Banking Crisis: The Rise of the "N" Word

Even taking into account Tuesday's 3%-plus rally the major stock indexes have fallen over 11% since Treasury Secretary Timothy Geithner announced to universal derision the Treasury's plan for rescuing the banking sector from collapse. That was just a little more than two weeks ago. Of course the pummeling that stocks have taken these past weeks are not a reaction just to Geithner's plan, but also to the concern--prompted by the ham-handed rollout of the plan--that the Treasury isn't quite up to the task at hand.


At the heart of Geithner's plan was a public-private "partnership" that would buy toxic bank assets and thus clean up the banks' balance sheets. This would require the banks to undergo a balance sheet "stress test," thereby exposing for all to see the sorry state of their balance sheets. According to Andy Kessler, a former hedge-fund manager and author of "How We Got Here" (Collins 2005), the stress test idea is a worthy one, but he doesn't think Geithner's plan will work. Writing in the Wall Street Journal the day after Geithner's announcement Kessler argued that "banks are more than able to sell these toxic loans today. They just don't like the price." TARP didn't work because buying toxic assets at face value is a terrible deal for the taxpayers. But selling the assets at market value (assuming this could be determined) would effectively wipe out the troubled banks' equity and make then insolvent, which is why they don't want to play along.

Kessler calls for using Geithner's stress test to determine the truly dead banks and then "nationalize" them, by which he means a temporary FDIC take-over. Presumably the idea of taking over the banks will rattle the markets, as will any "stress test" that shows that banks are in far worse shape than anyone acknowledges. But the short-term pain may be far more bearable than a continued paralysis of the credit markets.

Under Kessler's plan the government would strip the dead banks of their toxic assets and recapitalize the banks with hundreds of billions of dollars of fresh equity. The toxic assets would sit in a Treasury "holding tank" until their true value can be ascertained and realized. At the same time a new board and new management team would be put in place at the banks and billions of shares would be created and spun off to U.S. taxpayers in rough proportion to their income tax payments. Although current management would be thrown out on the streets, undoubtedly they would receive hefty lifetime sinecures as a reward for having piloted their banks onto the rocks.

The spin-off would have to occur within days of the take-over, according to Kessler, so that the banks do not become politicized. "Politics," says Kessler, "will kill a nationalized bank."


Well, duh. And there's the rub. Kessler's theory, which has appeal even to a capitalist pig like me, falls apart when it meets the reality of our political system. Does anyone think that our geniuses on Capitol Hill or at the Treasury would ever agree to inject hundreds of billions of taxpayer dollars into the capital of the banks without strings attached? And I don't just mean debt-to-equity ratios or other financial regulations, but populist measures like executive-pay caps or lending quotas to members of protected classes or what have you. The banks would become laboratories for all manner of social experimentation, and would not be an attractive investment for shareholders. Beyond that, who in this Congress would actually agree to issue new bank shares only to those Americans who actually pay income taxes?

I don't know if Mr. Kessler was the first to use the "N" word, but he surely wasn't the last. Senator Lindsey Graham, President Obama's favorite Republican, has endorsed some form of "nationalization" as has Alan Greenspan (whose name will one of these days be a synonym for something stinkier than "mud" as his role in the creation of an unsustainable credit and consumerism bubble becomes clearer). Since neither is a socialist presumably they are thinking along the lines of the Swedish model of the 1990s, not the Venezuelan model of the 2000s. Under conservative Prime Minister Carl Bildt-- with the backing of the opposition party-- Sweden undertook a speedy take-over of the banks, aggressively wrote-down the asset values and recapitalized the banks, with the shares being held by the government in trust for the taxpayers. The bad assets--real estate mostly--were sold off rather quickly and the crisis was resolved without political gain for one side or the other.

But this ain't Sweden, notes Gerald P. O'Driscoll Jr., a former banker and Dallas Fed vice president. Writing this week in The Wall Street Journal, O'Driscoll says a Swedish-style temporary nationalization may be the least costly of a lot of bad alternatives in principle, but in practice it would be a disaster. Says O'Driscoll:

From the beginning, the handling of the U.S. crisis has been politicized. The partisanship is as toxic as the bad assets on bank balance sheets. Both parties are coming up with schemes to impede the process of foreclosing on homeowners who can't afford their homes, which would get those homes into the hands of new owners who can afford them. Does anyone believe that a government bad bank will squeeze homeowners? To ask the question is to answer it.

We have a model already for what happens to government-run financial institutions--Fannie Mae and Freddie Mac. Those giant, supposedly independent institutions became vehicles for patronage and crony capitalism on a scale yet to be uncovered. But worse even than the huge
bonuses and the shady accounting practices benefiting the well-connected executives at Fannie and Freddie was the politicization of their lending guidleines for FHA/FHLM loans which encouraged banks to lend to non-creditworthy borrowers for a decade. Fannie and Freeddie were part of the problem, not the solution.

Rather than nationalization or further bailouts, O'Driscoll calls for a lessening of government involvement in the banking sector. Part of what led to this mess is the implicit "public-private" partnership that Geithner has called for. "Deposit insurance, access to the Fed's lending, and the implicit (now explicit) government guarantee for banks 'too big to fail' all constituted a system of financial corporatism. It must be ended not extended," says O'Driscoll.

Fat chance. Based on President Obama's speech to a joint session of Congress last night, one thing is certain: the banking industry will not escape the government's tight embrace. Obama and the Democrats are committed to sinking their hooks ever deeper into the financial sec(not to mention, inter alia, the automobile, energy and health care sectors). Just yesterday in order to try to calm the markets Secretary Geithner pooh-pooed the talk of bank nationalization. But whatever form this intervention takes--more bailouts, equity and debt purchases or some form of nationalization--you can be sure that the banks will become political playthings.

Politics may not will kill the banks as Mr. Kessler fears. But based on the results of the government's current forays into the mortgage and finance sectors I woudn't bet against it.