Friday, March 6, 2009

First Bad Bank of the United States

Congress and banking have never been good working partners. Alexander Hamilton conceived the First Bank of the United States to handle the colossal government debt created by the Revolutionary War. Congress drafted and George Washington signed the bank’s charter in 1791. Twenty years later Congress voted to abandon both the charter and the bank. Today the government faces another colossal debt that is being created by the US banking system itself because the system is becoming insolvent. Saving the system may well require Congress to nationalize it. They may draft a charter for Barack Obama to sign creating the First Bad Bank of the United States.

Right now the nation's largest banks are carrying half a trillion dollars in bad debt. According to Nobel Prize Winner Paul Krugman, of the New York Times and Princeton University, the idea of temporary bank nationalization has “moved from the fringe to mainstream acceptance.” Krugman championed the cause for nationalization before the Bush Administration began its bungling government-intervention. "The chances of your being able to do this without nationalizing at least a couple of really troubled banks are not too good," Krugman told ABC.

Nor is he alone in that assessment. Economists Matthew Richardson and Nouriel Roubini may not be names that non-economics types recognize but they are of guru status and in agreement with Krugman that nationalization is the only way out of the out of the current financial crisis. The $1.2 trillion subprime mortgage mess is only the beginning of the problem. “Another $7 trillion -- including commercial real estate loans, consumer credit-card debt and high-yield bonds and leveraged loans -- is at risk of losing much of its value,” Richardson and Roubini wrote in the Washington Post.

How big of a hole are the banks in? It is huge, about $400 billion. This includes losses on loans and the drop in market value of the assets they hold but not the federal bailout funds that they got last fall. Nationalization appears to be the only option that would permit solving the bad asset problem on the banks balance sheets and allow lending to resume.

I use the word bad instead of toxic to describe assets with unknown value. Toxic is a buzz word that pertains to poison. Bad means bad and assets are at the core of this nationalizing business.

Here is the way nationalizing the banks would work. The government takes over running the banks. The bank assets are separated into two piles, good and bad. The good assets would again go private for sale to a buyer or to many buyers through stock offering to the public, such as an IPO. The bad assets would be valued, depressed as that might be, then either sold at their new value to investors or held by the government until the value comes back up to be sold at a profit in the future. In either case, first depositors and then debt-holders would share in the proceeds of the sold assets, with a fee going to the government. The idea is that in time the depositors are paid off and the government breaks even.

Bank nationalization means giving the U.S. government the power to control banks. The government could then choose and install new boards of directors and management as well as set corporate strategy. However, without creating a mega-fund to absorb the bad assets and remove them from the banks’ books, nationalization by itself would do nothing to solve the banking problem.

This is where the Bad Bank comes into the picture. The Bad Bank would be the mega-fund to take a trillion or more dollars of troubled loans and securities off the banks’ books so that credit could get moving again. In other words, the banks could loan money again because they would know what their inventory of money really is. Right now, they do not.

“A bad bank, perhaps run by the Federal Deposit Insurance Corp., would be a big step toward patching up the financial system,” Michael Mandel wrote in Business Week. “However, a bad bank would not eliminate the toughest choices that need to be made. In particular, Treasury Secretary Timothy F. Geithner, FDIC head Sheila C. Bair, and other regulators would still have to decide which banks are insolvent and need to be closed, partly nationalized, or completely taken over.”

What about the government running the banks? It would not make much difference, really. The government would not do a bad job at running the banks since clearly no one has done a good job at it. The problem is the borrowing. The federal government already borrows over a trillion dollars a year. Nationalizing our banks would add trillions of dollars more.

It is not that the government is not already in the banking business, either. Last September Uncle Sam stepped in and effectively nationalized two of the largest mortgage buyers in the country. The government placed Fannie May and Freddie Mac into conservatorship. It could because it backed both of those companies, which had federal charters.

It might have been hard to imagine before the election, but even Republicans such as Senator Lindsey Graham (R-SC) concede that nationalization may be necessary. “To me, banking and housing are the root cause of this problem. I'm very much afraid any program to salvage the banks is going to require the government . . . I would not take off [of the table] the idea of nationalizing the banks."

The president opposes it. "This administration continues to strongly believe that a privately held banking system is the correct way to go, ensuring that they are regulated sufficiently by this government," White House press secretary Robert Gibbs said when asked about nationalizing the banks. I am suspicious whenever a White House press secretary says anything because that is how it launches trial balloons.

Lawmakers already semi-nationalized the banking sector after the first rumbles of the credit crisis last fall. The Bush/Paulson treasury forked over $350 billion in government aid to more than 300 institutions in turn for some of those firms’ shares and other securities. Bank nationalization worked in Sweden with its five banks while we have thousands of banks here, but that does not mean nationalization cannot work here. To say “no” to nationalizing US banks because that is not the way we do things in the good old USA does not make much sense. The First Bad Bank of the United States is an idea whose time has come.

Originally published in Blogcritics Magazine, February 10, 2009