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February 18, 2009

Comments

That's "ad nauseam," in the parlance of our times. (The only reason I noticed that spelling error is that I formerly spelled it incorrectly that way constantly.

Oh, and )

Thanks. Appreciate the correction.

All Hail Marx and Lennon!


Whether we call the flower in question "pre-privatization," "temporary receivership" or good old-fashioned "nationalization," the endemic aroma remains sage. It is unfortunate that such semantic subterfuge is necessary

Minor nitpick: isn't this haggling over nomenclature rather than semantics?

It seems to me that the semantics here are relatively stable and what we are searching for is a politically acceptable terminology with which to label them and sell them to the public. The semantics are: the banks need to go thru a restructuring process very much like bankruptcy, to reduce their ratio of liabilities to assets down to a sustainable level.

The "national" part of nationalization comes into play not because long term public ownership of the banks is being sought by anyone influential, but rather because the US Federal Govt. is just about the only entity that is potentially (i.e. once we make up our minds to act) large enough and powerful enough to force the banks and their largest creditors (i.e. bondholders and other at-risk counterparties) to do this whether they wish to or not. This is a reflection of the painful reality that they are more powerful than every other private actor, and almost all other sovereign nations. Like Roy Scheider in Jaws, we need a bigger boat, and the US Govt. is the biggest one we can get.

The other reason this is a national issue is that the major creditors of these banks include foreign central banks and sovereign wealth funds, so there are geopolitical factors involved here. IIRC there is speculation (I think I read this on Setser’s blog within the last month) that the interests of the PBoC (who were heavily investing in Agencies) may have been a key factor in influencing Paulson’s decision to nationalize the GSE's last fall, so as to avoid converting a financial crisis into what diplomats call "an international incident". The issue we now face with the banks is going to be like that, only much larger.

Damn you TLTABQ!!!!

You're right. You know, I didn't like my choice of words but couldn't figure out why. I'm going to fix that. Thanks.

And ral: You win a T-shirt...

TLTIA,

I unfortunately recall what happened to the boat in your example. Who gets to play Roy Scheider?

Obama drives the boat Fraudy!

Okay, then, worse yet, who's Robert Shaw (Quint)?

Quint is the next Republican who tries, unsuccessfully, to jump the shark.

That's kind of difficult because Republicans are really adept at jumping the shark...

So TARP tranche II is the air canister?

Then my vote for Quint is Geithner, and Krugman as Hooper, the marine biologist.


Okay, then, worse yet, who's Robert Shaw (Quint)?

That would be US taxpayers, if Timmy and Larry don't come up with a better plan than what we've heard about thus far.

I'm not altogether pessimistic, as I think the the O. admin economic team shows signs of working towards a better plan (both technically and politically,) and Obama is at least aware of comparisons with Japan and Sweden*.

Also, if you haven't been reading the macro-econ blog posts by ndk (who often comments at Yves's N.C.), this would be a good place to start.


*I'm going to print for myself a bumper sticker that says:


I want a Swedish Model!

[below, in fine print]
of banking reform.
(what, were you thinking of something else?)

Quint is the next Republican who tries, unsuccessfully, to jump the shark.

I can't top this. dmbeaster wins the thread (IMHO).

The Swedish model won't work, TLTIA, and it's not necessary. There's no need to nationalize solvent banks. And allowing the government to participate in the upside is only going to increase the price of the assets its acquires to the point that it becomes prohibitively expensive. (The degree of this expense, which results from the size and diversity of the US banking community and economy, is something that Sweden lacked.)

The risk of having upside participation make any Swedish-style plan prohibitively expensive in the US is a particular concern. The primary cause of insolvency is not that banks hold valueless assets. Well, that's part of it ... but not the only part or the most important part. The most important cause of insolvency is that the banks have assets that are potentially quite valuable, but which are very illiquid in the current market. Many banks have the mother of all cash-flow problems and balance sheets that can't be reconciled because there's no market for the assets. But home prices are going to some day stabilize and rebound, assets are going to be valued, and banks will eventually be healthy again.

