In an earlier post, I took Kevin Drum to task for referring to partially state-owned, but publicly listed Nordbanken, as "the state bank". I noted then that I didn't know what percentage of the bank was state-owned.

Kevin Drum is not lazy. He's managed to dig that up. In an e-mail, he reports that at the time of Nordbanken's nationalization, it was 77% state-owned, and private shareholders were bought out at better than the market price. At 77% government ownership Kevin's characterization of Nordbanken as a state bank seems pretty defensible. (That the Swedes bought out the old shareholders doesn't interest me very much, as long as the bank's price had already collapsed. For example, paying Citi's shareholders a substantially above-market $4 per share — Citi closed at $3.11 today — after the shares have fallen in value by more than 90% wouldn't much change the incentives of pre-crisis shareholders.)

"Nationalizing" a bank already 77% owned by the state might not seem like a big deal. But, reading an insider's account of the Swedish crisis, it was a big deal:

The crisis continued. We had to make a big quick fix for Nordbanken. However, it was soon clear that the quick fix was not enough. So we decided to nationalize the bank and recapitalize it. Nordbanken was very large, as its asset base equaled 23 percent of GDP. The initial cost of recapitalizing Nordbanken equaled 3 percent of GDP. A few years later we were able turn it around at a profit for the taxpayers and that transaction, more or less, paid for the banking crisis.

The restructuring of Nordbanken was really important in that it served as a showcase for the rest of our work. It demonstrated the government's determination to address and resolve the crisis and it helped us to gain respect.

Britain is in a similar situation today. The British government already owns 68% of RBS, but the question of whether or not to "fully" nationalize the firm remains important. Why? What's the difference between a "full nationalization" and majority ownership? Does "full nationalization" matter?

I think it does matter, quite a bit. First, there is the obvious matter of unity of control. A fully nationalized bank can be reorganized in the public interest, e.g. by division into smaller firms, without minority shareholders complaining or even suing on the theory that a different structure would be more profitable.

More importantly, only full nationalization eliminates investors' incentives to concentrate capital in "too big to fail" banks before the crisis. Assume that a bank is insolvent, such that if it were not "too big to fail", regulators would insist it merge or wind down at a cost the the deposit insurance fund. But the bank in question is too big to fail, so regulators cannot wind it down. The government is then forced to become the capital provider of last resort. Existing shares would be worthless under this scenario, if the bank had no power to threaten a chaotic failure. However, after a recapitalization, the reorganized bank might become a very valuable. The bank retains its existing network of branches, benefits from the deposits and habits of its old customers, and may leap from sickest bank to safest bank with a single "bold" injection of government capital. If the old shareholders are permitted to ride along after the reorganization, they reap a large reward from having invested in a bank that was too important to fail.

Suppose that a bank whose true book equity is $0 has failed to mark down some assets, and shows a position of $10B. The bank receives a $90B capital injection, valuing existing shares at book. Then the old equity whose true value was precisely zero prior to the recapitalization suddenly has a real book value of $9B. That is, old shareholders reap an immediate windfall from the recapitalization, and the size of the windfall increases in direct proportion with the amount to which management had lied about the banks losses! Further, the market value of old equity should rise by much more than that $9B, since all of a sudden, the bank switches from a horseman of the apocalypse to a going concern with a bright future. Failing to exclude old shareholders from a post-recapitalization bank results in a transfer of wealth from taxpayers to shareholders in proportion to the degree to which i) they invest in "too big to fail" banks, and ii) encourage management to understate asset impairments in their books. Those are really bad incentives. The details of this story change a bit if, for example, the recapaitalization comes in the form of preferred equity with warrants, or if market values rather than book values are used to estimate the how much dilution old shareholders suffer. But the core bad incentives do not change.

