More Bad News for the Trade Bubble

I like what this article says : Either governance becomes more globalised or finance less globalised.

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More Bad News for the Trade Bubble

from BusinessWeek Online -- Economics Unbound by Michael Mandel, 16 Apr 09

I was readily favorite bloggers, Brad Setser, and he had this to say:

The FT – more than most – has recognized the challenges created by a global banking system and national regulation. A recent leader argued: “The current mismatch of globalised finance and national governance is unsustainable. Either governance becomes more globalised or finance less globalised.“

My guess is that finance will necessarily become a bit more national. The current crisis has shown than highly leveraged intermediaries require a government backstop, and for now there is no global taxpayer willing to bailout global banks that go bad.

Now, I'd argue with Brad about the FT--I've written about the importance of having a global central bank multiple times over the years. For example, back in 2006 I had a cover story "Can Anyone Steer This Economy?" where I wrote:

No matter which party you belong to, or which Big Idea or school of economic policy you subscribe to, one thing is clear: Globalization has overwhelmed Washington's ability to control the economy. Whether you're a Republican supply-side tax-cutter, a Wall Street deficit hawk of either party, or a Silicon Valley techie type, your preferred levers of economic policy just don't work as well as they once did.

and

a Big Big Idea--probably too big to even consider right now--would be the creation of global institutions for governing the world economy. History tells us that market economies are prone to financial crises, to which the only solution is a strong central bank. During the Asian financial crisis of the 1990s, for example, the Fed played that role.

But with the explosive growth of China and India, that sort of role for the Fed is no longer feasible, and no new institution has arisen to take its place. As former Treasury Secretary Robert E. Rubin, now a top official at Citigroup, recently said: "There's no policy mechanism for bringing together the countries that really matter in the global economy." The best solution would be some sort of global central bank with real powers--but that's not going to happen until there's a big enough financial crisis to truly scare people.

This was written in 2006. Is this crisis big enough to scare countries into a global central bank?

No. No. No. The U.S., utilizing its privileged position as the world currency, has one get out jail free card, which it is playing now. This crisis is more like to end the way that Brad says above--a retreat from the globalization of the financial system, which will mean a retreat from unbalanced trade (which requires massive cross border capital flows).

It's worth repeating that. You need to have a global financial system to support the cross-border capital flows that come along with unbalanced global trade. So if we don't have a global financial system...which we won't...we will inevitably end up with more balanced trade, by one way or another. Poof. Wave a big part of the trade bubble good bye.

Good bank, Bad Bank

Here is the original article by Bulow and Klemperer

Reorganising the banks: Focus on the liabilities, not the assets

Jeremy Bulow Paul Klemperer 21 March 2009

Fixing the banks is an absolute priority in G7 nations. Doing this by buying toxic assets is costly, inefficient, and risky. Governments should focus on which liabilities, rather than which assets, they need to support. This column proposes creating “bridge” banks as a way of re-establishing a healthy banking system.

Summary of the argument

1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this.

2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power.

3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank.

4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts.

5. Coordinating actions with other countries will reduce any risks.

As we pour good money after bad in trying to save the banks, far too much time and attention has been focused on attempting to value or transfer or shore up the so-called “toxic” assets. This is natural enough, since they arguably caused the crisis, but it’s also wrong. Here’s why.

Flaws of the current approach

First, the toxic assets are very difficult to value. Many are held by only one or two owners so there is no real market even in good times. And even if a hedge fund buyer and a bank seller both thought that an asset was worth 50, the bank might demand 80 in the hopes of receiving that price in the next government bailout. Furthermore, the banks may be the “natural” owners of these assets. Say a bank makes a construction loan. Even if the loan sours, the bank may be the most knowledgeable party to hold and possibly renegotiate the loan.

Second, purchasing or guaranteeing “toxic” assets creates other problems too. Putting aside the obvious inequity of paying bank creditors a “risk premium” for having invested in failed businesses, how can we ever again rely on market signals to allocate capital efficiently among banks if their capital structures are effectively guaranteed by the government? And under schemes like the recent Citigroup, RBS and Lloyds bailouts, banks’ incentives to manage the “insured” assets are drastically reduced, as the government bears up to 90% of any marginal losses.