A forced receivorship -- which is, really, what we're talking about here when we talk about "nationalization" off the Swedish model -- might work. I'm certainly willing to consider it. The main risks in a forced nationalization is that it renders equity positions valueless and guarantees debtholders by putting the government on the hook. The former is already being factored into the market to and extent .... and the latter is pretty much already here through government guarantees.

So: Nationalization, receivorship, etc. ... consider it. But, whatever you call it, don't do what the Swedes did. What worked in Sweden won't work here. And don't think that there is only one kind of "nationalization." Just like stimulus, there are infinite varieties. Which one you pick is important.

There's no need to nationalize solvent banks.

Huh? Has anyone, anywhere actually suggested this?

The primary cause of insolvency is not that banks hold valueless assets. Well, that's part of it ... but not the only part or the most important part. The most important cause of insolvency is that the banks have assets that are potentially quite valuable, but which are very illiquid in the current market.

So the banks ARE insolvent? But not?

And you don't think we should do what the FDIC is already doing? Why? Why should the big banks get preferential treatment with taxpayers providing the backstop to ensure the investments of shareholders that voluntarily took the risk - unlike said taxpayers?

Many banks have the mother of all cash-flow problems and balance sheets that can't be reconciled because there's no market for the assets. But home prices are going to some day stabilize and rebound, assets are going to be valued, and banks will eventually be healthy again.

No -- the illiquidity aspect of the problem (while it exists) it not nearly as dramatic as the vaporization of over $1 trillion in actual value in the toxic assets (and today I read an article pegging it at over $2 trillion, with half of it being suffered overseas). In ten years, home prices will probably recover to what they were at peak bubble (that is, I think, about how long it took after the '91 debacle), but that does not make these toxic asset regain their full value. Part of what you are missing in your analysis is the interest component. If it takes ten years to regain the prinicipal value of something, you have lost ten years of interest on it, it is therefore currently worth around 50% of face value even if in ten years it will recover its full value.

Also, a lot of the toxic asssets are worth essentially nothing. A sliced mortgage pool in which the derivative represents the highest rate of return but is last in place to be paid from the pool (a common type of derivative, I am told) is basically wiped out by a 20% decline in values and the dramatic increase in foreclosure rates. Also, so much of the derivative market served as devices to highly leverage the bet on the underlying mortgage pool. A 20% correction in values therefore has the effect of entirely wiping out the value of huge swaths of these leveraged securities. It is no different than the effect of a 20% drop in stock prices, which can be borne readily by someone who has no margin, but who is 100% wiped out if the margin was 80% of the stock price (I know, not what happens anymore in stock due to margin limitations, but it was the underlying reality for the Great Depression, and is the underlying reality for the unregulated derivatives market today).

We are faced with a massive loss of capital by the banks, who are insolvent without regard to the additional problem of liquidity concerning these problem assets. Put another way, the illiquidity is a direct result of uncertainty as to exactly how bad these assets are and the full extent of the loss -- it is a side effect and not the cause of the banking problem.

The main risks in a forced nationalization is that it renders equity positions valueless and guarantees debtholders by putting the government on the hook.

"Nationalization" in some form will occur because the equity positions are already valueless -- it does not cause it. And it is absolutely not correct to assert that the governemnt goes on the hook for the debt. Debtors recover only to the extent that there are assets remaining to cover their debt position.

None of this is new -- we have been "nationalizing" banks for years with the FDIC, and did it with Continental Illinois in the 80s. It was done successfully with WAMU recently -- shareholders got wiped out and bondholders are not going to get much since the values in excess of liabilities had dropped to almost nothing. The only real difference now is the unprecendented dimension of the problem, which could result in an FDIC-type take over of probably more than half of the industry.

allowing the government to participate in the upside is only going to increase the price of the assets its acquires to the point that it becomes prohibitively expensive.

