Brad DeLong made my day:

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

  • grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship

  • requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury

  • requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

  • grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

...It's time for the Democrats to pass a nationalization in the taxpayers' interest bill and dare Bush to veto it.

There's a beautiful irony here. The superficially private-sector-friendly Paulson Plan is likely to entail socializing losses and undermining the incentives that give capitalism its efficacy and its legitimacy. Outright nationalization, on the other hand, may look like a Commie statist plot, but strengthens the "invisible hand" in the long run, as long as the nationalization is temporary.

To understand the paradox, go back to Zingales' excellent essay. Under ordinary circumstances, when firms can't manage their debt, Chapter 11 reorganization is an excellent means of preserving market discipline while preserving the "going concern" value of the enterprise. Unfortunately, bankruptcy is a slow and uncertain process. In the current crisis, the insolvent enterprises are so large, numerous, and interconnected that financial markets might self-destruct if we "let nature take its course".

Temporary nationalization could serve as a kind of fast-track bankruptcy. Creditors, counterparties, and customers would have some certainty that firms in conservatorship would continue to function, and most could expect to be made whole (although the state could and should force haircuts or debt-to-equity conversions on the some junior claimants). Stockholders and incumbent management would be unceremoniously booted from nationalized firms, creating a strong incentive for companies to avoid the state's tender mercies if at all possible.

Besides reassuring counterparties, nationalization provides an opportunity for the government to restructure firms prior to reprivatization with an eye towards reducing systemic risk. "Too big to fail" firms can be sold off in pieces, rather than merged into superbehemoths with a government-arranged subsidy, as is the current fashion.

Of course, nationalization does represent a "taking" by the government of private sector assets. The salutary effect with respect to market discipline has to be weighed against a corrosive effect on property rights. But if the terms under which firms can be nationalized are reasonable and carefully spelled out, especially if nationalizations generally occur where firms otherwise would have fallen into bankruptcy, the harm to property rights would be minimal. Also, procedures and timetables for reprivatizing or liquidating nationalized enterprises would have to be built into the plan.

Nationalization is a hard sell politically. Small government, free-market types naturally have a problem with the Feds coming in and taking over stuff. But counterintuitive though it may be, overt nationalization is more consistent with the principles of a free market than covert government subsidy. Real capitalists nationalize.

Update History:
  • 27-Sept-2008, 2:oo p.m. EDT: Changed "let nature taking its course" to "let nature take its course". Fixed spelling of "mericies".
Steve Randy Waldman — Saturday September 27, 2008 at 4:09am permalink
Benign Brodwicz (mail):
The switchboards at Congress were tied up this week with the public outrage at the bailout (notice how it's now called a "rescue" plan?).

Two responses:

1. The DeLong proposal is similar to the Chilean solution in the 1980s of loaning the banks the money, calling it capital, and requiring them to repay with interest, while not being allowed executive bonuses or the ability to pay dividends for the duration, as I posted earlier. It's all funny money anyway. The banks enjoy substantial rents from being granted money-creation priviledges, and are so highly regulated they are practically government agencies anyway. "Nationalization" in this sense is just another way to keep insolvent institutions open. The important behavioral point is not to reward moral hazard. The Paulson plan is exactly the worst plan for this reason, but then, as our host has pointed out, Paulson's conflicts of interest are manifold.

We'll see what our puissilanimous elected representatives come up with this weekend. There have been contrarian statements issued by some real heavyweights.

2. On the larger questions of how much outright gangs of crooks are running the show, if you want a shrewd, really pessimistic view (one of many, this one from a COINTEL guy), see John Robb's Global Guerillas blog, excerpted here (welcome to the jungle; see also Strauss and Howe's The Fourth Turning on the crisis/depression generation):

Monday, 22 September 2008

The modern nation-state is in a secular decline, made inevitable by the rise of a global market system. Even developed nations, like the US, are not immune to this process. The decline is at first gradual and then accelerates until it reaches a final end-point: a hollow state. The hollow state has the trappings of a modern nation-state ("leaders", membership in international organizations, regulations, laws, and a bureaucracy) but it lacks any of the legitimacy, services, and control of its historical counter-part. It is merely a shell that has some influence over the spoils of the economy. The real power rests in the hands of corporations and criminal/guerrilla groups that vie with each other for control of sectors of wealth production. For the individual living within this state, life goes on, but it is debased in a myriad of ways.

