What are banks doing to stay independent?

Are we still planning to nationalize the banks?

When Congress first approved TARP, Treasury was slated to buy mortgage-backed securities from the banks.  The government ultimately deemed it impossible to assess securities’ values.  Instead, Treasury used TARP to inject free cash flow into banks by purchasing convertible bank shares — effectively bank stock options.

As banks’ losses mount and real estate prices continue to drop the banks have been unable to push these deadweight securities from their balance sheets.  Banks have accepted government cash but have not been able to match that influx with equity.  This prolonged series of red balance sheets is the source of all the sturm and drang about nationalization.

But what are banks doing to protect themselves?

Just last week unnamed Obama officials told the New York Times that the three big American banks are converting government-owned stock from preferred to common.  Ostensibly this move protects public resources (tax bucks Big G is using to snatch up bank shares in the first place) by paying less per share but continuing to “bail out” the banks stuck absorbing our securities failure.

Remember though that nationalization isn’t about ownership; it’s about control.  When government dollars go to preferred stock, banks monitor what Big G owns and how many dollars are going to and from this significant stockholder.  When Big G pulls out of preferred and keeps instead to common, the banks are less attentive to exactly how much the gov’t owns.

More insidiously, when gov’t dollars go to common stock instead of preferred, it’s not like the gov’t pulled out some of its cash to match the lower equity it was purchasing.  Instead, the same number of G dollars are still flowing to the banks, but holding many more shares.

See Krugman’s post, taking all of this at face value:

What, after all, is the purpose of bank capital? It’s to protect the bank’s creditors: equity holders are first in line for any losses, so that creditors only take a hit if losses exceed capital. And that’s why banks have to have adequate capital in order to function.

Now, preferred shares are sort of like a junior loan: the preferred shareholders are second in line for losses, but ahead of the rest of the bank’s creditors. So from the point of view of the creditors, capital includes preferred shares as well as common equity. Or to put it a bit more generally, from a creditor’s point of view capital is everything that has a more junior claim than you do.

But in that case, converting preferred into common does nothing: it’s just a swap among the junior stuff, with no impact further up the line. It’s certainly not a fresh infusion of capital in any meaningful sense.

There is, I guess, one possible advantage of the move: by increasing the government stake, it means that taxpayers get more of the upside if the government throws money in the banks’ general direction, say by overpaying for toxic assets. But aside from that, nada.

Silly Krugman. Krugman wants to suggest that this is a cost-saving move by government. But the government has not withdrawn funds; instead, the same number of G-dollars are invested in a much larger mass of stock. The “upside” (not for individuals) here is that the government gets more control over the banks. More control, and less supervision over how much they’re controlling. When was the last time you saw taxpayers benefit from a scheme as diffuse as this?

Keynes might say that for every dollar the government pumps into the market, eight dollars come back. But friends, countrymen: Open your eyes. Look at what’s happening to those dollars. They’re being sucked up like a black hole into Detroit, into flailing and failing companies, into a series of industries necessarily kept secret to avoid the stampede to Argentina if the blue dogs who wanted the bail-outs knew we’d bailed out the porn industry to the tune of $5B. We’ve printed and spent the dollars before they come back. So for every $8 we print to send to Detroit, we’re getting less than $1 back on GM bonds.

There is little question our new Executive <3’s Keynes. The more pressing question right now is whether nationalization is a viable solution for saving the banks. My answer (shockingly) is No.

By acquiring the banks, Big G would acquire their liabilities. Estimates for these liabilities are still rolling in. We’ve seen numbers from the government, from private investors, even from the IMF. We continue to print money to buy off these deadweight mortgages, but home prices continue to fall — precipitously, in some places. Because are printing cash but not equity, we are not matching anything. So we’ve created a mini-cyclone of inflation that will continue to shake this country. When we can’t buy anything with all this free cash flow there is no way for the public to make foreclosure claimants whole. And there you have the classic recipe for a prolonged depression.

More ominously, because the numbers are all so liquid, there will be a round of litigation over exactly how much everything is worth. As we know, I only get paid when people are fighting, so I won’t quibble over litigation. But we’re looking at enormous transaction costs as banks and individuals negotiate how the value of each asset and class of claims should be determined. This will cause a long period of instability with system-wide consequences.

The government has considered writing huge checks to banks now to cover expected losses in the future. Has this ever worked? Imagine giving a teenager $10 and explaining that $5 is for today’s hamburger and the rest is because you’re sure he’ll get hungry again tomorrow. If he’s a disciplined kid then that might work. Is our government acting like a disciplined kid? Our government is like a teenager who knows that every time he asks, you’ll give him $10. It would take a highly irrational teenager not to spend the whole $10 today, when he’s absolutely certain you’ll replenish it tomorrow!

The alternative, as always, is to sever the gangrenous limb and let the flailing banks fail. Initially this would cause the same period of instability and economic pessimism warranted by the nationalization option outlined above. But while the former system would cause further long-term instability as these losses get absorbed into the balance sheets, the second option would result in a short period of instability but long-term confidence in the strength of our banks.

That’s the thing about inflation: At some point you have to deal with it. We can either pass it forward and just keep our problems growing ever-worse for the future. OR we can insulate the problem, swallow our losses, and look forward to an equity-based (instead of the present artificial dollar-figure based) economy deserving of the confidence required for it to thrive.

A couple good sources not linked above:

Describing the mechanics of securities buying; and

Framing the issue: Bail-out or Nationalization?


1 Comment

Filed under Uncategorized

One response to “What are banks doing to stay independent?

  1. Pingback: How the Crash Will Reshape America « Unkategorized

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s