Why Haven’t The Banks Been Nationalized?

Elrod postulated that the reason why the banks haven’t been nationalized is because they believe the economy will recover. That could be, but I’m not entirely sure that’s the case. The larger issue is the sheer size of losses. Here’s an excerpt from Hussman Funds (h/t Mish) marked up by me:

Make no mistake. Buying up “troubled assets” will not materially ease this crisis, nor will it even improve the capital position of financial institutions (see You Can’t Rescue the Financial System if You Can’t Read a Balance Sheet). Homeowners will continue to default because their payment obligations have not been restructured to any meaningful extent. We are simply protecting the bondholders of mismanaged financial institutions, even though that bondholder capital is more than sufficient to cover the losses without harm to customers.

I am unsure whether that last statement is true. I’ve read multiple places that most of the bond holders are foreign banks, governments and pension funds, so taking massive losses would lead to large systemic problems.

Institutions that cannot survive without continual provision of public funds should be taken into receivership [aka nationalization], their assets should be restructured to better ensure repayment, their stockholders should be wiped out, bondholders should take a major haircut, customer assets should (and will) be fully protected, and these institutions should be re-issued to the markets when the economy stabilizes.

The course of defending the bondholders of insolvent institutions is not sustainable. Do the math. The collateral behind private market debt is being marked down by easily 20-30%. That debt represents about 3.5 times GDP. That implies collateral losses on the order of 70-100% of GDP, which itself is $14 trillion. Unless Congress is actually willing to commit that amount of public funds to defend the bondholders of mismanaged financials so they can avoid any loss, this crisis simply cannot be addressed through bailouts. Bondholders have to take losses. Debt has to be restructured. There is no other option – but the markets are going to suffer interminably until our leaders figure that out.

Nearly 5 years ago, in Freight Trains and Steep Curves, I wrote “The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated… much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.” Was this really so difficult for Wall Street and our leaders to recognize at the time? Is it not clear that if we issue trillions in additional debt to foreigners in order to defend bondholders, it will act as a claim against the future output of the nation, at exactly the time that an aging population will be most dependent on that production?

Here is my understanding of the steps that have been proposed by people with Hussman’s view (although this is just my own list and contains views of various people) on the steps for bank nationalization

0) Get Congress to authorize the program
1) Grab everything, wiping out shareholders
2) Spend a few months examining all assets and honoring commitments
3) After the books have been examined, spin out the good assets and deposits into a number of “good banks” that will be the seeds for the new financial system. They will be highly regulated and act like old fashioned banks, meaning low leverage, most loans stay on the books and they refrain from investment banking activities. I’ve heard people referring to this as the “utilities” model type of banking since it’s providing a core good to the public and they get to profit in return for not ruining everything. The government would have a large stake that would decrease over time.
4) Cancel all the CDS contracts that are just speculative in nature and don’t represent an underlying bond.
5) Throw all the bad assets into a pool that is now separated from the world at large. As money flows into the pool it is distributed to bondholders but losses are given partially to the government and partially to the bondholders. The bondholders would most likely end up with a 20-30% haircut. [Hussman seems to call for more]
6) Do something about mortgages: either sell them to private investors in return for the principal being reduced, reduce the principal but carry it on government books or foreclose on bad mortgages but rent them out. Maybe a combination of all three.
7) Repeat as necessary because doing all that would start a chain reaction of failures.

So there you go. The problem is very close to being too large for the government mathematically, and definitely too large politically. It also explains why a few decades of growth would be needed to work off the problem if we do just backstop all the bad debt, at minimum.