Belligerati

« Interesting interview | Main | Deeper into the mystery of the matching covers »

January 22, 2009

How to handle bank nationalization

There are a lot of problems with bank nationalizations. As I've said before, nationalizations eliminate the price mechanism's role in evaluating bank health. On the basis of efficiency, they also make bank lending more politically driven, put bureaucrats and not risk takers and innovators in charge of the allocation of capital, and run the risk of keeping bankrupt banks alive indefinitely. From a justice perspective, they reward the banks creditors and punish the equity holders, when both should suffer. Also, like all bailouts, they take the money of people that had nothing to do with the poor behavior that led to bank insolvency and force them to invest in the operations of a firms that seem to have taken horrible and unprofitable risks. They also distort government incentives as a fair arbiter. Before they nationalized the banks (although maybe you'd have to go back to before the first round of bailouts), they were more impartial arbiters of the financial system. Creditors and equity holders would get exactly what their contracts said they deserved. But now that the government is the equity holder, can rewrite the rules, and has access to effectively unlimited lending facilities, how can we expect them to treat debtors right.

So we are in an interesting position. Equity holders get wiped out, though they probably would be anyway. Bond holders get the full faith and guarantee of the government, but once they hold the debt in the nationalized companies, they are all set to get treated like dirt. I don't really have a solution to all this. It probably would be best to provide bridge financing for an orderly liquidation of the banks that are not properly solvent. Public identification of solvent banks with loans to purchase at fair prices the best assets (brands, buildings, branches) of the insolvent banks could go a long way to insuring that most or all Americans have access to financial services provided by solvent institutions.

But nationalization may happen anyway. So are there ways that we can improve nationalization so that it isn't a huge disaster? I don't mean that salary cap nonsense or having a group of bureaucrats review every bank's investment decisions. I want ideas that could actually work. The only idea that comes to mind is converting the debts to the banks to debts with the treasury. An example would help.

The treasury announces that it is nationalizing Bank of America and all new debt (but no existing debt) from Bank of America after February 1st will be guaranteed by the treasury. Existing debt holders are in a pickle. They know they won't be treated well by the government and they may still lose their investments to default. The government exploits this, saying that anyone who wants to trade in their Bank of America (secured or unsecured) debt will receive a treasury bond of the same duration and a yield associated with that duration. Say you have a ten year Bank of America bond with a 7% coupon but trading at 90 cents on the dollar because BoA may default. The ten year treasury is yielding 2.6% and trades at par. Yes, this increases the value of bond holder holdings by 11% or so, but think about what would happen if they both nationalized the bank and guaranteed the debt. Then BoA bond holders would hold 10 year government bonds paying 7% when others were only getting 2.6% for holding the same risk. According to this bond calculator, that bond would trade at 138% of face value. So this deal would be simple to administer and in this example saves the government almost 40%. Interestingly, this is a decent example. I found a 9 year Citibank bond with a 6.125% coupon, and in that case that they got a government guarantee, that'd be worth $130.69 for every $100 invested while currently trading at $90.351 per hundred invested.

Posted by OneEyedMan at January 22, 2009 11:14 AM

Comments

Post a comment