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 [ 15 comments | 0 Trackbacks ] permalink

It will come to no surprise of readers of this blog that I favor nationalization of failed, systemically important banks. But James Surowiecki and Floyd Norris have a point. We absolutely should not nationalize as a means of persuading banks to issue credit more freely. If the government (idiotically) wants looser lending than banks are willing to provide, it oughtn't take their money and lend it. The government can lend its own damned money (well, our own damned money) if it thinks that profitable loans are not being made, or that for the good of the economy unprofitable loans must be made.

The reason to nationalize a bank is because the bank has failed and its former owners have no legitimate claim to its assets. The government has been forced to offer support with public money, thereby purchasing the corpse fair and square. We take the bank into public ownership because taxpayers who have been conscripted to accept extraordinary losses are entitled to whatever gains follow the reorganization they finance.

When a bank is nationalized, shareholder equity should be written to zero, and existing management should be handled as roughly as the law allows. If we have a bit of courage, we should impose haircuts or debt-to-equity conversions on unsecured creditors, but I don't think we have that kind of courage. "Toxic" assets should be revalued at pennies-on-the-dollar market bids or else written to zero and hived into "bad banks". Once we have a conservative valuation of the assets and know exactly what is owed, we'll know how much public money would be required to cobble a robustly funded bank from the wreckage. However, if we recapitalize "too big to fail" banks without restructuring them, we will quite deserve our next mugging. We had better cut these monsters into little, itty, bitty pieces. We should embed strict size and leverage limits into their itty, bitty charters, restrict their ability to recombine, and then hire management to run the little things on strictly commercial terms. Hopefully we will change what it means for a bank to run on commercial terms — We should create a tax and regulatory structure that penalizes scale and leverage across the board. Better yet we should decouple the payment system from risk investment by reorganizing banking functions into "narrow banks" and credibly not-guaranteed investment vehicles. But whatever the banking industry comes to look like, nationalized banks should be recapitalized once, then managed to compete in it, and for no other purpose. Taxpayers should seek to extract maximum value from their eventual privatization. But should any of the reorganized banks seek a second helping of at the public trough, they should be ostentatiously permitted to fail. Rather than an implicit government guarantee, successors of nationalized banks should face a particularly itchy trigger finger.

Having nationalized "banks" make loans that prudent managers of a well-capitalized bank would not make is just a way of obscuring a subsidy and ensuring permanent quasipublic status by requiring on-going guarantees, bail-outs, and capital injections. Further, putting easy-lending public banks in competition with ordinary thrifts would resuscitate the destructive dynamic we have just put behind us, wherein bank managers must match the idiocy of their most foolish counterparts or watch their businesses wither.

If we want to stimulate the economy, put idle resources to work, stoke animal spirits, whatever, we should do that with some combination of transfers, investment subsidies, inflation, and public works. But if we are dumb enough to force-feed credit into the economy, let's not hide that behind a bunch of puppet banks. And let's keep it very clear that we are not confiscating private firms in order to make them tools of the state. We nationalize reluctantly, when we have had no choice but to inject public money (or guarantee assets, which amounts to the same thing) in banks that otherwise would have failed. We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers.

Some nationalization links

Update History:
  • 20-Jan-2009, 7:00 p.m. EST: Eliminated an artless overuse of "guaranteeing" by changing to "ensuring".
Steve Randy Waldman — Tuesday January 20, 2009 at 12:16pm [ 12 comments | 0 Trackbacks ] permalink

I don't mean to pick on Kevin Drum, whom I really admire (and who offered a very nice response to my previous piece). But in the post I already picked on, he wrote this...

So what are the lessons [of the Swedish experience] for us? ...[W]e could consider a systemwide guarantee of all bank obligations, instead of the one-offs we've (partially) applied to Citi and BofA.

And then I read this (ht Felix Salmon):

Another top option under discussion would be to broaden a technique the government has already used in its rescue of Citigroup and Bank of America. In both instances, the government agreed to share losses with the banks on a certain group of assets. The banks agreed to take the first hit, and taxpayers are on the hook for much of the rest. In the case of Citigroup, the total amount of assets protected is more than $300 billion. This loss-insuring plan under discussion would be available to banks large and small. Ms. Bair said she and other regulators are keen to provide sweeping solutions instead of the ad hoc approaches of last year. Officials don't agree, though, on whether guarantees could be offered broadly, given the complexity and variety of instruments held by many institutions.

