Reader Questions: Nationalization

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

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

1. Question:

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

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

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

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

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

2. Question:

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

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

3. Question:

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

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

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

By James Kwak

30 thoughts on “Reader Questions: Nationalization

  1. So assume six months pass and your predictions are coming true—output gap and unemployment rising and banking crisis still very much alive, too little credit flowing etc., and at this point Obama has a better idea about which banks need to be taken over and the political will to do it, how bad is that? How much of our bailout money are we likely to recoup under that scenario?

  2. I still haven’t seen this questions answered:

    Are the proposed nationalization schemes a ‘default’ condition for triggering the CDS’s?

    If not, why not?

    If the answer is yes, they are, how can Uncle Sam possibly cover those liabilities and the resultant “fall-out” in a market estimated at between ~$40-50 trillion?

    We haven’t enough children to pay off that kind of debt.

  3. It seems to me there are several levels of seeing these problems.

    Now, it seems Chris is a corporatist who basically approves of the operations of the banks and is averse to neither Too Big To Fail as a theology nor to its extortion racket. Indeed, makes their argument: society must knuckle under to the ransom demands of “freaked-out markets” and “stockholder confidence”.

    “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.”

    Of course they have the option to change their minds, if they cared about facts and the public good. The only way they wouldn’t have that choice would be if they were committed to the corporatist ideology which they clearly are.

    So we have the corporatists who are dedicated to looting the country, who see everything which has happened as according to plan, and want to continue with that same agenda. For them, both the system and the bailout policy are fundamentally sound.

    At the next level we have those who still believe in the system and the bailout in principle, but who object to the tactics deployed so far. They tend to support nationalization, with more or less enthusiasm. They may not be corporatists by conviction, but they seem to accept it as a given fact, just as they seem to grudgingly accept Too Big To Fail. So they want the same policy and take the system as given, but want to tinker with it.

    Neither the aggressive corporatists nor the anodyne reformers seem particularly concerned with the size or inherent sustainability of the system, and no one seems to regard downsizing it as the paramount concern

    What I want to know is, what if the system itself, leaving aside its moral qualities or lack thereof, was in fact unsustainable? What if the exponential debt model could not be sustained on its own, let alone with Peak Oil and general resource limitation knocking at the door? Then what should we be doing with these banks instead of temporarily propping them up as zombies and throwing what little real wealth is left down a rathole?

    If the system must decentralize regardless, wouldn’t the rational thing be to use our resources to strengthen real regional and local banks, to prioritize their lending to real regional and local businesses, and try to protect these real economic entities from the reverberations which will, according to Too Big To Fail, allegedly come to them when the elephantine fictive-money Wall St entities suffer their inevitable collapse?

    It’s the bailout policy itself which is fundamentally flawed, not the false distinction between de facto nationalization (what we have now) and de jure receivership, which is allegedly so politically toxic.

    (I don’t get that at all. It looks clear to me that here as in every other aspect of this crisis the people are out ahead of the elites. They understand intuitively that we’ve nationalized these banks already in terms of propping them up with our money, and that we’ve just failed to take the control our ownership entitles us to, so we get all the downside and none of the upside.

    I haven’t heard a shred of evidence that the people would oppose official nationalization. That looks like nothing but a right wing talking point.)

  4. Why would it take 5 years to deal with an insolvent Citibank? Just because it was possible to take years with Continental doesn’t mean it is necessary or desirable to do so in our present circumstances. What we have needed urgently for the last year is a process that will allow insolvent banks that are “too big to fail” to be seized, recapitalized and returned to the private sector over-night. To do this you need management teams ready to move in at a moment’s notice, in-depth understanding of the banks’ operations and a crystal clear procedure for administering the necessary haircuts. All of this is possible.

    Of course bank creditors are anxious about taking haircuts. That’s why it needs to be done. And once it is done, the creditors will have equity in solvent banks which they can sell for whatever it’s worth.

    As to the domino effect, you simply have to be ready to deal with any banking system insolvencies that result in the same way. At some point the dominoes stop falling.