The shift from a marginally functional nation-state in manageable decline to a hollow state often comes suddenly, through a financial crisis. This crisis typically has the following features:

* Corporations and connected individuals systematically loot the nation-state of financial assets and natural resources through a series of insider/no cost deals. These deals are made to "save" the nation's economy or financial system from collapse.
* Once the full measure of the crisis is known, the nation-state's currency falls precipitously, it's debt becomes expensive, and it is forced to submit to international oversight/rules.
* The services the state provides rapidly evaporate as its bureaucracy is starved for cash/financing. This opens up a window for the corruption of government employees unused to deprivation.

The Dynamic of Primary Loyalties

The decline from functional but weak nation-state is extremely sudden. For individuals, there is a rapid and sustained decline in the standard of living. Additionally, there are spot shortages of critical items and commodities -- particularly food, medicine, and energy (since these are globally fungible). Large and small business fail across the board, or become prey to connected companies/individuals with access to the remaining coercive power of the nation-state. As the deprivation becomes commonplace, people turn to primary loyalties for support and services -- loyalties to a corporation, tribe, gang, family, or community. These groups, energized by new levels of loyalty but deeply obligated to reciprocate this loyalty with support, become extremely aggressive in pursuit of their survival. Once this shift in loyalty is made, a self-generating cycle of violence, crime, and corruption (fueled in large part through connections to the global market system) becomes entrenched. The nation-state, at that point, becomes irretrievably hollow.

The Looting

It's instructive to view the US Treasury's plans for a bail-out of the global financial system through the lens of the hollow state. By this measure, the bailout as it stands today, is a form of financial looting of the US Treasury (it isn't socialism, since the government isn't nationalizing the financial system). Trillions of dollars in government monies ($700 billion to begin with) will be infused directly into the coffers of corporations and wealthy individuals (via hedge funds). Specifically, the plan buys toxic assets at inflated prices and sells them back for nearly nothing -- no equity or assets of real value are provided in exchange for the purchase. The national debt will likely grow 20-30% in a single year, with obligations extended to many trillions more in guarantees.

Given this, one potential next step forward is a decline the credit rating of US debt (which radically increases the costs of US borrowing), a collapse in the dollar relative to more stable global currencies, and a rapid decline in government services. Other scenarios achieve the same result with different timing. Regardless, our (the US and the UK) journey to a hollow state has officially begun.

NOTE: Philip Bobbitt got it wrong in his book, "The Shield of Achilles." The prosperous market-state he envisioned through constitutional reform isn't possible. The REAL market-state, the form of governance that that has truly embraced the global market system, is hollow. In effect, a state that doesn't place any barriers between itself and the global marketplace. As a result, the only real opportunities created by the emergence of the market-state are opportunities to steal extreme wealth.

My guess is that either Barack brings us together into a new social contract as a viable response to the crisis epoch, or the USA descends into banana republicdom.
9.27.2008 5:15am
I prefer each of the following to Zingale: (Spaventa) (Buiter)

It's useful to distinguish between the liquidity problem and the solvency one.

Zingale and like-minded others assume the Paulson plan is no good mostly because it doesn't tackle the solvency problem. They make no allowance for the possibility that the Paulson plan could be followed up with solvency specific action, after the liquidity log jam is blown up. They also reject the economics of the Paulson liquidity mechanism. Presumably they also reject both the importance of the liquidity problem and the importance of distinguishing between liquidity and solvency.

Spaventa and Buiter assume the liquidity problem is real, distinct, and urgent, and must be addressed now. They also assume the Paulson liquidity mechanism makes economic sense. They leave open the possibility that solvency specific solutions may be required as a further step. They caution against bundling a solvency mechanism in with the liquidity one, or worse, instead of it.

The Paulson plan assumes a liquidity problem, but assumes away a solvency problem. This was probably a tactical mistake. He should have left the door open for possible solvency specific actions as follow up to the liquidity mechanism, and positioned the liquidity mechanism as a necessary and distinct action, but not necessarily a sufficient one.

I'll be very curious to see how equity participation is priced relative to the reverse auction mechanism for debt pricing. I'm not sure there's any free lunch for the taxpayer here when the price of equity admission is implicitly factored into reverse auction pricing.

