Monday, January 19, 2009 5 comments ++[ CLICK TO COMMENT ]++

The end of modern private least in the Western world

ContrarianDutch, a reader of this blog, is concerned about the "'nationalise the banks' meme that is gaing ground." Unfortunately, that is exactly what is happening and I don't see any other alternative. Royal Bank of Scotland is indicating that it will post the largest loss in British history, amounting to US$41.3 billion. A lot of that seems to be a non-cash loss due to the ABN Amro acquistion but it still means that the book value just collapsed. What other option is available, other than the nationalization of such a bank?

This is pretty much the end of modern private banking in most of the western world. It's definitely the case in America, Britain, and Ireland, but may end up being the case in countries such as Spain as well. (It's likely that the banks in China are insolvent as well, but they are already majority-owned by the government.)

This is a terrible thing for the free market but, unfortunately, contrary to the blame being placed on regulators, the so-called free market supporters brought this upon themselves. Excessive de-regulation and extreme greed has literally brought down the whole banking system. It was not too long ago when Alan Greenspan was supporting the unregulated shadown banking system and the massive build-up in derivatives*. We also had executives like Henry Paulson, when he was the CEO of Goldman Sachs, calling for regulations to be slashed. Influential bankers such as Robert Rubin, a big influence on the Democratic Party thinking, were patting themselves on the back while overseeing Citigroup entangle itself with death. Perhaps the most greedy of all were the shareholders, who kept pushing executives to take risks and convert the traditional banks to a hedge-fund-like model.

The fact of the matter is that if the banks have worthless assets, there is no other hope other than nationalization. Or else, let the bank collapse, a la Lehman Brothers, and face all sorts of side-effects. Paul Krugman has an article talking about how there is really no way around nationalization (he has a blog entry on this as well.) The alternatives such as the 'aggregator bank' idea is nothing more than an attempt to transfer wealth to the banks from taxpayers. Unlee the government wants to become a hedge fund, there is no way it can price the toxic assets better than the market. I am of the opinion that many assets are likely undervalued due to irrational selling but that doesn't mean that I believe the government can price things properly on a grand scale.

I don't like the nationalization of many of these banks but if taxpayers are footing these massive bills, it is proper for the government to take ownership. The consequences of this are not going to be pretty.

Since the government is quite inefficient, banking is going to be less efficient in the future. Innovation will decline (some may argue that's a good thing for the time being.) The hundread-million paycheck for executives are also probably a thing of the past. You are unlikely to see someone like John Thain being paid $83 million in 2007 for simply switching jobs while the company implodes. So it's going to suck for the workers but many of them were overpaid for doing nothing more than gambling.

An unfortunate side-effect of the nationalization is that it will kill off private competitors. Government may end up monopolizing the banking system even if it doesn't intend to. For instance, government banks may provider cheaper loans (mortgages, corporate loans, etc) while providing a greater implied guarantee. Will you deposit your money with a private bank with question marks around it (say JP Morgan with its massive derivatives exposure) or will you be happier depositing your money with a government bank, knowing that if the bank collapses the whole country goes down with it?

ContrarianDutch also raised an important question about an exit strategy. Well, I think the current nationalization strategy is not without precedent. I'm not an expert but I believe the US government nationalized a whole bunch of banks in the 1930's and then sold them off later, when the banks were capitalized properly and the economic conditions improved. A somewhat similar thing was done in the 80's with the Resolution Trust Corporation. However, do note that the details are different in these cases (e.g. RFC dealt with banks that were already insolvent whereas most of the current intervention is before the banks are declared insolvent.) I suspect a similar thing may happen. Governments may own the banks for 5 or 10 years and then sell them off.

This goes without saying, and the market already knows it, but it's prudent for investors to avoid investing in these banks unless you are a distress investor. Shareholders will likely end up with very little and these banks cannot be treated as if they were a "normal bank."

