Author: James Kwak

Nationalization for Beginners

“Nationalization” has been the word of the last month, with support not only from the usual suspects, but from Lindsey Graham, Alan Greenspan, and (to some degree, although they won’t say the word) Richard Shelby and John McCain. However, different people ascribe different meanings to this word; in particular, opponents like to define nationalization as the government taking over every bank permanently and turning banking into a government service.

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

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Everyone Has a Banking Plan Now

Another day, another banking plan, this one from two senior partners at McKinsey and Company, which may be the most influential company you may never have heard of.

The authors recognize the toxic-asset pricing problem: If the government buys them at market value, the banks become insolvent instantly; if the government pays book value, it is paying a massive subsidy. They also recognize the rough scale of the problem, predicting another $1 trillion in writedowns. And here’s the proposal:

[W]e propose that the government step in and establish a voluntary program to create a real market price and terms for the sale of bad assets. Rather than use modeling for valuation, the program would set discounts from either of the two basic approaches to accounting value [fair value and “hold-to-maturity,” which isn’t quite accurate, but that doesn’t matter], based on some recent past date (for instance, December 31, 2008). A reasonable level might be 10 percent off for securities already marked to fair value and 20 percent off for loans being held to maturity. Upon their sale to the government, existing shareholders would absorb the loss taken on the discount, and that loss of common stock value would be replaced by converting TARP preferred stock to nonvoting common (which would be vested with voting rights if sold to private parties).

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KC Fed President for Temporary Nationalization

Nemo alerted me (after in turn being alerted by Calculated Risk) to a recent paper by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, brilliantly entitled “Too Big Has Failed.” Here is an excerpt:

[T]he current path is beset by ad hoc decision making and the potential for much political interference, including efforts to force problem institutions to lend if they accept public funds; operate under other imposed controls; and limit management pay, bonuses and severance.

If an institution’s management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.

You could call this a free market argument in favor of temporary nationalization.

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Regulatory Arbitrage in Action

From the Washington Post:

[Scott] Polakoff [acting director of the Office of Thrift Supervision] acknowledged that his agency technically was charged with overseeing AIG and its troublesome Financial Products unit. AIG bought a savings and loan in 1999, and subsequently was able to select the OTS its primary regulator. But that left the small agency with the enormous job of overseeing a sprawling company that operated in 130 countries.

Is there another side to this story or is it really as simple as that?

Update: ProPublica had a good story on this back in November. Here’s one short excerpt:

Examiners mostly concurred with the company’s repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG’s huge capital base . . . and because securities underlying the swaps had top credit ratings.

A Quick Note on Bank Liabilities

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

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The Biggest Story of the Week

Or the year. Frightening.

I’ve been wondering why the impact of the financial crisis on the overall retirement “system” hasn’t gotten more attention in the media. We already knew the system was in bad shape before September 2008. According to the Fed’s Survey of Consumer Finances, in 2007, only 60.9% of households where the head of household was age 55-64 had retirement accounts . . . and their median retirement balance was $98,000. Given that the stock market has fallen by over 50% from its October 2007 peak – and that, for decades, the standard investment advice has been that stocks do better than any other asset class in the long term – we would be lucky if that median balance were more than $70,000 today.

The Bloomberg article linked to above describes the fragile state of state and local pension systems. These systems suffer from two major problems today. One is that even if they had been managed in a reasonable way, the fall in asset prices over the last year would have blown a huge hole in their long-term solvency.

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AIG in Review

Well, it’s done. AIG is getting another bailout.

I have to admit I don’t fully understand the ongoing AIG bailout saga, so I thought I would do a little research to try to figure out what is going on. I thought I would just look up all the term sheets, but I found it’s harder to get that kind of information from the Federal Reserve web site than from the Treasury web site. For example, the original September 16 press release doesn’t say what the terms of the 79.9% equity interest are, and I still haven’t been able to figure that out. If you know the details, let me know and I’ll update this post. In any case, I think this is the best single-page overview you’ll find on the web.

