Fed Credit

graphic by twolf1

Nationalization fears are not what is killing banks. It is not the fear of nationalization, but the question that economist Paul Davidson asked a year ago: "Who will take the haircut?" Bank shareholders have taken a hair cut already. The people who are left in banks are either fighting for the control of the bank itself, or speculating that the banking system will rebound and stay private. The banks however, are not where the money is. Banks package revenue streams into instruments that are sold. It is the people holding the securities that are at issue. Do they get paid back in full? Or do they take a haircut? It is time, as Martin Wolf notes, to think anew. And this is the subject that people are thinking about.

In the area of options on banks, the choices are simple. We have a Mexican stand off: the holders of deep liquidity have to put their money someplace. The people selling securities need money. A simple churn of no risk paper creates no real wealth. Thus someone has to slip. Summers and Geithner clearly understand half of Rubin’s formula on government finances: they are playing poker with the bond holders. That is what is behind the announcement of slashing deficits from Obama: telling bond holders to keep buying long term and short term bonds, because soon there will be less of them. It is an attempt to run the Clinton play again: hard dollar, low deficit, and then the holders of liquidity will have to invest in private capital. As Bob Rubin dryly remarked: "What are they going to do with the oil? Drink it?"

But Rubin’s day is passed precisely because the various pieces of that play are broken. It requires that the financial sector, as the supplier of investment, be in an arms race with the wave of investment demand, and able to siphon off a large portion of the revenue stream. Without the faith in this wild west kind of financial world, without bankers being seen as the Atlases that hold up the roof of the world, there is no social buy in for such a system. Rubin’s stock has fallen farther than Citigroup, precisely because he was the person who gave the green light to doing this. Even if others were driving it. Credibility and bankers is always the same: as soon as someone question’s a banker’s credibility, it vanishes in a puff of smoke.

Thus, with the faith in the arms race financial system broken, the options for the banks are simple:

  • Subsidize
  • Rationalize
  • Nationalize
  • Marginalize

We are doing the first: throwing money at banks and other packagers, such as hedge funds, in hopes that they will be able to get the magic back and find ways of chopping up risk. The hope is the bank-o-matic money processor – it slices, it dices, and just look what it does for sub-prime mortgages – will get going again. Please God, the subsidizers are saying to themselves, just one more bubble, we promise not to screw it up. But we tried to be smarter in Clinton’s bubble, and people would have none of it. And that is still true. Example: 6 months ago, gasoline was 4 dollars a gallon in Massachusetts. Now it is $1.89. The local conservative paper is telling it’s working class readers to rebel against a 19 cent a gallon gasoline tax, which would bring gasoline to about $2.08. People are willing to pay 2 dollars a gallon to Exxon to not fix the problem, but not 19 cents a gallon to keep their children’s schools open.

But subsidization leads, inevitably, to the move for another round of shifting away from public investment, and to deficit-producing tax cuts. As J. Bradford DeLong points out: we know how this one comes out. And it is not with smaller deficits, but with the country on the road to another ballooning fiscal deficit.

The reason we are subsidizing is to avoid the second option: rationalizing. That means bankruptcy and the financial architecture falling into the hands of creditors. Many of these people are not Americans. Rationalization has a hooverite populist appeal. Get the banks. But remember something: the bankers of this decade are like lawyers, they are the intermediaries for others. The collect the money, but most of the proceeds go elsewhere.

Another form of rationalizing is to have a "bad bank" system, however, the cost of doing this is high, and effectively leads to…

The third option now in play: Nationalization. Because it is clear that financial welfare breeds dependence. I’ve never seen a welfare queen drive a Cadillac, but several welfare kings have flown into Washington on private jets. But nationalization is really about the question of who takes the haircut. Having a nationalized banking system whose purpose is to pay back the securities holders in full, is like combining the worst parts of the IRS and a collection agency. At 20% interest.

Thus, nationalization is no better, and no worse, that the people doing it. If the people who tried to subsidize first do it, you can bet that nationalization is merely a place holder to turn the banks back over to the same people who ran them. For example, the most likely option is to nationalize the losses. This is like the old story of the fox and the mole: they planted onions, the fox asked the mole "Do you want everything above the ground, or below it?" The mole chose above. The next time they planted lettuce, and the fox asked the same thing. The mole, not wanting to be fooled twice, chose below. This is the choice the public is being offered with the banks.

Thus nationalization depends, entirely, on how it is done. Roubini points out that subsidizing and rationalizing aren’t going to work, and there is a clear and present danger that several large money center banks will fail and leave their entire portfolios as toxic stew. Nationalization is being shouted, because the time to do it is running out. The banks may be zombie banks, but at least they are still ambulatory. But the vultures are circling, and the banks may not be the living dead for much longer.

That is why the last option is being whispered: marginalize the banks. The Fed is already lending to hedge funds, to the commercial paper market. Marginalization would have the old banks churn the old paper, but that virtually all new small business or consumer loans would come through the Fed directly. It has been discussed at the Fed, but no one with political standing has yet had the courage to say that we can have a "Fedit" card system, with credit extended at prime or above based on national priorities. Want to energy proof your house? Prime. Want to buy a new house? Prime plus 1%. Want to take a vacation? Whatever the market will bear.

So those exhaust the choices. We can throw money at the banks and hope that the holders of deep liquidity start buying. We can sell the banks to the holders of deep liquidity and take on the toxic debt, hoping to hold it for very long periods of time, on borrowed money. We can take over the banks and force new terms on borrowers and lenders, with who gets it in the posterior being the key question. We can end run the old banking system and jump start the economy based on new priorities.

Thus the government can be the banker to banks, the investment banker to bond holders, the investment banker to would be bankers, or the bank itself.

Which solution is the simplest?

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