Lurching towards bank nationalization worldwide

Thailand's banks may be in healthy condition but banks in the US certainly not (Read on Thai banks). There is more and more discussion of bank nationalization in both the US and the UK (following loosely based on Surowiecki):

* A “nationalize now” meme has taken hold in the blogosphere
* But people are talking about nationalization very casually
* Sweden and Norway in the early 1990s is the example where quick and vigorous nationalization worked (Read best report via Bronte Capital).

But there are reasons to be sceptical:

* The US has no prior experience with nationalizing large chunks of its economy like Sweden did. (!!!!)
* Private enterprise is typically better at efficiently allocating resources than government In the US
* Having the state ration credit would be problematic for many in the US

Advocates of nationalizing are downplaying:

1. The magnitude of change.
2. The duration of change.

To be more specific:

In Paul Krugman’s Op-Ed on Monday, for instance, he suggested that nationalization would be like what the Resolution Trust Corporation did with the savings and loans at the end of the nineteen-eighties: seizing the banks, hiving off their bad assets, paying off debts to make them solvent, and then selling the banks to new owners. But when you nationalize the entire banking system, who, exactly, are these “new owners” who are buying the cleaned-up banks supposed to be? And what investor is going to be interested in putting up money to acquire a bank that has to compete with nationalized, and therefore subsidized, banks (since the government presumably won’t be able to privatize all at once). Krugman also adds that any government takeover will be “temporary.” But does that mean eighteen months, or does it mean a decade?

Then what?

Once the big banks are nationalized, the government can take its time salvaging whatever assets are still worthwhile and preparing for the reconstruction of a private banking system under a completely new system of regulation, a task that is likely to take several years (Source).

Then there is the "bad bank-good bank" model:

That is not the only possible plan. An alternative would be to allow banks to divide themselves into two entities, a bad bank with all the toxic assets and a good bank, with lending etc. Ownership of these two entities will be allocated pro quota to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with 30 billion of bad assets and 70 billion of good assets will see its debt divided 30-70 and its equity divided 30-70. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity.

...After the spin off, the toxic assets will not contaminate the lending part of the business anymore. On the one hand, bad banks would simply be closed-end funds holding the toxic assets. If these assets turn out to be worth more, the original investors will be rewarded. If they are worth less, the most junior claimants (common and preferred equity) will be wiped out.

The good news is that these entities could be allowed to fail, because their failure would only be a rearrangement of their liability structure with no negative consequences on the economy. On the other hand, good banks will have a clean balance sheet and will be able to raise private capital without too many problems. If private capital is nowhere to be seen is because sovereign wealth funds that tried to take advantage of the situation experienced enormous losses. In November 2007, for instance, when the Abu Dhabi’s sovereign wealth fund took a stake in Citigroup the stock was trading at $29 per share, while today is worth only $3.5. After these bad early experiences all the smart money stayed away.

By eliminating the uncertainty on the magnitude of the losses in good banks, the spinoff will make it appealing for private capital to invest in these banks. Even if private capital would not flow back (which I doubt), a government equity infusion in the good banks would be cheaper and more effective. Cheaper because the value of debt in the good banks would be close to par and thus an equity infusion will not go to bail out the existing creditors, but only to promote lending. More effective, because instead of trying to improve the capital ratio of a $100 billion entity (in the example), the government will do it only with respect to a $70 billion one.

(Source Luigi Zingales at Vox EU)