Nationalization without Prices: A Recipe for Disaster

In all likelihood, political constraints severely limited the ambition and effectiveness of the new financial stability package. Economists need to unite behind relaxing these constraints. Talking lightly about nationalization, as is increasingly taking place, does exactly the opposite.

There are essentially two types of arguments for nationalization. One argument is simply a gut reaction that enough-is-enough and we must stop transferring resources to Wall Street’s “crooks and oligarchs.” This type of reaction only adds fuel to the fire and exacerbates self-destructive mob-mentality behavior. We need to stop this. The second argument is a more reasoned one and wonders whether it is not too late for any other solution. At current prices banks are either insolvent or will soon be, and hence the only option is a time-out in which the government takes control of some of these banks, at least temporarily.

While I sympathize with this second view on both the underlying premise that policy has been behind the curve and the call for a time-out, I disagree with its policy conclusion. This view takes for granted that nationalization would buy us the much needed time-out. I think this will do just the opposite. The risk is enormous that it may trigger fears, uncertainties, and indirect effects that would make the aftermath of the Lehman’s episode seem like the “good old times.”  (Very much as the Lehman event made the Bear Stearns one look extremely mild by comparison.) In fact, I think that even the mere discussion of this possibility is causing more wealth destruction to taxpayers than any saving that we may eventually get from stopping the “transfers” to the financial system.

There are at least two reasons why nationalization is likely to backfire: First, at this time there are no (sensible) prices for the key assets in the balance sheets of financial institutions. Uncertainty and fear have ravaged all types of explicit and implicit financial insurance markets, destroying any sensible metric for the fundamental valuation of almost every risky asset. But without these prices, any decision of who is insolvent and needs to be nationalized is arbitrary. Wherever the line is drawn, the fear of nationalization will immediately swallow the next financial institution, and then the next one, and so on. Of course, there is no problem of fear, uncertainty and contagion if the U.S. government takes over all banks, and insurance companies, and pension funds… and foreign governments do the same with their banks, and insurance companies, and so on… but this is lunacy at best, and it is one of the main reasons why the existing evidence of nationalizations in small economies is irrelevant for the case at hand.

The second and related reason, which we should have learned from the Lehman event and the near collapse of money markets that ensued, is that the interlinkages of the modern financial systems are just too complex to risk any major dilution of any stakeholder in this jittery environment. We simply do not know, at this time, the systemic impact of such an action. Moreover, this complexity interacts with uncertainty aversion, and has the potential to trigger massive flight-to-quality episodes.

But if nationalization is not an option, how do we get the much needed time-out? My preferred (part of the) solution is to provide universal insurance for the assets that are currently clogging the balance sheets of banks and other financial institutions. For now, this insurance should be provided at pre-crisis prices for the corresponding asset class (or one notch below). This arrangement should be coupled with tight monitoring of the insured institutions and with retroactive punishments a few years down the road to those institutions (and their management) whose assets underperform relative to their asset class. This retroactive punishment is needed to limit adverse selection problems, where banks insure their worst assets without declaring them as such. The great advantage of dealing with long-lived institutions holding a large number of assets is that there is no need to resolve the thorny issue of the insurance price right  now. We can wait for the passage of time to determine whether their assets were worse than the representative asset in the corresponding asset class.

Another important aspect of this insurance arrangement is that it effectively removes from these institutions much of the burden of holding aggregate risk in an extremely volatile environment. It does so forward and backward. While it is often highlighted that some of these financial institutions did play an important role in causing the crisis, it is less noticed that a significant share of the losses of the surviving financial institutions stem from poor policy responses, which have exacerbated the systemic problem. There is no reason to concentrate the cost of the policy mistakes on these institutions. Once this risk is removed from their balance sheet, the short run need for recapitalization which is behind the nationalization push is eliminated, and we can wait until normality returns for financial institutions to rebuild their capital if the need is still present.

There are related proposals which I also like, such as injecting capital now and determining the price of it in the future, again once normality returns. Although a problem of this initiative is that it still seems to leave the aggregate risk in the balance sheets of financial institutions.

