A year ago, I predicted that the losses of US financial institutions would
reach at least US$1 trillion and possibly go as high as $2 trillion. At that
time, the consensus among economists and policymakers was that these estimates
were exaggerated because it was believed that subprime mortgage losses totaled
only about $200 billion.
As I pointed out, with the US and global economy sliding into a severe
recession, bank losses would extend well beyond subprime mortgages to include
subprime, near-prime, and prime mortgages; commercial real estate; credit
cards, auto loans, and student loans; industrial and commercial loans;
corporate bonds; sovereign bonds and state and local government bonds; and
losses on all of the assets that securitized such loans. Indeed, since then,
the write-downs by US banks have already passed the
$1 trillion mark (my floor estimate of losses), and institutions such as the
International Monetary Fund and Goldman Sachs now predict losses of more than
$2 trillion.
But if you think that the $2 trillion figure is already huge, the latest
estimates by my research consultancy, RGE Monitor, suggest that total losses on
loans made by US financial firms and the fall in the market value of the assets
they hold (things like mortgage-backed securities) will peak at about $3.6
trillion.
US banks and broker dealers are exposed to about half of this figure, or $1.8
trillion; the rest is borne by other financial institutions in the US and
abroad. The capital backing the banks' assets was only $1.4 trillion last
autumn, leaving the US banking system some $400 billion in the hole, or close
to zero even after the government and private-sector recapitalization of such
banks.
Another $1.5 trillion is needed to bring banks' capital back to pre-crisis
level, which is needed to resolve the credit crunch and restore lending to the
private sector. So, the US banking system is effectively insolvent in the
aggregate; most of the British banking system looks insolvent, too, as do many
continental European banks.
There are four basic approaches to cleaning up a banking system that is facing
a systemic crisis: recapitalization of the banks, together with a purchase of
their toxic assets by a government "bad bank"; recapitalization, together with
government guarantees - after a first loss by the banks - of the toxic assets;
private purchase of toxic assets with a government guarantee (the current US
government plan); and outright nationalization (or call it "government
receivership" if you don't like the dirty N-word) of insolvent banks and their
resale to the private sector after being cleaned.
Of the four options, the first three have serious flaws. In the "bad bank"
model, the government may overpay for the bad assets, whose true value is
uncertain. Even in the guarantee model, there can be such implicit government
over-payment (or an over-guarantee that is not properly priced by the fees that
the government receives).
In the "bad bank" model, the government has the additional problem of managing
all the bad assets that it purchased - a task for which it lacks expertise. And
the very cumbersome US Treasury proposal - which combines removing toxic assets
from banks' balance sheets while providing government guarantees - was so
non-transparent and complicated that the markets dived as soon as it was
announced.
Thus, paradoxically nationalization may be a more market-friendly solution: it
wipes out common and preferred shareholders of clearly insolvent institutions,
and possibly unsecured creditors if the insolvency is too large, while
providing a fair upside to the taxpayer. It can also resolve the problem of
managing banks' bad assets by reselling most of assets and deposits - with a
government guarantee - to new private shareholders after a clean-up of the bad
assets (as in the resolution of the Indy Mac bank failure).
Nationalization also resolves the too-big-to-fail problem of banks that are
systemically important and that thus need to be rescued by the government at a
high cost to taxpayers. Indeed, the problem has now grown larger because the
current approach has led weak banks to take over even weaker banks.
Merging zombie banks is like drunks trying to help each other stand up.
JPMorgan's takeover of Bear Stearns and Washington Mutual; Bank of America's
takeover of Countrywide and Merrill Lynch; and Wells Fargo's takeover of
Wachovia underscore the problem. With nationalization, the government can break
up these financial monstrosities and sell them to private investors as smaller
good banks.
Whereas Sweden adopted this approach successfully during its banking crisis in
the early 1990s, the current US and British approach may end up producing
Japanese-style zombie banks - never properly restructured and perpetuating a
credit freeze. Japan suffered a decade-long near-depression because of its
failure to clean up the banks. The United States, the United Kingdom, and other
economies risk a similar outcome - multi-year recession and price deflation -
if they fail to act appropriately.
Nouriel Roubini is a Professor of Economics at New York University's
Stern School of Business and co-founder and chairman of RGE Monitor. He has
served as a senior adviser to the White House Council of Economic Advisers and
the US Treasury Department.
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