Subprime Mortgage Crisis Solutions Debate - Solvency - Nationalization - Arguments For Nationalization or Recapitalization

Arguments For Nationalization or Recapitalization

Permanent nationalization of certain financial functions may be an effective way to maintain financial system stability and prevent future crisis. There is strong evidence that within the U.S., competition between mortgage securitizers contributed to declining underwriting standards and increased risk that led to the late 2000s financial crisis. The largest, most powerful entities – with the strongest ties to the government and the heaviest regulatory burdens – generally originated the safest, best performing mortgages. Furthermore, the period of greatest competition coincided with the period during which the worst loans were originated. In addition, countries with less competitive financial sectors and greater government involvement in finance proved to be far more stable and resilient than the United States in the late 2000s (decade).

Another advantage of nationalization is that it eliminates the moral hazard inherent in private ownership of systemically important financial institutions. Systemically important financial institutions are likely to receive government bailouts in the event of failure. Unless these bailouts are structured as a government takeover, and losses are imposed on bondholders and shareholders, investors have incentives to take extreme risks, to capture the upside during boom times, and to impose losses on taxpayers in times of crisis. Permanent nationalization eliminates this dynamic by concentrating the full upside and downside with taxpayers. Permanent nationalization therefore may lead to lower and more rational risk levels in the financial system.

Permanent nationalization also provides the government with profits, a source of income – other than taxes – which can be used to recoup losses from past bailouts or to build a reserve for future bailouts. The political power of the owners and top executives and board members of private, systemically important financial institutions may insulate them from taxes, insurance charges, and regulations aimed at curbing risk. Nationalization could be an effective way to curb this political power and open the door to reform.

Another advantage of nationalization is that it gives the government greater knowledge, understanding, and capabilities within the financial markets, and may enhance the government's ability to act effectively during times of crisis.

Economist Paul Krugman has argued for bank nationalization: "A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners." He advocates an "explicit, though temporary government takeover" of insolvent banks.

Economist Nouriel Roubini stated: "I'm worried that many banks zombies, they should be shut down, the sooner the better... otherwise they will take deposits and make other risky loans." He also wrote: "Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume." He recommended four steps:

  1. Determine which banks are insolvent.
  2. Immediately nationalize insolvent institutions or place them into receivership. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off.
  3. Separate nationalized bank assets into good and bad pools. Banks carrying only the good assets would then be privatized.
  4. Bad assets would be merged into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers.

Harvard professor Niall Ferguson argued: "Worst of all are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt... banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down."

Banks that are insolvent from a balance sheet perspective (i.e., liabilities exceed assets, meaning equity is negative) may restrict their lending. Further, they are at increased risk of making risky financial bets due to moral hazard (i.e., either they make money if the bets work out or will be bailed out by the government, a dangerous position from society's point of view). An unstable banking system also undermines economic confidence.

These factors (among others) are why insolvent financial institutions have historically been taken over by regulators. Further, loans to a struggling bank increase assets and liabilities, not equity. Capital is therefore "tied up" on the insolvent bank's balance sheet and cannot be used as productively as it could be at a healthier financial institution. Banks have taken significant steps to obtain additional capital from private sources. Further, the U.S. and other countries have injected capital (willingly or unwillingly) into larger financial institutions. Alan Greenspan estimated in March 2009 that U.S. banks will require another $850 billion of capital, representing a 3-4 percentage point increase in equity capital to asset ratios.

The U.S. government authorized the injection of up to $350 billion in equity in the form of preferred stock or asset purchases as part of the $700 billion Emergency Economic Stabilization Act of 2008, also called the Troubled Asset Relief Program (TARP).

Steven Pearlstein has advocated government guarantees for new preferred stock, to encourage investors to provide private capital to the banks.

For a summary of U.S. government financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.

For a summary of TARP funds provided to U.S. banks as of December 2008, see Reuters-TARP Funds.

Read more about this topic:  Subprime Mortgage Crisis Solutions Debate, Solvency, Nationalization

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