Zombie Bank Apocolypse: The Potential Case for Bank Nationalization

Following Secretary Timothy Geither's outline of the Treasury's and Obama Administration's "New Financial Stability Plan" there was an immediate and negative reaction in the marketplace, primarily driven by a lack of details, and concerns over the "stress test" to be conducted on the nation's largest banks. Noticeably absent from the plan, too, was any language that indicated a "bad bank" scenario (thankfully), or any form of nationalization (seemingly replaced with the Public-Private Investment Fun). Ultimately, based on leaks in recent weeks, the plan seemed weaker than what was anticipated, and was revealed to still be largely a work-in-progress.

Although it is difficult to gauge the likelihood of success, or lack thereof, in the new TARP plan given so few details, an analysis of the planned "stress test" is warranted, as it clearly has posed significant cause for concern. It would be foolish to assume that the Nation's largest banking institutions were not already swarming with regulators and in-house analysts prior to this announcement, indicating that even more scrutiny is required to comprehend the situation, and, that reality of insolvency may finally need to be acknowledged. The NY Times, in fact, noted that "nearly 100 federal banking regulators descended on Citigroup Wednesday morning". Furthermore, at least for now, the test will continue to stifle bank's desire the make the loans other parts of the plan seek to reinforce. No intelligent board of directors would do anything but hoard cash, as regulators scrutinze their balance sheets. The "stress test," logically, will place banks into one of three categories:

• No assistance required



• Need for additional assistance (Capital Assistance Program)



• Liquidation/Nationalization

Clearly, this "stress test" attempts to continue to avoid zeroing of shareholders, discounting lenders to these institutions, nationalizing, and reorganizing the banks if at all possible, however, as Martin Wolf explains, such a notion may be fundamentally flawed:

"All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency. Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so.

But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government...

...Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing...

...The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once."

So what is President Obama's thoughts on the scenario, the driver behind the Treasury's "stress test", continued bailout, and unwillingness to even consider true insolvency?:

PRESIDENT OBAMA:

"Well, you know, it's interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what's called "The Lost Decade." They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn't see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country."

Speaking of pumping money in:

Obama clearly believes American culture will not warrant or allow the case for nationalization. I'm a strong proponent of free-market capitalism, but failure on the part of the government can become much more damaging than the failure of the invisible hand. I'm also not convinced that public perception of nationalization is so damaging it is impossible to execute, against a scenario where the private sector enjoys the upside while the taxpayer is exposed to all the downside as is likely to be the case with the Public-Private Investment Fund. Perhaps more frightening in Obama's statement is the comparison of number of banks. Sweden may have only had "like 5 banks", but the problem in the U.S. is concentrated in the 6 largest institutions. Insolvency may ultimately be an unavoidable reality, and it lays the basis for a case for bank pre-privatization.