Treasury Secretary Geithner’s proposal has elements of both approaches, and it is probably as much as he could get in a heavily politicized environment. Coupled with the bad bank arrangement and guarantees for private asset buyers, it resembles the insurance solution described above. This mechanism appears to be more complex to jump start than the insurance one as it depends on more private sector decisions, and it transfers much of the upside to private capital rather than to the financial institutions that have been hurt the most by the systemic crisis. It is also somewhat worrisome that this strategy will require further capital injections in the short-run, which given the current political environment may not allow the Treasury to honor its commitment to not nationalize the supported institutions. In any event, if this concern can be put to rest, the principles behind the Financial Stability Plan point in the right direction.

Of course time-outs are not very useful unless, in the meantime, we work at restoring the pieces that are needed to return to normality and to restart the key securitization markets.  From this point of view, supporting distressed homeowners and mortgages is an important step, both in alleviating households’ debt and in boosting the value and liquidity of the assets clogging the balance sheets of financial institutions.

It is true that the recent announcements are short on details, and perhaps revealed that the Treasury’s economic team overestimated people’s ability to distill the good news in an abstract message of principles when in panic mode. But there is good news in them, as they reflect a much deeper understanding of the fundamental uncertainty problem than commentators and politicians possess.  It is time for all of us to stop proposing ideas that only add fuel to the fire, and focus instead on facilitating the difficult task which lies ahead.

13 Responses to "Nationalization without Prices: A Recipe for Disaster"

  1. Guest from the Netherlands   February 17, 2009 at 12:30 pm

    I believe this is the (only sensible) way to go for. Blunt nationalization only contributes to doom, gloom and fear, whereas at the end of the day it resolves nothing. People voting in favor of nationalization have no clue about the uncontrollable dynamics it will cause. Quite unfortunately, we are facing hundreds of politicians having no clue whatsoever about what needs to be done. Furthermore, their horizon is less than 4 years (election time). They talk a lot about not willing to shuffle the financial burden to their (grand) children, whereas they don’t look any further than just a couple of years, at the most.And when we tackle the banks? We should screw all those miserable credit raters like Moody’s, S&P and Fitch. What they do now is downgrading banks for products on their balance sheets, which they gave the highest possible security grade just a few years back. Has everyone forgotten that, in the meantime? They should be sued to death, all of them.

    • Guest   February 17, 2009 at 4:45 pm

      “Furthermore, their horizon is less than 4 years (election time).”Better than quarter to quarter.

    • Anonymous   February 17, 2009 at 11:18 pm

      “Better than quarter to quarter. “bingo!

  2. ex VRWC   February 17, 2009 at 1:51 pm

    I agree that nationalization is not the answer. But neither is this proposal. Here is the telling quote. It lets the cat out of the bag, as it were:

    it is less noticed that a significant share of the losses of the surviving financial institutions stem from poor policy responses, which have exacerbated the systemic problem. There is no reason to concentrate the cost of the policy mistakes on these institutions.

    Please. Lets blame the governments because they ‘mismanaged’ the crisis? Why should the poor banks be on the hook for all of their toxic assets run up in their pursuit of huge bonuses and double digit growth when the good times were rolling? Let me guess, you think the biggest problem was letting Lehman fail? After all, Lehman should have been bailed out, then we wouldn’t have this ‘systemic’ problem that has brought the banks to the point of collapse. Never mind all of the bad behavior that brought them to the point of failure in the first place.You advocate insurance, bought at unrealistic (ie, pre crisis) rates. Who, pray tell, will write this insurance? Oh, I know, the government! Lets have the government insure trillions of toxic assets, like they insure our FDIC deposits, and annuities, and pension funds, and their own treasuries, and our Medicare, and our Social Security, and our union jobs, and, well, everything. Lets have the government insure everything. Thats it! All consequences of bad and risky behavior should be insured by the government.There is only one problem. When I die, my debts die with me. But when I die, my government’s debts fall to my children, and their children, etc. Sorry, I am willing to saddle my children with the bad debts of those who should have known better.

    • btd   February 20, 2009 at 7:18 am

      i could not agree with you more. are people so ignorant that they think the government has an endless money supply. Wait they do, its called taxes! What are these same people going to say when they are paying over 50% taxes? Hey you want it, you got…..or better yet, you want, then you PAY for it! Another issue which is bigger then any of these debates are about government power. So they insurance and gaurantee everything, and people think they will no do this for a cost, wake up!! Stop wanting the government to take care of it, because when they do, don’t be surprised if they want to take care of more, and more, and more!!!! You can’t have your cake and eat it to people, don’t be ignorant and think you can ask the government to rescue everyone with insurance gaurantees and bailout and not expect more control!!!!!!!!!!!

