A Ghoulish Prospect

Nationalisation carries risks, but it may still be the best way to deal with American banking's undead.

This strikes some as fiddly at a time when the markets crave boldness. Drip-feeding equity as needed avoids the appearance of nationalisation. But by adding to the complexity of banks’ capital structures and not revealing what would constitute adequate capital it risks sowing confusion about their ability to ride out losses.

Next for Shaving

Nor has the government brought clarity to its treatment of bondholders, which was anything but consistent under the previous administration: Bear Stearns’s creditors got their money, Washington Mutual’s were all but wiped out. Credit-default swaps on Citi have widened lately (see chart 2), as have those on other big banks. This reflects fears that the state, in return for injecting more capital, might force a “haircut” on creditors, who sit above shareholders in the capital structure.

Economist umbrella

Compelling troubled banks to default on their debt may seem just. Christopher Whalen, an independent banking analyst, argues that some banks’ bondholders may have to take a hit if depositors are to be made whole. The danger, however, is that this causes the sort of liquidity runs that wreaked havoc after the demise of Lehman Brothers last September.

If bond investors are forced to share the pain, they may at least want some potential gain. Some restructuring specialists have suggested that bondholders be handed shares in the most troubled banks through debt-for-equity swaps, a common device in non-financial corporate workouts. That, however, would leave the banks partly owned by foreign governments and central banks. American politicians may find this unpalatable.

Doubt also surrounds a centrepiece of the bail-out plan announced by Tim Geithner, the treasury secretary, on February 10th: a public-private partnership to buy distressed mortgages and other bad assets. Mr. Geithner envisages vulture investors snapping up as much as $1 trillion-worth of the stuff, helped by cheap government loans and perhaps a floor under prices. But details are still being worked on, leaving potential participants sceptical of its merits. Under Hank Paulson, his predecessor, two asset-buying plans foundered after proving unworkable.

Bank executives, meanwhile, are livid that they have not been consulted on the plan’s mechanics. They also question the logic of performing stress tests that do not take account of the gains in store, at least for some banks, if a market for distressed assets takes off. It could send the prices of the most illiquid securities up by 80 percent in short order, reckons one chief executive.

Even if banks can offload at reasonable prices the dross they piled up in the boom, they have lots of other assets that will sour this year, from credit-card debt to corporate loans. High-quality, or “prime,” mortgages look ever wobblier, too, as joblessness climbs towards 8 percent. American banks have recognised more than $1 trillion in credit losses, but most analysts think this is only around half the final tally. The most pessimistic expect losses on American loans to reach $3 trillion-4 trillion.


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