(*I actually support Greenspan's views to some degree. I am fine with the lack of regulation in the shadow banking system. I also do not think that derivatives, which are contracts anyone can make up on anything, can ever be regulated. Since derivatives are a zero-sum game, the overall damage will be minimal--although this doesn't preclude collateral damage. However, unlike Greenspan, Bernanke, Paulson, Geithner, Bush, and other influential parties who set policy, I am strongly in favour of detaching the commerical banks from the shadow banking system. Conventional banks should not fund the shadow bank entities and anyone else speculating in the derivatives arena. These banks should also be prevented from excessive use of off-balance-sheet vehicles, which masks the true risk and hides speculative bets from regulators and public investors. Half the problem is the lack of transparency and hence trust. For instance, I don't follow banking and am not an expert, but as a casual observer, I have no idea if JP Morgan is insolvent or not, since they have huge exposure to derivatives and questionable parties such as hedge funds. I'll bet that the regulators have no idea of the true state of JP Morgan either. The free market is confident in JP Morgan, as evidenced by the strong share price action, but I personally am unsure. Shadow banking entities should be funded by alternate, niche, banks. Similarly, alternative high-risk banks focused on derivatives should play in the derivatives arena. But bankers, shareholders, and government officials are unlikely to separate any of this. There is just too much money to be made with high-risk derivatives or various other new inventions that pop up every decade.)


5 Response to The end of modern private least in the Western world

January 19, 2009 at 4:08 PM

The major preliminary question here is if the banks are in fact insolvent under a reasonable valuation of their assets. On a "mark to market" the banks arguably are insolvent. But then, on a mark to market basis pretty much everybody is insolvent because attempting to liquidate every asset on God's green earth in the mother of all firesales will utterly destroy asset prices. Yet the mark to market zealots will hear of no other method of valuation. Still, is that enough to justify a massive expropriation?

On a cash flow basis the banks, even the rather awful ones such as Citi or RBS, are almost certainly solvent. John Hempton at Bronte Capital has more on this.

The problem is that nobody is completely sure about this so the banks cannot borrow without assistance. They thus have a liquidity problem. Unfortunately liquidity problems can kill a bank right quick (the reason I don't like them as investments at the moment).

If you nationalise outright you have to seize the assets of the shareholders. These assets might have a relatively low market value at the moment but it still amounts to many billions of dollars for the world's banks together. Moreover, shareholders lose the option value inherent in the possibility of benefitting from recovery and the value inherent in their control rights.

If you seize these rights without compensation you would be trampling all over the most ancient and sacred rights known in Western Civilization. Here in Europe you would be breaking Treaty obligations as well. If property rights are no longer secure the economy cannot funtion and we will have gotten ourselves a truly massive mess.

If you seize and pay compensation you get yourselves in he pickle of having to value the banks. Good luck on getting agreement on that...

The answer that the banks are worthless anyway, at least without government support, so there is nothing to be compensated is far too easy. Shareholders will certainly not see it that way (neither does the market) and the precedent that the goverment can declare assets to be worthless and then seize without compensation is still horrible in its consequences.

I disagree that shareholders as a group "deserve it" because they caused the current mess. Most shareholders are quite passive, arguably too much so, and they can at most be blamed for not intervening when ill-conceived incentive structures encouraged management to take big risks for short term pay-offs. Still, should shareholders (who include your pension fund by the way) be punished exclusively for this?

Lack of confidence is a big part of the current problem. Governments going out grabbing assets will make that problem infinitely worse.

Another issue is that nationalisation will consolidate the massive liabilities of the banks onto the government balance sheet. FT Alphaville noted that for the UK this would balloon government debt to over 360% of GDP. Not exactly confidence inspiring...

There is also the problem of the banks ceasing to be commercial organisations and becoming extensions of the political/state apparatus. Here in the Netherlands the now partly government owned banks have suddenly started to refuse banking services to organisations deemed insufficiently friendly to the government.

The experience with state banks is also that they are systemaically abused as slush funds for the politically connected. If you are concerned about the cost to taxpayers you should want the government to have as little say in the running of the banks as is practicable given it's status as a major shareholder. The unholy mess of politicized lending will make the current credit crash look like a picknick.

Last but not least. I really don't see how governments will be able to sell the banks in a few years after they have established the principle that they can seize them at any time. Who would be crazy enough to buy? And gettng stuck with centrally planned banking is not good at all given experiences with government attempts at running almost any industry...

