We Cannot Afford To Wait To Recapitalise US Banks (Letter To The FT)

(The following is now available in the on-line edition of the Financial Times; link to original Martin Wolf article added here)

Sir, Martin Wolf’s excellent article on the pros and cons of nationalisation suggested, quoting Nouriel Roubini, that we could wait six months to determine how solvent US banks are before making decisions (“To nationalise or not to nationalise is the question“, March 4). This is possible but surely risky.

At Wednesday’s close, the junior subordinated debt of Citigroup (for example debt underlying the Citigroup XV 6.5 per cent Enhanced Trust Preferred Securities) yielded 27.6 per cent, and similar securities at many other large US banks yield high double digit amounts. With such yields on debt, anyone conducting business as a creditor with these banks must think twice. Why not withdraw the business to another safer bank, or just halt such business, until we understand the US government’s ultimate plan? If enough businesses and individuals take such actions, the core franchise of Citigroup and other similar large US banks could collapse. The government, six months from now, will be left with distressed bank franchises that are worth far less than they are today. At that point politicians and policymakers will probably determine it is only fair that creditors bear part of the cost, thus justifying the current high default risk priced into bank debt. This scenario, which is ever more likely as we wait, illustrates why authorities must take actions urgently.

A gradual disintegration of bank franchises will be met with more credit contraction and some new panics, thus deepening the recession and further reducing solvency of banks. The only credible solution is to embark immediately on a Federal Deposit Insurance Corporation-type intervention, recapitalisation, and early reprivatisation of US banks. The recapitalisation needs to be so large that it is near impossible to imagine an economic outcome where they fail in the next five years. That requires several trillion dollars, not the small sums left in the Trouble Asset Relief Programme and earmarked in the new US budget. Without these urgent measures, whether we nationalise or not, we are risking a highly undesirable outcome.

Peter Boone, Chairman, Effective Intervention; Centre for Economic Performance, London School of Economics, UK

Simon Johnson, Senior Fellow, Peterson Institute for International Economics; Professor, MIT Sloan School of Management, US

28 thoughts on “We Cannot Afford To Wait To Recapitalise US Banks (Letter To The FT)

  1. But our financial ship is not doing a passable imitation of sinking because of a lack of intelligence. What was lacking was the backbone to publicly resist the establishment’s greedy joyride of risk-taking and sloppy standards. —Jeremy Grantham

    It seems that backbone is still what is lacking.

  2. Recapitalize what? There isn’t enough money in the world to pay off the debt that is due on the nearly 1 Quadrillion derivatives out there. The banks are completely insolvent. Yes, assets that backed these derivatives may come back up in price, but not for a very long time. The only way around this is to add 0’s, today, to everyone’s paycheck and bank account. Yes, what is needed isn’t just recapitalization, but wholesale, large scale, apocalyptic inflation. If we don’t do that, then just declare all debts null and void, we all get a jubilee, and tomorrow we go back to work and start the whole entire maddening game over again.

  3. I do not disagree with the recapitalization idea – though I am not sure if you are recommending a debt wipe-out/exchange for equity – which surely runs the immediate risk of another Lehman – only worse – a risk I don’t think we can afford.

    In any case even a recap won’t be enough. We need to decisively change price expectations – from deflationary to inflationary. This would help both the recap and the stock market.

    This website –

    has the position that the Fed could immediately and decisively intervene – by changing expectations – through two actions:

    1. Stop paying interest on reserves. This is deflationary and is an echo of the raising of reserve requirements as done by the Fed in the 1930’s. It was nutty then and is nutty now.

    2. Have the Fed announce a firm price level target – and commit to doing whatever they have to do to get it. This was recommended by Mankiw and I truly do not understand why Bernanke has not done this.

    The Obama administration – for whatever reasons – is frozen – like a duck hit on the head. They yack about our long term problems and dither on the present crisis. Everything they do is too slow and too small.

    Only the Fed has the freedom to act. And they do have it – if only they would use it.

  4. So much focus on bank recapitalization is dangerous when there is no focus on creating permanent jobs massively directly.

    #1: In such a jobless economy, recapitalizing banks will be ten times more costly than if the job issue was tackled head-on.

    #2: When banks are recapitalized, the resumption of credit access without long-lasting job creation will mean that banks will be facing significant pressure as the loans they make once again start to default, and we’ll end up with folding banks soon after beginning to emerge from the current recession only to plunge into a new one. This time, we won’t have any margin left to tackle the recession’s return.

    Most of you economists are either purposely avoiding the true issue, or you haven’t given it much thought at all: Bank recapitalization will only be fruitful if done in PARALLEL to permanent job creation by lowering the trade deficit with China using all imaginable forces.

    This is NOT protectionism. Enforcing downward pressure on wages and currency to grow one’s GDP is protectionism.

    The US will face its worst recession when it will begin to emerge from the current one if it does not directly address the diminished purchasing power of Americans. Your wages and purchasing power has been falling for a decade, but it was hidden under massively heightened and credit access.