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Bad Banks on This American Life This Weekend

For public radio fans, Simon is on this weekend’s episode of This American Life, “Bad Bank,” with Adam Davidson and Alex Blumberg of Planet Money, explaining what happened to our banking system. Regular readers of this blog will already know most of what they cover, and some of it comes from episodes of Planet Money you may already have heard (including the “ransom note” conversation). But if your friends and relatives are not quite as up to speed as you are, feel free to recommend this episode. (It’s the third TAL episode to focus entirely on the economic crisis; the others are listed on our Beginners page.)

TAL plays at different times on public radio affiliates this weekend. Starting Sunday night or Monday, the free online stream will be available from the TAL page. And if you subscribe to their podcast, you’ll get the episode Sunday night or Monday.

In my opinion, TAL is the best show available in any medium anywhere, so I recommend listening to them even when they’re not talking about the economy.

Citigroup Arithmetic Explained

Since I’ve been writing about preferred and common stock so much this week, I thought I would just try to explain the arithmetic of the Citigroup deal announced today. (By the way, it isn’t a done deal: all it says is that Citi is offering a preferred-for-common conversion to its outside investors, and the government will match them dollar-for-dollar, although the WSJ says that several investors have agreed to participate.)

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No, Wait! You Got It Backwards!

AKA, Convertible Preferred Stock for Beginners.

There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a “preference,” which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department’s new Capital Assistance Program has this precisely backwards.

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But What About the Slump?

Simon’s reaction to Obama’s speech last night is up at The New Republic.

I think Simon and I agree that the speech was strong on long-term issues, but did not shed much-needed light on how we can emerge from our short-term challenges. One way to position this is to say that if we really are facing a potential “lost decade,” then talking about the long term is a bit premature. Imagine ten years of zero real GDP growth as opposed to 2.5% real GDP growth (with population continue to grow at 1-1.5% or something like that). That would take decades to make up (if it is even possible) and could outweigh any well-meaning efforts to bolster our long-term government finances.

On the other hand, I’m a bit more positive than Simon, because I wasn’t expecting the details of the banking rescue plan in a major speech to the whole country, for both practical reasons (I don’t think they are ready yet) and political ones (Obama wants to keep some measure of distance from whatever Geithner does). If I have time later today I’ll say something about the long-term issues.

Update: Now it’s later. The main thing I liked about the Obama speech is that it reflected what I believe to be the true long-term economic priorities of the country. The day after Obama was elected, I listed what I think are our top four long-term challenges (economic and non-economic): global warming, terrorism and nuclear proliferation, retirement savings (both the insufficiency of retirement savings, and the fact that retiree benefits threaten to break the federal government’s balance sheet), and health care.

Obama’s speech yesterday was mainly about four things: energy, health care, education, and fiscal sustainability. That maps pretty closely to what I think our priorities should be. He was willing to say that these are urgent, serious problems. And when it comes to the government deficit and the national debt, he has chosen to forgo the gimmicks used in the past: not only keeping the Iraq War out of the budget, but also pretending that the AMT will not be fixed every year in the future.

Admitting you have a problem, and recognizing its magnitude, is a necessary, though not sufficient, step on the way to solving it.

Tangible Common Equity for Beginners

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

You may have seen in the news that the government is thinking about exchanging its “preferred stock” in Citigroup for “common stock.” Here’s one of many articles. Which, if you are at all sensible and have any sense of proportion in your life, should be complete gobbledygook. The first part of this article will try to explain the gobbledygood; advanced readers can skim it. The second part will offer some of the usual commentary.

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Everyone Get in Line

For months now, Ricardo Caballero has been proposing yet another solution to the toxic-asset problem: universal, government-provided insurance for the assets. He recently let loose a double-barrelled volley in both the FT’s Economists’ Forum and the WSJ’s Real-Time Economics blogs. I believe he is correct that this would solve the problem: if the government is insuring any bank assets that the banks want them to insure, then the banks are protected from any further write-downs, and they are healthy by construction. However, there are other ways of getting to the same outcome. One would be for the government to pay face value (or current book value) for any assets that the banks would want to sell. Another would be to take over every single bank that fails Mr Geithner’s stress test, pull out all of their bad assets, and reprivatize them. All of these solutions will result in banks that are not encumbered by the fear of further writedowns on toxic assets.

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