“In the end, either banks will have to be nationalized or have their bad loans split off into another institution."

From the NY Times:

"In Europe, New Efforts to Bolster Lending

By DAVID JOLLY

PARIS — After a first round of costly bank bailouts and stimulus programs came up short, governments in Europe and the United States are moving more forcefully to assure that bailed-out banks lend more money( MORE LIKE DON'T NEED TO HOARD MONEY ) to offset the recession that has engulfed both continents.

On Monday, a day after officials of the incoming Obama administration promised to take steps to force banks to lend, Britain outlined details of a new £100 billion, or $147.5 billion, plan to limit banks’ losses from troubled assets in exchange for their pledge to increase the flow of credit.

“In return for access to any government support, there will have to be an increase in lending, and that will be legally binding,” Gordon Brown, the British prime minister, said.

As if to illustrate the depths of the problem, the Royal Bank of Scotland warned on Monday that it faced losses of up to £28 billion or $41 billion for 2008, a record for any British company. The bank’s already depressed shares fell nearly 67 percent, touching off a rout in European financial stocks that could extend to United States markets when they reopen on Tuesday.

The second round of efforts in Britain and Europe to jump-start lending comes as the region girds for a more painful recession than expected. The European Commission warned on Monday that the 27-nation European Union faced a “deep and protracted recession” that would shrink the economy by 1.8 percent in 2009 and cut 3.5 million jobs across the bloc.

Adding to the sense of urgency, Standard and Poor’s ratings agency downgraded Spain’s sovereign debt from its AAA rating. Greece’s sovereign debt was cut on Wednesday, rekindling worries about what might happen to the euro zone as a whole if a member were to default on its public debt.

The bleak prospects have prompted leaders to try other ways of urging banks to lend as it becomes more clear that the bailout measures pledged by governments at the height of the financial crisis in autumn have not flushed away the bad loans that still clog the system( THEY ARE STILL BEING CALLED ). If anything, the problems are set to worsen as the downturn accelerates( YES ).

President Nicolas Sarkozy of France is to meet on Tuesday evening with French bankers to press them to lend more money to French businesses. “The banks must understand that the times have changed,” Christine Lagarde, the finance minister, told a business daily, Les Échos, on Monday. The French plan would require banks receiving new capital injections to make “precise commitments,” including giving up bonuses this year, she said.

Late Sunday, Denmark announced an $18 billion aid plan for its banks, saying it would inject the funds on the condition that the recipients increase lending.

In Germany, Deutsche Bank’s chief executive, Josef Ackermann, who is also chairman of the Institute of International Finance, an organization of the world’s largest financial institutions, suggested last week that the creation of so-called bad banks might be the way forward( A POOR WAY, BUT IT IS A WAY. ).

In a bad-bank arrangement, governments would buy up scorched( ANOTHER NEW TERM? ) assets, said George Magnus, senior economic adviser at UBS Investment Bank in London. That contrasts with the method now being used in the United States and Britain, where troubled assets remain on the balance sheet, but losses beyond some limit are insured by the government.( COULD ALSO WORK. THE GUARANTEE IS THE IMPORTANT THING TO ENDING THE CALLING RUN. )

“There is no ‘right’ way and both schemes have their merits and drawbacks( A FAIR POINT ) under given and local circumstances,” Mr. Magnus wrote in a research note. He said the bad-bank plan might be more suited to the United States, while Britain might be able to manage with its plan for an insurance program because it has far fewer banks.

Members of the incoming Obama administration are considering proposals that include buying up bad assets, a return to the original vision of the $700 billion Troubled Asset Relief Program.

“The focus isn’t going to be on the needs of banks,” Mr. Obama’s chief economic adviser, Lawrence H. Summers, said on the CBS program “Face the Nation.” “It’s going to be on the needs of the economy for credit.”

Simon Adamson, a banking analyst at CreditSights, an independent research firm in London, said he thought that Europe was also “edging toward the creation of bad banks.”

Under Britain’s latest bank bailout, its Treasury will “protect financial institutions against exposure to exceptional future credit losses on certain portfolios of assets” in return for a fee. Participating institutions will take the initial losses, with the Treasury bearing about 90 percent of the rest( YIKES ).