Not so, in the Swedish model "The key was that the banks were forced to write down their assets in one shot and then to sell them to the bad banks at realistic prices." (link)

A forced receivorship -- which is, really, what we're talking about here when we talk about "nationalization" off the Swedish model -- might work.

What forced receivorship in Sweden? Only two banks were nationalized. Some opted out of the government deal and arranged a recapitalization on their own.

So: Nationalization, receivorship, etc. ... consider it. But, whatever you call it, don't do what the Swedes did. What worked in Sweden won't work here.

Didn't you just say it might work?

Have you ever noticed that in time of crisis Obama is really good at standing around doing nothing until things align just right?

The primary cause of insolvency is not that banks hold valueless assets. Well, that's part of it ... but not the only part or the most important part. The most important cause of insolvency is that the banks have assets that are potentially quite valuable, but which are very illiquid in the current market.

von,

This is basically correct but not a very good argument against the Swedish model. The latter was successful in part because once they acquired control of the bad assets the Swedish govt. had a more credible capacity to hold onto them pending a market recovery (or to threaten to do so rather than accept fire sale pricing from potential buyers) than did the private banks whose more profitable operations were being impeded. See http://www.eurointelligence.com/article.581+M5b55b38d58a.0.html for an insider’s account of what this was like (and note that the deprecatory title of the article is directed at the "bad bank" plan which appears to have been shot down here in the US, at least for now).

In other words when there is a very serious divergence between mark to market and yield to maturity prices, you want to get the most illiquid assets into the hands of the entity with the greatest access to liquidity over the term of those assets, in order to minimize sale of those assets into a deflationary market.

This was the intent of the original Paulson TARP proposal, but it had the grave defect of needing to pay mark to model (or something close to that) prices for the bad assets - otherwise the plan would not have provided any recapitalization to the banks. This gave all the downside to the Treasury and none of the upside, in the event of an upswing in the housing market. A Swedish plan would not do this

[continued]

A big part of the reason why I think we need something like a Swedish plan is that solvency crisis has morphed into a transparency crisis as well. Nobody really knows just how bad things really are on the balance sheets of the (fomer) investment banks because they effectively closed their books last fall when the liquidity crisis hit and haven't opened them since. If we are lucky then Geithner's "stress test" will pry loose enough data to permit intelligent decision making, but I'm highly skeptical this will be enough, given the short time frame and the paucity of personnel involved.

I don't think we are going to get enough information to restructure these banks without removing current management and wiping out stockholder equity. Only then will those entrenched interests no longer stand in the way of a sufficiently thorough accounting necessary to determine how to proceed. So long as current management and equity hold out some hope of riding out the storm, they will have a built in incentive to conceal, withhold and distort as much of their most damaging information as they can get away with from anyone outside the firm (including the govt.) who is trying to judge the state of their balance sheets. The logic of triage dictates this – during a triage process you don’t want to be identified as one of the goners. For this reason the banks have to be nationalized first before a triage can proceed on an unbiased basis, rather than yield a large survival advantage to whichever firms are best at sanitizing their books so regulators don’t find all the dirt.

Incidentally, I strongly recommend this analysis of the complex solvency issues at play. It is not nearly so simple as solvent? or insolvent?

In particular, note that in the section "Solvency against definition 2: do the banks have positive net worth under GAAP?" (which IMHO is the most important solvency metric of the set), he makes a very important observation that individual banks may be (probably are) insolvent while the system as a whole is not, and that exposure to trading desk risk is a prime factor in distinguishing the walking dead from the merely wounded.

this is the eurointelligence link which for some reason I had trouble posting a moment ago.

Huh? Has anyone, anywhere actually suggested this?

Well, the Swedish model, as applied in Sweden, was to nationalize all the banks.

So the banks ARE insolvent? But not?

Insolvency is sometimes a difficult concept to grasp. Typically, insolvency merely means that one has a negative net worth, i.e., current liabilities exceed current assets. Insolvency is very different from cash flow or expected value. A firm can be insolvent but still continuing operating because it has a good cash flow to service its debt and a positive expected value to make the debt worth servicing.

