A slogan for the new administration: nationalisation after due process

A lot of my readers mis-understood my last post.  It was only to point out that with a government guarantee even fairly heftily insolvent banks will live.  

In some sense the conclusion is not surprising.  The purpose of capital in a bank is to ensure that the funding sources get repaid.  A government guarantee does that – and so is capital.  The guarantee ensures profitability because it ensures that there is adequate capital.  

Now there is a cost to these guarantees.  They are expensive – especially in an ex-ante sense.  The taxpayers are taking a risk – and they should be compensated for that risk.  That is a basic capitalist principal – but it also is just plain fair.  Real capitalists nationalise.

But there is a cost to nationalisation too.  The cost is that potential capital providers – sometimes with some justification – see it as theft.  I personally see the snitching of WaMu as theft – and nobody has yet come up with a credible argument against that.  

Who cares whether it was theft or not though – it appears to be theft – and that is sufficient to do damage.  The effect of the seemingly arbitrary action of Sheila Bair in confiscating WaMu was to discourage any and all new private capital to banks.  

Once capital providers have decided that the government will arbitrarily nationalise there will be no capital providers.  Nationalisation can be a nasty self-fulfilling policy.  We have – and I have blogged about it before – the opposite of moral hazard.  We (people who as a matter of course might provide capital for banks) are living in fear of arbitrary actions by government.   Believe me - I buy and sell bank stocks and I live in fear!

And if anyone here thinks the process for bailing out financial institutions hasn’t been arbitrary then you haven’t been looking.  Every single major failure has been handled differently.  I would say rules are being made up on the fly – but in fact there are no rules.

So here is a proposal.  Call it “nationalisation after due process”.

An organisation is in deep do-do – and needs a bailout.  Following Paul Krugman we will call it Gotham Bank.  

Gotham has stated $2 trillion in assets and $1.9 trillion in liabilities – a stated $100 billion in capital.  Suppose the required capital is $100 billion according to regulatory rules.  

But Gotham’s accounts are nonsense.  It has an unknown number of bad assets – say something between $100 billion and $500 billion.  If it has $100 billion in bad assets then there really is shareholder value there.  It has earnings potential and is solvent.  If there is $500 billion in bad assets the bank can be so insolvent that even time is not a solution.  

It goes to the government.  Under the Bush administration the government would make a set of rules up for Gotham over a disorganised weekend.  The fait-acompli would be presented before Asian markets opened.  

But it does not have to be that way.  The government could inject some capital into the bank as a temporary subordinated loan.  A third party could then be appointed (new management – or answerable to another arm of government) to produce fair accounts for Gotham.  Ten weeks should do it.  At the end of ten weeks Gotham will be found to have – as a middle estimate – say $150 billion in losses – it is thus negative capital by $50 billion or a full $150 billion short of its required regulatory capital.  

The management of Gotham can go to the markets.  If the management can raise $100 billion (something to get it back to half capitalisation) then the shareholders keep Gotham.  Sure existing shareholders might get diluted - but at least they get to have a decent go at keeping their capital stake.  

If they can't or won't fund the bank in full knowledge of its position then it is nationalised.  It is in that case unambiguosly not theft - shareholders had the chance to keep the bank under fairly administered rules.  

What I want is extreme government action (nationalisation) but with a process to ensure that existing property rights are honoured.  I want the benefits of nationalisation (that it works) without the costs (that it is seen to be arbitrary to capital providers).  

Due process if you will.

Due process is one thing that the Obama administration should get right over the Bush administration.  It is a mark of good government.

Here is hoping.

John Hempton

PS.  Why half capitalistion?  Because bank capital is there to buffer against losses.  Once the losses have occured the bank should be allowed to run to build the capital back up.  Full capitalisation at the bottom of a banking cycle would make banking regulation too procyclic for the general good.

PPS.  When I was a junior public servant (Australian Treasury) I saw the policy prescription - the events of the weekend or crisis - as the important thing.  The longer I looked at it the more I realised that the processes were as important as the outcome.  Indeed they are more important.  Markets work because we have a legal process.  They do not work in Cambodia because there is no process other than he-who-pays-the-biggest-bribe wins.  

A funding market for banks will not reappear until process reappears.  Getting the process right is KEY to solving the financial crisis.