Streetwise Professor

February 21, 2009

The Pricing Issue Cannot Be Avoided, Even in a Nationalization

Filed under: Economics,Politics — The Professor @ 12:08 pm

Alan Greenspan has come out in favor of bank nationalization.  He said:

Speaking to the FT ahead of a speech to the Economic Club of New York on Tuesday, Mr Greenspan said that “in some cases, the least bad solution is for the government to take temporary control” of troubled banks either through the Federal Deposit Insurance Corporation or some other mechanism.

The former Fed chairman said temporary government ownership would “allow the government to transfer toxic assets to a bad bank without the problem of how to price them.”

But he cautioned that holders of senior debt – bonds that would be paid off before other claims – might have to be protected even in the event of nationalisation.

“You would have to be very careful about imposing any loss on senior creditors of any bank taken under government control because it could impact the senior debt of all other banks,” he said. “This is a credit crisis and it is essential to preserve an anchor for the financing of the system. That anchor is the senior debt.”

Greenspan–and most of the advocates of nationalization–miss the point when he/they say that government seizure of the banks sidesteps the pricing problem.  This is especially true in Greenspan’s case, when he states that it is necessary to protect the interests–and thus the value of–senior debt.

Yes, it is true that by seizing some banks, and stripping out their assets, you don’t have to price them.  But, the value that the current claimants of the seized institutions receive in a nationalization implicitly prices the bad assets, along with all of their other assets and liabilities in the bargain.  Greenspan wants to conserve some of the value of senior debt.  Presumably this would entail wiping out junior debt, preferred equity, and common equity.  That effectively puts a price on the value of the seized institutions.  The individual assets and liabilities are not being priced, but by pricing the claims on the firm, you are assigning a value to all its assets and liabilities.

Indeed, the pricing issue is even more complex in a nationalization, because you are pricing all of a seized bank’s assets and liabilities, including, for instance, the franchise value arising from its deposit business and the information it possesses about borrowers.  Once you pick the compensation (which could be zero) that current claimants receive, you have effectively priced everything.  (A constitutional hurdle may require some compensation.  The 5th Amendment requires compensation for all property seized for any public purpose.)

The pricing issue is thorny primarily because of its distributive consequences.  Pricing individual assets or portfolios of assets in transactions between banks and the government determines an allocation of wealth, or more accurately, a probability distribution of wealth allocation, between the taxpayers and those with claims on the banks.  (It also affects the allocation of wealth among the bank claimants.)  But nationalization, nationalization light, guarantees, what have you, also imply a distribution of wealth between taxpayers and bank claimants.

One possible objection to arms length, voluntary transactions between the government and the current asset owners is that due to information asymmetries, the current asset owners will have an advantage in negotiations, and as a result the transactions prices will favor them.  This would result in a wealth transfer from the taxpayers to the current asset owners.

Conversely, a related objection to nationalization–a transaction forced by the government on unwilling private claimants, at a price dictated by the government–is that the government would have an advantage that would permit it to extract wealth from the holders of bank debt and equity.

In other words, any policy choice has distributive implications.  That is, assets and liabilities are valued, one way or the other.  It cannot be avoided, finessed, sidestepped.  Those who prefer one approach to another, are expressing a preference for one distribution of wealth between bank owners and taxpayers, and another.

Moreover, in a world with frictions and transactions costs, wealth distribution can have efficiency effects.  Taxes are distorting, so policies that transfer wealth from taxpayers to bank owners tend to increase deadweight losses from taxes.  However, in a world with informational frictions and transactions costs, undercapitalized banks offer inefficiently low levels of intermediation, creating other deadweight costs.  Similarly, nationalization can lead to distortions due to the politicization of lending and investment decisions.

These are all thorny, difficult issues.  There is no immediately “right” policy.  However, it is better to approach the problem based on a recognition of the distributive and efficiency implications of alternative approaches, rather than to propose a policy based on facile, not to say puerile, analyses like Greenspan’s.  His statement that nationalization avoids pricing problems is just plain wrong, and is arguably all the more dangerous because it offers the false promise of avoiding the issue of that has derailed all previous attempts to solve the crisis.  Nationalization doesn’t avoid the pricing problem; it assigns prices by fiat.

Listening to Greenspan of late makes me wonder whether he’s lost it, or never had it in the first place.  I’m leaning towards the latter interpretation.

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  1. You know, the oil and gas producing states already went through all of this in the early 1980’s, when oil and gas prices cratered.

    People went through foreclosures and bankruptcy, the RTC came in and took care of the banks that went belly up (even Chase Manhattan and Continental Illinois were affected, although they did not go belly up), everything eventually cleared out and re-adjusted, and people went on with their lives.

    At that time, there was an additional factor – inflation.

    The oil and gas producing states had the same kind of bubble that Florida and California have had recently – in real estate.

    Lots of people were crowding into Oklahoma and Texas and Louisiana for the oil boom, driving up real estate, while the rest of the country labored heavily under very high inflation and high interest rates.

    The Resolution Trust Corporation did a very nice job of sorting everything out – and provided much work to lawyers and receivers and others for years.

    Florida, California and New York City are the main places currently where the housing bubble has burst.

    I just don’t understand, amid all of this Democrat fear-mongering, why there has to be an sort of bailout or nationalization or stimulus plan, and why the normal mechanisms already proven in the past are not good enough.

    I don’t understand why the rest of the country has to bail out the shysters in Florida who took out 110% equity loans, with the help of mortgage brokers and “underwriters” and “investors”, on thoroughly inflated housing values, with “stated income” loans.

    I thought that “investors” were the ones who undertook investment risk – not taxpayers.

    Instead, we get the fearmongering from Obama and the Democrats – if you don’t agree to this, your neighbor’s house will be foreclosed, and the value of your house will go down.

    Outside of Florida, New York City and California, I don’t think any of that is true.

    Besides, this was another tulip craze – in Florida, California, and New York City.

    I don’t see why the taxpayers in the rest of the country have to foot the bill for a tulip craze in specific parts of the country.

    Comment by elmer — February 22, 2009 @ 2:58 pm

  2. You’re right Elmer. I can’t remember the exact statistic, but a very large number of the foreclosures are in 4 counties. Yes, 4.

    The ProfessorComment by The Professor — February 22, 2009 @ 4:55 pm

  3. Isn’t it possible to recognize that while valuing these MBSes ? I am sure it would depend on the way the mortgages were bundled. But I am thinking perhaps the ones from the same counties were bundled together…

    Comment by Surya — March 2, 2009 @ 3:16 am

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