Roubini Misunderstood

Nouriel Roubini is the New York economist and professor who is one of a very few to predict the timing and dimensions of the present economic recession. So, it makes sense to pay attention to what he thinks about Treasury Secretary Tim Geithner's 'Bank Bailout 2.0' plan, which was announced yesterday.

The title of Roubini's article in today's RGE monitor ["It's Time to Nationalize Insolvent Banking System", free subscription to read the whole thing] more or less correctly states what Roubini thinks should be done if we were living in a perfect world. But the title distorts what he thinks actually can be done given "the political constraints facing the new administration."

Nevertheless, it's the title of the piece that's getting all the media attention, especially with the implication that "it's time" -- now -- to nationalize troubled banks. That's not quite what Roubini is saying.

He first identifies and rejects three other broad options as too ineffective, expensive, and unworkable: (1) recapitalization of the banks by taxpayers to save stockholders; (2) setting up a "bad bank" to buy bad assets to save creditors; and (3) helping a very nervous private sector buy bad bank assets themselves. The fourth option is putting the banks into receivership -- effectively, nationalizing them -- cleaning up their balance sheets, and then letting them re-emerge as smaller privately-held banks.

This “nationalization” approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze. Japan ended up having a decade long near-depression because of its failure to clean up the banks and the bad debts. The US, the UK and other economies risk a similar near depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.

Roubini's analysis then gets more subtle:

So why is the US government temporizing and avoiding doing the right thing, i.e. take over the insolvent banks? There are two reasons.

First, there is still some small hope and a small probability that the economy will recover sooner than expected, that expected credit losses will be smaller than expected and that the current approach of recapping the banks and somehow working out the bad assets will work in due time.
Second, taking over the banks – call is nationalization or, in a more politically correct way, “receivership” – is a radical action that requires most banks be clearly beyond pale and insolvent to be undertaken.

Today Citi and Bank of America clearly look like near-insolvent and ready to be taken over but JPMorgan and Wells Fargo do not yet. But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit in a matter of six to twelve months even JPMorgan and Wells will likely look as near-insolvent (as suggested by Chris Whalen, one of the leading independent analysts of the banking system).

Thus, if the government were to take over only Citi and Bank of America today (and wipe out common and preferred shareholders and also force unsecured creditors to take a haircut) a panic may ensue for other banks and the Lehman fallout that resulted from having unsecured creditors taking losses on their bonds will be repeated again.

Instead if, as likely, the current fudging strategy - of temporizing and hoping that things will improve for the economy and the banks - does not work and in 6-12 months most banks (the major four and the a good part of the remaining regional banks) all look like clearly insolvent you can then take them all over, wipe out common shareholders and preferred shareholders and even force unsecured creditors to accept losses ( in the form of a conversion of debt into equity and/or haircut on the face value of their bond claims) as the losses will be so large that not treating such unsecured creditors would be fiscally too expensive.

So, the current strategy – Plan A - may not work and the Plan B (or better Plan N for nationalization) may end up the way to go later this year. Wasting another 6-12 months to do the right thing may be a mistake but the political constraints facing the new administration – and the remaining small probability that the current strategy may by some miracle or luck work – suggest that Plan A should be first exhausted before there is a move to Plan N. Wasting another 6-12 months may risk turning a U-shaped recession into an L-shaped near depression but currently Plan N is not yet politically feasible.

But with the government forcing Citi to shed some of its units/assets and the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.

You can expect a similar path and an eventual government takeover of most financial institutions in other countries – such as the UK – where many banks are effectively insolvent.

In other words, since we don't live in a perfect world, but one also inhabited by "Free Market or Bust" Republicans, we are compelled, first, to try "Plan a" -- a more expensive method for rescuing the financial sector. Only when these prove ineffective, as they almost assuredly will do, will it become politically feasible to turn to the one remaining solution that has a proven track record at little of no cost to the taxpayers.

Roubini's "Plan B", then, is to nationaliz the largest "too-big-to-fail" banking behemoths -- not now, but after Plan A has failed. In the meantime, he sees little to do but wait for the inevitable second crash.