    There is no reason to believe that there would be any future difficulties for the banking system in raising capital. No one would have been treated unfairly. On the other hand investors should and will demand a higher return for investing in banks, no matter what the government does. If anything a clear set of rules to deal with insolvencies and a competent group of regulators who can implement them efficiently will mean the cost of capital to banks will increase less than it otherwise would.

  5. Why not just call them bookkeeping mistakes and reverse all the transactions? All they were are bets placed by gamblers anyway. They should never have existed, they were a mistake, so just reverse them, leaving everyone in the position they would be in if they had never been made.

  6. I’ve heard that idea before. You would just unwind the CDS contracts by reimbursing the counterparties for the premiums paid.

    While that may run afoul of Summers’ odd notions about the “rule of law”, the administration could easily have sat down AIG and the bailed-out banks and made them hammer out such a deal.

    Of course the real reason this can’t be done is because the administration doesn’t want to do it, for ideological reasons.

  7. Is James Kwak concerned that the banks won’t sell their toxic assets at a low enough price that investors back by US government will buy? As such, the bank balance sheets don’t get clean up?

    If I were a big hedge fund, I jump at the chance to buy this stuff off the banks books; including paying above market. In fact, I’d fully expect to in order to beat other competing buyers.

  8. “If the system must decentralize regardless, wouldn’t the rational thing be to use our resources to strengthen real regional and local banks, to prioritize their lending to real regional and local businesses, and try to protect these real economic entities from the reverberations which will, according to Too Big To Fail, allegedly come to them when the elephantine fictive-money Wall St entities suffer their inevitable collapse?”

    I think you have identified a good strategy to restart the engines and generate some lift in the American economy.

    I think the President and his economic advisors are also trying to reconstruct a market for states and municipalities to sell their bonds, many of which need to be rolled over in the next five years. These bonds have a large impact on employment and property taxes at the local level, and are a stable investment opportunity in a market with credible debt ratings. Some states have successfully marketed their bond directly to investors, but we will need to re-establish confidence in the independent debt rating agencies.

  9. If guaranteeing creditors is necessary to restore confidence in the banking system, shouldn’t those guarantees apply only to NEW debt and not to existing debt? Why does making existing creditors whole do anything for anybody except those creditors?

  10. Yes, I am. I totally see why investors would buy, and would even pay above today’s market prices. I don’t see why banks would sell at a price that forced them to take a significant loss from their current book values.

  11. My paper “The Put Problem with Buying Toxic Assets” at suggests that the gap between the price at which banks are willing to sell toxic assets and the price at which the private sector is willing to buy toxic assets may be large. The bid-ask spread will be larger for banks that are more insolvent. It will also be larger for banks that have more distressed or volatile toxic assets. My research shows that it is much better to buy toxic assets from troubled banks in receivership than before their assets are written down.

  12. My paper “The Put Problem with Buying Toxic Assets” at suggests that the gap between the price at which banks are willing to sell toxic assets and the price at which the private sector is willing to buy toxic assets may be large. The bid-ask spread will be larger for banks that are more insolvent. It will also be larger for banks that have more distressed or volatile toxic assets. My research shows that it is much better to buy toxic assets from troubled banks in receivership than before their assets are written down.

  13. I have heard that people are calling for trading credit default swaps to be outlawed…if the size of the swaps traded were required to settle immediately,with maybe some of the gov. designated funds could be used as a loan facility for those who ran into trouble, and the only swaps left were to cover positions (the way one has to borrow stock before shorting that stock) would this change the size of the universal nuclear bomb that seems to be aimed at everyone?

    In the land of Oz, everyone acts with the greatest of care on behalf of each other, except of course the wicked witch–

    The Obama administration promised transparency which was supposed to give us a chance for a more Ozlike environment, but unfortunately, without more careful regard over the clear looting of our country from last fall to now, and by the fact that the Obama administration is continuing the Paulson/Bernake plan, no one can possibly believe that there is any chance that the right, and least harmful actions are or will be taken.

    Russ has it right.

