Bank Bailout Options

I wrote earlier that I think the Obama administration will nationalize the major banks. Now I'm not so sure. It has nothing to do with politics and everything to do with this:

Q: You have experienced and studied the Great Depression. What is the difference between the Great Depression and the current financial crisis?

A: Well, the present one in America is still primarily a Wall Street phenomenon. But right behind that is going to be a Main Street downturn, because all of the swollen population, aged 50 to 65, have lost from these subprime ridiculous mortgages.

They've lost much of what they're going to need to retire. And when I say "lost," it's not something that the government can stuff back in. It's gone. And, it all traces to bad deregulation, to incompetent appointments, to conflict-of-interests appointments. [Emphasis mine.]

I'm sure his policymakers are currently mulling this problem, since bank nationalization would likely imply that not just stockholders, but also bondholders, would see their assets wiped out. Bonds issued by banks were likely considered AAA, rock-solid stuff, and primarily owned by large institutions in mutual fund and money market fund portfolios. Which is a long way of saying, a lot of that stuff currently sits in the 401Ks of retiring baby boomers, and default would punish them all, even the ones who invested conservatively in high grade bonds. Whereas there may be some moral hazard in making whole these investors, it may be better to break the chain of losses here than to allow it to propagate further. Surely conservatively-invested retirees and near retirees ought be held blameless for the imprudences of the deregulatory coterie of Alan Greenspan and his banking fellow travelers. We live in a consumer economy and our largest demographic cohort is moving into retirement. To further curtail their future spending would be folly.

Nationalization, per se, must therefore be off the table. That pretty much leaves a big fund of financial toxic waste — a Superfund, if you will. The assets in it will either be sold off as is; insured and sold off; resecuritized, insured, and sold off; or held to maturity. If Nouriel Roubini is right and this is a $2T problem for the US, be prepared for very large fiscal deficits for the next few years. It will be a problem for the Democrats in the 2010 midterms and in the next presidential contest.