Nationalization.  Such a big word. Such a scary word. Such political word.  Such a misleading word.
 
Treasury Secretary Geithner has already announced, according to Politico.com, that banks will not be nationalized.  “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,” he said.
 
Indeed.  But what does the United States do, when financial institutions are insolvent?  What is the correct policy, tested by history, when the value of  capital held by "private shareholders"  has already been reduced, by business losses, to zero?
 
Is it appropriate, in a system "managed by private institutions"  for the government to step in and reverse the insolvency, simply by purchasing assets at an unrealistic price? Is this a wise use of public funds?  And what are the incentives facing a bank, if private shareholders and subordinated debt-holders are protected from loss, while managers face no consequences for driving the bank into insolvency?
 
I thought it would be useful to get an expert perspective on these issues.  So I passed National Journal's question to a true expert, William K. Black of the University of Missouri - Kansas City.  Black was chief litigator for the Federal Home Loan Bank Board in the early 1980s, and in that capacity was among the first to understand the developing savings and loan scandal.  He was also the note-taker in the room, and the whistleblower, on the infamous meetings of the Keating Five. He later played a central role in the resolution of the crisis, which experience informs his comments below. His work is chronicled in his book, The Best Way to Rob a Bank is to Own One (University of Texas Press).
 
I have known Bill Black for many years and commend him to you.   James Galbraith
 
COMMENTS BY WILLIAM K. BLACK, PROFESSOR OF ECONOMICS AND LAW, UNIVERSITY OF MISSOURI-KANSAS CITY.
 
I have been asked to address the following questions:
 
•Is it now inevitable, or even very likely, that the Obama administration will acquire a controlling ownership of major U.S. banks to help revive the credit markets?
•Would it work?
•Is it even practical to think about nationalizing most of the banking sector, as Sweden did in the early 1990s?
•How might the government decide how banks would lend money?
•If the credit freeze continues, are there alternatives to nationalization?
 
The framing of the questions as “nationalization” reflects a significant aspect of the policy problem that we face.  In the U.S., it is a pejorative term that smacks of socialism.  The Bush administration had been following a policy of state socialism that is extremely poor policy.  The Bush policy increased moral hazard and cynical compensation abuses by elites that are already among the richest of all Americans.  The prior administration left insolvent banks open, under the control of the officers that caused their failures (even through fraud), and with inadequate controls to prevent abuses.
 
The obvious alternative to these disastrous policies is receivership.  For well over a century, under administrations with diverse ideological views, nations have placed insolvent banks into receivership.  Receivership is essentially a bankruptcy process.  It formally removes the interests of “risk capital” (equity and subordinated debt holders).  The Federal Deposit Insurance Corporation (FDIC) is expert at placing banks into receivership at the close of business on a Friday and having them open for business as usual on Monday morning to preserve any going-concern value and to prevent cascade failures.  There is ample unemployed banking talent for the FDIC to hire to continue the bank operations temporarily while the FDIC does something else it is expert at – arranging a purchase of the bank.  These temporary operating receiverships were used hundreds of times during the S&L crisis without any serious scandals.  The Bush administration crippled the FDIC through downsizing, so we need to rehire many former FDIC staff with expertise in examination and receiverships.
 
We do not have to take over most banks.  Unlike Sweden, which had a small, universally insolvent banking sector, most U.S. banks are not insolvent. 

Risk capital bears only a portion of total losses under receivership because the doctrine of “limited liability” limits their risk exposure, but it is essential that it bear the initial losses.  Equity holders receive the great bulk of the economic benefits when a firm prospers (or uses accounting fraud to
purport to prosper).  If they do not bear the losses when the firm fails then “moral hazard” is maximized.  Maximizing moral hazard increases fraud and excessive risk and guarantees recurrent financial crises.  It also will damage society.  It creates crony capitalism (or corporate socialism), which leads to substantial elite corruption and rewards individuals who embody the worst traits.
 
We need to distinguish between two strikingly different models that are sometimes referred to as “bad bank” resolutions.  When you conduct a receivership you take three key steps.  First, you stabilize the situation by dealing with any acute liquidity problems.  Second, you find the truth about the bank’s asset quality problems.  One of the worst aspects of the Bush program was that by keeping the senior bank officers who caused the insolvency in charge, we ensure that insolvent banks will cover up their losses.  This prevents the crisis from being resolved.  The FDIC has the expertise and the proper incentives (absent political interference) to find out insolvent banks’ true condition.  Third, and directly related to the success of the first two points, the FDIC markets the
bank.
 