    The cheap-goods for lost-jobs system does NOT work, it is a contradiction of which the impact was delayed through a blanket of credit.

    Fix it, or fix nothing.

  5. Why is Citibank debt trading at 27%, and how can I get a piece of that action? The govt has shown time and time again that it is absolutely, unquivocally committed to keeping creditors whole. This is a puzzling attitude, to be sure — taxpayers and shareholders are allowed to lose money, but bondholders are not, for some reason — but even more puzzling is that the debt would be priced at 27%

    Can someone explain this to me?

  6. this may be a dumb observation but. . .where does the “several trillion dollars” come from? The FDIC doesn’t have it. Do we just print it?

    I may be ignorant but even I know that there’s only so much money in a monopoly game.

  7. Since we appear to be doing requests. I keep reading that the big “19” can’t be nationalized because it would be a CDS triggering event that would set a spark in the powder keg of a $40 trillion market? Is it that if you only whipe out the equity holders rather than the bondholders it’s not a triggering event? That’s the best I could come up with but pure speculation.

  8. “The only credible solution is to embark immediately on a Federal Deposit Insurance Corporation-type intervention, recapitalisation, and early reprivatisation of US banks.”

    I agree. But answer me this: Bernanke and Bair said this week that the FDIC cannot seize large banks. Since we do not let banks go bust in the US, and the FDIC can’t do their usual job of seizing banks when the insolvent banks are large banks, what was the plan in place in case a large bank became insolvent? It seems that the plan was to merge the large bank with another large, surely a good idea, with the government paying whatever the costs of this merger would take. This is now clearly seen to be a de facto explicit guarantee.

    Also, since the government pressed the B of A to take over Merrill, doesn’t the government now believe that it has an obligation to save them if this merger causes them problems.

    If this is correct, what could the solution to this crisis be other than a total overhaul of our banking system? The only question is when we should start. I say now, even though it will involve risks. But so does every plan. After all, we are going to need a plan to deal with large insolvent banks going forward, unless we outlaw them.

  9. Isn’t it obvious to everyone that Citigroup is a zombie bank? It is existing on goverment life support via capital injections or share conversions. Is there anyone who thinks it can continue as a “going concern” other than the morons on CNBC? The franchise is already dead.

    Nationalization is not the issue; C has already been “nationalized.” The market has already digested this information (why yields are at 27%). The administration’s focus should now be on breaking the zombies up and creating good banks (from the zombie parts and/or fresh air). This is simple common sense. The media and politicians appear to be 3/4 weeks behind the curve.

    The only one I’m not worried about is Ben. Per textbook, he will (if hasn’t already) engage in massive quantitative easing at the back-end of the curve.

  10. No, do NOT recapitalize the banks. The American financial system is dead and this is no time for Weekend at Bernie’s, act two.

    Capitalism failed just as Adam Smith said it would if it were not accompanied with moral and governmental regulation. It is time to end the denial and move on.

    Far too many American’s have already discounted the depression in their forced minimalist lifestyles. We are ready for the worst. It is the wealthy and powerful interests that cannot accept reality and remain in denial. It is they, who will attempt to spend any amount of taxpayer money in support of their denial, and this must not be allowed to happen.
    To the rich, the game is over and you lost.

    We must employ effective dissent when necessary to protect taxpayer funds from the wealthy raiders. History strongly suggests that the outcome will not be in your favor. Wake up and take your medicine. This disaster is of your own making.

  11. I have seen only two serious attempts to explain this disastrously (for the stock market) long delay in confronting what Monty Python used to call “the bleedin’ obvious”:

    (a) Obama and his team have been overwhelmed by events

    (b) These delays are all about acting out a scenario intended to convince foreign debt holders that the market took down the banks, not the US government, so the government can then take the position that it is not responsible for bondholder losses and still hope to minimize the impact on the dollar.

    At this stage both seem plausible.

  12. No more bailouts for banksters. Cover depositors – period. Outlaw derivatives – period. Put Paulson (who was shorting securities he (GS) was pushing on clients) in jail, along with other investment crooks.

    No one on main street who is paying attention trusts politicians or academics any more. You’re all blind as bats, naive as hell, or just crooked. (How do you explain the ransacking of GE? Duh? The CDS players. My guess it those players are playing with taxpayer money handed over to them via our bailouts. It wouldn’t surprise me one bit to find Goldman Sachs on the other end.)

    Stop pouring taxpayer (current and future, for generations) dollars into the pits-of-evil.

  13. Death to the financial market, the financial gamblin’ games! Let’s get back to markets grounded in “real wealth” instead of “phantom wealth”!!!!!!!!!

  14. Promises of transparency – lies, lies, lies. There will be NO confidence in the markets until all the information sought is forked over by the Fed and Treasury. There will be NO confidence in the markets until the CDS game is STOPPED COLD. There will be no confidence in the market, until crooks start to be arrested and prosecuted (we can start with Paulson, but even the BoA banksters, who hid from shareholders the bonus payouts to the Lynch-pins, would be a start.)