I think it is very important to point out that what we have done as "one-offs" for Citi and Bank of America bears absolutely no resemblance, and is quite opposed in spirit, to what the Nordics did during their banking crisis. Yes, Sweden issued a blanket guarantee of bank obligations. That was a bail-out to customers and creditors of Swedish banks, who otherwise might have seen deposits lost or loans defaulted.

What the US has done for Citi and Bank of America is put a floor under the value of the particular "toxic" assets. That means the government takes the loss before shareholders do. In Sweden they bailed out the creditors, but insisted that the stockholders, and at least in the case of Nordbanken the management, take losses before taxpayers. In the hypercapitalist US of A, we prefer to bail out creditors, stockholders, and management, full stop.

Guaranteeing obligations is arguably necessary as a means of protecting the financial system and the economy at large. Guaranteeing assets is a means of protecting incumbent institutions that might otherwise participate in the miracle of creative destruction.

If I had any more capacity for apoplexy, I would go totally apoplectic about a proposal to institutionalize transfers targeted at the most negligent and devious stakeholders in the banking crisis. Fortunately, my brain exploded months ago.

Steve Randy Waldman — Sunday January 18, 2009 at 8:21pm [ 3 comments | 0 Trackbacks ] permalink

Of Sweden's banking crisis in the early 1990s, Kevin Drum writes (ht Tyler Cowen, Mark Thoma):

A lot of the sentiment in favor of nationalization appears to be driven by admiration for Sweden's "quick and decisive" action to clean up its own banking mess in the early 90s, so let's take a look at what Sweden did and didn't do. First off, here's what they didn't do:

  • They didn't act all that quickly. The real estate crash and the resulting credit losses began in late 1990, solvency problems started to become acute in late 1991, and a variety of treasury guarantees and capital injections were tried for another year after that. (Sound familiar?) It wasn't until late 1992 that the Swedish government finally took serious, systemic action.

  • They didn't nationalize the banking system. Only one bank, Gota, was taken over, and that happened only after it had collapsed. And aside from Gota, only one bank received a substantial amount of capital injection: the state bank, Nordbanken, which had much bigger problems than most of the private banks.

  • Generally speaking, they didn't fire existing bank management.

So what did the Swedes do? The main thing was simple: in late 1992 the Swedish government guaranteed all bank obligations throughout the system...

What else? Not too much, actually. An agency was formed to dig into the portfolios of nearly every major bank, and this resulted in a capital requirement guarantee for one bank that was never used. In addition, the shareholders of Gota and Nordbanken were mostly wiped out.

So what are the lessons for us? First, we don't necessarily need to nationalize. If we have to, then we have to, but with the exception of Gota that's not what the Swedes did.

Second, we could consider a systemwide guarantee of all bank obligations, instead of the one-offs we've (partially) applied to Citi and BofA.

Third, we still have to take care of the toxic assets clogging up bank balance sheets. The Swedes did this for Nordbanken and Gota by hiving off "bad banks" to handle the valuation and eventual sale of their bad assets.

I've a great deal of respect for Kevin Drum. He's a trustworthy guy. And there's murkiness in the definition of what it means for a bank to be nationalized. (Has AIG been nationalized in the US? How about Fannie Mae?)

But substantively, Drum is just wrong here. The state took full ownership and control over Nordbanken in 1992, actively cleaned it up, and eventually reprivatized it. During the crisis, Nordbanken purchased Gota, effectively nationalizing the smaller bank. It is true that only these two banks were nationalized, and a Swedish government description of the crisis is careful to note that, as a matter of policy "the state would not endeavour to become an owner of banks or other institutions." But Nordbanken alone had an asset base of 23% of GDP. To put that in perspective, in US terms that's almost as large as Citi and Bank of America. (Citi and Bank of America together had an asset base of 26% of US GDP at the end of 2007.) Nordbanken was not just some little bank. (I don't think it's fair to characterize Nordbanken prior to the crisis as "the state bank" either, as Drum does. Nordbanken was a product of mergers, and one of its parents was a large state-owned postal bank. Other parents were private. Nordbanken was a listed public company, and was not actively controlled by the state prior to the nationalization. I do not know how much of the firm was owned by the government prior to the banking crisis. [Update 23-Jan-2009: 77% state-owned — thanks Kevin! — see here for more.])