(Econ nerds: I use the term "expected value" and certain other terms somewhat nontraditionally here, but the meanings are essentially correct.)

A bank with a bunch of bad mortgages has a grim looking mortgage sheet and no cash flow. It's insolvent, illiquid, and can't service its debt. But that doesn't mean that the bank's assets have the same, low expected value. Each one of those bad mortgages represents, after foreclosure, a real asset that does have value and that can, one day, be collected upon.

That's one significant reason why folks talk about the government sharing in the "upside" from rescuing the banks. The banks' expected value exceeds -- usually far exceeds -- their current value (where current value reflects ability to operate and book value).

Broadly stated, if the government shares in the upside, a la Sweden, it will purchase the banks' assets based on their expected rather than current value. That will radically increase the cost of "nationaliation" - to the point of making it prohibitively expensive.

This is one reason, I suspect, why many in the Obama Administration are pouring cold water on a Swedish-style rescue. That doesn't mean that they won't do something that every can (and might) call nationalization. It just means that the nationalization will almost certainly be substantially different from the Swedish nationaliation. It will look a lot more like a reorganization.

My comment regarding forced nationalization of all Swedish banks is incorrect, and based on a misunderstanding on my part in quickly reviewing a background summary. The Swedish government did support and involve itself in all the banks by guaranteeing creditors, but it didn't nationalize all of the banks. So your first criticism was quite apt, Eric.

TLTIA, I don't disagree with a lot of what you write. I'm arguing, however, against an upside-sharing plan, which will increase the cost of any reorganization.

Insolvency is sometimes a difficult concept to grasp. Typically, insolvency merely means that one has a negative net worth, i.e., current liabilities exceed current assets. Insolvency is very different from cash flow or expected value

Insolvency has many meanings, it's best to specify the one you mean when you use the term. From Wikipedia's entry on insolvency:

A business may be cash flow insolvent but balance sheet solvent if it holds illiquid assets, particularly against short term debt. Conversely, a business can have negative net assets showing on their balance sheet but still be cash flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default – for instance, if it holds long term debt.

I just read an econ blog the other day talking about 5 different definitions of the term and complaining about people not defining the one they are using but I can't find the link now. It's probably particularly important in an international discussion since the term is used in different ways in different countries.

A big part of the reason why I think we need something like a Swedish plan is that solvency crisis has morphed into a transparency crisis as well.

I think it's the other way around: the lack of transparency was what allowed the solvency crisis to come about. We've been in a transparency crisis for almost a decade; we're only reaping the "rewards" now.

*notes von's apparent certainty that Swedish plan won't work*

*notes von's subsequent concession that he had a crucial detail of Swedish plan wrong "based on a misunderstanding on my part in quickly reviewing a background summary" -- a detail that played an important part in his initial argument*

*wonders about contrast between confident dismissal of others' views and slight evidentiary basis*

*is puzzled*

hil: if you start from the following basic two assumptions -- (a) Von believes that the administration is following the wrong course; and (b) Von hasn't done his due diligence -- then things mostly become clearer.

frex, this: I'm arguing, however, against an upside-sharing plan, which will increase the cost of any reorganization. is precisely backwards. The greater the equity stake that the taxpayer takes, the lower the cost to the taxpayer. The reason not to have the taxpayers share in the upside has nothing to do with the long-term cost. Instead, the real reason is that as a matter of policy the US government, Democratic or Republican, is reluctant to nationalize.

Ah, hilzoy, you're just biased because it's the "Swedish" plan.

I'm at least 25% biased myself ;)


I just read an econ blog the other day talking about 5 different definitions of the term and complaining about people not defining the one they are using but I can't find the link now.

