Reprivatization After Paulson

The worst possible way to nationalize would be to assume responsibility for the liabilities of banks, at the same time as not putting in place adequate oversight and failing to ensure that the taxpayer gets any upside.  Even worse, we could install managers with a proven track record of incompetence.  Anyone who proposed such a scheme today – as we collectively kick the tires of plausible alternative approaches – would be dismissed as an ridiculous crank.

Yet it is exactly this kind of nationalization that we – or, more specifically, Hank Paulson – already did.

It is true that there has been no change of control and bank shareholders have done remarkably well under the circumstances.  And it is also true that the amount of new capital, from the original TARP funds, is relatively small for most banks (Citi and Bank of America are exceptions).  But, make no mistake about it, the Federal Reserve and the Treasury – acting on behalf of taxapayers – saved the banking system in late September/early October 2008 through making available large and extraordinary lines of credit, as well as key injections of capital.

Of course, this was not formal nationalization – but it placed us on the hook for most, if not all, of these banks’ liabilities.  In effect, we provided a massive cheap insurance policy to the banks, the people who run them, and their boards of directors.  Focus on these boards for a moment; they are very much part of the problem.

Corporate boards are supposed to represent shareholders, but to a large degree they do not.  Most board members are appointed by the CEO or hold their position due to the CEO’s tacit support.  The idea that these board members effectively oversee the activities of these large banks seems almost quaint.  While I am sure they are all fine, upstanding citizens, many of them seem considerably out of their depth.  Others seem too deeply intertwined with the company executives, with other boards, and with the corporate elite more broadly.  Strikingly few of them have stepped forward to take any kind of responsibility.

Fannie Mae and Freddie Mac were “taken over” by the government – placed into conservatorship – in summer 2008 because the Treasury determined that they did not have enough capital, so there was a risk they might need to draw on the government.  Both boards of directors were removed at the direct instigation of Secretary Paulson.  He had the legal right to do so precisely because these institutions had special access to the public purse.  Note, however, that Fannie and Freddie had not actually drawn on the Treasury at the time they were taken over.  It was the view that there was a prospect of drawing that entitled the Secretary to act.

Since then, of course, all banks have received similar access – through TARP and the Federal Reserve, to be topped up by further such support announced last week by Secretary Geithner.  Some might still argue that accessing liquidity from the Federal Reserve is not the same thing as the Fannie/Freddie arrangement, as the Fed supposedly never takes credit risk.  But this is not a widely held position, particularly after the second round bailouts of Citi and BoA.  And Secretary Geithner, following in the footsteps of Secretary Paulson, clearly indicated that the Treasury would provide risk capital in all the schemes involving the Fed, i.e., the bookkeepers may quibble about the details, but you and I will be providing extraordinary financial support to the banking system for the foreseeable future.

Why did Secretary Paulson therefore not seek the legal authority to remove or change boards of directors when a bank drew – or potentially could draw – on the government?  Presumably, he did not want to upset the banks’ executives.  Perhaps there were other reasons.

In any case, the issue today is not whether we should nationalize.  Mr Paulson effectively nationalized the liabilities of major banks without putting in place any effective supervision of banks’ operations.  This is not a winning combination.

What we really need is to reprivatize – to return the banks to real private owners, preferably with strong voices on boards, and perhaps with controlling ownership stakes.  And we must, above all, make sure those owners have the incentive to break the banks into smaller, more manageable pieces, none of which are “too big to fail.”  As part of this process, some boards of directors will either have to go or be reshaped dramatically.  And new boards can decide who should or should not run these greatly restructured banks.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.