Tuesday, February 10, 2009 0 comments ++[ CLICK TO COMMENT ]++

Martin Wolf's thoughts on bank nationalization

I came across Yahoo! Finance TechTicker's excellent interview Martin Wolf of the Financial Times (thanks to Naked Capitalism for originally linking to it.) You can access part 1 here and part 2 here. I say this is an excellent interview because it covers some of the core problems facing us today. There is this huge battle in the background over the state of American banking and what to do about the lack of trust. The situation is very bad in the banking sector and I was intially wrong about the core problem.

I had thought last year or two ago that we were facing a liquidity crisis. Unfortunately, I was wrong and it is actually an insolvency crisis. I made a mistake and paid a huge price. If I felt it was an insolvency crisis, I never would have invested in Ambac or even considered investing in other financial institutions. About an year ago, I wasn't very sure that there were some megabanks that were insolvent or would end up being insolvent. Right now, I am pretty certain that several key banks are insolvent. I'm just an amateur and never worked in banking but I get my feeling from the fact that the reported losses are unbelievably large and there may be more to come.

So, early this year I started favouring nationalization of banks. Governments have been throwing tens to hundreads of billions and nationalization seems inevitable. You can only prop up a $20 billion bank by injecting several times its market cap for so long. The market and everyone else would quickly come to the decision that, either the government is giving away money for free (hard to justify this in a democratic country) or that the bank is insolvent and needs to be restructured.

So far the Obama administration, as well as the Bush administration before, have avoided nationalization of the megabanks. America is very capitalistic and nationalization would be a hard sell while Republicans control the Senate. In the 80's, from what I understand, America has nationalized banks (or at least taken them over) after they went bankrupt. Unfortunately, presently, we need to nationalize the banks, after they are shown to be insolvent but, before they go bankrupt. This is needed to avoid systematic explosion. I think nationalization is inevitable given how the losses are staggering and there seems to be clear indication of gross incompetence by management and employees of these firms--there is no other way to describe a $200 billion company run down to nothing and clinging for life.

I don't think nationalization will occur any time soon. It is difficult for the government to pursue that right now. This is one reason I believe the US Treasury Secretary and central bank have come up with band-aid solutions, sometimes seemingly unrelated to the core problem. However, if the situation deteriorates I think it will hit a crisis point at which the US government will get enough support to nationalize the insolvent banks. I think you should not be surprised to see the Obama adminstration nationalize the banks. I'm not saying it will happen for sure but it is one of the scenarios.

Now we come to the Martin Wolf videos, linked above. I think he does an excellent job describing how such a nationalization should be done and what the repercussions will be. One the first point, he says it must be all-encompassing, quick, and powerful (those are my words but that's his point.) If you pursue the nationalization path, you must absolutely make sure that the market has faith in the remaining solvent banks.

On the second point, Martin Wolf is very clear to describe some of the massive repercussions. The bond market will almost certainly lock up again (somewhat like post-Lehman but not as badly.) This is something that I casually mentioned a few days ago when I said that the bond market may lock up in the future. This will happen because, as Wolf alludes to, bond investors who financed the banks to undertake all these risky ventures never expected to take losses. If the bond investors there was risk, they never would have let some of these banks lever up so much. The bond market doesn't let 30-year-old, world class, industrials lever up very much and they clearly wouldn't let financial companies do that. So when the bond investors do take losses, credit may tighten.

As Martin Wolf points out--a point raised by John Hussman in the past--someone has to take the losses. Given how the equityholders of the insolvent banks have almost been completely wiped out, the next ones in line are the bond investors. But the bond market will not take it kindly. It has been financing these banks as if default was a remote possibility, for a very long time. Change is painful.

If the credit markets lock up again, I think it's a good opportunity to consider investing in bonds. We may face a situation similar to late last year, when bond yields skyrocketed.

Until the bank insolvency questions, and in the future insurance company insolvency, are dealt with a scepter will haunt the capital markets of the world...

(On top of the banking problems, we have a slowing economy and collapsing world trade but those are totally different issues. Problems like the trade imbalance or the overcapacity in Chinese manufacturing, are independent of this financial crisis and we would have faced the end of those at some point anyway.)


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