators never mention how the sudden and amazing growth of the global telecoms industry in the 90s proved to be a rapidly rising tide (e.g. Ericsson) that lifted all boats in the Swedish economy.

  3. A few comments:

    1) TARP was a bad idea because either you buy crap for what it’s worth or you buy it for more than it’s worth. If you do the first, it’s basically a loan and won’t help an insolvent bank. If you buy crap for more than it’s worth, it’s terribly unfair and costs more since you’re bailling out more stakeholders than you need to bailout.

    2) Chile has a good example of a bank bailout that worked. It was well done but was still very expensive.

    3) Did it ever occur to anyone that the high income levels in the U.S. and Sweeden before the banking crisis weren’t really high incomes but high consumption levels financed with lots of debt?

    4) The banks are broke (they have more liabilities than assets). No matter how you split up the negative equity or over what time period you stretch it, we will still have to pay the entire amount. The effect on U.S. and world GDP is the same and is inevitable. You can stretch out the cost over a decade like Japan did or you can take it over a short period of time like many banana republics have done when they defaulted on their debt (Argentina for example). You can split the cost almost anyway you want between taxpayers, shareholders, bondholders, etc.

    5) You can always use the Argentinean solution. The government spends a ridiculus amount of money very inefficiently. Finances the ridiculous amount with government bonds issued to foreign bond holders. The government then tells the foreign bond holders that it can’t (or doesn’t want to) pay. The currency depreciates and exports soar. The country is better off mainly because of the money it stole from people dumb enough to buy its bonds. This is exactly what the U.S. plans to do except that nobody thinks there is any chance of a U.S. default and that the default will be simply take the form of inflation.

  4. Banks do not know how much their assets are worth. They don’t know whether their equity is positive and how much lending they can support; so they do not lend.
    How to solve that ? Take Citigroup. It has 3 trillion in assets, 600 billion in deposits and government-guaranteed liabilities, 2400 in other liabilities and basically no equity. It cannot lend in such a situation. 50, 100 billion in additional TARP money would make no difference.
    Citigroup plans to create a good bank with 1100 billion of good quality assets, 600 of guaranteed liabilities and an equity of 500. Then (which is not currently planned) Citi has just to SELL the good bank to the public – for cash. Such a strong, capitalized company will go for more than the equity value, maybe for 700 billion.
    Then Citi takes the proceeds, gradually liquidates the 1.900 toxic assets (realizing losses of course) and pays what it can of the 2.400 guaranteed liabilities. Maybe the shareholders will get something, maybe not.
    The most important thing: the good bank will be around as a public entity with a strong, clean balance sheet and will resume lending. No nationalization, no taxpayer money involved.
    Do this with BofA and JPM as well. This will end the crisis.

  5. Why did Sweden nationalize? Perhaps it was a national issue to maintain control of their banking system. There was simply not enough money inside the country to do it privately without relinquishing control outisde its borders.

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


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

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

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

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

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

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

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

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

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

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

  7. The trouble is many banks appear a) unhappy with mark to market b) unsure what their liabilities are and thus c) are not ‘fessing up’, as commentators like to say, to their debts

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

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

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

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

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

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

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

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

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

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

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

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

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


  8. Tom K,

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

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

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

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

  9. Dear Mr. Sadowski,

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

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

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

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

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

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

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

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

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

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

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

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

  10. What is often forgotten about the 1991 crash in the Swedish economy is that it was largely created by a fixed peg of the Swedish currency. The currency peg the Swedes used to keep their exports artificially cheap is similar to China’s current peg of the Renminbi. When the peg moved against them the Swedish government refused to give it up resulting in overnight interest rates of up to 500%. When the peg was given up due to foreign currency speculators (including Soros) essentially “breaking the bank” the Swedish banking system collapsed.

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

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

  11. Addendun to the above:

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

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

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

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

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

  12. Gota was also nationalized and merged into Nordbanken. Together they had over 20% of banking assets. That would be roughly like nationalizing Citigroup and one smaller bank.

  13. Thank you very much for your explanation, but I have a few questions about what was said. Were Securum and Retriva nationalized institutions? What are private equity firms and asset management companies. Finally, and most importantly, why did you imply at the end that it is not nationalization that is so important but the pricing of bad assets? Again, thank you very much for your explanation.

  14. Securum and Retriva were created by the government as government entities. They then bought assets from banks that were nationalized. Their job was to manage assets until they could be sold; once the assets were sold, Securum and Retriva were dissolved.

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

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