Monday, March 9, 2009

What Does Nationalizing the Banks Mean?

Here's Chuck Schumer and Lindsey Graham on Meet the Press talking about possibly nationalizing insolvent banks.

Schumer does a good job explaining the differences between what he calls "good" and "bad" nationalization. Good nationalization is essentially FDIC receivership on steroids - the government seizes the bank, separates good and bad assets, sells the good parts back to private investors quickly, and holds the bad assets to sell back over a longer time frame. This is more or less what the government did during the S&L crisis. Bad nationalization means the government permanently running the banks, with political connections determining who does and does not get loans. It is crony capitalism. Think Mexico in the 1980s.

Schumer did neglect one key, though technical, question: what to do with unsecured bondholders? Within any corporation, the capital structure flows up from common stock to preferred stock to unsecured debt to senior debt. If the government puts a bank into receivership, the common stock is automatically wiped out (not that the markets haven't more or less done that to troubled banks already). But who else should take a loss? Simon Johnson has argued that CDS spreads on financials peaked last week in response to the government converting its Citigroup preferred stock to common. Johnson speculates that the markets have interpreted this action as the harbinger of a move up the food chain to eventually include unsecured debt. If there were debt-for-equity swaps, or even outright haircuts, there could be a run on unsecured bank debt. This is the nightmare scenario Bill Gross of PIMCO describes. While Gross obviously is obviously not impartial on this issue, his point is valid. While forcing bondholders to share some of these losses with taxpayers certainly makes the package cheaper, it must be done transparently and simultaneously so that there is not a generalized panic.

Still, even without addressing these thornier issues, it's certainly encouraging to see a bipartisan consensus emerging around temporary nationalization (or receivership or pre-privatization if the N-word is still too taboo). Of course, the administration is still dragging its feet on a banking fix, preferring instead to put lipstick on a pig, and trot out TARP 2.0. But the fact that Wall Street's senator himself admits that putting failed banks into receivership might be our best option should prod Geithner and Summers to reconsider their non-plan plan.

Update: E.J. Dionne and Paul Krugman both summon the appropriate level of concern over the Obama administration's timidity in dealing with the economic crisis.

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