Sunday, February 22, 2009

Nationalization is not the answer

Failed banks should not be temporarily nationalized, they should be failed banks. The FDIC should not exist to protect depositors.

These statements may seem contrary to what a lot of people in the media believe, but to me they are some of the causes of the problems we are facing today. Let's start with the FDIC.

The FDIC was started in the 1930s to "protect" depositors money from being wiped out in the case of a bank failure. The idea was that banks could pay into an insurance fund that would take the liabilities out of managing a loan portfolio built on deposits. The insurance fund would simply gather money during good times and wait for a rainy day. That rainy has come, and the FDIC was grossly unprepared. It has had to call on the treasury to back them to take receivership of over 30 banks in the last year: Failed Bank List. So the FDIC failed at what it was supposed to do, price the risk of bank failures. This is not surprising to me as the government really fails at doing anything well other than collecting taxes and spending money rather inefficiently. If the FDIC were a private corporation, it would be insolvent just like the rest of the banks. So to me, the FDIC is moral hazard defined. It created an illusion of safety for depositors and bank management to take on more risk in search of better returns.

Bank nationalization is also not the answer to our problems. FDIC receivership is also a form of nationalization, which I also believe is not a good way to flush out bad banks. Nationalization sets another moral hazard precedent. To bank managers it says, "If you manage your risk poorly, the taxpayers will bail you out of your mistakes." The bank managers therefore say, "Well, I have government insurance so I'll go out and take big risks for the next 5 years, make a boat load of money and hope that I don't have to answer to some politician when my bank fails." They may not say that explicitly, but as an example, a small bank executive that received TARP funds decided that it would be a good idea to finance purchasers of his residential builder's homes. He would take the 5% TARP money and lend it out using teaser rates of 3.5% to take the risky builder loans off the books and transfer risk out (to the taxpayers) through the GSEs (Fannie and Freddie).

What needs to happen is a bankruptcy proceeding for each and every failed bank. Creditors and stockholders need to be wiped out. Bank management needs to be fired. Counterparties need to lose on credit default swaps. This will send the message out that there is no such thing as a taxpayer funded bailout. If you think it is fine to let taxpayers pay for private losses, then morally you think nationalization is okay. I think it is theft on the grandest scale and is morally reprehensible. All of the solutions that are being proposed are still aimed at symptoms rather than causes. If a doctor keeps placing bandaids on a ruptured artery, he will continue to have a weak artery ready to explode and pissed off patient that will sue his ass for malpractice. If the government does not solve the financial crisis by analyzing its causes, the financial crisis will come back bigger and better, and taxpayers will be pissed off that they have to pay through job losses and socialized losses of bad companies.

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