What Does “Private” Mean?

Yesterday, Tim Geithner told reporters, “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.” On its face, I think most Americans would agree that a private banking sector is better than just having one big government bank. But “private” can still mean a lot of different things. For starters, here are three: (a) day-to-day operations are managed by ordinary corporate managers who are paid to maximize profits, rather than by government bureaucrats; (b) those profits flow to private shareholders, rather than the government; (c) the overall flow of credit in the economy is determined by private market forces, rather than the government.

When people debate “nationalization,” it’s not always clear whether they are talking about ending (a) and (b) or just (b).  The recapitalizations to date under the TARP Capital Purchase Program have bent over backwards to avoid either one. Because the government purchased nonconvertible preferred shares, it has no ability (that I know of, although Robert Reich thinks otherwise in an article I’ll come back to) to turn them into common stock with voting rights that lead to management control; and because the shares pay a fixed 5% dividend, they are a lot like a loan, where any profits after paying off the loan flow to existing shareholders.

However, the two could theoretically be separated. If we want taxpayers to benefit from any recovery by the banks, but we are worried about government bureaucrats making lending decisions, the government could theoretically buy a new class of common stock that earns dividends and trades on the market like ordinary stock, but has diminished voting rights – say, enough for the government to appoint a minority of the board of directors. In other words, letting the taxpayer benefit from banks’ future recovery does not necessarily imply government bureaucrats.

(As an aside, Sweden plunged wholeheartedly into (a) as well as (b), although it did later reprivatize the banks it took over.)

More broadly, though, what about (c)? In the financial sector, the flow of credit is not determined solely by banks’ lending decisions – or, rather, those lending decisions are heavily influenced by the secondary market for their assets. As the story has been told many times, mortgage lenders were pushing subprime loans because investment banks wanted them to fill their securitizations, and they wanted to fill those securitizations because hedge funds and other investors on the other end wanted those CDOs. In this model, the banks are the intermediaries, and the investors with the money in the first place are the ones determining where credit goes, on the large scale.

The government has always been in this game. One of the best-known examples is Fannie Mae and Freddie Mac (although, whenever I bring up those names, I feel bound to mention that they actually provided a declining proportion of housing money during the boom, precisely because everyone else was piling in), who influence the mortgage market by buying mortgages on the secondary market. But the government has become a much bigger player in the last few months. In the latest move, the Treasury Department is setting up a conduit to buy new and existing student loans from lenders. The goal is to give those lenders a market where they can resell student loans, which will hopefully encourage them to make those loans (because now they don’t have to worry about the loans going bad – although I believe many of these loans were already guaranteed). Like the already-announced program to buy asset-backed securities, this is an attempt to restart (influence) the flow of credit by intervening in the secondary market. Conceptually, the government is trying to lend its own money, using the banks solely as originators, since the banks are nervous about lending their money. Although I am probably misusing the term, it’s an attempt to get around the liquidity trap: if banks prefer cash to any non-cash assets, then give them a way to immediately turn loans into cash.

(Still, I’m confused about why you would open the program to existing as well as new loans. If banks can sell existing loans to the conduit, then they will do that, and it won’t necessarily stimulate new lending.)

(Also, I tend to think that a program like this one has positive externalities, in that education is a good thing. Although, as a commenter on my earlier post whom I greatly respect argues, subsidies for education just end up pushing up the price of education.)

As Robert Reich points out in his article, even the “bad bank” idea doesn’t necessarily keep the banking system in private hands. He has a good description of the current situation, though I’m not sure I agree with him over the degree:

But as the Mini Depression worsens, “toxic assets” are no longer all that distinct from a vast and growing sea of non-performing or endangered loans on the banks’ balance sheets. Toxicity has spread to loans made to people and companies that were good credit risks as recently as early last year but are now bad risks. You don’t have to be an honest financier (no oxymoron intended) to figure this out: Ten percent of Americans are behind on paying their mortgages. Millions more are behind on paying their credit-card bills. Hundreds of thousands of small businesses are behind on paying their own bills. Auto suppliers are can’t pay their bills. And so it goes.

As a result, he says, a government “bad bank” might end up buying most of the assets in the banking system (that seems like an exaggeration, but I get the point), and suddenly the government is the biggest bank around. That is, if it isn’t already.

If you are worried about government influence over credit, it’s always been here, and it’s increasing, because without the government there might not be any flow of credit in certain markets. It does make sense to debate the forms that influence should take, but there’s no getting rid of it.

7 thoughts on “What Does “Private” Mean?

  1. “Still, I’m confused about why you would open the program to existing as well as new loans.”

    In general, it is extremely difficult to limit any support just to “new” loans, since in general people can refinance from old loans into new loans. (Or construct more complicated financial arrangements to achieve the same effect. If arbitrage is possible, someone will find a way to do it.)

  2. Good point. Student loans would be harder to refinance than home loans – if I’ve already spent two years’ worth of tuition, who is going to give me a student loan to pay back my first loan? – but I imagine someone would find a way.

  3. You left out the largest non-private aspect of all – the Federal Reserve (& having it’s notes be legal tender).

  4. You’re right that the government can’t convert its preferred shares into common stock with voting rights. Moreover, the terms of the warrants prohibit the government from exercising voting power on any common stock issued by the banks upon exercise of the warrants.

    The preferreds have standard contingent voting clauses (i.e., if the bank misses 6 or so dividend payments, the government gets the right to elect some number of directors). But since it’s inconceivable that those rights would ever be triggered, that’s the equivalent of no voting rights whatsoever. I’ve heard from lawyers involved in the negotiations that the government never seriously considered taking voting rights. That’s for the best, as far as I’m concerned.

    Treasury has posted the contracts online now, if you’re interested.

  5. Even without voting rights, the research of my coauthor and I (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321666) shows that common stock creates better lending incentives than preferred stock for banks.

    Nevertheless, it would be sensible for the government to require banks to not pay dividends, buy preferred stock, or engage in cash acquisitions after accepting government capital. Other decisions about the management of the bank can be left to private shareholders and its managers.

  6. Any strings attached to government common stock purchases such as restrictions on paying dividends, buying back common shares, and engaging in cash acquisitions could expire after a couple years.

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