Should US take over weak banks?

Nationalizing troubled banks may end the credit crisis sooner, some experts argue. Others cite huge risks.

Pier Paolo Cito/AP
Soft on banks? Treasury’s Timothy Geithner hopes to avoid takeovers.

The Obama administration is trying to pull off the bank-policy equivalent of a high-wire act: It hopes to intervene at troubled banks forcefully enough to avoid a multiyear recession but not so forcefully as to take control of large banks.

Judging by the history of other financial crises, it’s a hard act to pull off – especially when officials want to keep a lid on the amount of taxpayer money spent on the rescue.

That explains why lawmakers in Congress and Wall Street investors are so eager to see more details from Treasury Secretary Timothy Geithner, who unveiled the outlines of a bank-rescue plan last week.

With the world economy mired in recession, and with troubled banks a key obstacle to recovery, the matter of how to fix the financial system was a key question over the weekend at a summit in Rome of seven developed nations’ finance ministers.

How tough to be on banks is at the heart of the debate. Nationalizing weak banks, even large ones, is the surest way to end the credit crisis, say many finance experts. But that course carries large risks for the economy, say others, arguing that the Obama team is right to seek an alternative fix.

“We’ve dug ourselves a deep hole here,” says Douglas Elliott, a finance expert at the Brookings Institution in Washington. “There are no good solutions.”

He sees big costs and risks if the government takes over large troubled banks. But if bank losses keep rising, he says, that may become the best way out.

The battle over how to fix the banking system has been getting sharper in recent weeks, because of grim economic data and anticipation of the Obama administration’s plan.

Secretary Geithner laid out a two-pronged approach to dealing with America’s commercial banks. First, the US Treasury plans to set up a public-private fund to buy soured loans from banks. If it succeeds, it would remove many of the assets that have raised doubts about the banks’ health.

Second, the largest banks will face a new US-administered “stress test,” looking at how well they could survive over the next couple of years in an adverse economy.

Those needing more capital will get an infusion from the government. In return, the Treasury will get preferred shares in the banks, which would be convertible after seven years into common stock, Mr. Elliott says.

By taking preferred stock initially rather than common stock, the government delays the question of nationalization. If a bank’s share price recovers, the Treasury might never end up with a majority stake.

This course of action is driven by Geithner’s conviction that the government should avoid nationalizing big banks, if possible. Bureaucrats and politicians have no track record running America’s biggest banks, and he doesn’t want to run an experiment on that during a crisis.

Many financial experts agree.

“I do not think it would be taken very well by the markets,” says Jim Sarni, a managing principal at Payden & Rygel, a mutual fund company in Los Angeles. “Having a major bank go down would not be good.”

Why isn’t the government willing to let a major bank fail?

In most industries, firms that don’t succeed go into bankruptcy or liquidation. But banks, especially major ones, play a central role in the economy, channeling credit where it’s needed. If the government allowed a large bank to collapse, the economy would lose an important river of funding. Financial markets would be rattled. Bank regulators would be stuck with providing the insurance they have pledged to depositors, and stuck with the bank’s pool of loans – good and bad – to be disposed of for the best prices possible.

Thus, outright failure of a big bank is not considered, by most economists and US overseers, to be a viable option.

Nationalization is another possible outcome.

This means that a troubled bank’s shareholders would be wiped out, and the government would temporarily take ownership of the institution. Its former staff would largely stay in place. Bad loans would be stripped out to be managed separately and new capital would be put in at taxpayer expense. Eventually, the bank would be sold back to the private sector – the point at which taxpayers could recoup their investment.

How realistic is this option?

Sweden went down this road in the early 1990s. Britain last month took a majority ownership stake in the Royal Bank of Scotland but has not totally wiped out RBS shareholders.

In a congressional hearing last week, eight of America’s top banking executives were asked whether they believed that taxpayers or shareholders should bear the losses at banks.
They were in a box. It wouldn’t have pleased Congress if any had responded, “the taxpayers.” They responded that shareholders, if possible, should take the hit.

But one mentioned that Congress would need to consider the possibility of a “chain reaction” in financial markets.

That response points to the challenge for policymakers. The question now is not so much what is fair as what will best patch up the credit system so the economy can recover.

A chain reaction of fear followed the collapse of Lehman Brothers, the large investment bank, in September.

Wiping out shareholders in a large bank would not necessarily cause the same fallout, some experts say. Whereas the Lehman failure ended in bankruptcy court, a bank could keep operating pretty much as usual the day after government intervention. Depositors would be protected, and new government guarantees for various business partners, or counterparties, have been put in place since Lehman failed.

By nationalizing a bank, the government no longer needs to craft elaborate mechanisms, such as the public-private fund, to remove bad loans from bank balance sheets.

But regulators would still need to figure out what to do with all the bad loans once they had them – a much more complicated stew of credit instruments than Sweden had to deal with.

Other experts suggest that nationalizing a large bank would be a severe shock to financial markets. The stock prices of other banks would probably drop as investors tried to figure out which institution might be next. It’s a risk to avoid if possible, they say, as Geithner is trying to do.

The big question, policy analysts say, is how strict the stress tests will be – whether they achieve a Swedish-style purging of bad assets and recapitalization while avoiding full federal control.

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