It’s interesting that, to a lot of people in the non-specialist press, the key question respecting the banking system is the “N” word: whether or not we should nationalize troubled large banks. There’s quite a lot more to the story.
It’s true that we have a lot of large financial institutions at or near the fuzzy edge of insolvency, given the losses they’ve experienced on mortgage-backed assets. It’s also true that we’re having a recession characterized by a sharp decline in the amount of credit available to consumers and smaller businesses.
So it seems pretty simple: fix the first problem, and you automatically fix the second, right? Not so fast.
Most of the discussion centers on what it might take to open up the balance sheets of the largest banks. They’re holding vast portfolios of assets that have declined sharply in value on a current market basis, but have declined only moderately in terms of their stable long-term value.
What does that mean? It means that if you sell a mortgage-backed security today, you’ll receive a fire-sale price. But if you hold it to maturity, you’ll realize almost the entire value of the asset.
(Part of the calculus here is that Congress and the FDIC have deemed it politically unacceptable for people to default on mortgages. So there’s an arbitrage between the real default risk of a typical mortgage, which is reflected in its current market value, and the realizable value in the long term. The government won’t let these assets lose value.)
So on a hold-to-maturity basis, most of the large banks are not likely to fail. (Citigroup is an exception because it’s half bank and half broker/dealer. Arguably, Citi is functionally insolvent now, absent massive government support.)
So why would we want to even consider nationalizing these entities? Because they’re at the edge of their asset-carrying capacity now, and can’t raise new capital. That translates into little or no net new credit for economy. The nationalization idea (and neither-fish-nor-fowl ideas like Tim Geithner’s toxic-asset rescue plan) contemplates recapitalizing the banks with public money.
You could argue against this on free-market grounds, but free markets seem like a gauzy memory now anyway.
What’s more important is that the loss of new bank credit isn’t what’s driving the credit crunch in the first place.
Up until 2007, banks provided perhaps one-third of the credit in the United States. The rest came from the asset-securitization markets (the so-called “shadow banking system”), which has now come to a near-complete halt. We should be asking what it will take to bring securitization back.
Let’s say we follow through on one of the various plans to finance the huge wad of overpriced mortgages that are currently in force with public money. And let’s assume just for fun that we can print or borrow enough money to do that without consuming too much of the world’s private capital.
Does that mean we’re going to encourage companies like Bank of America and JP Morgan Chase to start expanding powerfully, into the gap left by the retreat of securitization? Weren’t we already concerned that they were too big to fail?
And in any case, shadow-banking finance depended greatly on the use of extremely high leverage ratios, once available to hedge funds and Wall Street firms, but never available to banks for on-balance sheet assets, and certainly not today. That financing model won’t be coming back either.
Bottom line, nationalization isn’t going to do much harm, or much good either. What we really need to do is prepare for a world in which capital is scarce and expensive, compared to the recent past.