Too much is being bundled into a single stage where the components would be addressed more efficiently and effectively in discrete steps – liquidity, solvency, equity participation, and executive compensation.

All of these things are debatable, but that's roughly how I see the analysis of the problem.
9.27.2008 11:14am
Steve Randy Waldman (mail) (www):
Benign — The post you excerpt captures my mood and my fears all to well. I hope it is overblown. But, as they say, hope is not a plan.

JKH — If we divide interventions explicitly into solvency-folcused and liquidity-focused (which Paulson and Bernanke have not, they have given us no clarity and evolving stories about why and how they expect this to work), why not use the pre-existing mechanism for addressing, that is the central bank? One can argue that there is a liquidity crisis so deep that for the Fed to overcome it, it must expand its balance sheet by $700B and lend freely against. OK.

But if we are addressing liquidity, there is no reason for a permanent transfer of assets from, and potentially a permanent transfer of wealth to, the illiquid institutions. If there is both a liquidity and a solvency crisis as you suggest, and the current plan addresses liquidity, why is TARP as both Buiter and Spaventa suggest a kind of "good start" rather than an unusually flawed approach to the liquidity aspects. The reason we are considering this plan is because Paulson claimed it was "comprehensive", a way to speed ahead of all the stopgaps that have thus far failed. The mild defenders of TARP acknowledge that it is not that, point out (accurately) that it could help a little, but so could a lot of less interventions that are far less radical and fraught with distributional hazard.
9.27.2008 12:50pm
RueTheDay (mail):
Putting aside questions of equity and efficiency, and only focusing on effectiveness for the moment, the key question that remains is:

What happens if Paulson buys up $700 billion of steaming shitpile, and a few weeks later the credit markets seize up, the stock market tanks, banks start going belly up, etc.?

Stephanopoulos asked Paulson this question a week ago and all Paulson could say was "this plan has to work, it will work".
9.27.2008 2:35pm
Benign Brodwicz (mail):
The banks are gaming the government, as someone pointed out on Bloomberg recently. They're bluffing in hopes of a handout. So what if the TED spread is 200 bp? Who the f*ck cares? It will come down when nerves calm. I just don't buy that there is a "liquidity problem," just as I never bought that there was "so much liquidity out there" when it was all really debt.

Make the banks solvent at market with the stroke of a pen (call it debt, call it equity, call it high-powered reserves...) and trading will go through the roof. Why can't the Fed increase the size of its balance sheet? It's all funny money.

You got it Rue, the whole thing stinketh.

And as Roubini points out, none of the plans so far address the households' balance sheets. Why should we just bail out the financial institutions [who caused the problem]? If anyone deserves debt forgiveness, it's the poor households. The stench is unbelievable.
9.27.2008 3:54pm

“If there is both a liquidity and a solvency crisis as you suggest, and the current plan addresses liquidity, why is TARP as both Buiter and Spaventa suggest a kind of "good start" rather than an unusually flawed approach to the liquidity aspects.”

I don't understand your point here. Both are quite clear on the distinction and the role of TARP:


“Bernanke and Paulson's Troubled Assets Relief Program (TARP) is not perfect, but it is a good start. Both aspects of the problem – assets' illiquidity and shortage of capital – should be addressed in sequence. By removing troubled assets from the banks' books, TARP would remove uncertainty. This will encourage private injections of capital and provide better information for public intervention if they prove necessary.”


"The Paulson Plan addresses market illiquidity for toxic assets but the real problem is a lack of bank capital and the risk of widespread insolvency. Fixing this requires a government injection of new bank capital or a forced conversion of bank debt into equity."

TARP is intended to address liquidity. Something else must address solvency if the government needs to address it. Paulson stated explicitly in Congressional testimony he was not targeting a solvency problem.

The division of labour between the Fed and Treasury balance sheets is really not very relevant. The only aspects of the Fed's balance sheet that are critical to its mission is that it is able to control the level of bank reserves, and that it deploy the funds that it sources from currency issuance. The default employment is treasuries and normal loans to banks and dealers. There is no requirement that the government's involvement in markets of any particular type be positioned on the Fed's balance sheet. Just because the Fed has broken the mould in this credit crisis doesn't mean it has to position everything on its balance sheet. And the only reason that the JPM loan is there is that there was no facility in place to put it on Treasury's balance sheet.
9.27.2008 4:34pm
Steve Randy Waldman (mail) (www):
JKH — I agree with you about the (financial) insignificance of the question of whether a program is taken from the Fed's balance sheet or the Treausry's. They are ultimately consolidated. And, I am pleased this debate is about a Treasury action, not a Fed actions, at least that compels some democratic process.