  3. Mandarin   February 17, 2009 at 1:53 pm

    Heh heh what well-endowed private entity wouldn’t love Uncle Sam to limit its risk by statute or appraisal? There’s only one, teency-weency fly in the ointment: the amount of junk and risk most likely exceeds the government’s full faith and credit and when push comes to shove, such a guarantee is worthless. And happily for we observers of the macroeconomy, the proof of this assertion is coming thick and fast every day. No friends, we won’t have to wait long for the market’s verdict on the solvency of the state. The trick will simply be, surviving it.

  4. MichaelLittlebig   February 17, 2009 at 4:23 pm

    Let the market decide-no more bailouts. If you as a banker can’t compete in the economy then you are out of business. The Banking system gave us a global crisis with their business plan based on greed and cheating people out of money. Why should anyone with common sense want to keep supporting those banking charlatans will trillions of dollars?Remember,It is almost impossible to fight a lie,but it absolutely impossible to hide the truth.The Banks lied,and everyone found out. We do not need people who cheat people runinng banks.

  5. interested reader   February 17, 2009 at 5:12 pm

    Subsidizing and insuring pre-crisis prices… these toxic assets mature in 5-10 years on average, so you are basically advocating a lost decade just for the sake of avoiding a takeover and a writedown as was already done during S&L in this very country. Was there a run on each and every bank or just on those with similar exposures (in this case the top 4 to 6 banks?)Moreover: the market value of these assets is that price at which you find a private investor wanting to buy it without government subsidy. If you think the intrinsic value of an asset is much higher than that price, then you should buy it.

  6. DocBerg   February 17, 2009 at 5:47 pm

    Instead of nationalization of insolvent banks, why not just run them through bankruptcy. Getting courts and lawyers involved would certainly buy a considerable amount of time for the mess to be sorted out. I would also expect that it would be cheaper for the already challenged taxpayers than merely bailing out our “too big to fail” Wall Street bankers. The banks essentially rewrote the federal bankruptcy statutes a while back, so I can see no reason not to hoist them on their own petard. Bankruptcy is what the markets and governments have evolved to handle just these sorts of circumstances.

  7. Aristophanes   February 17, 2009 at 10:31 pm

    I have zero confidence in the current management of the big 3 US banks. They must go and fresh faces with more responsibility and less sense of entitlement need to to be found to step up and correct the internal workings of these failed institutions. There is no confidence in keeping the same, incompetents around. The private reward and socialized risk as proposed in this solution is the biggest confidence sucking, capital draining impediment to baking sector operations and relations with the public and the investing public.I would also argue that “normalization” is a moving target now. It can take years to reach.

  8. DJC   February 18, 2009 at 8:48 am

    The Treasury’s newest Financial Stability Plan (Bailout 2.0) is only the first step. It aims at putting in place enough new bank-lending capacity to start inflating prices on credit all over again. But a new bubble can’t be started from today’s asset-price levels. How can the $10 to $20 trillion capital-gain run-up of the Greenspan years been repeated in an economy that is “all loaned up”?One thing Wall Street knows is that in order to make money, asset bubble prices need to rise again.So here’s the situation. The first objective is to preserve the wealth of the creditor class – Wall Street, the banks and the other financial vehicles that enrich the wealthiest 1% and, to be fair within America’s emerging new financial oligarchy.

  9. Guest   February 20, 2009 at 8:15 am

    Which is the price-tag of a universal insurance for the assets that are currently clogging the balance sheets of banks and other financial institutions?

  10. Marc   February 21, 2009 at 6:43 am

    I thing this man is comming from the same group of incompetent people that cause this mess. I agree that the public sector will not take over bad institutions, BUT i dont agree that the goverment need to garanty the tixic loans at pre-crisis prices. This is crazy!! Why should the taxpayesr support the assets prices of some wall streets charlatans? NO, the prices had to come down to market-based price. I.e. in many cases to 10% or less og the nominal value. This is the rigth thing to do! let the market priced those “assets” !!