Too bad that nobody thought to post a link to that blog in this very same thread. Especially not at at 731pm on Feb 18th

[evil grin]

Here it is again, only more obviously this time:

Bronte Capital: Bank solvency and the Geithner Plan

Hilzoy -

notes von's apparent certainty that Swedish plan won't work*

*notes von's subsequent concession that he had a crucial detail of Swedish plan wrong "based on a misunderstanding on my part in quickly reviewing a background summary" -- a detail that played an important part in his initial argument*

*wonders about contrast between confident dismissal of others' views and slight evidentiary basis*

*is puzzled*

To clarify: Whether or not Sweden nationalized all or some of Sweden's banks or only some of the banks isn't relevant to the objection that "allowing the government to participate in the upside is only going to increase the price of the assets its acquires to the point that it becomes prohibitively expensive." (From my first post.) My mistake isn't relevant to my primary objection.

Now, if my pricing model is wrong, or if Sweden didn't actually share in the upside, those are relevant to my primiary objection.

It's fair for you to be confused, however, because I did mention two discrete objections to the Swedish model. The second objection was that Sweden nationalized even solvent banks. SFAI(N)K, it didn't. Sweden did provide guarantees to the entire banking sector, which is something I also wouldn't recommend for the US, but that's a far cry from nationalization.

So, yup, I made an error that resulted in a gross exageration on my part. My bad. But that error isn't relevant to my primary objection -- that adopting a Swedish-style plan will be prohibitively expensively for the valuation reasons I note -- and it doesn't mean that the "unexaggerated version" of what Sweden did for all its banks isn't still a problem as applied in the US.

Insolvency has many meanings, it's best to specify the one you mean when you use the term. From Wikipedia's entry on insolvency:

I agree with you Now_what, but (1) I was trying to avoid confusion by introducing , (2) the typical meaning of insolvency is as I describe, and (3) insolvency is still a difficult concept to grasp in whatever flavor you present. (I did expressly note, by the bye, that I was using certain terms somewhat nontraditionally in hope that my nontraditional usage would be clearer to a lay audience.)

By the bye, just to make clear that we're all on the same page: my objection is not that the Swedish model "won't work" anywhere. The Swedish model worked by all accounts in Sweden. My objection is that the Swedish model shouldn't be blindly imported into the United States.

But, look, I'm kinda with Eric on this one. If we need (what I would call) a "reorganization," I really don't care if you want to call it "the Swedish model" so long as it differs from the actual model used in Sweden in certain key respects. You can call it Triumpth Of Krugman for all I care -- just get the substance right.

The first sentence of my response to Now_what should read "I agree with you, Now_what, but (1) I was trying to avoid confusion by introducing different kinds of insolvency, ...."

"allowing the government to participate in the upside is only going to increase the price of the assets its acquires to the point that it becomes prohibitively expensive."

von,

I'm confused as to how to interpret what you are saying here. From my reading, the term "upside" refers to acquistion by somebody of an asset at a discounted price, which is likely to increase in value thereby giving them the chance to sell it later at a profit. That is the "up" in "upside" - the asset price is expected to go up, not down.

I don't get how the way you are using the term "upside" relates to a Swedish plan as I understand the term, which would involve the following steps:

1 - Identify which banks are insolvent (see the Bronte Capital link above for a discussion of the details of how to do this).

2 - Nationalize the insolvent ones only.

3 - Break the insolvent nationalized banks up into smaller organizational units and triage those into healthy units and unhealthy units.

4 - Reprivatize the healthy units more or less immediately.

5 - For the unhealthy units, evaluate if they are terminal cases or merely suffering from short term problems (e.g. liquidity). Liquidate the former and recapitalize the latter using govt. money.

6 - If the recapitalized units show themselves to be healthy again then after some period of time reprivatize them, otherwise liquidate them.

Note that the equity shareholders of insolvent banks are not compensated in step 2. Aside from money due to depositors and operating expenses (salaries, etc.) the primary cost to the govt. in this process is the recapitalization of unhealthy units in step 5. The creditors of the liquidated subunits in step 5 are to be made as whole as possible from the liquidation sale of the assets held by that unit in the case of bondholders, but not by govt. money.