The government (taxpayers) should get something back for it's support and the current approach of buying preferred/common stock and granting guarantees on debt for a fee seems to do that just fine without expropriating shareholders. Nationalisation in my opinion is unnecessary and will create a ton of additional problems that we do not need.

Or do you still favour it, and if so why?

January 19, 2009 at 8:21 PM

You make a valid claim about the possible bank nationalization. As an example, Infosys in India has more deposits with nationalized banks than private banks which in hindsight was a good decision...

January 20, 2009 at 8:18 PM


I share a similar sentiment on several issues that you raise. But, I just don't see how the government can do much without nationalizing the companies. Don't forget that the market cap of these companies have fallen so much, including a massive plunge across the sector today, that anything the government does will essentially amount of majority ownership. If the government injects as little as $20 billion, some of these firms will end up being owned by the government. Technically it depends on the nature of the government injection, and if you kept it strictly non-common shares, it may avoid the ownership question but that would cause all sorts of conflict of interest (e.g. failed banks will keep increasing their risk on the hope of hitting a home run, if you will.)

"The major preliminary question here is if the banks are in fact insolvent under a reasonable valuation of their assets. On a "mark to market" the banks arguably are insolvent."

Well, I've been critical of mark-to-market accounting. In the 90's, the US govt allowed the banks, many of which were insolvent on a mark-to-market basis but we didn't have the same accounting and regulatory standards, to earn their back to solvency. Unfortunately, I think that is out of the question the way the accounting regime, as well as the regulators have been behaving. I think the seizure of Fannie and Freddie without any deep justification sealed that.

"If you nationalise outright you have to seize the assets of the shareholders. These assets might have a relatively low market value at the moment but it still amounts to many billions of dollars for the world's banks together. Moreover, shareholders lose the option value inherent in the possibility of benefitting from recovery and the value inherent in their control rights. "

I don't think that's a strong argument BUT I am assuming that it occurs with shareholder consent. As long as the govt pays market prices or better (many deals have been on easy terms,) it's hard to argue that the govt is stealing the company. No one is forcing the shareholders to sell their shares; but obviously if they didn't get the govt help, the company may be bankrupt.

"Last but not least. I really don't see how governments will be able to sell the banks in a few years after they have established the principle that they can seize them at any time. Who would be crazy enough to buy? "

I don't think it'll be difficult to sell at the right price. Quite a few oil&gas companies were nationalized in the 70's and then investors happily snapped up their shares in the 90's.

Make not mistake: I'm not arguing that nationalization is good. I actually think it's very bad. However, the current situation doesn't present many other choices. The market of these companies have fallen so much that anything that the government does results in literally owning the company.

Regardless of what happens, I think we can both agree that this is turning into a disaster of epic proportions. I mean, even Wells Fargo, backed by Warren Buffett of all people, is collapsing. Down 25%+ in two days.

January 21, 2009 at 3:03 PM

Instead of nationalizing outright letting the current program of capital injections and loan guarantees work out is a definite option. Despite claims to the opposite, these programs have come a very long way in steadying the credit markets. That is what they were meant to do and it is exactly what they are achieving. Solving the bigger economic mess is a different matter, but nationalization will not help.

I also think the most recent round of steep falls in bank share prices has everything to do with fear of the government. All that nationalisation talk is making people nervous...

January 22, 2009 at 10:39 AM

The problem with the status quo is that banks are requiring greater and greater capital injections. To make matters worse, while the government keeps pumping billions into these banks, the banks are unwilling to increase lending. This obviously makes sense because the banks are de-leveraging but it is not politically acceptable.

The core reason for considering nationalization is because the reported losses are growing. We even have one of Berkshire Holdings, USB bank, which is not thought to be exposed to big losses, reporting large losses and seeing its shares being sold off. Bank of America, through its Merrill Lynch holding, obviously reported a large loss.

If you continue the status quo, you will "save" some banks but it will be at the expense of taxpayers. Even these "saved" banks are likely to resemble the zombie banks of Japan.

I agree wtih your view that the nationalization concern is an additional reason shares are being sold off. However, there is also the deteriorating fundamentals with banks reporting higher losses (the losses at BAC and RBS are big surprises.)

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