  14. This is the sort of thing that should happen more often. Answers to Questions from others, which are reasonable and the answers potentially illuminating.

    I’ve found this particularly interesting.


  15. I worry about the possibility that we might successfully plow through the banking crisis, only to discover that there isn’t much of an underlying economy to sustain us going forward. Our manufacturing base is so weak (thanks to NAFTA and CAFTA) that unemployment is going to continue to be a big issue. Making Wall St. whole and healthy isn’t the same thing as fixing the economy.

  16. Yes indeed, which is why instead of $trillions for bailouts of globalist banks, there should be a focus on shoring up real banks at the local and regional level and a vastly larger stimulus which is focused on reinvigorating a domestic manufacturing base, with an emphasis on regional distribution networks with a lower fossil fuel intensivity.

    These initiatives would complement one another, unlike the schizoid policies we have now which run away from one another in every direction.

  17. I’ll be interested to see how much bailout money, beyond that being allocated to covering bad credit default swap bets, goes toward buying up smaller banks (“increasing market share”) by the big bailout beneficiary banks.

  18. On Q1: [Apologies if pasting things this long aren’t the norm here, but the context seems also important to point out, so I didn’t want to post the bold portions all by themselves…] Regarding the length of time to get the banks back up to ‘normal’, James K. Galbraith says this at [emphasis by me]:

    …The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

    What did not recover, under Roosevelt, was the private banking system. Borrowing and lending — mortgages and home construction — contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

    It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.

    All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. <b?After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.

    A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

    If he is correct, 5-10 years sounds about right. There remains one IF:

    If Obama has the gumption to LEARN from the GD and not pretend that ours is different. From all I have read in many sources lately are true, and it all appears to be, this crash is very, very similar to that one. And compared to that one, we are only in the middle of 1930.

    Wow. What WILL those 5-10 years bring?

    On Q2: For what my opinion is worth (not a lot!), I like Bebchuk’s idea of guaranteeing creditors’ liabilities up to a point. It sounds very FDIC to me, and that has worked. The first objection in my mind is that the investors are not just saving for a rainy day, which is what the FDIC guarantees are basically all about. They KNOW they are risking their money! They aren’t just trying to do the mom-and-pop thing; they are trying to do the JP Morgan thing. I would set that guarantee level pretty damned LOW. AS to the repercussions in the marketplace, it would tell everyone, you all need to see that you will have SOME safety net, but just enough to keep you on your toes.

    On Q3: This one I will take some credit for seeing the damage: When they let Lehman Bros. go belly up, my first reaction was, “Oh my freaking God!” I got on Der Spiegel and immediately saw the reaction overseas. It was NOT a pretty sight. The reaction was like Götterdämerung – “goddamnation,” as my German brother-in-law tranlates it. I thought it was just the worst thing they could do. PART of that reaction, IMHO, was that it just happened pretty much out of nowhere. The two, Bernanke and Paulson, had bailed Bear out just days before, and letting Lehman go – the world was not prepared for that. I believe that part of the reason people NOW think letting Lehman go was a failure is BECAUSE of the blowback from overseas. I just don’t think B-P even considered the overseas aspects.

    Now, letting Citi go at THIS time? They aren’t going to do it, but if they did, it would be much less of a shock. The entire world has had 6 months to get used to this craziness and they’ve all had time to think about Citi maybe not being around. No one had an INKLING that Lehman was going to get thrown under the train.

  19. Qizmo:

    I am an owner of a small manufacturing company, and I have been in manufacturing for 35 years. I can tell you, NAFTA and CAFTA didn’t weaken our manufacturing base, except maybe 2-3% of it. Our manufacturing got shipped first down out of our NE industrial sector down to KY, AL and TN. I remember one company that tried MS, back in around 1980, and they brought it back up north after they found out the MS folks back then had no head for mechanical things. Manufacturers have been trying to find cheaper labor pools since time immemorial. We were already talking with the Chinese back in the early to mid Reagan years, sending over trade missions. Our manufacturers were drooling at the prospect of $1.00/day labor, vs $25/hr labor here. All that preceded NAFTA by a lot. CAFTA is a fly speck, even compared to NAFTA. By the time NAFTA kicked in, Mexico was already losing out to China; Mexico wasn’t cheap enough.