What issues do you have with this sort of process?

Von,

What I don't understand is something that Atrios mentioned today.

We are already "nationalizing" banks on a near-daily basis. The FDIC is eating up insolvent banks left and right. So my question is: Why not simply apply FDIC procedures to the bigger banks.

The most logical answer is that those bigger banks have political clout. But is there a good-faith argument as to why some banks should be treated differently under established FDIC rules?

For some reason my response to TLTIA doesn't seem to be posting. Try #2:

As I understood it, Sweden guaranteed all creditors to all 114 of its banks. Thus, I don't understand your comment "The creditors of the liquidated subunits in step 5 are to be made as whole as possible from the liquidation sale of the assets held by that unit in the case of bondholders, but not by govt. money."

Indeed, that's one of the significant bases for my objection to repeating an exact facsimile of the Swedish model in the US. The government put itself directly on the hook to creditors, which means that taxpayers were on the hook to creditors.

Eric, see my comment to TLTIA, above. The FDIC becomes a receiver, not a guarantor. That's the 64 dollar (plus) difference.


Why not simply apply FDIC procedures to the bigger banks.


The government put itself directly on the hook to creditors, which means that taxpayers were on the hook to creditors.

Hopefully this comment will answer both Eric and von's questions/comments above.

A very crucial distinction has to be made between different groups of creditors, which is based on what sort of bank was involved and/or what kind of transaction was involved when they gave money to that bank.

Most of the firms in big trouble right now originated as investment banks, not commercial banks, although under the pressure of events last fall they reorganized to become bank holding companies, which makes them quasi-commercial banks now, while finessing the issue that they were probably not in compliance with regulatory capital requirements for normal commercial banks at the time they reorganized (this was done with the connivance of the govt., in a wink-wink-nudge-nudge-Say-No-MORE! fashion)

Prior to the deregulation of the FIRE sector (of which the 1999 repeal of Glass-Steagall was only a small part) these two different kinds of banks were distinct. Since then more complex hybrid firms (like Citi) have come about which manage both deposits and brokerage accounts and also sell commercial paper, all under the same roof (as well as operating trading desks, and all sorts of other investment bank-ey kinds of things). In the latter case not all creditors of the same firm are treated equally.

FDIC protection covers depository accounts only. Bondholders - folks like PIMCO (and you and me via 401ks) who purchased paper issued by the banks have no such protection. Thus not all bank creditors are equal.

If the govt nationalizes one of these banks, nothing changes in terms of obligations to FDIC insured deposits, while obligations to bondholders will be driven by reputational hazard, not legal obligations. The possibility of default is a risk assumed (and presumably understood) by bondholders at the time they purchased those securities (hence the credit default swaps market), so the govt. is not legally obligated to pay out 100 percent on those bonds. How much to pay out on those bonds is a fiscal and political decision, not a legal one, and it is likely that the best course of action for the Treasury and the taxpayers will be to pay out most but not all of the value of those bonds. The amount by which bondholders are shorted is what people are talking about when they use the term "haircut".

I think in a prior comment thread on this subject J.Michael Neal pointed out that a reasonable baseline to start from in calculating this haircut would be to pay out these bonds so their effective yield is reduced to the same level as Treasuries of equivalent term. IMHO that should be the minimum haircut, probably it should be a bit deeper than that.

Thanks.

The possibility of default is a risk assumed (and presumably understood) by bondholders at the time they purchased those securities (hence the credit default swaps market), so the govt. is not legally obligated to pay out 100 percent on those bonds.

Unless the government has made, or makes itself, legally responsible to pay those bonds .... as occurred (as I understand it) in Sweden and which is already occurring to a certain extent here (to maintain the price of credit).

What you describe answers one of the objections I raise on this thread and may be a reasonable solution, but it is not the Swedish solution (at least how that solution had been reported). And it's a mistake to try to equate anything currently under discussion with FDIC (as I understand that Atrios may have).

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