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Sunday, March 15, 2009

Nationalization for Beginners

Baseline Scenarios offers a good summary of various schemes of bank nationalization:

"Nationalization" has been the word of the last month, with support not only from the usual suspects, but from Lindsey Graham, Alan Greenspan, and (to some degree, although they won't say the word) Richard Shelby and John McCain. However, different people ascribe different meanings to this word; in particular, opponents like to define nationalization as the government taking over every bank permanently and turning banking into a government service.

As I see it, there are at least five different meanings of nationalization.

1. Owning more than 50% of the bank, by which people typically mean owning more than 50% of the common equity

This is a red herring, despite Treasury's complicated efforts to keep its ownership stake in Citigroup below 50%. One entity can have effective control over another with less than 50% of its equity - through stock with special voting rights, or simply by being the largest shareholder. Conversely, one entity can own over 50% of another's equity, yet not have any control, perhaps because it holds non-voting stock, or perhaps because it simply chooses not to exercise control.

2. Consolidating the bank onto the government balance sheet

Above 80% ownership, things do get serious: at that point, the bank becomes part of the government balance sheet (unless there is some special treatment for the U.S. government that I'm not aware of). This means, among other things, that the bank's debt becomes U.S. government debt, which increases the potential liability of the taxpayer. This is why, for example, all of Iceland's banks defaulted on their debt just before being taken over by the state; otherwise Iceland's citizens would have become responsible for their debts. This is also why it is unlikely to happen here.

3. Turning the bank into a government agency

In this scenario, banking becomes a government service, like getting a driver's license or going to the unemployment office. Banking decisions - how much to pay depositors, who gets credit, on what terms, etc. - become the province of government bureaucrats. This would most likely be a bad idea, because these decisions - which, collectively, shape the flow of capital through the economy - are best entrusted to the free market. This is why no one is seriously considering this option here. However, when people argue against nationalization, this is often the straw man they are aiming at.

4. FDIC-style conservatorship

This is what the FDIC does when a bank it insures fails. FDIC bank supervisors determine that the bank's assets are worth less than its liabilities. The bank itself is shut down and its assets are transferred to a new entity controlled by the FDIC. The FDIC attempts to maximize the value of these assets, typically by selling them to another bank or banks. From the customers' standpoint, little changes during this period: the branches, ATM machines, web site, and so on remain in operation during the transition, except that customer may not be able to withdraw amounts above the insurance limits. If the proceeds do not cover the bank's liabilities, the creditors lose out, but the FDIC makes sure that all the insured deposits are paid back. Note that going into conservatorship does not mean that the bank is consolidated onto the government balance sheet; the liabilities are not automatically guaranteed.

#4 is what most proponents of nationalization mean.

Those are four different versions of what it might mean to nationalize a bank. In addition, there is another type of nationalization that must be discussed and that, in fact, has largely occurred:

5. System-level nationalization

Banking in the United States, as in all advanced economies, has always been a public-private partnership rather than an unregulated free market. Banks play a critical role in the economy and therefore enjoy certain protections - such as FDIC insurance - and certain constraints - such as regulation. If the government had failed to act as the financial crisis unfolded, things would probably have gotten much worse, very quickly: not only Lehman Brothers but also Bear Stearns, Fannie Mae, Freddie Mac, AIG, Morgan Stanley, Citigroup, and probably Bank of America would have collapsed, causing trillions of dollars of losses for creditors and counterparties and bringing down other banks in sequence.

Instead, the government, primarily through the Federal Reserve, stepped into the breach. The government is the only source of capital for the banking system; it guarantees a large proportion of bank liabilities, including virtually all deposits and new bank debt; it implicitly guarantees all large banks under the Too Big To Fail doctrine; it ensures the liquidity that keeps the system afloat, both by providing cheap money and by lending against illiquid assets; and it has stepped up buying of various securities on secondary markets in order to encourage lending. In short, the government is where the money comes from, and the government decides on a high level where it goes, through capital injections, loans, and securities purchases. And the government bears the vast majority of the risk.

The net result is we have a semi-nationalized banking system largely made up of some very sick but private banks. As Thomas Hoenig put it:

We understandably would prefer not to "nationalize" these businesses, but in reacting as we are, we nevertheless are drifting into a situation where institutions are being nationalized piecemeal with no resolution of the crisis.

I am all in favor of debating to resolve the crisis. And I think that nationalization should be on the table, rather than being written off as some fundamental denial of the laws of physics.