How to Keep the Banking System in the Private Sector

Tim Geitner said today, in response to questions about the prospect of bank nationalization, that the Treasury is considering a range of options with the intent of preserving the private banking system. “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 told reporters.

Well, it all depends on what “private” means. The fact that the Treasury has not sought voting rights or outright control over day-to-day operations doesn’t mean the banks are still “private.” Nor does it mean that much remains of the former “system” to be preserved. The Treasury now owns preferred shares and warrants of many of the banks that have received bailout money. These can be converted into common stock and cashed out whenever the government wants. Technically, the Treasury has a controlling interest in many of these banks if it wanted to exercise that interest. As to many other banks, the Treasury could easily gain a controlling interest; their remaining common shares are worth so little now that Treasury could buy just buy them up. In addition, the Treasury, as well as the Fed, is monitoring these banks carefully, and the banks are highly sensitive to what Treasury and Fed officials want from them.

But “nationalization” is a dirty word in America. More to the point, it’s far from clear that federal officials would have any better idea how to manage day-to-day operations than the current managers — although it’s hard to imagine how they could be managed any worse than they’ve been managed.

Yet the real issue here isn’t about day-to-day operations. It’s about something much larger. Put simply, the big banks are going under. No one wants to say this out loud for fear of causing even more panic, but the fact is that many of these banks are insolvent. Their assets are worth far less than their face value because so many borrowers can’t — or won’t be able to — repay the loans.

Six months ago it may have made sense for the government to buy up so-called “toxic assets,” based on home mortgages that should never have been issued. Three months ago it may have made sense to establish a “bad bank” to store them in, until they could be resold.

But as the Mini Depression worsens, “toxic assets” are no longer all that distinct from a vast and growing sea of non-performing or endangered loans on the banks’ balance sheets. Toxicity has spread to loans made to people and companies that were good credit risks as recently as early last year but are now bad risks. You don’t have to be an honest financier (no oxymoron intended) to figure this out: Ten percent of Americans are behind on paying their mortgages. Millions more are behind on paying their credit-card bills. Hundreds of thousands of small businesses are behind on paying their own bills. Auto suppliers are can’t pay their bills. And so it goes.

A “bad bank” collecting all these non-performing or in-danger-of-becoming non performing loans might well become larger than the rest of the banking system — nationalization through the back door of lemon socialism, where the government (and taxpayers) own and control this vast sea of junky loans.

Geitner et al have to think bigger, and examine history.

Back in the banking crisis of 1907, J.P. Morgan got all the major bankers into one room and forced a kind of reorganization on all of them. We need the same today — a giant reorganization of the banks, in which their shareholders lose what little value they have left, their creditors get paid 20 cents or so on the dollar, and their assets are written down to about 20 percent of their face value. In effect, it’s an industry-wide reorganization under bankruptcy. This way, bank balance sheets are cleared up, there’s no run on any one bank, everyone starts anew, and taxpayers aren’t left holding the bag.

To the extent Geitner is serious about preserving a truly private financial system, this kind of broad-based reorganization of the entire sector in the shadow of bankrutpcy, seems to me to be the best alternative at this point.

Originally published at Robert Reich’s Blog and reproduced here with the author’s permission.

2 Responses to "How to Keep the Banking System in the Private Sector"

  1. Guest   January 29, 2009 at 8:37 pm

    You are speaking truth once again. You see the big picture, which is sometimes hard to decipher reading all the separate analyses. I hope THEY’RE listening!

  2. Anonymous   January 30, 2009 at 6:32 am

    Mr Reich –Allowing a Citi or JPM to default on its preferreds is one thing; allowing it to default on the $2 trillion of debt obglitations, and the TENS of trillions of derivative credit exposure, is wholly another.That would be Lehman on steroids, would shatter the entire world’s financial system, and guarantee that we have a Greater Depression. You cannot seriously advocate this.