But I reject strongly your, and Buiter's and Spaventa's characterization of this as a liquidity intervention. Liquidity issues are properly addressed with loans, whether from the Treasury or from the Fed. What characterizes the current proposal is an insistence that assets actually be purchased, that the US (Treasury/Fed/whatever) bear the risks of ownership of these assets before the banks that voluntarily built or bought them. That is not a liquidity function, period. That is a risk transfer, the true definition of an injection of capital.

Calling this a liquidity operation is simply a mischaracterization, quite frankly a lie, unless the risk of ownership is trivial at the price purchased. It is quite clear from Benanke's discussion of the program that this will not be the case, the Treasury will purchase at prices that might be the "expected value" of the assets under somebody's forecast, but does not include compensation for the incredible downside variance.

That is, by any financially literate definition, overpayment.

The Paulson Plan, then, is an injection of capital at prices that are far too high and include no compensation for risk.

That is not a liquidity operation, it is a wealth transfer.
9.27.2008 6:11pm
A Debt Free Sovereign (mail):
I've been an occasional lurker here and I do appreciate your efforts.

There are any number of proposed solutions to the liquidity issue, but thus far and in the mid to long term, the solvency issue is by far the key variable for the economy and the health of the credit and stock markets. For if the solvency issue is not addressed, liquidity will return again and again as a symptom until the housing market stabilizes.

I've seen Barry Ritholtz 30/20/10 proposal and Nouriel Roubini's HOLC/HOME proposal, and of course there is the miserable HOPE Now Alliance. What other proposals have you seen that at least attempt to morph the mass of insolvent and increasingly delinquent mortgagees into sustainable debtors?
9.27.2008 6:13pm

“That is not a liquidity function, period.”

OK. I thought that might have been an objection.

I know you've done some posts in the past about liquidity, including one mammoth exchange with Moldbug (who once more has posted something quite unusual and thought provoking about money on his blog). Don't want to emulate such depth here, but I've been thinking a bit about liquidity lately and come to my own conclusion that there is no categorical definition of liquidity. It is an attribute that is context dependent. I won't define that attribute generally here, but I think you get my approach. You may think of this as a cop out, but bear with me.

In this case, I would use liquidity in characterizing at least two phenomena:

a) The seizure/upheaval of the interbank pricing and lending markets
b) The general chaos and futility of transaction price discovery in mortgage derivative and securitization assets

Thus, I don't use liquidity to characterize the institutional mechanism that acts on the problem of liquidity as I have characterized it. I.e., I don't discard liquidity as the focus of risk and of problem solving, based on whether the institutional action operating on it is a loan or a purchase, in this case.

I also don't discard it based on the degree of credit risk that the actor is taking on in this case. It is a question of degree in an action that normally should involve low credit risk but now doesn't, due to the liquidity environment and the credit conditions underlying it.

One ironic thing about our exchange here, to me at least, is that inevitably when I do read about liquidity, categorical definitions are usually aimed at the liquidity of markets in movement, rather than the liquidity characteristic of institutions or their actions, as it pertains to their asset/liability configuration. I'm actually very aware of the latter in my own experience, and ironically you seem to be thinking more in those terms than the former, when interpreting the liquidity content of the problem we are writing about. Roles have been reversed in that sense, at least in my case.

“That is not a liquidity operation, it is a wealth transfer.”

I think there is a risk of wealth transfer. I also happen to think that the risk not necessarily limited to one direction. Your point about downside variance is fundamental to the pricing problem. Treasury is definitely taking a view with taxpayer dollars. But the reverse auction pricing mechanism is decent. And if downside variance is the determining criterion, why are so many people worried about missing out on the potential upside and insisting on some form of equity participation? Upside seems not to be unthinkable.