By eliminating private shareholders entirely, full nationalization permits regulators to "do what needs to be done" to restructure the firm without having to hew to a fiduciary duty of profit maximization in designing the new structure. Full nationalization limits the ability of shareholders to extract windfalls from taxpayers by becoming "too big or interconnected to fail". Finally, full nationalization makes it possible to value assets ruthlessly, thereby eliminating market uncertainty about whether a bank is really fixed. Either to maximize their share of a recapitalized firm or to maximize the subsidy in a "toxic asset" purchase, legacy shareholders will always insist on optimistic asset values. But getting past a banking crisis requires working from an assumption of extremely pessimistic values.

So I do think that Nordbanken still "counts" importantly as a nationalization (and that AIG, for example, remains importantly undernationalized). But kudos to Kevin Drum for unearthing the public/private split. What do you think? Does a shift from 77% government-owned to 100% government-owned really matter?

Steve Randy Waldman — Friday January 23, 2009 at 5:10am permalink
A stock with a book value of $ 0 probably trades for pennies.

A capital injection of $ 9 billion using the existing share base would require a discount even from this share price combined with a punishing reverse split. The dilution would be monumental. I wouldn't worry too much about existing shareholders making out like a bandit in this example.
1.23.2009 9:07am
Response to anon:
Based on past precedents under the Paulson regime, there isn't necessarily a discount applied, unless that discount is to the American taxpayers.

Also, in addition to providing enormous amounts of equity via preferred stock at simply stupid terms, we've also guaranteed interbank lending, and most liabilities of a number of banks.

Taking a look at Citigroup, which is generally believed to be effectively insolvent without the government intervention it has received, you can see that their equity is most assuredly not trading for pennies. At this point, why not nationalize them? The profit motive (particularly the short term profit motive that drives American businesses) is directly contrary to the motives of the US government, which is keeping Citi afloat.
1.23.2009 9:48am
If it's of any interest, the state owned 70% of Nordbanken pre-crisis. When the bank first faced problems it took in capital from both the state and the private shareholders (the offer was partly guaranteed by the state). This lead to the ownership rising to 77%. The reason the private shareholders were bought out, facing the nationalization, was to compensate them for their part in the first capital injection. The rationale being keeping the restructuring from being slowed down by litigation from the private owners.
1.23.2009 10:18am
John N. Winn (mail):
Chapter 11 bankruptcy should precede government purchase. In that manner, debtholders and deferred comnpensation/bonus pool recipients take the very haircut/cram down they fully expected as a possibility when they signed up for the out-sized postive returns in the first place. No new instiutional arrangements are needed and no current contractual provisions are violated. The Federal role becomes one of merely supplying debtor-in-possession financing; and, its DIP loan is superior to all bondholders in the capital structure. Nationalization then becomes purchase of the near-zero delisted stock at, say, a 50 cents per share premium. Deposit holders remain protected by the FDIC throughout.
1.23.2009 10:47am
john c. halasz (mail):
Actually, John N. Winn, technically, commercial banks themselves can not go into bankruptcy. It's the holding company that owns the banking subsidiary that goes bankrupt, while the insolvent bank itself gets taken over by the FDIC, with its "assets" either liquidated or merged with a sound bank by the FDIC.

I think the key point here is that it is only with a nationalization/public take-over of a bank, that it's "toxic" assets can be genuinely rendered "dead", and hence susceptible to being ring-fenced into a "bad bank", separated from a re-capitalized "good" bank. Needless to say, any remaining share-holders' equity, and senior bond debt converted into equity should, to the fullest extent possible, provide the capital for the "bad bank", whose assets are to be run-off or managed to maturity. But perhaps equally key, is that a consistent legal framework needs to be set up in advance, if it's not to be an ad hoc, botched enterprise that accomplishes little besides further unsettling markets through increased uncertainty. That way, banks can understand beforehand their options and their consequences and effectively be forced to recognize promptly their losses and impairments, if, indeed, they have any capacity to do so without incurring insolvency. Otherwise, as Mr. Waldman has it, scarcely solvent banks would be left "free" to manipulate the regulators. I was advocating setting up such a framework last April and May in blog comments, though I would have done it through an enhanced FDIC, provided with extra funds, man-power and regulatory authority, rather than through the adventitious/authoritarian usurpations of the Treasury Dept., though I found precious little uptake or discussion of the prospect at the time. There is nothing that violates the rights of contract or the rule of law in seizing semi-insolvent, under-capitalized banks, since they are licensed to operate under a regulatory regime. But, in the contrary case of pursuing an ad hoc approach, both the rule of law and the soundness of markets are undermined. Ironically, it is solely an ideological barrier of "free market" dogma that has thus far precluded such a "forceful" approach, since "private" re-capitalization is the distant, vanishing prospect that the prevailing authorities have been laboring to preserve, since "we" all know, as recent evidence all too clearly testifies, that "private" markets are always much more efficient allocators of capital and operators of enterprises.
1.23.2009 10:30pm
"or if market values rather than book values are used to estimate the how much dilution old shareholders suffer"

