Turn the news on or read a Roubini blog and you'll never hear the end of how we must nationalize our banks to get out of the mess we are in. Even Krugman is saying Nationalize!
Stepping away from the immediately obvious deficit of shareholder equity in these insolvent bank institutions, it is clear two things are happening independent of the status of bank valuation (yet perpetuating the feedback loop of insolvency): credit is tight, and asset values are thus forced down.
A true nationalization of a top 5 bank (or two), where debtholders are wiped out, would be less than optimal considering many debtholders are generally other banking institutions. Here counterparty risk (ie AIG) is revisited. Why force the issue?
The present Obama administration manifestation of TARP 1, one where money was blanketed over banks (instead of toxic assets being purchased above market), is being improved by the latest Treasury-Citibank agreement to convert preferred shares to common. Without the banks possessing a payment liability (free of dividend), their equity position genuinely improves.
In the end, though, if the bad bank is still truely insolvent, it will not lend as it knows it is insufficiently capitalized. Again I ask (from previous blogs), does it matter if Citi is technically bankrupt if it is somehow sustaining itself on a cashflow basis? If its assets are actually worthless in the end and the business can not maintain cashflow, there will be a day where it will have no choice but to fail. When the overall credit system is healthy enough (10 years from now?), I think it is reasonable to think we will be able to absorb a failure of Citi and allow an old-fashioned bankruptcy. Right now, however, the system is too fragile. So for now, we have a zombie bank.
Why can't we have zombie banks and healthy banks run concurrently? Why push the issue of nationalization, causing more systemic risk and further asset writedowns (perpetuating the negative feedback loop) when the alternative may be to simply to leave the presently insolvent institutions alone?
We know two things: 1) Fed through its control of Fed funds or any other arbitrary credit device it creates can capitalize banks at will (if the Fed loaned $20T to Citi tommorow at 0% interest, it could quickly recapitalize at zero cost) and 2) Mark-to-market on long term bank assets just does not work, mainly because it serves to reinforce the negative feedback loop that we experience in downturns.