It should be obvious that unless the insolvent banks’ true condition is found and revealed the marketing process will be crippled.  When the banks’ true condition is unknown the best acquirers will refuse to bid, because they cannot evaluate the risks of the acquisition.  The only way they can be induced to bid, is for the government to guarantee that the acquirer will suffer no losses – but that creates perverse incentives.  Some buyers, of course, may purchase failed banks without either knowing the depth of the insolvency or receiving unlimited governmental guarantees against loss.  That, however, is not good news for the government because these buyers are typically large banks (e.g., Bank of America) and if they purchase a bank that is far more insolvent than they
guessed, then the acquirer is rendered insolvent.  Instead of resolving the initial failure, the acquisition spreads the crisis.
 
The FDIC uses “bad banks” to increase the pool of potential acquirers.  Acquirers do not like to purchase large amounts of bad assets.  In addition to the obvious problems of direct loss, working out bad assets takes a huge commitment of specialist and senior management time.  It can also cause reputational injury, e.g., when borrowers assert “fraud in the inducement” as a defense to foreclosure.  The solution can be to sell the good assets and to retain the bad assets to be worked out by FDIC specialists (who are often contractors with appropriate incentive contracts).  As long as the failed bank is put through a receivership and risk capital is wiped out, this kind of “bad bank” poses no special risks.
 
Apologists for officers who caused bank failures, however, use “bad bank” in a different manner.  They would permit failed banks to sell hundreds of billions of dollars of bad assets to a governmental “bad bank” that would overpay for these assets.  The failed banks could sell these assets at “sucker” prices to the taxpayers without going through receivership.  This is crony capitalism at its worst.  It would transfer hundreds of billions of dollars from taxpayers to the
shareholders, officers, and subordinated debt holders who are supposed to be providing risk capital.  This transfer is wholly unnecessary to contain and resolve the ongoing financial crisis.  If the transfer occurs in this fashion, it will intensify the already perverse incentives created by modern executive compensation and cause repeated, intensifying financial crises.   That would be public policy at its worst.

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For a politician from Chicago this must seem like someone left the bank vault open.  Government control of the banks? All loans made on a political basis?  The opportunitities for graft and corruption are endless.  We have been here before....and this did turn out rather badly when the federal government nationalized part of the  banks portfolios with the Community Reinvestment Act that told banks to make loans the politicians demanded.  Heck, we will just bankrupt the banks as Barney Frank and Chris Dodd and Rahm Emmanuel did with Fannie Mae and Freddie Mac...and then we blame the private sector for the crimes of politicians and have another bailout.  Rinse. Repeat.

Nationalization in the sense of full government control and ownership of major U.S. banks is, in my view, not inevitable, nor likely, nor would it be an effective policy response to the financial crisis.  Further, additional steps on the road to nationalization are similarly unnecessary, unhelpful, and could well be counter productive.   

 

The central problem facing financial institutions is that the price discovery process is working poorly.  Banks still don’t know the value of many of the assets they hold on their own books, in many cases the apparent values continue to decline, and they don’t know the value of similar assets on the books of their current and potential counterparties.  This uncertainty naturally makes them reluctant to accept new risk, or even engage in relatively normal market activities.

 

Banks don’t need Uncle Sam in their boardrooms.  They need clarity, transparency, consistency, and capital above all – clarity as to the value of the assets they hold, transparency of their own books so other market participants regain confidence in their value and viability, consistency of policies from Washington so markets are no longer buffeted by the latest gust of uncertainty-enhancing policymaking, and once, these pieces are in place, the banks will need to raise private capital.

 

Nationalization, either creeping or full Monty, does nothing to get at the price discovery process or the processes that follow from it. Further, nationalization only becomes relevant when the capital infused is or has the potential to become significantly greater than the banks’ exposure to loss.  Are we willing to consider that size federal footprint?  

 

Rather than helping to clear the air, nationalization raises a new raft of troubling, debilitating uncertainties in the financial and non-financial sectors.  For example, would banks be forced to loan out the capital injected?  To what extent would banks again be pressured to make unwise loans due to political pressure?  Would banks be able to raise private capital later?   How and when would the banks be de-nationalized?  And, while the banks and the government sort out these questions, the price discovery process slows further and effective policy responses are crowded out.

 

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