My friend the astoundingly-smart investment manager is less impressed by the Woodward-Hall-Bulow plan than I was. He’s not against it, but he doubts it has much advantage over a straight nationalization that would wipe out the stockholders and make the bondholders and other non-deposit creditors take a haircut to be determined. The text below crunches together a couple of emails.
Note that insofar as this is a disagreement among experts, it’s my friend vs. Woodward, Hall, Bulow, and DeLong. I can just about follow the arguments, but I’m not entitled to an independent opinion.
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First of all, the plan isn’t new. Luigi Zingales previously advanced a similar idea. Soros, too.
Woodward and Hall say: “The key property of this approach is that neither the shareholders nor the bondholders suffer any impairment of their existing intrinsic values.”
The problem is that the bonds aren’t currently priced at intrinsic values. The bonds are priced on a strong presumption that bank losses beyond common equity will be absorbed by taxpayers rather than bondholders. The Woodward/Hall plan is trying to create a bad bank that can be allowed to fail without affecting the ongoing lending business of the good bank—i.e., can be allowed to fail without a taxpayer bailout. Which is precisely why bondholders would never agree to the Woodward/Hall plan.
But assuming, for the sake of argument, that the government could figure out how to force acceptance, is the Woodward/Hall plan a good idea?
Because the plan would significantly impair bondholders, it has the same major drawbacks as other nationalization/reorganization plans. First, it could prompt another post-Lehman panic in the credit markets by reintroducing the notion that lending to banks is very risky. (Presumably the plan would put all non-bond liabilities in the good bank, but given policy inconsistency over the course of the crisis, I doubt the government can credibly draw an irrevocably bright line between obligations to bondholders and obligations to short-term lenders and deriviatives counterparties, especially when bankruptcy law doesn’t draw a clear distinction, and all unsubordinated debts were lumped together in the Lehman case.) Second, insurance companies and pension funds, the largest holders of bank bonds, would likely suffer major new losses. Not good.
My sense is that Geithner and Summers think these risks are not worth taking, even though fairness and the prevention of future moral hazard argue for having bondholders shoulder bank losses instead of taxpayers. I’m guessing Summers would argue that because the ownership of bank bonds is so widely distributed throughout insurance policies, pension funds, and other retirement plans, the fairness argument is weak once you measure actual incidence. And if the class of bondholders looks similar to the class of taxpayers, then why not hit taxpayers with the losses and avoid further systemic risk?
I disagree with that view. I think the hole that should be plugged as a result of bank losses is too large to fill with taxpayer dollars alone. I’m more optimistic than some that a new administration is in the position to draw a convincing line between bank obligations to customers/counterparties and obligations to bondholders. And I think that writing off existing bank liabilities where banks are effectively insolvent is critical to expanding lending. (Stiglitz illustrates this by asking: what if the govt, instead of bailing out existing banks with $700 billion, had instead created a new bank? With standard 10-1 leverage, that would have created $7 trillion in new lending. It also would have caused the collapse of existing banks.)
I’m in the nationalization camp. As I see it, Woodward/Hall has the risks of other nationalization/reorganization plans, but without the benefit of relying on established procedures. As Mark Thoma has emphasized, better to go with a well-practiced but imperfect approach than an untested, theoretically better, plan.
Econ-prof-turned-money-manager John Hussman offers a nice, concise description of how receivership or nationalization would work with Citi.
The frequent framing of the nationalization debate in capitalism vs. socialism terms is unfortunate and misleading. The Obama administration, with its repeated statements that the banking system should remain in private hands, is most guilty here.
The real issue isn’t ownership, it’s whether bank losses are borne by bondholders or taxpayers. Nationalization opponents want taxpayers to continue to bear losses that bondholders freely consented to when they invested risk capital in banks, while nationalization advocates want bondholders to take the hit, as they did when the government seized WaMu.
Someone recently titled a blog post or article, “Real Capitalists Favor Nationalization.” Hear, hear.
Now it’s possible that the Obama administration is planning to do a WaMu, or something similar like a prepackaged reorganization, with Citi and B of A. Roubini and Krugman, for example, have raised the possibility that the stress testing could be an effort to lay the groundwork for such plans. But I don’t see any evidence that the administration is thinking along those lines.
Because repairing the banking system is far and away the nation’s most important policy need, I regard the Obama administration as an utter failure to date. Geithner looks every bit as clueless as Paulson, and seems determined to match Paulson in badly investing taxpayer capital.
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This space remains open to further thoughts by other experts.
One thought about the politics: I have suspected for some time that the Obama folks want to nationalize — i.e., want to make the stockholders and bondholders take a hit by reorganizing the banks — but are waiting to let conservatives such as Alan Greenspan and Lindsay Graham push them into it so that they can’t be accused of reckless socialism. (Though note that Greenspan, in endorsing a federal takeover, specifically called for the senior bondholders to be protected.) But that’s pure speculation.