"Nationalization Again
Responding to my earlier post on the insurmountable obstacles to nationalization, one of the bloggers at The Economist's Free Exchange writes:
But developing a resolution regime for too-big-to-fail banks will be a very long, multi-year process, and it may not ever produce a mechanism that allows a Citi or a JPMorgan to fail without bringing the entire financial system down with it. The Bankruptcy Code and the FDIC's resolution regime didn't just magically appear and gain the trust of the financial markets. They developed over decades, slowly winning the trust of the financial markets as gaps in their procedures were fixed, and bankruptcy courts and the FDIC proved themselves to be compentent authorities who would apply their respective rules in a consistent and fair-minded manner.
Even with the FDIC's resolution procedure as a blueprint, there's no way a workable resolution regime for too-big-to-fail financial institutions could possibly be developed before this recession is over (or at least before financial markets, which always lead the real economy, start to recover). It's just not possible. Developing this kind of resolution regime is an enormously complex undertaking.
Remember, a quirk in the way a single clause in the initial merger agreement between Bear Stearns and JPMorgan was drafted caused havoc in the financial markets for a week. The initial merger agreement provided that JPMorgan would guarantee all of Bear's trades until either (a) the deal closed, or (b) the merger agreement was terminated, whichever occurred earlier. But the way the guarantee was drafted, if Bear's shareholders voted down the deal, the merger agreement technically wouldn't terminate for another 12 months, during which time JPMorgan would still be guaranteeing all of Bear's trades. Essentially, the agreement gave Bear a one-year option to use JPMorgan's balance sheet, regardless of whether Bear's shareholders approved the deal.
Does anyone think the government could develop a resolution regime for major financial institutions relatively quickly without making this kind of minor but extremely consequential mistake? The consequences of even legal uncertainty could throw the financial markets into chaos, because the specific treatment of an institution's assets and debts in the event of insolvency significantly influences pricing in the market.
Treasury would have to specify how the new resolution regime would interact with hundreds (if not thousands) of state and federal laws, as well as hundreds of bilateral and multilateral treaties. Major financial institutions—Citi, BofA, JPMorgan, Wells Fargo, Goldman, and Morgan Stanley—are involved in so many different markets around the globe, and have so many counterparties with such diverse businesses, that successfully winding down any one of them would require clear rules on each and every counterparty's rights under all possible contingencies, the likely timing of each stage of the resolution process, etc., etc. Eventually, all these details will get worked out, and over time the market may come to trust the resolution regime.
In this financial crisis, however, nationalization is off the table. It's literally not possible, no matter how many commentators stomp their feet and demand that the government nationalize. The sooner people realize this, the better off we'll all be.
Given the fragility of the current global economy and the real economy impact of financial market spasms (remember, remember that week last September), it's difficult to imagine the Obama administration contemplating nationalisation in the absence of a very clear, legally sound, internationally accepted procedure for taking control of the banks.I certainly didn't mean to suggest that nationalization is forever off the table. At some point in the future, I suspect we'll have a formal resolution regime specifically for bank holding companies—especially now that Treasury is asking for the authority to develop such a regime.
Economics of Contempt says that this means nationalisation is therefore now and forever off the table. I disagree. The American government has created mechanisms for taking control of financial institutions before, and it can do it again.
But developing a resolution regime for too-big-to-fail banks will be a very long, multi-year process, and it may not ever produce a mechanism that allows a Citi or a JPMorgan to fail without bringing the entire financial system down with it. The Bankruptcy Code and the FDIC's resolution regime didn't just magically appear and gain the trust of the financial markets. They developed over decades, slowly winning the trust of the financial markets as gaps in their procedures were fixed, and bankruptcy courts and the FDIC proved themselves to be compentent authorities who would apply their respective rules in a consistent and fair-minded manner.
Even with the FDIC's resolution procedure as a blueprint, there's no way a workable resolution regime for too-big-to-fail financial institutions could possibly be developed before this recession is over (or at least before financial markets, which always lead the real economy, start to recover). It's just not possible. Developing this kind of resolution regime is an enormously complex undertaking.
Remember, a quirk in the way a single clause in the initial merger agreement between Bear Stearns and JPMorgan was drafted caused havoc in the financial markets for a week. The initial merger agreement provided that JPMorgan would guarantee all of Bear's trades until either (a) the deal closed, or (b) the merger agreement was terminated, whichever occurred earlier. But the way the guarantee was drafted, if Bear's shareholders voted down the deal, the merger agreement technically wouldn't terminate for another 12 months, during which time JPMorgan would still be guaranteeing all of Bear's trades. Essentially, the agreement gave Bear a one-year option to use JPMorgan's balance sheet, regardless of whether Bear's shareholders approved the deal.
