A Ghoulish Prospect

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

Moreover, far from being an alien concept, nationalisation is, as Mr. Krugman has put it, “as American as apple pie”. Banks have often been seized by the state, in the form of the FDIC. Some of them, such as Washington Mutual, have been big. The FDIC runs those with assets that it cannot sell quickly, as it did with IndyMac, a Californian lender, before finding a group of private-equity buyers in January.

Even the most vocal proponents of this approach accept the need to tread with care. Those banks deemed insolvent would have to be dealt with in one go, to avoid the seizure of one bank starting a run on the liabilities of others that are seen as weak, points out Nouriel Roubini of New York University’s Stern School.

That is not the only risk. Political owners find it hard not to meddle: they have wasted no time turning America’s mortgage agencies and Northern Rock, a British bank, into tools of the state, or arm-twisting banks that took taxpayer money into modifying mortgages. And state control tends to rattle nerves abroad. Mexico’s authorities, for instance, are sure to frown on Citi’s local subsidiary, Banamex, falling into the hands of another government.

Moreover, the nationalisation of American International Group, an insurer, is no advertisement. In state hands AIG has gone from bad to worse. Already in hock to the taxpayer for $150 billion, it is estimated to have lost another $60 billion in the last quarter of 2008 and is reported to be in talks about a further bail-out and possible break-up. Adding to its woe, the auction of an Asian subsidiary faltered this week.

Then there is the exit strategy. Governments can become attached to banks they get their hands on. Those that resist the temptation cannot always find buyers. It took the FDIC seven years to sell Continental Illinois, which failed in 1984. Sweden deftly managed its overhaul and flotation of bust banks in the 1990s, but its financial system was much smaller and simpler than America’s today.

Finally, government takeovers are risky amid a systemic crisis because of the scale and distribution of creditors’ potential losses. Jeffrey Gordon of Columbia Law School cites Citi as an example. With total liabilities of $1.9 trillion and deposits of just $800 billion, not all of them insured, it has over $1.1 trillion of claims at risk in the event of a seizure. Their value would depend on how much the receiver would get for the bank’s assets. Were it to push for a quick sale, the price would doubtless be low, clobbering creditors that included pension and money-market funds. Though full-blown nationalisation “appeals to the desire for a clean sweep and the punitive distribution of losses”, it is, Mr Gordon argues, a gamble.

Is there a way to deal with bombed-out banks that falls short of greatly increased government ownership? Some, nostalgic for the past, point to the Latin American debt crisis of the 1980s. Then, Western regulators went soft on their banks, allowing even the insolvent to limp along until they had regained enough strength to withstand the Brady-bond restructuring. But that is an imperfect parallel. The economy was in better shape, so it was easier for banks to return to health. And there was no mark-to-market accounting. Suspending that today would ease the burden on banks, but would also make it easier to avoid admitting to losses.

With such forbearance unlikely this time, greater state control seems inevitable, despite its drawbacks. To keep recapitalising hopelessly insolvent banks without more draconian measures merely necessitates further bail-outs, argues Joseph Mason, an expert on banking crises at Louisiana State University. He suggests the Depression as a model: the Reconstruction Finance Corporation ended up with effective control over large parts of the banking system. It used its power to fire executives and shake up operations, with dramatic results. In each successive crisis, he says, authorities have to relearn the lessons applied by private-equity firms: “Keep control of the firm and the capital.”

That is hard to swallow in a country that likes its capitalism red in tooth and claw. But better a temporary ward of the state than a permanent zombie.

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