Lastly and perhaps most important, the obvious fiscal risks associated with the huge incremental costs of current policies may undermine confidence far more than paying off creditors in full may temporarily boost it, however superficially attractive the latter approach may seem.

Re-establishing a healthy banking system is crucial, but doing so through the purchase of toxic assets is costly, inefficient, and risky.

How to reorganise the banks

How then can we make banks healthy without separating the “bad assets”? The answer is, instead, to separate the “bad liabilities”.^*

Take Citigroup, for example. At the end of 2008 the bank had roughly $1.8 trillion in liabilities on its consolidated balance sheet, of which less than $800 billion were deposits.

Say Citi’s assets were worth $1.5 trillion. A new (“bridge”) bank that included all the assets plus say $1 trillion of the old bank’s most senior liabilities would still be comfortably well capitalised, even if the asset values were overestimated. The original bank would be left with all the equity in the new bank, worth $500 billion, and the remaining $800 billion in liabilities.

The original bank would still be insolvent, but that would not prevent the healthy new bank from operating efficiently and making good loans. If a risky original bank's marginal cost of funds is, say, 10% it will not be profitable for it to make new riskless loans at 7%, even if the market riskless rate is zero. By contrast, because the new bank is well capitalised, it can borrow on sensible terms if it has a profitable investment to fund.¹

Giving the old bank an equity stake in the new bank is the best way to compensate the holders of old bank’s liabilities to the full liquidation value -- but not more than that value -- of their claims. It may also facilitate the reorganisation of the old bank if, as is likely, it goes into bankruptcy, since creating marketable equity in the new bank resolves the difficulty of valuing the old bank's assets, and avoids any need to sell the new bank on to a third-party – a transaction from which the government might be unlikely to get full value.²

The reorganisation could be managed under a regime like the UK’s Special Resolution Regime (SRR) or similar to that of the US Federal Deposit Insurance Corporation (FDIC)³ (there may be other possibilities too). The government’s role ends when the old bank has sold its shares or allocated them amongst its creditors.

Who loses?

Paying all creditors at least their liquidation claims is probably a pre-requisite for maintaining market confidence. It is anyway mandated by the Fifth Amendment in the US and by Human Rights legislation in Europe, and it is enshrined as the “no creditor worse off” principle in the recently-enacted UK Banking Act. So both the FDIC and the SRR assure the non-guaranteed creditors of the banks that they will be paid at least as much as they would receive under a liquidation of the institution, but not that they will get back every penny they are owed.⁴

Under a liquidation the junior creditors would suffer losses of $300 billion in our example (and the old bank’s shareholders would be wiped out), unless there were further government subsidies. A key virtue of isolating the junior liabilities rather than the troubled assets is that while the government may then choose to subsidise some of the junior creditors’ losses, it can more easily get off its current path towards subsidising them 100%.

For example, in the U.S. system the order of priority for debts is the following: (1) administrative expense of liquidation; (2) secured claims up to the value of collateral; (3) domestic deposits (both insured and uninsured); (4) foreign deposits and other general creditor claims; (5) subordinated creditor claims; and (6) equity investors. Recently issued subordinated debt has been guaranteed by the government, which would therefore take any loss on those securities in a reorganisation. (The UK prioritisation is a little different; in particular, it does not make domestic deposits senior to foreign deposits or other general creditors).

For a large bank like Citi or Bank of America the first three categories would be placed in the new bank, and so would be fully protected. Foreign depositors should probably also be made whole. As when the Icelandic banks defaulted, countries will try to “ring fence” the operations within their borders if their deposits are not paid. Furthermore, not paying foreign deposits would lead to tit-for-tat behavior and might increase systemic risk. Making these depositors whole, and protecting domestic depositors in a jurisdiction like the UK that does not have depositor preference, may give them more than their liquidation values, so the government would have to either infuse the new bank with enough capital that the claims of the remaining creditors would be worth as much as in a no-intervention insolvency, or make a cash payment directly to the old bank. (The infusion to the new bank makes its equity more valuable and therefore raises the value of the claims of the “original bank” creditors in insolvency. The amount of the equity infusion or cash payment is easily calculable if the new bank’s stock is traded, as explained in this note.⁵)

However, other general creditors (other than those with a government guarantee) including non-guaranteed bondholders and owners of credit default swaps that are not fully collateralised need not be paid in full. The government may, if it wishes, choose to pay these creditors more than they would receive in liquidation. (It can even buy their claims from the old bank at full value and place them in the new bank.) But because the old bank’s creditors’ leverage would be reduced to their financial claims, and they would not have the threat of bankrupting the new healthy bank were they not paid in full, this need only be done when not doing so would contribute to systemic risk.