Other banks were not nationalized for the simple reason that only Nordbanken and Gota required significant recapitalization by the state. Other banks faced a liquidity crisis, which was resolved by a blanket guarantee and central bank lending. But Nordbanken and Gota were insolvent, were unable to raise private capital, and were nationalized. (A third bank did receive a very small amount of public capital without being nationalized.)

Again, nationalization was never a grand policy. It was the natural result of the principles that defined the Swedish response to the crisis. From a 1997 speech at Jackson Hole by Swedish cental bank governor Urban Backstrom:

In September 1992 the Government and the Opposition jointly announced a general guarantee for the whole of the banking system... The bank guarantee provided protection from losses for all creditors except share-holders... The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard... One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders...

Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria... The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank's current income for a gradual write-down of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic. [bold mine, italics original]

Why did the Swedes nationalize? Not because they wanted to, but because the (sound) principles under which they provided capital demanded it: They required aggressive write-downs prior to the provision of public capital, and they demanded that shareholders take losses before taxpayers. Nordbanken was insolvent. The value of shareholders' equity was negative. The first dollar krona of public capital bought the bank.

Drum also points out that during the Swedish crisis, existing bank management was not generally shown the door. But Nordbanken's management was replaced. Whether or not the Swedes insisted on management changes as a policy matter, in practice they did defenestrate the managers of their largest bank. The neighboring Norweigians made changing the board and senior management of failed banks an explicit condition of state support during their contemporaneous crisis. The Norweigians didn't issue a blanket guarantee to bank creditors. (Norway, like Sweden, is viewed as having responded to its banking crisis effectively and successfully. Rather than the "Swedish model", people sometimes refer to the "Nordic model". Both Sweden and Norway forced exhaustive write-downs and wrote off shareholders prior to committing public capital, effectively nationalizing the recapitalized banks.)

Anyway, I'll show you mine if you show me yours. My sources are below. (I've no special expertise on this — Drum's post challenged conventional wisdom that I had accepted, so I decided to have a look around.)

Update: Added the bit about Nordbanken's prior state affiliation (postal bank was a parent), and the replacement of Nordbanken's management.

Update History:
  • 18-Jan-2009, 3:30 p.m. EST: Added information about Nordbanken's previous state affiliation and replacement of Nordbanken's management.
  • 18-Jan-2009, 3:30 p.m. EST: Corrected my dyslexic multiple spellings of Nordbanken.
  • 18-Jan-2009, 3:30 p.m. EST: Changed dollar to krona...
  • 18-Jan-2009, 7:30 p.m. EST: Removed an "also", and also "myself".
  • 23-Jan-2009, 5:15 a.m. EST: Added update with info from Kevin Drum on Nordbanken's prenationalization share of public ownership [77%].
Steve Randy Waldman — Sunday January 18, 2009 at 2:51pm [ 8 comments | 0 Trackbacks ] permalink

I have a little secret. Please don't tell anyone. I am glad that the banks, for all the hundreds of billions of dollars we are giving them, are not lending. That is not because I want banks to improve the quality of their balance sheets. On the contrary, I don't want banks at all, at least not banks anything like what we've had. I don't want to "use all of our resources to preserve the strength of our banking institutions". Since we have already bought and paid for our nation's banking institutions, we are within our rights to, um, transition them to a different business model. Let's do that.

But credit is the lifeblood of a capitalist economy, right? I keep hearing that line. It's a dumb line.

Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources. You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called "investing". There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like "common stock" and "cumulative preferred equity"? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you're on it. Almost certain to, um, cause problems, eventually. Our overall goal ought not be to kickstart the credit economy, but to kick the habit and move towards financing arrangements that are more equity-like than debt-like. That's going to be hard to do, because historically, we've subsidized the hell out of debt financing, especially bank credit, and alternatives are underdeveloped. But with the exception of war, no still-practiced human institution provokes catastrophe as regularly or as grandly as the misuse of debt. We ought to phase out banks as we've known them since before Bagehot's time, and move to a regime of what are lately referred to as "narrow banks" (banks that lend only to the government that issues the currency of their deposits). We should encourage the development fine-grained equity markets and local-market investment funds to replace bank financing.

The rush to ramp up "consumer credit" is particularly dumb. Usually, financial investing involves funding wealth generating projects in exchange for a share of the anticipated wealth. Consumer credit funds current consumption in exchange for a share of, um, what exactly?