Does anyone think the government could develop a resolution regime for major financial institutions relatively quickly without making this kind of minor but extremely consequential mistake? The consequences of even legal uncertainty could throw the financial markets into chaos, because the specific treatment of an institution's assets and debts in the event of insolvency significantly influences pricing in the market.
Treasury would have to specify how the new resolution regime would interact with hundreds (if not thousands) of state and federal laws, as well as hundreds of bilateral and multilateral treaties. Major financial institutions—Citi, BofA, JPMorgan, Wells Fargo, Goldman, and Morgan Stanley—are involved in so many different markets around the globe, and have so many counterparties with such diverse businesses, that successfully winding down any one of them would require clear rules on each and every counterparty's rights under all possible contingencies, the likely timing of each stage of the resolution process, etc., etc. Eventually, all these details will get worked out, and over time the market may come to trust the resolution regime.
In this financial crisis, however, nationalization is off the table. It's literally not possible, no matter how many commentators stomp their feet and demand that the government nationalize. The sooner people realize this, the better off we'll all be.
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I'm not sure what facts you're referring to, since I didn't mention Krugman at all in this post.
If you were referring to Krugman's attack on securitization, the "facts" would have to have changed since February, when Krugman was all for the TALF. In any event, nothing about the securitization market has changed in the past year, so that's not a credible defense for Krugman.
March 27, 2009 7:04 PM
George,
In theory, it's possible to argue that nationalization is the best solution. But in practice, there's a 100% chance that, even if we had a legal mechanism for winding down major banks, nationalization would still be a disaster. The complexities are too great, the opportunities for mistakes too numerous, and the stakes too high for anyone to seriously believe that the government could pull the whole process off without causing substantial collateral damage.
I don't think nationalization is the "only viable recovery plan." Pro-nationalizers generally argue that nationalization is the best solution, but not the only solution. And it's true that, if we assume a well-developed and credible resolution regime for major banks and perfect execution by the government, nationalization would probably be the quickest and least expensive solution. But that's not the world we live in. Not even close. So the relative attractiveness of nationalization falls way, way below other solutions, like the Geithner plan (i.e., toxic asset purchases + government recapitalizations). The Geithner plan, while not as good as a theoretical perfect nationalization, is nonetheless a "viable recovery plan," and quite possibly the most viable recovery plan.
Also, the analogy between emerging market banking crises and the current banking crisis in the US doesn't really withstand scrutiny. The emerging market banks that the IMF has dealt with are nothing at all like a Citi or a BofA, in terms of sheer size, complexity, role in the international financial system, etc. When an emerging market government nationalizes one of its banks, it knows that there are bigger financial institutions who can either buy the bank from the government once it's cleaned up, or provide financing for other other buyers like private equity firms.
If the government nationalizes Citi, there's no one who will be able to buy it back once the government has cleaned up Citi's balance sheet. Citi has about $2 trillion of assets; the size of the entire hedge fund industry is only about $1.3 trillion. Even if the government breaks Citi up into smaller pieces, there's no way private buyers would be able to get the financing required to pay remotely reasonable prices for the pieces of Citi. Who would provide the financing? The other major banks who would then undoubtedly be terrified of being nationalized themselves?
With no buyers, the government would either be stuck operating Citi for several years, or taking a huge loss for the taxpayers on the re-sale. It took 7 years for the FDIC to sell off Continental Illinois, and that was during a boom market. If the government nationlized Citi, there's a decent chance it could end up operating Citi for something like 10 years. And it's difficult to imagine that 10 years of government control -- no matter how "independent" -- would do much to strengthen Citi.
So while there's precedent for successfully nationalizing much smaller and much simpler banks, there's absolutely no precedent for nationalizing a bank anywhere near the size of Citi or BofA.
March 27, 2009 7:56 PM
"Even if the government breaks Citi up into smaller pieces, there's no way private buyers would be able to get the financing required to pay remotely reasonable prices for the pieces of Citi."
You've convinced me, but that leaves us with the ugly question that I posed earlier: Can Citi get itself out of this mess?
Take Banamex: It could be sold for $10 - $12 Billion, I've read. When you add up the other holdings, they don't seem to amount to much. Now, going forward, they might be worth more. But don't forget, Citi is having to finance keeping them for now. If you sell these assets now, Inca Kola points out that they disappear into a black hole of debt.
I'm simply wondering if people accept that Citi has a viable plan to get out of this, without much more financing from the government, to the point where we own the vast majority of their stock. I don't know the answer to this, but that's my worry. I'm simply advocating that, if Citi couldn't pull itself out of this, it might be cheaper and cleaner for the US to seize it and run it. I suppose that one option would be to simply own it and put in our own managers.
Don the libertarian Democrat
March 28, 2009 11:48 AM