But that's exactly what's done. Book value is not the basis for the calculation of dilution. You can calculate book values pre and post dilution as an interesting exercise, but they've got absolutely nothing to do directly with the actual level of dilution.

Suppose as in your example the book value is $ 10 billion and the new capital injection is $ 90 billion.

There's no way the market will be valuing the $ 10 billion book as $ 10 billion market value, given the uncertainty and risk around book value as an indicator of true value. It will be valued somewhat like an option on book value. And in any event, the government determines the offer price when the alternative is bankruptcy – just look at the first offer on Bear Stearns relative to the previous market price.

Suppose there are 1 billion shares outstanding with a market value of $ 3 billion and a share price of $ 3.

Suppose the government also offers $ 3. (It can “offer” anything it wants because it will force the result through the Board of Directors using various implied threats, including bankruptcy or fully coercive nationalization.)

So the government buys 30 billion shares.

The new book value of the bank is ((1 x 10) + (30 x 3)) / 33

= 3.3

The original book value doesn't matter in the sense that it is a risk like everything else (indeed, that's the core premise of the post) and will be treated as an option by the pre-capital injection shareholders. The market is the best judge of what the bank is worth in a time where it needs more capital. And new capital will force the post-capital injection book value down much closer to the market price, but book value is still irrelevant, since risk still remains. It's relatively more relevant post capital injection, only because it has been forced closer to market. The government takes the risk that the bank is operationally salvageable and the existing shareholders participate on the same terms. But book value is a completely misleading and false indicator of a presumed and false “subsidy” to existing shareholders. And if nationalization is the only non-bankruptcy alternative, is the government really going to “pay” $ 0 for the existing shares? I think that's also pretty absurd, so there's a false comparison here.
1.25.2009 6:23am
Another thing. The original shareholders in the above example will now be entitled to 1/31 or 3 per cent of the total earnings stream to which they were previously fully entitled. Now that's dilution.
1.25.2009 6:33am
Another example - Citi's book value is currently about $ 15. It's stock price is trading like an option on its book value. Book value is irrelevant for dilution analysis.
1.25.2009 7:19am
RebelEconomist (mail) (www):
May I suggest my own way round the problem of the reluctance of the US authorities to nationalise banks struggling under the shadow of troubled assets? My idea is to separate the troubled assets, without giving shareholders either a subsidy or grounds to complain that they have been disposessed, using a reverse-TARP (or PRAT) scheme.

Instead of the difficult task of valuing the troubled assets to buy them out from a bank, simply separate the troubled assets from the bank without valuation, replace them with enough government debt to give the bank a strong capital base, and sell the cleaned up bank, which should be relatively easy to value, to new shareholders. The existing bank shareholders keep the troubled assets, whatever they are worth, plus the proceeds of the sale of the clean bank, in a holding company with liabilities matching the government debt that was given to the cleaned up bank. If the troubled assets come good, the holding company shareholders will not lose out, having received a fair market price for the untroubled part of their bank; if not, the government will end up holding the troubled assets anyway, but will have at least burned through the shareholders' equity before taking a loss on behalf of the taxpayer. A cleaned up bank should be regarded as trustworthy as banks ever were, and should be able to resume normal banking business immediately.
1.27.2009 7:57am

I had a first look at your (now vintage) PRAT a few days ago, after seeing your reference to it on that other blog - over in your neck of the woods (or seas). After thinking about it a bit, I quite liked it, because of its apparent fairness and flexibility.