  15. “French President Nicolas Sarkozy and three top government ministers have been sent anonymous death threats in letters stuffed with bullets, a judicial official said Tuesday.” — Huffington Post

    I think this speaks for itself.

  16. I think the nationalization game is over. The government response – “shan’t, won’t, can’t make me” – shows that there are some incredibly dirty photographs floating around out there, home truths that the nation cannot afford to surface, unthinkable enough to still keep Madoff out of jail. No wonder President Obama is going grey.

    If the fall of the Roman Empire teaches anything, the next battleground will not be oil or money but food supply. See “Quest for food security breeds neo-colonialists” in The Times (http://business.timesonline.co.uk/tol/business/columnists/article5846987.ece). No accident Michelle Obama is frequenting soup kitchens.

  17. Simon, so many economists are basically saying the same thing (see, e.g., Krugman in today’s NYT). I think a single statement, signed by many economists of all political stripes, might have more impact with the administration than numerous piecemeal editorials. As you frequently point out, the administration is going out of its way not to nationalize, but a unified call from respected economists might provide some cover.

  18. i am a corporate bond trader. you say the trust preferred are trading at 27. the subordinated of bac and c are atarting to trade at 35 and the senior unsecured at 58 but they are not reported by trace as they are kicked out as “out of range”. also, foreign sellers do not report to trace and are totally panicking. bondholders will have to bear part of the pain in thje recapitalization of the banks.

  19. To just nationalize and kill the debt would be just entirely insane. Read the post just above from the corporate bond trader. A recap that destroyed the bonds would destroy every one of us. The idea is totally insane. It would be Lehman to the cube. It is pure populist demagoguery.

    Read this post from the Economist. As they say, there is a lot of point missing by Krugman on this risk – as compared to Martin Wolf.


    I continue to feel that inflation is the better way to go.

    Here is another post on that:


  20. To quote the Economist on the Krugman article:

    “There is a great deal of point-missing in these paragraphs. Mr Krugman suggests that the way to avoid spending trillions helping the banks, and rewarding those who wrecked the banks, is to nationalise them. But nationalisation doesn’t make the debtholders go away. Would the government make them whole, or simply give them a minor haircut? If so, then you still have a situation where the government is spending trillions of dollars and rewarding people who don’t deserve a reward. Or would the government simply say, sorry debtholders, you’re stuck with the losses? That would save taxpayers a lot of money and strike a major blow against moral hazard—but only if it didn’t precipitate a Lehman Brothers-like meltdown.

    If Mr Krugman hopes to convince me—and, I suspect, if he hopes to convince those with their fingers on policy levers—he needs to address this question. So far, he’s taken the easy way out, asserting that Ben Bernanke and Tim Geithner don’t get it, and are just too chicken to nationalise. “

  21. Citibank’s debt has become junk (eupmemistically and accurately called ‘high-yield’). It is trading at such low prices that the payout is very high relative to the price that you would pay for it if you were to buy it today or tomorrow. But, it is trading at low prices because the sellers don’t expect the payout to continue for very long (i.e. it’s risky). The high yield is your reward for assumming that risk. Good luck…

  22. The longer this mess drags on the more difficult it is to solve. Why do we have to have an either/or solution? Why can’t the zombie banks be allowed to fail while banks that still have some life be supported?

  23. Everytime I read the word “nationalize” I wonder what that means in detail. Does it mean the equity and debtholders are wiped out or not. Ot is such crucial detail considered too trivial to identify?

  24. Since the Govt is not going to let Citi fail. ( Reason being is that such huge bets are made thru CDSs at AIG that the Govt would have to pay that too. )
    Why doesn’t Uncle Sam act like a wily hedge fund and start buying up the most Senior Debt with Social Security fund money.

    Its a WinWin since SS doesn’t have to mark to market, has a long time horizon and becomes closer to solvency with annual returns that are significant from their Citi bonds.

    Other may see this is risky but as Gross says in for a nickel in for dime. We’re already all in with Citi since they cannot be allowed to fail due CDS concerns. We the taxpayer might as well make money on its final executions and resolution. If we keep the bondholder whole we might as well be the bond holder except we buy at a huge discount to maturity value.

  25. “The recapitalisation needs to be so large that it is near impossible to imagine an economic outcome where they fail in the next five years. That requires several trillion dollars…”

    Such sums imply Govt. ownership until the taxpayer is made whole. I don’t think gifting trillions of dollars to banks like Citi or Bank of America without changing management and making a claim on turnover is either politically or indeed morally possible, and steps like those imply ownership, ie. nationalisation.

    I know Prof. Johnson has turned every possible way to avoid nationalisation, but the fact is nobody has invented a way for the Govt. to recapitalise banks without owning them. Nor should anybody really try.

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