Britain’s central bank could buy up to £50 billion worth of “high-quality assets” from banks, giving it more monetary policy tools after it cut its benchmark interest rate to a record of 1.5 percent this month. The government is also extending measures to increase liquidity, including a £250 billion program to let banks to issue government-backed( THE GUARANTEE IS THE IMPORTANT THING ) bonds. The latest steps would cost taxpayers an additional £100 billion on top of the £37 billion plan announced in October and a £20 billion stimulus plan announced in November.

Mr. Brown said he was angry at Royal Bank, whose losses include as much as £20 billion of good-will write-downs from the acquisition of a portion of another bank. “Almost all their losses are in the subprime markets in America and related to the acquisition of the bank ABN Amro,” he said. “And these are irresponsible( NEGLIGENT ) risks, which were taken by a bank with people’s money in the United Kingdom.”

European bank stocks fell sharply on Monday on fears that more pain, including the wiping out of some shareholders, might lie ahead( TRUE ). Last week, the Irish government nationalized the Anglo Irish Bank, rendering equity stakes worthless.

Peter Dixon, a global equities economist in London for Commerzbank, said the latest British rescue plans were “a step in the right direction.” But, he added, “In the end, either banks will have to be nationalized or have their bad loans split off into another institution. That’s the only way they will be clear( GUARANTEED. ONLY THE GOVERNMENT CAN DO THIS. ) about their capital positions( YEP ).”

Carter Dougherty contributed reporting from Frankfurt."

"Given how messy all of these alternatives are, why not simply go down the nationalization route?"

The enormously talented Felix Salmon posts:

"Why Nationalization is the Best Alternative

Kevin Drum is a bit like Joe Nocera: he's reluctant to nationalize, but he doesn't really say why.

It's wise to be wary of nationalization. It should be a last resort( FIRST ), and I've gotten a sense recently that a lot of people are talking about it awfully casually( FOR 4 MONTHS ). Still, it's true that there are some benefits to nationalization, and one of them is that it allows us to avoid the problem of valuing and buying up toxic assets from troubled banks( BINGO! ). If the government owns the whole bank, then the bad stuff can be easily hived off without any kind of valuation at all, and then left to sit for a while before it's sold off -- which is what the Swedes did.
If we have to nationalize, then we have to nationalize. But we should understand the precedents before we do, and go ahead only if we have to.

The only argument I can find in here is an argument in favor of nationalization, not against it. Why should nationalization only be a last resort?( AMEN )

Let's work from an ex hypothesi assumption that a certain bank -- let's call it Citigroup -- is insolvent. This is not an unreasonable assumption, given what happened to the likes of Lehman Brothers and Washington Mutual. But I don't want to get into the details of Citi's balance sheet here: I want to ask what we should do if we've already determined that its assets, many of which fall into the "toxic" category, are significantly smaller than its liabilities.

Now the red-blooded American way of dealing with insolvent companies is bankruptcy: either Chapter 11, where the company continues as a going concern, or some kind of liquidation. For a bank, Chapter 11 is pretty much impossible, since you're not going to find anybody to provide debtor-in-possession financing to keep it going. Except the government. And if the government is in possession, then, hey, you've just nationalized the bank.( TRUE )

As for liquidation, that's not an option, because Citigroup is too big to fail. Dumping Citi's trillions of dollars of assets onto the market in a fire sale would depress asset prices worldwide so much that we'd enter a global depression, not just one in the US. ( TRUE. THE CALLING RUN WOULD PICK UP SPEED. )

So what about the bad-bank option? The government buys Citi's toxic assets, taking them off Citi's balance sheet, and leaving behind a healthy bank. Sounds good -- except remember that, ex hypothesi, Citi is insolvent. If the government buys the toxic assets for what they're worth, then that doesn't help, since the amount of money that Citi gets in return isn't enough to pay off the loans that Citi essentially took out against those assets. In housing parlance, Citi's underwater on its recourse loan, and when you're underwater on a recourse loan, selling the house at its market price doesn't make you any less insolvent.

