February 18, 2009

Nationalization = We Pay To Liquidate Bad Private Debt

When both Alan Greenspan and Lindsey Graham are suggesting a "temporary" nationalization of troubled banks, that's a pretty good sign that a) deep panic has set in, and b) the rest of us should take a step back and question whether that panic is justified. Nationalization means that the government simply takes over a bank (or some other kind of private business). It takes the equity in the bank away from the stockholders and begins to operate the bank itself.

The Fifth Amendment would require that this be done to advance a "public purpose" of some sort, and that the existing stockholders be paid the market price for their stock. When the government condemns real estate, it's difficult to value it and there's usually a significant battle of valuation experts involved. But in the case of corporate stock, it's extremely easy to determine the price, because there are highly advanced markets in place.

Shifting industries for a moment, General Motors has a market cap of $1.33 billion (the stock is trading at $2.16 a share today, and there are a little bit over 610 million shares outstanding). GM's assets are valued at $30 billion, which means that liquidation is about the only economically sane thing for the company to do. If the government wanted to step in and treat GM as a massive jobs program, now would be the time to make the purchase; playing the role of corporate raider would yield the government an immediate profit of over $25 billion. Of course, this may not be the role most people had in mind for the government's handling of the financial crisis. But it is what a rational private investor would do.

With that in mind, let's consider banks. Even a deeply troubled bank under consideration would cost the government a very high price as compared with General Motors -- Citigroup, for instance, usually leads the list of "troubled banks." Citigroup's market capitalization is $16.7 billion. That's not to say that the company is doing well, though. Its current profit margin is a stunning -97.75% and its overall enterprise value is -$36 billion. That's $36 billion in the hole -- if Citigroup were to be liquidated now, someone would have to absorb a $36 billion loss.

This means that Citigroup cannot be liquidated outside of a bankruptcy, and it is bleeding money out of its eyeballs. The $3.17 you'd pay for a share of Citigroup stock today therefore cannot possibly represent either an estimation of the assets and debts of the company, or a reasonable forecast of the company's earnings. What that price represents right now is pretty much only the hope that, somehow, things will get better for Citigroup in the future. (I'm reminded on more than one level of a fleeing Scarlett O'Hara turning back to watch the Union soldiers put Tara to the torch, and vowing that she'll never be hungry again.)

So $3.17 a share represents hope. To be sure, Citigroup has substantial assets that generate revenue. (Remember, those assets are, to a large measure, mortgages given to people who are still able to make their monthly payments.) But those revenue-producing assets have been completely swamped by a combination of decreases in value of other equity holdings and a large number of other real-estate secured loans that no longer generate positive cash flow and whose foreclosure value is substantially less than the outstanding debt. So if you think about it, the only force on the scene that is fueling the hope of Citigroup eventually bcoming profitable again is the government and its talk of bailing out, or now nationalizing, the bank.

With that in mind, let us consider these words of wisdom:
Although additional protectionism will prove inevitable during the crisis, all of us must display a sense of proportion.

Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake. True, the state's increased role in times of crisis is a natural reaction to market setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent.

The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation. In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated.

Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state.

And one more point: anti-crisis measures should not escalate into financial populism and a refusal to implement responsible macroeconomic policies. The unjustified swelling of the budgetary deficit and the accumulation of public debts are just as destructive as adventurous stock-jobbing.
When Vladimir Putin goes out of his way to deliver this message at the Davos World Economic Forum, aimed directly at the United States, while Alan Greenspan is talking about nationalizing banks, you know we've gone through the hourglass and water is now flowing uphill. But damn it, his is one of the few voices out there that's making even the remotest bit of sense.

Hyper-nationalization did cost the Soviets dearly -- their entire nation collapsed, and Putin felt, and still feels, that loss keenly. While I shed no tears for the collapse of the USSR, Putin has both had enough time and enough experience to have shed his old ideology and pragmatically embrace Russia's capitalist future. (Call that "grudging admiration" on my part.) He lived through, and saw from the inside, how the government taking over every aspect of daily economic life proudced shortages and not surpluses -- shortages of consumer goods like clothing, food, and toilet paper; shortages of tax revenue for the government and money for people to spend; shortages of people to perform labor at all as the population fled the dire economic conditions; and ultiamtely, a shortage of the government's ability to hold the nation together resulting in complete collapse and restructuring of society as anyone had known it and years of bizarrely shifting quasi-anarchy in what had been a global hyperpower.

Do not think for a second that Vladimir Putin acts out of any motive other than a Kissinger-like sense of national self-interest. Putin is not warning the United States to avoid that trap out of a sense of benevolence or admiration of America. He is doing it because he knows very well that if what happened to the USSR happens to the USA also, it will be bad, very bad, for Russia. And the rest of the world, too.

It is a shame that our own leaders lack the ability to see and respond to today's challenges with the same clear vision. Nationalizing Citigroup is not going to solve any problems. It will simply shift the burden of absorbing the inevitable losses that must be absorbed from Citigroup's stockholders to the public as a whole. Citigroup, at least in its current incarnation, is doomed. (So is General Motors, as discussed above and in the link.)

I can scarcely believe that a bank in this much trouble -- one that, for every dollar of stock I own in it I have to pay out two more dollars in order to be rid of the problem -- is going to turn around. The business model requires that the property values securitizing the loans the bank has written exceed the total debt on the books, and the loans were written, functionally, at the very peak of a real estate market that has lost nearly half of its total value. So that means that if the government is going to nationalize Citigroup, it will need to either a) hold on to and operate the bank as a government-owned enterprise, with greater competence than the former management, until the debt-to-asset ratio returns to the black; b) use my tax dollars (which will be collected over the courts of the entire remainder of my anticipated working lifetime) to underwrite the liquidation of the debt so as to favorably shift the debt-to-asset ratio; or c) all but inevitably, some blend of "a" and "b."

And when will this glorious day that the government can spin off The Government Enterprise Soon To Be Formerly Known As Citigroup back to the private sector? The process can be hastened by the amount of "b," diversion of public funds to write down losses, but ultimately it can't be done until "a" is acheived. When will this happen? Probably roughly at the same time I am no longer upside-down on my home mortgage again. At current rates, that will take place in 2019. By then, people will have simply forgotten that Citigroup ever existed and have become used to the idea that the government will take over bad private loans, that the government is the nation's largest direct home lender, and that in that capacity, the government is in the business of lending people money to buy homes and then writing off huge chunks of the principal.

That's why when I hear government leaders talking about nationalization of bad banks, what that tells me is that the government is going to write checks to shareholders and then, inevitably, liquidate the bank because it cannot be saved. It will suck -- S-U-C-K -- in the short run to do it, but in the long run, the hope of having a truly a vibrant economy will require us to go through the bankruptcies of many of the private businesses that took hard blows last autumn. That's what bankruptcy is for, that's what capitalism is.

We took the sweet, and now we have to take the bitter. At the end of the day, there's no way to get around that.

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