Financial Sector Endgame

Here's my guess:

The Obama administration preparing to nationalize the banking system. Then they'll spin most of the bad assets into a separate vehicle and sell the recapitalized banks back into the market (IPO) in a couple years. The bad asset vehicle will perform mortgage modifications, repackage and insure securities, and generally dispose of assets in a timely, but not rushed manner.

Why do I think this way?

Nationalization is at this point inevitable. The major banks have essentially no equity, relative to their balance sheets, and even that has been subject to considerable debate, with many taking the position that they are in fact insolvent. The perception -- right or wrong -- that in receiving support from TARP, etc, they have a civic responsibility to lend implies a level of direction appropriate to the boardroom. At present the executives have a fiduciary responsibility to their bondholders and shareholders, and they are not well advised to risk capital in an adverse market because a non-voting party thinks they ought. If the US government wants Citigroup, et al, to make loans, then it needs to displace -- at the very least -- the common shareholders and members of the board.

I trust the Obama administration gets this.

Selling it, politically, is a different thing. We Americans have a knee-jerk reaction to nationalization: it's a dirty word, up there with 'communism' and 'socialism'. I think that's why we're hearing some really atrocious proposals around a 'bad bank'. Think good cop, bad cop.

Now, suppose we have three or five or seven formerly-too-big-to-fail banks nationalized. Push out the top execs, replace the boards, and put them under the oversight of the Office of Thrift Supervision. What next?

This would be an explicitly temporary arrangement, and the exit strategy should be to release the rehabilitated bank back into the market. IPO is the usual way that a private company is made public. It's a well-understood mechanism, and the obvious thing to use. That takes some time, six months or so, just for the mechanics of it. It'll also take a six months to a year for the new executives and boards to stabilize after they've been reconstructed, and the reconstruction itself will take some time. So, say two years, maybe three. 2012ish.

Given that a lot of the problem assets are related to mortgages, it's certain that a lot of these 'bad' assets will still exist and will still be performing poorly. It's not the stuff that makes an IPO easy. With the backing of the government, the CDOs, ABS, MBS, etc, can be aggregated into one vehicle for central management. This will allow mortgages to be modified, securities to be insured for sale, assets to be held to maturity, written off, without the constraints of capital ratios, liquidity, and solvency that plague the ailing banks. This would be good for pension funds, as their holdings could be guaranteed for a modest fee; good for homeowners, who could see a reduction in their mortgage balances; good for the wider economy, as it would reduce debt service cash flows and increase disposable income for goods and services.

It would be inflationary, as the government would be absorbing hundreds of billions in losses and commensurably expanding the fiscal deficit. It would, however, exactly offset the deflationary aspect of loan defaults and principal write-downs. It would increase the supply of Treasury debt, putting upward pressure on interest rates, and possibly as well putting downward pressure on the dollar. It would also give the Fed a chance to remove much of the bank reserves injected into the system, reducing the risk of rapid inflation once monetary velocity returns to more normal levels. It would replace fear with stability and give us a functioning banking system in just a couple months.

Of course, by then we'll be in a global recession or worse.