My impression is that its critical structural feature could be viewed as either a strength or weakness, depending on one's point of view and ideology. I'm still trying to figure out why so many people insist on “wiping out” shareholders equity almost as a first principle in these situations. Why not a mechanism like PRAT that structures good bank transitions to ensure full recovery of government costs while channelling residual upside to the existing shareholders after such full cost recovery? (Although, I think you do need to ensure more explicitly that the government also ranks senior to the creditors in PRAT.)

What is it about a 99 per cent loss in shareholders' value that makes so many people so insistent on seeing the final 1 per cent gone as well, regardless of the eventual economics?
1.27.2009 1:22pm
RebelEconomist (mail) (www):
Thanks for looking JKH; I always appreciate your thoughtful comments.

The PRAT scheme is meant to be scrupulously fair to shareholders, partly so that they cannot block the abstraction of the vital utility banking business from the business of holding high yield, now troubled, assets. I did wonder whether it would be criticised on the grounds that the bank shareholders effectively get to borrow the funding for their troubled assets at a government interest rate, and keep all the upside if the troubled assets come good. I agree that the shareholders have probably been punished enough to avoid moral hazard. I note, however, that your point could be turned around to say that, if the bank shareholders have already lost 99% of their stake, taking the last 1% does mean that it is not necessary to inflict much additional pain to establish the principle that shareholders take their losses first.

Actually, I suspect that bank shareholders were less culpable than the bank employees, and I would like to see a windfall tax levvied on the bubble period earnings of the highest paid employees. This is not just about punishing those responsible for the financial crisis, but also about minimising the cost of sorting it out to those who are not responsible.
1.28.2009 12:59pm
RebelEconomist (mail) (www):

I also meant to ask you what you had in mind by "eventual economics". Do you think that writing shareholders down to zero causes wider or longer-term problems? If so, that would provide reason not to take the last 1%.
1.28.2009 1:48pm

I wasn't clear in my comment, but “eventual economics” was intended to refer to something like the full economic process of a PRAT-like workout.

That way, it can be determined whether the final 1 per cent of shareholder value is more or less than the “true” value of the residual firm, after the toxic asset problem is properly accounted for and accurately monetized by PRAT or something like it.

You make an interesting point about government funding costs as an element of subsidization. That might argue for leaving the shareholders nothing, given the risk the government is taking. On the other hand, if that were the case, the PRATs that end up being worth something subsidize the government for the PRATS that don't.

The point regarding the difference between shareholders and employees makes sense. I haven't seen much discussion of this.

My basic problem with “wiping out the shareholders” as an objective is that moral hazard becomes binary. 99 per cent loss isn't enough punishment; only 100 per cent will eliminate moral hazard – i.e. future capitalists won't be dissuaded from reckless risk taking if the punishment is only a 99 per cent loss.

My interpretation of it is that those who seek the 100 per cent solution are interested in vengeance more than justice. Otherwise they might acknowledge that a 99 per cent loss is not painless. The objective should not be to set a 100 per cent loss as the desired consequence for messing up; the objective should be to calculate the true cost of the problem and ensure that the shareholders bear that cost, up to a maximum of 100 per cent of their capital.
1.28.2009 10:01pm
RebelEconomist (mail) (www):
To be honest JKH, I suspect that in most cases the cost of the problem, on a mark to market basis at least, is way more than 100% of shareholders' capital. I presume that you are familiar with the Merton model of the firm that explains why the share price will always be positive no matter how negative the sum of the values of its assets and liabilities?
1.29.2009 6:35am

You're probably right. The share price is just an option at that point.

But options occasionally bear fruit.
1.29.2009 8:27am
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