Given the fragility of the current global economy and the real economy impact of financial market spasms (remember, remember that week last September), it's difficult to imagine the Obama administration contemplating nationalisation in the absence of a very clear, legally sound, internationally accepted procedure for taking control of the banks. Economics of Contempt says that this means nationalisation is therefore now and forever off the table. I disagree. The American government has created mechanisms for taking control of financial institutions before, and it can do it again.I certainly didn't mean to suggest that nationalization is forever off the table. At some point in the future, I suspect we'll have a formal resolution regime specifically for bank holding companies—especially now that Treasury is asking for the authority to develop such a regime. But developing a resolution regime for too-big-to-fail banks will be a very long, multi-year process, and it may not ever produce a mechanism that allows a Citi or a JPMorgan to fail without bringing the entire financial system down with it. The Bankruptcy Code and the FDIC's resolution regime didn't just magically appear and gain the trust of the financial markets. They developed over decades, slowly winning the trust of the financial markets as gaps in their procedures were fixed, and bankruptcy courts and the FDIC proved themselves to be compentent authorities who would apply their respective rules in a consistent and fair-minded manner. Even with the FDIC's resolution procedure as a blueprint, there's no way a workable resolution regime for too-big-to-fail financial institutions could possibly be developed before this recession is over (or at least before financial markets, which always lead the real economy, start to recover). It's just not possible. Developing this kind of resolution regime is an enormously complex undertaking. Remember, a quirk in the way a single clause in the initial merger agreement between Bear Stearns and JPMorgan was drafted caused havoc in the financial markets for a week. The initial merger agreement provided that JPMorgan would guarantee all of Bear's trades until either (a) the deal closed, or (b) the merger agreement was terminated, whichever occurred earlier. But the way the guarantee was drafted, if Bear's shareholders voted down the deal, the merger agreement technically wouldn't terminate for another 12 months, during which time JPMorgan would still be guaranteeing all of Bear's trades. Essentially, the agreement gave Bear a one-year option to use JPMorgan's balance sheet, regardless of whether Bear's shareholders approved the deal. Does anyone think the government could develop a resolution regime for major financial institutions relatively quickly without making this kind of minor but extremely consequential mistake? The consequences of even legal uncertainty could throw the financial markets into chaos, because the specific treatment of an institution's assets and debts in the event of insolvency significantly influences pricing in the market. Treasury would have to specify how the new resolution regime would interact with hundreds (if not thousands) of state and federal laws, as well as hundreds of bilateral and multilateral treaties. Major financial institutions—Citi, BofA, JPMorgan, Wells Fargo, Goldman, and Morgan Stanley—are involved in so many different markets around the globe, and have so many counterparties with such diverse businesses, that successfully winding down any one of them would require clear rules on each and every counterparty's rights under all possible contingencies, the likely timing of each stage of the resolution process, etc., etc. Eventually, all these details will get worked out, and over time the market may come to trust the resolution regime. In this financial crisis, however, nationalization is off the table. It's literally not possible, no matter how many commentators stomp their feet and demand that the government nationalize. The sooner people realize this, the better off we'll all be.
Friday, March 27, 2009