Too big to fail

Having economies of scale is one thing. Being too big to fail is another. One can have beneficial effects in terms of reducing unit costs to the consumer. The other, as we have seen over the past months, can bring an economy to the brink of disaster. Yet, governments regulate companies able to produce goods cheaply through large quantities once their size threatens competition. Ironically, governments are slow to recognize the systemic risk with financial institutions that become too big to fail.

If there is any lesson that stares us in the face arising from the current crisis, it is the need to keep banks from becoming too big to fail. Our universal banks come to mind. In fact, governments should use this crisis to fix this anomaly by cutting down such banks to more manageable size. Or require such big banks to be subject to more stringent regulation.

Actually, the market has already greatly diminished the size of giant banks as this graph from Bloomberg shows. But governments, particularly the US, are reluctant to take the next step, outright nationalization, because of free market ideological reasons.

Experts appear to agree that the solution to the current crisis necessarily involves nationalizing the now severely weakened banks that were previously thought of as too big to fail. These banks dubbed “zombie banks” because they are now unable to survive without government bailouts should be nationalized temporarily to complete the cleansing process that would bring in the financial system.

According to Nouriel Roubini, the Stern-NYU economics professor who warned the world about this crisis long before it was apparent, nationalization will just formalize the current reality. “Between guarantees, liquidity support, and capitalization, the government has provided between $7 trillion to $9 trillion of help to the financial system. De facto, the government is already controlling a good chunk of the banking system. The question is: Do you want to move to the de jure step.”

Another reason why bank nationalization is a good idea, Mr. Roubini continues, is that “we started with banks that were too big to fail, but what has happened, in the process, is that these banks have become even-bigger-to-fail. J.P. Morgan took over Bear Stearns and WaMu. BofA took over Countrywide and then Merrill. Wells Fargo took over Wachovia. It doesn’t work! You can’t take two zombie banks, put them together, and make a strong bank. It’s like having two drunks trying to keep each other standing.”

His suggestion: “So if you took over a big bank, and you split the assets in three or four pieces, maybe you create three or four regional or national banks, and they’re stronger! Nationalization — or “temporary receivership,” if you like, if the N-word is a political liability — is an occasion to undo the sort of consolidation that has created an even bigger systemic problem. And the only way to do it is by essentially taking them over and breaking them up.”

Free market believers need not worry. Even Alan Greenspan who admitted being blindsided by his free market ideological bias when he failed to regulate the greedy banks is now saying nationalization is okay. When placed in the context of what the Swedes did in the 1990s to address a similar problem with their banks, — i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector — it’s clear that it’s temporary.

Roubini also thinks there is another reason why the concept should appeal to fiscal conservatives: “The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic. Paradoxically, the proposal is more market-friendly than the alternative of zombie banks.”

It may also be inevitable. According to CNN Money, Citigroup is in discussions with regulators about a plan for the federal government to take a larger ownership stake in the bank. Citing a Wall Street Journal report that cites sources familiar with the matter, Citibanks wants the government to convert a large portion of its preferred Citigroup shares to common shares.

The government received the preferred shares in return for investing $45 billion in Citi as part of the $700 billion bailout of the financial system. But why would government convert their preferred shares to common and risk a political backlash if it does not complete a take-over through nationalization? Besides, converting to common will only window dress Citi’s capital adequacy to make it look healthier than it really is.

What is the impact to us in the Philippines if for example, Citibank was nationalized? Nothing that’s unpleasant. In fact, local Citibank patrons, depositors, wealth management clients are better protected by the fact that Citibank is owned and managed by Uncle Sam. The finances of Uncle Sam may look less than desirable these days but we should not forget that the world’s rich uncle owns the printing press that prints the dollar which is still the default world currency… the desired currency when people fly to quality out of fear.

They are supposed to do some stress tests on the big banks that got bailout money from Uncle San in the next week or so. The question is, will President Obama have the guts to do what he should and nationalize all at once the big US banks that cannot otherwise exist without Uncle Sam’s support? That will be Mr. Obama’s first big test of leadership, I guess.

Local view

I asked former banker and Citibanker Ray Orosa to give me a local reaction to the bank nationalization issue. Here’s his reply.

Boo, I would think that the Fed should allow some of the big boys to go under and let the shareholders take the hit. It is better to strip out of those banks the good things and re-create a new bank after the separation and re-privatize after 2-3 years when the market has improved.

Or else sell the good portions to other institutions that remain standing, even the international market or even sovereign funds but this time on a much sounder basis. Turn over the toxic assets to a board of liquidators so they can then determine how toxic the assets truly are and attempt to salvage as much as possible to be distributed first to FDIC that paid out to the depositors and if any be available after doing so, to the other uninsured depositors on a pari-passu basis.

This will require reconstructive banking skills that may elude the present crop of bankers. This process will probably take years to unravel and pursue but there is no other recourse… certainly not simply writing those loans off and letting the public (through the government) absorb the loss. Then, for all the irresponsibility of the banks, send to jail some of the bankers and lawyers and regulators for their malfeasance.

Moreover, the government can provide some incentives to those that would purchase the good parts by way of either tax breaks or subordinated debt to enable them to make the purchase in a responsible way and not run into liquidity difficulties in making the purchase. 

Sheer Nightgown

This one is from Lal Chatlani.

A husband walks into Victoria’s Secret to purchase a sheer negligee for his wife. He is shown several possibilities that range from $250 to $500 in price — the more sheer, the higher the price. Naturally, he opts for the best, pays the $500 and takes it home. He presents it to his wife and asks her to go upstairs, put it on and model it for him.

Upstairs the wife thinks (she’s no dummy), “I have an idea. It’s so sheer that it might as well be nothing. I won’t put it on, but I’ll do the modeling naked, return it tomorrow and keep the $500 refund for myself.”

She appears naked on the balcony and strikes a pose.

The husband says, “Good Grief!  You’d think for $500, they’d at least iron it!”

He never heard the shot.

Funeral on Thursday at Noon.

Closed coffin…

Boo Chanco’s e-mail address is [email protected]