If there is still concern that the new bank is undercapitalised, the government can infuse more equity, but in contrast to the current situation the infusion would no longer have to be large enough to pay off the junior creditors.

Finally, coordinating actions with other countries would resolve the concern that some have expressed that if one country alone fails to bail out a category of creditors, its institutions will find it hard to raise funding in the future. International coordination may also make it politically much easier to favour some groups of systemically-important creditors (especially foreign ones) over others.

For some banks, particularly those whose liabilities are almost entirely deposits, this approach may save little money relative to the current bailouts. And, of course, if it is systemically important to make every creditor completely whole, then there is no saving at all. But if the authorities do not believe that any bank creditors can be asked to lose a penny then they should say so. We can then stop worrying about things like whether, if the government buys (or “insures”) the troubled assets from the banks the government pays fair price or an extra couple of hundred billion, since in this case any overpayment simply reduces the amount the government will ultimately have to pay to make good all the creditors, by an equal amount.

If governments feel that they need to absorb more of the risk in the system, they should consider whether providing subsidies to bank creditors is the most effective use of their funds.

Conclusion

A plan that isolates the bad liabilities rather than the bad assets of the banks, and pays the owners of those claims everything they legally deserve in liquidation but does not fully immunise them from losses, will achieve three major objectives.

• It will help unfreeze the credit markets by creating healthy banks able to lend.
• It will assure that depositors are paid in full, and all creditors are paid at least their entitlement.
• It will make the bailout cheaper for the government, increasing its flexibility.

Finally, as an additional benefit, paying creditors based on market values rather than government guarantees reduces moral hazard in bank finance, and increases the prospect of better monitoring by sophisticated private creditors in determining the future allocation of capital across financial institutions.

There will be a lot more we will need to do to solve the financial crisis -- let's not make the bank bailouts more expensive than absolutely necessary.

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* While presented in the form of a plan, what follows is intended to raise questions that deserve answers, rather than make definitive recommendations; some of this might require other legal means than those suggested here.

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1. Why do undercapitalised banks have difficulty funding good, relatively safe loans?

First, because any new capital raised is effectively bailing out the senior creditors. If any capital raise has to come primarily from junior creditors, as is likely since the supply of depositors’ funds is relatively fixed, the senior creditors benefit because there will be more collateral available to secure their claims. If the new funds are used for any new zero net present value investment, then any gain of the senior creditors must be matched by an equal loss for the junior creditors – regardless of the riskiness of the new investment. So an undercapitalised bank will need a higher return on even the riskiest investments, if the funding must come from issuing more equity or junior debt.

Second, shareholders in a risky bank are biased against safe investments. Say that a bank that wished to borrow 80 pounds had to promise to return 100 – reflecting a 20% chance of not paying – even when the riskless interest rate is zero. Say that it could make a riskless investment with these funds that would pay off 90 – well above the riskless market rate (of zero). The sum of these two transactions would be a bad deal for the shareholders because they will receive 10 pounds less if the bank is able to pay all its obligations in full, and nothing otherwise. In addition, the probability that they will wind up with nothing will increase, because the risky assets the bank already holds will need a 10 pounds higher payoff to pay off the bank’s debts in full.

2. We have put all the assets, including the "toxic" assets, into the new bank, because this avoids the need to value or trade them (except to the extent that the market will estimate the value when putting a price on the new bank’s equity). A possible danger--depending in part upon regulatory rules--is that the new bank might nevertheless feel under pressure to sell these assets to improve its regulatory capital position. In that case, the "bad assets" might be better left behind in the old bank if the old bank’s liquidation procedures did not create even greater pressures to sell rather than to run to maturity or renegotiate, etc., as appropriate. (A plan that credibly focuses the government’s bailout efforts on liabilities rather than assets should reduce the difficulties of trading the troubled assets, but it may still be inefficient to trade them.)

