|
Doctor Doom
Nationalize Insolvent Banks
Nouriel Roubini, 02.12.09, 12:01 AM EST
Paradoxically, this is a market-friendly solution to the crisis.
A year ago I predicted that losses by U.S. financial institutions would be at least $1 trillion and possibly as high as
$2 trillion.
At that time, the consensus was that such estimates were gross exaggerations--the naïve optimists had in mind about $200
billion of expected subprime mortgage losses. But, as I pointed out, losses would rapidly mount well beyond subprime mortgages
as the U.S. and global economy spun into a severe financial crisis and ugly recession.
I argued that we would see rising losses on subprime, near-prime and prime mortgages; commercial real estate; credit cards,
auto loans and student loans; industrial and commercial loans; corporate bonds, sovereign bonds and state and local government
bonds; and massive losses on all of the assets--collateralized debt obligations (CDOs), collateralized loan obligations, asset-backed
securities and the entire alphabet of credit derivatives--that had securitized such loans.
By now, write-downs by U.S. banks have already passed the $1 trillion mark (my floor estimate of losses), and institutions
such as the International Monetary Fund and Goldman Sachs predict losses over $2 trillion (close to my original expected ceiling
for such losses).
But if you think $2 trillion is already huge, our latest estimates at RGE Monitor (available in a paper for our clients)
suggest that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding
will be, at their peak, about $3.6 trillion. The U.S. banks and broker-dealers are exposed to half of this much, or $1.8 trillion;
the rest is borne by other financial institutions in the U.S. and abroad.
The capital backing the banks' assets was just $1.4 trillion (last fall), leaving the U.S. banking system some $400 billion
in the hole, or close to zero even after the government and private-sector recapitalization of such banks. Thus, another $1.4
trillion will be needed to bring back the capital of banks to the level it had before the crisis, and such massive additional
recapitalization is needed to resolve the credit crunch and restore lending to the private sector.
These figures suggests the U.S. banking system is effectively insolvent in the aggregate; most of the U.K. banking system
looks insolvent, too, and many other banks in continental Europe are also insolvent.
Comment On This Story
There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:
No. 1: Recapitalization together with the purchase by a government "bad bank" of the toxic assets;
No. 2: Recapitalization together with government guarantees--after a first loss by the banks--of the toxic assets;
No. 3: Private purchase of toxic assets with a government guarantee and/or--semi-equivalently (a provision of public capital
to set up a public-private bad bank where private investors participate in the purchase of such assets--something similar
to the U.S. government plan presented by Treasury Secretary Timothy Geithner for a public-private investment fund);
No. 4: Outright government takeover (call it nationalization--or "receivership" if you don't like the N-word)
of insolvent banks, to be cleaned after takeover and then resold to the private sector.
Of the four options, the first three have serious flaws. In the bad-bank model (the first, above) the government may overpay
for the bad assets, at a high cost for the taxpayer, as their true value is uncertain; if it does not overpay for the assets,
many banks are bust, as the mark-to-market haircut they need to recognize is too large for them to bear.
Even in the guarantee-after-first-loss model (No. 2 above), there are massive valuation problems, and there can be very
expensive risk for the taxpayer, as the true value of the assets is as uncertain (as in the purchase of bad assets model).
The shady guarantee deals recently done with Citigroup (nyse: C - news - people ) and Bank of America (nyse: BAC - news
- people ) were even less transparent than an outright government purchase of bad assets, as the bad-asset-purchase model
at least has the advantage of transparency of the price paid for toxic assets.
In the bad-bank model, the government has the additional problem of having to manage all the bad assets it purchased,
something that it does not have much expertise in. At least in the guarantee model, the assets stay with the banks. The banks
know better how to manage--and also have a greater incentive than the government to eventually work out such bad assets.
The very cumbersome U.S. Treasury proposal to dispose of toxic assets, presented by Geithner, taking the toxic asset off
the banks' balance sheets as well as providing government guarantees to the private investors that will purchase them (and/or
public capital provision to fund a public-private bad bank that would purchase such assets). But this plan is so non-transparent
and complicated it got a thumbs-down from the markets as soon as it was announced. All major U.S. equity indexes dropped sharply.
The main problem with the Treasury plan--that in some ways may resemble the deal between Merrill Lynch (nyse: MER - news
- people ) and Lone Star--is the following: Merrill sold its CDOs to Lone Star for 22 cents on the dollar. Even in that case,
Merrill remained on the hook in case the value of the assets were to fall below 22 cents, as Lone Star paid initially only
11 cents (i.e., Merrill guaranteed the Lone Star downside risk). But today, a bank like Citi has similar CDOs that, until
recently, were still sitting on its books at a deluded value of 60 cents.
Since the government knows no one in the private sector would buy those most toxic assets at 60 cents, it may have to
make a guarantee (formally or informally) to limit the downside risk to private investors from purchasing such assets. But
that guarantee would be hugely expensive if you needed to convince private folks to buy at 60 cents assets that are worth
only 20--or even 11--cents.
So the new Treasury plan would end up being again a royal rip-off of the taxpayer if the guarantee is excessive in relation
to the true value of the underlying assets. And if, instead, the guarantee is not excessive, the banks need to sell the toxic
assets at their true underlying value, implying that the emperor has no clothes.
A true valuation of the bad assets--without a huge taxpayer bailout of the shareholders and unsecured creditors of banks--implies
that banks are bankrupt and should be taken over by the government.
Thus, all the schemes that have so far been proposed to deal with the toxic assets of the banks may be a big fudge--one
that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.
So, paradoxically, nationalization may be a more market-friendly solution to a banking crisis. It creates the biggest
hit for common and preferred shareholders of clearly insolvent institutions and, most certainly, even the unsecured creditors,
in case the bank insolvency hole is too large; it also provides a fair upside to the taxpayer.
Nationalization can also resolve the problem of the government managing the bad assets: If you're selling back all the
banks' assets and deposits to new private shareholders after a clean-up, together with a partial government guarantee of the
bad assets (as was done in the resolution of the Indy Mac bank failure), you avoid having the government manage the bad assets.
Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold
back, through a reprivatization scheme, the government could outsource the job of managing these assets to private asset managers.
In this way, the government can avoid creating its own Resolution Trust Corp. bank to work out such bad assets.
Nationalization also resolves the too-big-to-fail problem of banks that are systemically important, and that thus need
to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-than-too-big-to-fail
problem, as the current approach has led weak banks to take over even weaker banks.
|