I find the general debate about this directional risk aspect to be fiery but binary – the extremely negative skews versus the neutral to possibly positive skews. But there's not much in the way of robust analysis or even summary quantification in either case. I guess people are pretty dug into their binary views on the value of these assets. I don't know. But the perceived potential usefulness of TARP is a function of this.
9.27.2008 9:27pm
Steve Randy Waldman (mail) (www):
JKH — Even if <i>ex post</i> taxpayers break even, and even if <i>ex ante</i> the risk is symmetrical, totally unskewed, paying the expected value discounted at the risk-free-rate represents both an overpayment, and an uncompensated transfer of risk. I am quite pessimistic about these assets, about the likelihood of this mass operation doing much good even in a narrow sense, and about the ability or desire of the officials running it <i>not</i> to overpay for the assets. We don't know discount rate that would be applied in determining "hold to maturity value", but I'm nervous. An auction process can be carefully designed to get good prices, or can be used as a figleaf to legitimate a transfer. Without transparency, I'll be cynical. (Did you notice that JP Morgan's "bid" was accepted on WaMu's assets?! That alleged auction was so secret that WaMu's principals had no idea it was happening on the day they were sold. I'm sure there were a wide array of auction participants, then, and that FDIC got the best possible price.)

I do agree with you that "liquidity" and "solvency" are not cleanly separable (and that the variety of ways liquidity is used is fascinating). The proposed operation is allegedly about both transaction and balance sheet liquidity I think: they claim they can jump-start and unfreeze the market in these securities, while replacing illiquid with liquid assets on firm balance sheets. I don't think we'd be far apart definitionally.

But "liquidity", as a political matter, is being used as a fig leaf to suggest that taxpayer's will be getting perfectly good assets that just take a little while to sell, like a homeowner short of cash who needs to buy groceries. In the latter case, we understand the balance sheet illiquidity says nothing about the quality of the asset, and it would be reasonable to lend against the asset or even make a market in it at a small spread to help the homeowner eat. Here the quality of assets is unknown and arguably unknowable, with estimates all across the spectrum. Lending against (which we are already doing quite a lot of) or taking on inventory in this case is an assumption of risk, a substitute for the asset-shedders risk capital. This is not merely a liquidity operation. It's an infusion of risk capital that should be compensated as such. But if it were, that would kill the banks. So, it's unworkable, unless taxpayers accept a transfer. Even if the skew is symmetrical and assets are "fairly valued", taxpayers will not be compensated for bearing private risk, which under any fair accounting amounts to bearing a cost. Given the amount of model risk we face in trying to value these assets, and the likely agency costs associated with the people running the program... there's a whole lot of risk for taxpayers to swallow, at the gunpoint, when the people pointing the gun claim to have no choice, but we can't really know that.

So, what's wrong with nationalizing? Or debt-to-equity swaps? We'll agree to disagree on the Paulson Plan, but wouldn't those meet my objections without compromising your goals?
9.27.2008 10:20pm

I'm probably guilty of defending the feasibility of the Paulson plan to the point of not thinking through a vision for nationalization or debt/equity swaps, or the relationship between the two. My instinct is that there is urgency to taking whatever the next step is and that the Paulson plan with some modifications is the one that can respond more effectively to the issue of urgency. (And I agree the transparency of the auction process is essential for the taxpayer.) I have trouble visualizing the tactical implementation of nationalization or debt/equity swaps while the asset markets and the interbank markets are so seized up. It seems that the Feds would have to go after some quota of bad assets and knock off a number of institutions until that quota is met. Only then would the market believe in the certainty of systemic solvency to the point where it started to function again. But I just don't know how they would go about identifying the list of candidate institutions and taking action quickly enough, given the uncertainty of asset valuations in these institutions. That's why I see dynamiting the asset logjam as least as a prelude to more targeted capital infusions or conversions.
9.27.2008 11:02pm
Richard H. Serlin (mail) (www):
"Temporary nationalization could serve as a kind of fast-track bankruptcy" -- This is a very good way to look at it. It is mostly that. They would emerge well functioning with little or no debt if done right.

"Nationalization is a hard sell politically. Small government, free-market types naturally have a problem with the Feds coming in and taking over stuff." -- Very true. I noted this in my post, "'government takeovers may be the only way to get the financial system working again'", and Princeton economist Paul Krugman wrote today, "On the other hand, there's no prospect of enacting an actually good plan any time soon. Bush is still sitting in the White House; and anyway, selling voters on large-scale stock purchases would be tough, especially given the cynical attacks sure to come from the right."
9.28.2008 3:09am
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