3. An important difficulty in the US is that the FDIC procedures cannot be applied at the bank holding company level (where some large US banks hold significant assets and liabilities) rather than at the bank level, and subsidies may also be required at the holding company level to curtail system risk. It is easy to imagine a situation where the operating banks are themselves insolvent and perhaps appropriate for a “bridge” bank reorganisation, while at the same time the holding company would be required to go through Chapter 11 of the bankruptcy code in the US. In this case the US government might perhaps provide Debtor in Possession financing to the holding company as it resolved its affairs.

4. In fact, the SRR guarantees only that creditors will get back what would have been their liquidation values in the absence of prior government assistance. So the benefits they gained from the recent government schemes to insure their assets could be discounted from their liquidation values to compute their guaranteed minima. Whether the benefits that some groups of creditors gained from earlier bailouts, including the Lloyds/HBOS merger, can also be "taken back" by the government is beyond our legal expertise.

5. Say for example, that a bank had liabilities in the amounts of L1 and L2, both equal priority, but the government wished to elevate the seniority of L1 by making it a debt of the new bank. If the new bank, with this liability, establishes an equity value of E and a debt value of L1, the value of the L2 claim becomes E, whereas its previous value as an equal priority claim was ((E+L1) times L2/(L1+L2)), so the amount of a fair cash payment to the old bank is the difference between these values, which equals (L2-E) times L1/(L1+L2). (This reflects the facts that the excess of liabilities over assets is (L2-E), and the owners of L1 originally bore share L1/(L1+L2) of these losses).

Good Bank Bad Bank

Here's an explanation of the good bank- bad bank solution. Just note, that the main problem this tries to solve are banks with so much toxic assets (these can be bad loan portfolios with high NPL rates) that they can't continue lending.

A capital idea to get the banks to start lending again

By Tim Harford

Published: April 4 2009 02:13 | Last updated: April 4 2009 02:13

I’ve been weighing up a very elegant treatment for the banking crisis that has been buzzing around the economics blogs – so elegant, in fact, that it took me several days to convince myself that it wasn’t just a logical sleight of hand, the kind of subtle fallacy that mathematicians use to “demonstrate” that 1+1=1.

One way to understand the banking crisis is that the banks cannot raise new money and lend it to people who could use it. This is not because there is no money, or no deserving investment projects. It is because the banks, whose assets are worth less than they hoped, are now weighed down by their existing promises to repay depositors and other creditors. They cannot raise fresh money because nobody wants to lend money to a near-bankrupt bank.

So far, governments have been trying to raise or at least stabilise the value of bank assets, but an alternative is to reduce the burden of their liabilities.

The elegant approach I’ve been examining has been developed by long-time collaborators Jeremy Bulow and Paul Klemperer. They suggest splitting crippled banks such as Citigroup or RBS into a good “bridge” bank and a bad “rump” bank. The bridge bank gets all the assets, even the so-called “toxic” assets. These are not truly toxic, simply worth less than everyone hoped. The bridge bank also inherits sacred liabilities such as deposits. The rump bank gets no assets, only the debts the old bank used to owe to creditors.

With a leap and a bound, the bridge bank is well-capitalised and capable of raising new funds to lend out to good projects. Depositors feel secure and the economy acquires a functioning bank. The rump bank, of course, is a basket case, so one might think that the shareholders and creditors in the rump bank have suffered expropriation. They have not: Bulow and Klemperer propose giving all the equity in the bridge bank to the rump bank – this is full and fair compensation. The rump bank may well go bankrupt and the creditors will have to see what they can salvage – which will include shares in the bridge bank. But the bankruptcy process will not damage the bridge bank, nor prevent it from raising new money and making fresh loans.

The plan may not work, for a number of reasons. The most serious objection is that everything is now systemic, and that allowing creditors to lose a percentage of their claims – despite the fact that they lent money to the banks without any government guarantee – may cause further bankruptcies. Even so, the Bulow-Klemperer plan allows the government to pour further money into the banks in a more transparent way: to the bridge bank if the concern is to ensure well-capitalised banks; to the rump bank’s creditors if the concern is to prevent a chain reaction of bankruptcies. Transparency, of course, may be the last thing governments want, given the possible sums involved.