In theory, there's a good answer: consumer credit funds current consumption in exchange for a share of anticipated future wealth that is believed to be endowed already. Economists talk about consumption smoothing, how it may be optimal for a consumer whose income is volatile to borrow during periods of low income and repay (or save) during periods of high income in order to maintain a constant standard of living. That's very well in models where consumers know the true distribution of their future income, where the spread between borrowing and lending interest rates is not very large, and where consumer preferences are time-consistent. In practice, none of these conditions hold even approximately. As we are learning, the future is a very uncertain place. Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)

Some consumers behave this way, but very many do not, suggesting that consumers are myopic, overvaluing consumption today in a manner that they themselves will come to regret in the future. If consumers are myopic, if self-today has different preferences than self-tomorrow, then whether taking on credit is a good idea is beyond the comfort zone of positive economics. Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves. In the way that economists suggest "free trade" to be good — winners, losers, gains overall — myopic consumers imply that the absense of a credit constraint is bad. Thank goodness the banks aren't lending!

There are obvious wrinkles and objections — What about credit for cars, or home mortgages, or education? The analysis changes when the borrowing is exchanging one pre-existing long-term liability for another. (We are born short basic shelter, and, in much of America at least, short a cheap car as well.) Education can be viewed as an ordinary, wealth generating investment project that in theory could be equity rather than debt financed, but that might be too tricky in practice. It's not my intention to suggest that consumer credit is always bad, only to defend the commonplace notion that for many people and under many circumstances, even loans that will be never be defaulted can be positively harmful, and as a matter of policy we should not be exhorting banks to issue or consumers to accept credit.

But if we let consumer credit contract, and if investment demand is derived from consumption demand, doesn't that spell macroeconomic disaster? There is an alternative. It is called "transfers". What's good about credit from a simple Keynesian perspective isn't that loans get repaid tomorrow, but that they get spent today. If what consumers would do with funds would be better for the economy than what banks are doing with funds, we ought to stop the massive transfers of funds from buyers of government debt to banks, and transfer the funds directly to consumers. If you think that Americans consume too much, and that we need to grit our teeth and endure a "reduction in our standard of living", fine. I disagree, strongly, but at least you're consistent. Then the government shouldn't transfer to anyone, banks shouldn't be encouraged to lend, consumption, investment, and GDP should be allowed to fall until we find a new level. I think that's foolishly pessimistic, though. Americans may need to change the mix of our consumption, but overall I think our standard of living is not only supportable, but improvable, and that our goal should be to get the rest of the world to live as well as we do, rather than to reconcile ourselves with some pseudomoral poverty. The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid.

I'm trying to come up with a reasonable opposing view, a case for pushing consumer credit but opposing transfers. Perhaps you can help, because I just can't do it. One might argue on philosophical grounds against coercive transfers, but coercive transfers are a precondition of restarting bank lending, and we've already made transfers to banks on such a scale that banning them now would be like robbing a jewelry store, then piously arguing future looters should be shot. One might argue that bank lending is "smarter" than public transfers would be, that the patterns of consumption and investment that result from private sector credit allocation will lead to superior productive capacity and more sustainable patterns of consumption than direct transfers. Given the awful quality of aggregate investment this decade and the volatility now faced by consumers who were recently credit flush but who under any reasonable lending standard must now be credit constrained, it is hard to be enthusiastic about the special wisdom of bank-mediated credit allocation.

Of course, once we start redistributing purchasing power, there's the thorny question of who gets what. I have an answer to that, it is my new mantra. Transfer flat. Cut checks to every adult in the economy of interest, regardless of whether they pay taxes or have a job. Flat transfers are easy to understand and they pass the smell test for "fair". As an income source unrelated to work, flat transfers increase workers' bargaining power with employers by reducing the cost of refusing a raw deal. (Supplementary income is a better means of enhancing labor bargaining power than unionization, which serves the same purpose but may limit the flexibility and efficiency of production.) Finally, flat transfers align purchasing power in the economy with the problem that we want markets to solve — We want an economy that serves some people dramatically more than others, in order to preserve incentives to produce and excel. But we also want an economy that meets every person's basic needs, even those of people who are unable or unwilling to offer marketable goods or services. We won't let people starve, so why not fund a basic income, however miserly, rather than relying on an inefficient social services bureaucracy or taxing the virtuous by relying on charity?

Tax Pigou and progressive. Transfer flat. Encourage equity. Contain the banks.

Steve Randy Waldman — Saturday January 17, 2009 at 10:28pm [ 67 comments | 0 Trackbacks ] permalink