So maybe the government deliberately overpays for the toxic waste( WHICH IS WHAT WILL HAPPEN )? That's a recipe for opacity, and it's very hard to systematize. If you're willing to pay 150% of market prices for Citi's bad assets, shouldn't you do that for everybody else's, too? Even perfectly healthy banks which don't need the money? Or do you just decide that Citi, because it's too big to fail, is going to get a big handout which no one else qualifies for? If you do make that determination, why not just go the whole hog and write a check to the bank outright, and put it straight into Tier 1 equity? Oh, wait, you can't do that, because that's called buying equity, and if you spent that much money on Citi's equity, you'd end up with a majority stake in the bank -- which is nationalization. ( TRUE )

Essentially, any government purchase of toxic assets can be split into two components: the market price, and a subsidy. If the subsidy is greater than half the market capitalization of the bank, and the government doesn't end up controlling the bank, then there's something very fishy going on indeed.( TRUE )

It's worth bearing in mind here the first TARP proposal, which envisaged the government buying up bad assets at some kind of long-term value price which was greater than the distressed market price. That never happened, the bad assets stayed on the banks' balance sheets -- and then, in the fourth quarter, we saw some absolutely monster write-downs from those loans' end-September marks, including $15 billion at Merrill Lynch alone. You still think that the end-September marks were distressed bargain-basement prices?( THAT'S BEEN MY POINT )

Then there's the insurance proposal -- which is cropping up now in the UK after being rolled out in an ad hoc fashion with Citi and BofA here in the US. Robert Peston explains how it works:

Our biggest banks would identify their bad loans and foolish investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets.
But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.

This has all the same problems of the create-a-bad-bank idea: the government still has to come up with a price (a/k/a expected default rate) for the bad assets, and there will still be a huge implicit subsidy, in many cases greater than the bank's market capitalization, for any institution which takes the government up on its offer. After all, the mark-to-market value of the insurer is certain to be massively negative, otherwise Warren Buffett would have set up something like this already on a for-profit basis.( TRUE )

Finally, the government could take the Irish approach, and target the banks' liabilities rather than their assets. Keep the assets on the banks' balance sheets, and simply guarantee all of their unsecured debts. After all, there's a government guarantee on a lot of the unsecured debt already, and there has been for years: it's called the FDIC deposit guarantee.( TRUE )

This is basically a massive bailout for all the banks' bondholders, who thought they were buying risky leveraged single-A bank debt, and who will suddenly find it backed by the full faith and credit of the US government. At this point, it doesn't matter if a bank is insolvent, because it can roll over its debt indefinitely, since that debt has a government guarantee. Indeed, it should be quite happy to lever up as much as it's allowed, and spend its cheap new funds on all manner of risky assets, since that gives shareholders the best chance of making lots of money and recovering some of the billions of dollars that they have lost. It's akin to taking a man with a large debt, pointing him in the direction of a casino, and telling him he has unlimited credit to try and pay that debt off.( YIKES )

The best way for the government to avoid the obvious outcome in such a situation is for the government to take over and run the bank: nationalization. Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well -- i.e., ownership.( TRUE )

Given how messy all of these alternatives are, why not simply go down the nationalization route? It's transparent and easy to understand( I'VE SAID THIS FROM THE BEGINNING. ): if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too.

So I'm interested in what Kevin means when he talks about a situation where "we have to nationalize". Does he mean any situation where a too-big-to-fail bank is insolvent? Or are there further criteria he has in mind?"

Well played! However, I believe that Drum will go for nationlization.

How The Plan Could Work

Here are two quotes from William Gross about how this plan could work out:

"Mr. Gross is also skeptical of proposals to have the Treasury take ownership stakes in banks that sell troubled assets to the government.

Buying a pool of subprime mortgages is not like buying part of a company, he said. The Treasury would own something — the mortgages themselves, which, if it pays the right amount for those loans, could earn it a yearly return of 12 to 13 percent when they are resolved.

“All the capital gains will accrue to the Treasury,” he said. “There’s tons of equity here. It’s just that it’s very difficult for American taxpayers to understand.”

The key, of course, is price, which is where an adviser to the Treasury would come in. Mr. Gross says much of the opposition to the plan stems from a misunderstanding that the Treasury would buy troubled mortgage bonds at face value.

On the contrary, Mr. Gross said, he would advise the Treasury to pay closer to 60 or 65 cents on the dollar for the mortgage bonds.

“If the price is right, the Treasury’s going to make money,” Mr. Gross said. “They made money on Chrysler. They can make money on this,” he said, referring to the federal bailout of the carmaker in 1979 and 1980."

And another:

"And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that."

My problem is that I cannot assess the likelihood of this plan working. Now, someone could certainly point out that it isn't important what I think, but what William Gross thinks, and that's a fair point. But as a citizen, I do feel called upon to judge these proposals for myself, and this one seems to be assuming that everything goes right. It seems risky to me.