If you are still blinking at the idea that one can produce a healthy bridge bank like a rabbit from a troubled-bank top hat, without injecting new funds and without resorting to expropriation, you should be. But it is true. The confusing thing about the financial crisis is that the physical economy is in the same shape as ever, but it can be paralysed if investment money cannot flow from those who have it to those who can use it. A tangle of – unpayable? – claims against the banks is, like some modern-day Jarndyce and Jarndyce case, stemming that flow. Bulow and Klemperer try to set the tangle to one side to be resolved while the banks continue their business. Put like that, the idea does not seem like such a conjuring trick.

Ireland Sets Up A 'Bad Bank' As First Eurozone Country: Will Others Follow Suit?

Irish bank debt plan a first for Europe

By John Murray Brown
Published: April 7 2009 20:39 Last updated: April 7 2009 20:39

Brian Lenihan, Ireland’s finance minister, described it as a bold and radical measure. But the plan for the state to assume the bad debts of the country’s main commercial banks was attacked by the main opposition party as a "big time bomb" for the Irish taxpayer.

The Irish plan, the most striking part of Tuesday’s emergency budget, involves a government-controlled agency taking property assets and loans to developers off the banks’ books in return for government bonds. Mr Lenihan said the agency would take over loans with a book value of €80bn-€90bn ($59bn-$67bn, £54bn-£61bn), although actual value is much lower.

Ministers expect banks, which have benefited from a blanket government guarantee since last autumn, to co-operate with the plan though the government is willing to pass legislation to enforce the transfer if necessary. The government already has 25 per cent of Bank of Ireland and is finalising a plan to take a similar stake in Allied Irish Banks.

The transfer may force banks to recognise additional losses, although the government said it was prepared to recapitalise those institutions in return for ordinary shares if necessary.

The "bad bank" proposal makes Ireland the first European country to offer to take toxic assets off the balance sheets of lenders that are still privately owned. Similar structures have been examined in other countries such as the UK, but were abandoned because it would be too difficult to value the assets properly.

The Irish plan is simpler than schemes adopted by other European governments because the main problem for Irish banks is bad loans caused by a speculative property boom, rather than holdings of complex debt securities.

However, Mr Lenihan is likely to face considerable public anger over the plan. Aware of the public perception that it represents another bank bail-out, he emphasised "this is not something the banks especially want because we’re insisting on the banks taking their losses up-front for the sake of the economy".

The governing Fianna Fáil party has in the past been accused by opposition parties of favouring the building industry, many of whom are big political donors. But Mr Lenihan said those who borrowed money would have to repay their loans in full, and warned "there will be a hardening of the approach to these borrowers".

He acknowledged that the issuance of bonds would result in a "significant" increase in national debt levels, but "the cost of servicing this debt will be offset, as far as practical, from income accruing from the assets of the new agency." Any shortfall would be met by a levy on the banks’ assets.

Richard Bruton, Fine Gael finance spokesman, said it was an enormous gamble. "We don’t know what price the taxpayer will have to pay. We don’t know if the working out of this leaves a huge deficit. Will the bankers pay up?"

He pointed out the value of assets being assumed by the new agency was "equivalent to more than 50 per cent of GDP, the equivalent of 12 years of income tax".

In an interview with Irish radio, Mr Lenihan conceded it might be 10 years before the full cost would be clear.

Nationalisation of Banks

Another good piece here arguing for nationalisation by Matthew Richardson http://www.voxeu.org/index.php?q=node/3143

Treasury Secretary Timothy Geithner’s financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.

Economic analysts have already performed such a test at the aggregate level. The results were not pretty. For example, Goldman Sachs looked at the US banking sector’s holdings of the current “toxic” pool of assets, such as option ARM residential mortgages, subprime residential mortgages, Alt-A residential mortgages, credit card debt, second liens/home equity loans, consumer auto loans, and commercial real estate. Expected losses come in at around $900 billion. These losses give the banking sector very little wiggle room. Therefore, there is the real possibility that some LCFIs are bankrupt – the face value of their liabilities exceeds the current value of their assets.

Insolvent financial institutions

If a bank is insolvent, there are three general ways to attack the problem.