    An example of how bad it got: There is (was?) a tech school called the Tool and Die Institute. I don’t remember the numbers I was told, even, but in about 1988 a graduate ff that school told me that 30 years earlier they were graduating 300 tool makers a year, and that the previous year only 6 graduated. There were no jobs for more than that. Those were the cream of the crop of machinists. Jobs gone. Long before NAFTA.

    The problem was that there was nobody at the helm to try to stop the bleeding of U.S. jobs by fighting to keep those jobs here. The Reagan-Bush years was all about profits for corporations. Clinton didn’t fight for the jobs, either. And by the time this last Bush got in, most of the jobs were either gone of ready to go.

    But you are right, that there is no underlying economy to sustain us going forward. That was the case, all through these years of our glorified “service economy”. It was a bubble with nothing in the middle, just MacDonalds and Walmart on the outside, sucking it all out.

    What are we going to do to reestablish a manufacturing base? In my own opinion it will come from small shops making parts for other small companies (companies too small to be buying overseas much). In other words, it will have to be us lifting ourselves up by our own bootstraps. One sale at a time.

  20. All of this is pointless without:

    A) a currency adjustment (dollar dropping in value)

    B) recognition that some jobs are more valuable than other jobs (due to positive externalities and export opportuniites) regardless of what the market says (through price signals). This is so antithetical to free market doctrine that the entire notion has been written off as leftist propaganda foisted by idiots who just don’t understand “real economics”.

    C) recognition that those jobs which had strong price signals (wages) attached to them – notably, finance jobs – either did not materially contribute much to society, and/or benefited from strong price signals due to perverse government policies (like the utter failure to practice sound regulation).

    At every turn, I hear economists willing to blame this or that problem, but very few have the courage to stand up and admit that the much of the intellectual basis underlying their discipline has been incomplete for the last 30 years – and that they have been giving society bad advice.

  21. Nationalisation need not involve the government running banks on a day to day basis. Why not set up a sovereign wealth fund (e.g., with an eminent chairman such as Paul Volcker) with a clearly defined mandate to acquire any US bank on condition that (a) the existing board and CEO is replaced within 6 months, and (b) the bank is sold within (say) 10 years. (I understand the Swedish experience was that the banks were re-privatised too early and Swedish taxpayers could have got a better return had there been more time to re-privatise the banks). This approach would meet objections that governments are not good at running banks. It would also satisfy concerns about using taxpayer funds to bail out existing management (thereby aggravating moral hazard). To help ensure that the SWF does not overpay for acquiring banks, the US government could announce that taxpayer funds would only be provided to banks that are acquired by the SWF. I would be grateful if James or Simon could explain what’s wrong with using SWF to nationalise banks. As far as I can tell, no one seems to have given this approach any consideration. Note that Australia has a SWF called the Future Fund, which holds shares in Telstra (the telco incumbent) which the Ausralian government “privatised” last year. Telstra is now operated as a fully privatised company notwithstanding the fact that the government still owns a significant amount of equity through the Future Fund.

  22. Just a point about all the “domino” references. In our current situation, the “domino” effect is not addition, it’s multiplication. It’s one domino falling, knocking down two dominos etc. etc.

    The straight MBS market loss is in the $6 trillion range as we write. The derivative market overlaying this is much larger, of course, as is the other asset based derivatives.

    A “reset” unwinding of original contracts, if practicable, would help simply by “turning back the clock” to a time when the first dominoes fell. But how to do that?

    Outside of doing that, there’s no recourse but to take massive writedowns and losses throughout the international financial system. None. The math is clear.

  23. >Why not just call them bookkeeping mistakes and reverse all the transactions? All they were are bets placed by gamblers anyway.

    Aren’t some of the CDS “policy holders”, (ie, other big banks), carrying some of these polices as assets on their balance sheets?

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