The first is unbridled free-market capitalism. I am sympathetic to this view. I wish we somehow could figure out a way to let the market work and let these institutions fend for themselves. Shareholders, creditors and counterparties knew the risks they were getting into. After all, why is some debt secured, why do we have collateralised lending, why do riskier assets deserve larger haircuts, etc? But when Lehman Brothers went down, we looked into the abyss. This would be the equivalent of nuclear armageddon for the financial system.

The second option is to provide government aid to the insolvent bank – to in effect throw good money after bad. This is sanctioning private profit-taking with socialised risk. Since October of this past year, the government has followed this strategy. Let the banks plod along, throwing money here and there to keep them afloat, at usually way below-market prices at a high cost to taxpayers.

It is not a totally crazy solution. There may well be a positive externality to spending taxpayer money to save a few so we can save the entire system. For economists specialising in the field of banking, however, this approach has a familiar ring to it. In Japan’s lost decade of the 1990s, its banks kept loaning funds to bankrupt firms so as not to writedown their own losses, which resulted in the government supporting zombie banks supporting zombie firms.

As an example, consider the poster child for the “freebie” programmes, the Temporary Liquidity Guarantee Program, started in late November of 2008. For a cost of 0.75%, it allows banks to issue bonds backed by the government, essentially risk-free. The banks have accessed this market 97 times for $190 billion!

The biggest pig at the trough was Bank of America, which accessed it 11 times for $35.5 billion. Close behind were JP Morgan ($30 billion), GE Capital ($27 billion), Citigroup ($24 billion), Morgan Stanley ($19 billion), Goldman Sachs ($19 billion) and Wells Fargo ($6 billion). A not so surprising correlation with their respective writedowns (including merged entities): Bank of America $96 billion, JP Morgan $75 billion, Citigroup $88 billion, Morgan Stanley $22 billion, Goldman Sachs $7, billion and Wells Fargo $115 billion.

In terms of helping us exit the financial crisis, this programme has many problems. It charges each institution the same amount, so it hardly separates the solvent from the insolvent institutions. It charges a fee that is grossly below what these institutions could issue in the marketplace given their current balance sheets, distorting the system. Wasn’t that the Fannie Mae and Freddie Mac problem? And it is unlikely to cleanse the system of toxic assets, because it allows banks to continue business while out of money and hope that toxic asset prices increase. In effect, the access to this capital allows them to continue to make their original bets.

The final way of addressing insolvency is nationalisation. Over the past week, there has been debate about whether nationalisation is the right word. According to a standard dictionary definition, nationalisation is the act of transferring ownership from the private sector to the public sector. Although this is literally what we are discussing for certain banks, almost everyone agrees that the type of nationalisation that would take place would be a temporary one. Thus, if everything went as planned, a better analogy would be of the government acting as a trustee in a receivership of the bank.

That said, I do think a term like nationalisation is the appropriate description. It is a misnomer to think, as a number of pundits have suggested, that we have experience at nationalising banks through the FDIC. For example, the latest bank (and 39th of the current crisis) to be closed by regulators is the Silver Falls Bank of Silverton, Oregon. It has three branches and assets of approximately $131 million.

Silver Falls Bank is no Citigroup or Bank of America. The complexity, size and systemic nature of these institutions deserve deep analysis.

The basic argument for nationalisation is that we need an organisation to simultaneously facilitate the reorganisation of the large complex financial institutions and be a trustworthy counterparty to all current and ongoing transactions. The only one with the balance sheet right now is Uncle Sam. But make no mistake about it. With nationalisation of a LCFI, the government is the owner and the ultimate residual claimant. Once we take down the LCFI, we have crossed the Rubicon. The die is cast and there is no turning back.
It is therefore important to do it right. Nationalisation has its pros and cons.

The good bank, bad bank model

In order to have a healthy economy, we need a healthy financial system, and a healthy financial system requires that we cleanse the system of bad assets. Otherwise, creditworthy firms and institutions will not have access to needed capital, prolonging the economic downturn.

Such cleansing would be the primary benefit of nationalising some financial institutions. In receivership, it is much easier to separate a bank’s good assets and bad assets – to divest the firm from its toxic assets and troubled loans. This is because insolvent institutions will never take this action. If they did, it would by construction force them under.

How would it work? The healthy assets and most of the bank’s operations would go to the good bank, as would the deposits. Some of these deposits are insured; others (e.g., businesses and foreign holdings) are not. But the good bank would likely be so well capitalised that there would be no threat of a bank run. The net equity, i.e., assets minus deposits, would be a claim held by the other existing creditors of the bank, namely shareholders, preferred shareholders, short-term debtholders, and long-term debtholders.
The goal would be to reprivatise the good bank as soon as possible. After all, the point of the exercise is to create healthy financial institutions that can start lending again to creditworthy institutions. In almost every successful resolution of financial crises in other countries, this was the path.

Of course, the tricky part of nationalisation is the handling of the bad assets. The bad assets would be broken into two types – those that need to be managed, such as defaulted loans in which the bank would own the underlying asset, and those that could be held, such as the AAA- and subordinated tranches of asset-backed securities. With respect to the former, the government could hire outside distressed investors or create partnerships with outside investors as was done with the Resolution Trust Corporation in the 1980s savings and loan crisis.

Along with the equity of the good bank, these assets would be owned by the existing creditors. The proceeds over time would accrue to the various creditors according to the priority of the claims. Most likely, the existing equity and preferred shares would be wiped out, and the debt would effectively have been swapped into equity in the new structure. Under this scenario, it is quite possible, even likely, that taxpayers would end up paying nothing. This is because, for the large complex financial institutions, these creditors cover well over half the liabilities.

Does such a solution risk systemic bank runs?

The problem with the above solution is that it shifts all the risk of the insolvent institution onto the creditors of the LCFI. While this is fair to the extent the creditors were accruing the profits in normal times, it may lead to the “Lehman Brothers problem” – it risks runs throughout the system.

Why did Lehman Brothers cause systemic risk?

Was it the counterparty risk, e.g., fear of being on the other side of interest rate swap, credit default swap, or repo transactions? This fear was well founded. Ask any hedge fund whose hypothecated securities disappeared in Lehman’s UK prime brokerage operations. It is pretty clear that the government would have to stand behind any counterparty transaction and publicly commit to this rule. Since most of these are margined and collateralised, however, many of the assets would show up in the good bank.

Or was it the short-term debt? The run on money market funds was directly attributable to the Reserve Primary Fund’s holdings of a large amount of short-term Lehman commercial paper. One would presume the same thing would happen here as the short-term debt of all questionable LCFIs would come under pressure. It is highly likely that the government might have to step in.

Compared to the standard large complex financial institution, Lehman had very little long-term debt. To understand whether a collapse in the institution’s long-term debt value is systemic, one would have to analyse the concentration of this debt throughout the system. If it is widely held, it is unlikely to have systemic consequences. Of course, it would have profound effects on future financing of these firms.

If the government has to cover the creditors, or at least some of them, what has been gained?

On the positive side, the system will have cleansed itself of the assets.

Moreover, to minimise the cost to taxpayers, it is not clear that the government will have to step in. If the government is completely transparent to the market who is solvent and who isn’t, and the reasons why this is, then the type of uncertainty that surrounded Lehman’s failure may be mitigated. The runs on the equity and debt of banks in September and October 2008 may have occurred because there was no clear message from the regulator.

That said, actions speak louder than words, and, in a dynamic setting where conditions change rapidly, solvent firms can become insolvent very quickly. While the government needs to do a thorough stress analysis, consistent across all the major banks, to find out the trouble spots, the only definitive way it can prevent a bank run on solvent institutions is to backstop all the creditors of these institutions. Maybe the government can provide a haircut, guaranteeing X% of the debt. In any event, in this case, the creditors of the insolvent institutions would not have to be protected.

Advantage: Nationalisation solves the toxic asset problem

It has been argued that trying to implement nationalisation will be near impossible because we won’t be able to price the hard-to-value “toxic” assets. It is actually the opposite. The current problem is that banks don‘t want to sell the assets at the price the market is willing to pay for them. If we were banks, we wouldn’t want to sell them either. As long as the government is providing free money, why not continue to hold out? Hope is eternal.

But let’s be real. The banks bought illiquid assets with credit risk using borrowed short-term liquid funds. For taking these types of risk, the banks earned a hefty spread. And, in normal times, they raked it in. But there is no free lunch in capital markets. In rare bad times, illiquid, defaultable assets are going to be greatly impaired. There is no mulligan here. It will be easier to resolve this within a receivership.

To make the point using a real economy analogy, this past Christmas, Saks Fifth Avenue sold their designer lines at a 70% discount. Designer labels and boutique shops on Madison Avenue were up in arms. How could they sell $500 Manolo Blahnik shoes for $150? In this economy, they are $150 shoes.
Moreover, receivership allows one to separate out the assets without having to price them.

Disadvantage: How to manage a nationalised bank?

Does the government have the ability to run a large complex financial institution? In a recent conversation, Myron Scholes told me he was also in favour of nationalisation – as long as it lasts just 10 minutes.

These institutions have literally tens of thousands of transactions on their books –, who is going to manage a LCFI while it is a government institution, good bank or bad bank? Certainly, no one envisions Barney Frank or Christopher Dodd as the Chief Investment Officers of these firms, but there are many concerns. The government can go and hire professionals as they have done with Fannie Mae, Freddie Mac, and AIG. But much of the value of a Wall Street firm is in its vast array of intangible, human capital. This labour is incentive-driven. How much franchise value will be lost during the nationalisation process?

Let’s assume this gets sorted out and the government mirrors employment practices at other firms. But then, with the government’s protection in receivership, what is to prevent the LCFI from making too many, risky loans? They will have a competitive advantage over solvent, albeit less-supported banks. This issue has recently come up with other government-supported institutions. Indeed, the argument has been made that AIG and Northern Rock, to name just two institutions, have undercut their competition by offering overly cheap insurance and mortgages, respectively.

Advantage: Nationalisation addresses the moral hazard problem

There is something unseemly about managed funds buying up the debt of financial institutions under the assumption that these firms are “too big to fail”. In theory, these funds should be the ones imposing market discipline on the behaviour of financial firms, not pushing them to becoming bigger and more unwieldy.

It has been said by many that this is not the time for thinking about moral hazard. I disagree. If we bailout the creditors, then effectively we have guaranteed the debt of all future financial institutions. We have implicitly socialised our private financial system.

It is certainly true that we can institute future regulatory reform to try to quell the behaviour of large complex financial institutions. But this will be complex and difficult to implement against the implicit guarantee of “too big to fail”.

Thus, nationalisation resolves the biggest regulatory issue down the road, namely the “too big to fail” problem of banks that are systemically important. In one fell swoop, because the senior unsecured debtholders of a bank will lose when it is nationalised, market discipline comes back to the whole financial sector.

So the large solvent banks will have to change their behaviour as well, leading, most likely, to their own privately and more efficiently run spin-offs and deconsolidation. The reform of systemic risk in the financial system may be easier than we think.

Concluding remark

We are definitely caught between a rock and a hard place. But the question is – what can we do if a major bank is insolvent? Sometimes the best way to repair a severely dilapidated house is to knock it down and rebuild it. Ironically, the best hope of maintaining a private banking system may be to nationalise some of its banks. Yes, it is risky. It could go wrong. But it is the surest path to avoid a “lost decade” like Japan.

Epilogue: Sweden¹

Sweden has been cited frequently as a model of “nationalisation”. While this is probably an exaggeration, the Swedish approach is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden’s economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and US banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the US, while there are over 7,500 institutions, and the majority of assets are concentrated in the top 15 or so.

Sweden’s credit and real estate boom in the late 1980s closely mirrors the recent US boom prior to the crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies financed their operations via commercial paper; in the US, unregulated special purpose vehicles used asset-backed commercial paper. When the bubbles began to burst, there were also sudden collapses in these markets as a few of these companies and special purpose vehicles began to fail.² Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital or to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank – failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalised.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden for the current crisis are:

1. Decisive action in terms of evaluating the solvency of the financial institutions.
2. Some form of “nationalisation” of the insolvent firms.
3. Separation of these insolvent firms into good and bad ones with the idea of reprivatising them.
4. The management of the process was delegated to professionals, as opposed to government regulators.

While complexity may affect the application of these principles to the current crisis, it does not nullify them.

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1 Many of the facts here are taken from Tanju Yorulmazer’s “Lessons from the Resolution of the Swedish Financial Crisis.”
2 In Sweden, in September 1990, a finance company called Nyckeln went bankrupt, while in the current crisis, in early August 2007, three ABCP funds run by BNP Paribas halted redemptions, leading to a run on the system.